Want faster European growth? Learn to love creative destruction

Nicholas Crafts, 11 July 2008

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Paul Krugman once observed that 3% per year is about as good as it gets for GDP growth in advanced economies. While the United States has achieved this since 1995, the EU15 have fallen well short – averaging only 2.3%.

The real European problem is in sluggish labour productivity growth  over the same period it averaged 1.4% per year compared with 2.1% in the United States, so that Europe has been falling behind rather than catching up during the last decade, in contrast with the whole of the post-war period until the mid-1990s.1 There is, of course, huge variation around this European average, from Irish labour productivity growing at 3.7% down to Spanish labour productivity growth of 0.2%.

Two further aspects of comparative productivity growth should be flagged:

  • Weak European performance compared with United States is characterised by a shortfall in TFP growth rather than in capital deepening.
  • As analysis of the EUKLEMS dataset by Bart van Ark and his colleagues has revealed, market services are the key problem area, notably, but not only, in information technology-intensive sectors such as distribution (van Ark, O'Mahony, and Timmer 2008).

Again, the variation in the contribution from labour productivity growth in the service sector is considerable, from 1.6% per year in United Kingdom to 0.1% in Italy during 1995 to 2004.

Policy concerns

Understanding the policy implications of comparative growth outcomes requires an appropriate model. The most suitable is the Schumpeterian framework developed by Philippe Aghion and Peter Howitt.2 This places innovation and, indeed, creative destruction at the heart of the growth process and views these as determined endogenously by incentive structures.

A central feature of their model is that as catch-up becomes relatively complete, the institutions and policy settings that are conducive to good performance change –importantly there is a stronger role for competition as a key driver of rapid TFP growth. Thus, barriers to entry and regulations that sustain them become more costly. These arguments are powerfully amplified if, at the same time economies approach the frontier, a new technological epoch that rewards those who can flexibly adjust to the new opportunities arrives.

This helps explain a paradox

Standard American criticisms of European economies stress that there is too much taxation, too much regulation, and too little competition. All these points were at least equally valid from the mid-1970s to the mid-1990s, when Europe continued to grow faster than the US. The point then is not that economic regulation has become more stringent or that competition has weakened in the recent past but rather that existing policies became more damaging as catch-up (mostly) completed and the information and communication technology era arrived.

It is also noticeable that coordinated market economies such as Germany have generally experienced lower productivity growth after 1995 whereas the opposite is the case in liberal market economies such as United Kingdom.

Peter Hall and David Soskice, who introduced this terminology, stress that a key difference between “coordinated market economies” and “liberal market economies” is that the scope for creative destruction is greater in the latter.3 Whereas the former did well in the catch-up of the Golden Age, their institutions and policies are less well suited to the early 21st century.

Evidence that competition and potential entry promotes productivity growth

There is substantial evidence that competition and potential entry promotes productivity growth in today's European economies. The research programme led by Guiseppe Nicoletti and Stefano Scarpetta at OECD has provided an empirical handle on the inverse relationship between competition-inhibiting product market regulation and productivity growth that helps to account for differences across the OECD in recent productivity performance (Nicoletti and Scarpetta 2005). The analysis of Rachel Griffith and her colleagues at IFS has demonstrated that the transmission mechanism runs from barriers to entry through high mark-ups to lower investment and research and development (Griffith, Harrison, and Simpson 2006).

Against this background, it is disappointing to note that regulations that inhibit competition and the rapid take-up of new technologies are still prevalent in many European economies. This is particularly true in the retail sector, where the cost in foregone productivity has been considerable. It should be noted that this applies to the United Kingdom, which – despite being classified by the OECD as having the lowest product market regulation in the EU – still has strict planning laws that have blocked the development of out-of-town supermarkets and have exacted a considerable productivity penalty as Jonathan Haskel has shown (Haskel and Sadun 2007).
It is not just at the national level that deregulation has been too slow. The implementation of the Single Market Programme has been half-hearted and its impact on productivity has been impaired. The sad tale of the European Services Directive epitomises the problem. The symptom of inadequate competition in European service sectors is the relatively high mark-ups estimated by the OECD.

Conclusion

Politicians find it attractive to wax lyrical in support of the “knowledge economy” and rush to adopt targets for R&D spending and participation in tertiary education. This “happyclappy” approach to addressing Europe's productivity growth shortfall keeps them in the comfort zone. More progress would be made if the dark side of productivity improvement implied by creative destruction – exit of established producers and re-deployment of labour – were accepted and facilitated.

If only ministers could bring themselves to think (better still occasionally to say) “these job losses are good news”.

References

Crafts, N. and Toniolo, G. (2008), "European Economic Growth, 1950-2005: an Overview", CEPR Discussion Paper No. 6863.
Griffith, R., Harrison, R. and Simpson, H. (2006), "Product Market Reforms and Innovation in the EU", Institute for Fiscal Studies Working Paper No. 06/17.
Haskel, J. and Sadun, R. (2007), "Entry Regulation and Productivity: Evidence from the UK Retail Sector", mimeo, Queen Mary College, London.
Nicoletti, G. and Scarpetta, S. (2005), "Regulation and Economic Performance: Product Market Reforms and Productivity in the OECD", OECD Economics Department Working Paper No. 460.
van Ark, B., O'Mahony, M. and Timmer, M. P. (2008), "The Productivity Gap between Europe and the United States: Trends and Causes", Journal of Economic Perspectives, 22.

 


 

Footnotes

1 See Crafts, N. and Toniolo, G. (2008), "European Economic Growth, 1950-2005: An Overview", CEPR Discussion Paper No. 6863.
2 Aghion, P. and Howitt, P. (2006), "Appropriate Growth Policy: a Unifying Framework", Journal of the European Economic Association, 4, 269-314.
3 Hall, P. and Soskice, D. (2001), Varieties of Capitalism. Oxford: Oxford University

Topics: Competition policy, Productivity and Innovation
Tags: competition, GDP, labour productivity growth

Nicholas Crafts

Professor of Economics and Economic History at the University of Warwick and CEPR