Europe must stop choosing between employment and productivity growth

By: Bart van Ark, University of Groningen

 

With the European economy recovering from several years of slow growth, the temptation to cheer and stress the structural nature of the growth spurt is big. Still, when looking behind the aggregate numbers, one wonders how cheerful one can be. For example, when decomposing the growth increase of the “old” EU-15 from 1.5 per cent in 2006 to 2.7 per cent in 2007, about two thirds of that recovery came from faster growth in total working hours and only one third from an acceleration in labour productivity growth. In fact, according to estimates of The Conference Board, Europe’s productivity growth in 2006 at 1.4 per cent – at the top of the business cycle ! – equalled that of the United States which has halved productivity growth over less than three years coming down from productivity well above 3 per cent. The last time the old EU-15 hit 3 per cent productivity growth was in 1994.

 

Some would argue that the limited contribution of productivity to Europe’s recovery does not really matter. Firstly, large contribution of employment growth is desparately needed in this part of the world where participation are still among the lowest in the world. Secondly, productivity levels in old Europe are still quite high, in many countries even higher than in the United States. These arguments would suggest a choice is needed between either employment or productivity growth, an idea rooted in the infamous “lump of labour” fallacy. The latter suggests that we have a fixed amount of labour at our hands, and if one makes it more productive we will need less of it. While virtually no economist can seriously support this idea, it seems that the policies in many are still driven by this fallacy. For example, could any of the favourites in the French election campaign win the election on a ticket arguing faster productivity growth which will destroy jobs and – may be – create new ones? Would any Spanish politician argue against policies accommodating the huge supply of labour from nationals (women, long term unemployed) and migrants alike? Even in countries where productivity growth (like Finland, Sweden or the Netherlands) has been substantial, one uses various euphemisms for productivity like “innovation” or “creating the knowledge economy”. Even business leaders prefer to speak of “value creation” because productivity is too easily taken as suggesting the cutting of cost and trashing of jobs – not something that makes an employer popular with the workforce.

 

Productivity growth, however, has many faces and maybe it is badly understood for that reason. In a static sense it is simply about more output per unit of input, and gets close to “nominal” cost savings. But in a dynamic sense, it means raising output growth faster than input growth, which implies “real” cost reductions which provide firms larger market shares, and consumers and users with lower cost of the products and services they are buying. But there is no reason to expect “real” cost reduction to go at the cost of employment. In fact, there are quite a few countries, also in Europe, which have managed to grow productivity and employment over substantial lengths of time. And there are good reasons why. Bringing more people to the labour market will cause a slowdown in productivity in the first year, because new workers are unexperienced and because they often get employed in less productive industries, in particular services. But after a few years, the new cohorts adjust to the average through training and by moving on to better and more productive jobs.

 

Moreover, there is something else that has changed and will raise chances that productivity and employment growth can be raised in parallel. Ever since American economist, William Baumol, created the hypothesis that with the increased importance of services in the economy, productivity improvements are less likely because of their inherently labour-intensive nature, Baumol’s “cost disease” hypothesis has played in the cards of the believers in the “lump of labour” fallacy. However, with the increased potential for applications related to information and communication technology (ICT) in the economy, the potential to raise productivity has greatly increased. The acceleration in productivity growth in the United States since the mid 1990s can be largely traced to faster productivity growth in the services sector of the economy. Barry Bosworth and Jack Triplett of The Brookings Institution in the United States, even claimed that “Baumol’s Disease has been cured.”

 

A new database on growth and productivity in Europe shows that most European countries, however, still seem to suffer from Baumol’s disease. The database, called EU KLEMS, provides a lot of new information on the sources of productivity at industry level in individual European countries. For example, it shows that while the share of market services (excluding health, educatin and government) in Europe’s GDP has been steadily increasing from on average 34 per cent of GDP in 1980 to 41 per cent in 2004, labour productivity growth rates in European market services have been slow and declining in most cases. The database also shows that Europe’s productivity problem is not doe to a lack of investment in physical and human capital. In fact, in particular investments in ICT and in workers with high skills have continued to grow in Europe at positive rates despite slow aggregate growth. The slowdown is mainly assigned to the residual, multi factor productivity, which is negative after accounting for all input contributions to output growth.

 

But there is some glimmer of hope at the horizon: for example, the Netherlands and the UK have recorded accelerating productivity growth after 1995 in sectors such as retail and wholesale trade and the transport sector. In other countries there are also signs of greater economies of scope and creation of new service employment. Finally, the European Union benefits from its new member states. The significantly better productivity performance of the new member states (3.8 per cent from 1995-2006 and 4.1 per cent in 2006) has raised the European average. More importantly while employment growth in the new member states was, on average, zero between 1995 and 2006, in recent years total working hours have increased at around 2 per cent on average. So the new member states help Europe to turn its employment-productivity trade-off into a positive virtuous cycle of creating productive jobs, that increase real wages, raise consumption and create more wealth.

 

So why is it then that policy makers find it so hard to ditch the trade-off fallacy and focus instead on putting productivity higher on the agenda as the key to support economic growth and create better jobs? Is it just the connotation of the term? Or because it is not clear what one can exactly do to support it? It is hard to say. Clearly better “change management” by policy makers is needed to make structural reforms acceptable also for the losers in the process, and support them in finding the way to a betterment of their economic fortune. Education and training and the creation of new opportunities to start a new business or find a new job is important.

 

Innovation provides another key to the process. There are many industries (e.g., travel services, accounting, logistics, education) in which the potential for more productive technology use looms large. The long run potential for ICT as an enabling factor will depend on the development of new business concepts or even entirely new business sectors or paradigms (for example, in the areas of design, media and entertainment, and mobility) that are in their early days of development. The potential for innovation and growth in such sectors will also depend on investments in complementary intangible sources of capital, including brands, firm-specific knowledge and changes in shopfloor practices.

 

Bart van Ark is a professor of economics at the University of Groningen in The Netherlands and director international economic research at The Conference Board. He is project leader of the EU KLEMS project, which has constructed the new EU KLEMS Growth and Productivity Accounts, which is downloadable from http://www.euklems.net.

 

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