Structural rigidities in the US and Europe

Paul De Grauwe, 2 July 2007

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The perception of Europe’s economy has been almost universally negative during the last ten years. Declining productivity growth, lagging innovation in hi-tech industries, stubbornly high unemployment and declining population – these are the problems that have created a perception that Europe is on the decline. This negative perception has been fed by a positive one of the US economy: high economic growth, accelerating productivity growth, low unemployment, and flourishing hi-tech industries – these are the US success stories that have provided the contrast against which the dismal economic performance of Europe has been measured. The present European economic recovery does not seem to have changed this perception very much.

Structural rigidities: not the cause of every European problem

The distinctive feature of the European pessimism is that it has led to an intense search for all the things that are wrong in Europe’s economic structures. Many structural rigidities have been identified. Rigidities of all kinds in the labour and goods markets have been detected, and are claimed to be responsible for the poor European economic performance in general, as well as for the slowdown in productivity growth in particular. Quite often, these are claims for which there is little empirical evidence. To give a few examples: According to the OECD-index of employment-protection legislation, Ireland, Belgium, Denmark and Italy have about the same level of employment-protection (call it a structural rigidity). Yet since the start of the decade, Ireland has experienced an average yearly productivity growth rate of 3%, Denmark of 1.6%, Belgium of 1.1% and Italy a dismal 0.2%; Belgium, Austria, France and the Netherlands experienced approximately the same productivity growth of 1% per year while their employment legislation was significantly different. The following figure shows the relation between productivity growth and the OECD-index of employment-protection legislation since the start of the decade. The strong variation in productivity growth experiences of the EU countries does not seem to be related at all to the different levels of their employment protection. The regression line shown in the figure has a negative slope but it is not statistically different from zero.

I am not claiming that there are no problems with Europe’s labour markets. There are. Rigidities often make it difficult for newcomers to enter the labour markets and are responsible for the relatively high levels of unemployment among the unskilled and the young. But these rigidities are now used to explain almost anything that goes wrong with Europe’s economy: low productivity growth, declining market shares, insufficient innovation, etc. The ECB even tells us that it may have to raise interest rates because of these rigidities. The corollary of this overuse of rigidities in explaining everything is the belief that without “structural reforms” (whatever that means), the present economic recovery is not sustainable.

Figure 1

Source: For the PMR-index: Paul Conway & Véronique Janod & Giuseppe Nicoletti, 2005. "Product Market Regulation in OECD Countries: 1998 to 2003," OECD Economics Department Working Papers 419, OECD Economics Department.
For productivity growth: http://ec.europa.eu/economy_finance/indicators/annual_macro_economic_database/ameco_applet.htm

 

While pessimism leads to a search for hidden structural weaknesses, optimism has the opposite effect. The prevailing optimism about the US has lead analysts to search for all the nice structural things about the US economy. The list is well-known: flexibility, innovative spirit, great financial markets, etc. When seen through these rosy glasses, there are no structural problems in the US economy. But is this so? Let me identify two important structural rigidities in the US economy that are in need of reform.

Two US structural rigidities

First, there is the low productivity of energy use in the US compared to Japan and the EU. The statistics are striking (see figure 2). The EU and Japan are about 50% more productive in the use of energy than the US. Put differently, the EU and Japan manage to produce about 50% more with one barrel of oil (or its energy equivalent) than the US. This difference by far exceeds the difference in labour productivity between the US and the main European countries.

The reason why the US appears to be so much less productive in its use of scarce energy is well-known. Energy is not priced correctly in the US, i.e. energy’s price does not sufficiently reflect the environmental costs of its use. Using tax policies, European countries have been more successful in pricing energy in a way that comes closer to reflecting environmental costs. In a sense, one can say that there are structural rigidities in the US preventing prices from reflecting the true scarcity of energy.

In the future, energy is likely to become scarcer. The low energy-productivity of the US will be a serious handicap. Structural reforms will be necessary to overcome this handicap if the US wishes to remain competitive. 

Figure 2

            Source: UNDP, Human Development Report 2006.

 

A second structural rigidity has to do with mobility. It is well-documented that Europe lacks regional mobility compared to the US. What is less well-known is that social mobility in the US is now significantly lower than in a number of EU countries, especially the Nordic countries and the UK. (Unfortunately, as far as I know, similar studies for other EU countries have not been undertaken). Consider the evidence in Figures 3 and 4. The results are quite spectacular. Figure 3 shows that while in the Nordic countries and the UK, men born in the lowest income quintile (the income quintile of the father) have a probability of 25-30% to stay in this lowest quintile; in the US, this probability is more than 40%. Figure 4 shows that the probability of US men born in the lowest quintile to move to the top quintile is less than 8%, while in the Nordic countries and the UK, this percentage is around 12%.

Death of the American Dream

The strength and pride of America has traditionally been that it provides for a high level of social mobility. It is part of the “American Dream” in which the poorest of the poor can climb to the top of the social ladder in one generation. This dream has attracted millions of outsiders to the land of promise, away from old Europe, which was incapable of providing a future for the poor. The high social mobility has also worked as a “safety valve” that allows political acceptance of the high income inequality in the US. Finally, it has provided the basis for the extraordinary dynamics of the US economy. Developments of the last decades have shattered this American Dream. It now appears that many EU countries have created an environment in which it is significantly easier for the poor to climb the social ladder than it is in the US. Structural reforms will be necessary in the US if it wants to emulate the success of European countries in organising social mobility.

Figure 3


Figure 4

Source: Jäntti, M.,  Bratsberg, B., Røed, K., Raaum, O., Naylor, R., Österbacka, E., Oddbjørn, Björklund, A., and Eriksson, T.,  (2006), American Exceptionalism in a New Light: A Comparison of Intergenerational Earnings Mobility in the Nordic Countries, the United Kingdom and the United States, Institute for the Study of Labor (IZA), Discussion Paper, no. 1938

 

Pessimism unwarranted

The pessimism that has prevailed in Europe for at least ten years is unwarranted. True, there are structural problems that should be tackled. But this focus on structural problems is excessive, if not pathological. It also falsely implies that all we have to do is to introduce structural reforms to get better. Compared to the US, Europe has structural strengths and weaknesses. Seen from this perspective, it is not evident that Europe suffers more from structural weaknesses than the US.

Topics: Welfare state and social Europe
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De Grauwe discussed:
http://gabriel.mihalache.name/econ/2007/07/unconditional_vs_conditional_i.php
http://macroeconomicsandotherthings.blogspot.com/2007/07/paul-de-grauwe-on-structural-rigidities.html

In Slovenian (I think) http://drugidom.net/zanimive-povezave-07022007/

Professor of international economics, London School of Economics, and former member of the Belgian parliament.

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