Why Europe Is Even More Sluggish Than the U.S.

During 2002, Europe realized significant milestones on the road to economic and political integration. At the beginning of the year, the euro, the new European currency, replaced national currencies throughout the European Union. The conversion occurred on time, without economic disruption or political dissent. There are already signs that the introduction of a common currency is reducing national differences in prices and returns on financial assets.

Moreover, at the end of the year, leaders of the 15 EU members agreed to admit 10 new countries in May, 2004. This enlarged EU will constitute an economic market of 450 million people, with a gross domestic product of about $9 trillion--comparable in size to the gross domestic product of the U.S. economy. In addition, the Europeans are drafting an ambitious new constitution to shift political and policymaking power from member governments to the European Parliament and other European institutions. Many Europeans believe that the agreements forged at their 2002 constitutional convention will be as momentous for Europe as the agreements forged at the Philadelphia Constitutional Convention in 1776 were for the U.S.

But if 2002 has been a successful year for European political and economic integration, it has been a difficult one for the European economy. Although the limping American economy has attracted the most media attention, Europe has fared even worse, growing only about half as fast as the U.S. Exports have accounted for most of the growth in the euro zone economy, with domestic demand stagnant and capital spending continuing to fall.

Economic conditions have been particularly weak in Germany, by far the largest European economy. Germany continues to suffer under significant structural constraints to competition in its product and labor markets--including rigid central-wage bargains and restrictive labor practices--that deter investment, innovation, and growth. Germany's labor costs in manufacturing are the highest in the world, and it's losing competitiveness relative to its European neighbors.

Ironically, Germany is a victim of the rules it championed for European economic integration. The focus of the European central bank on a low average inflation target for the EU has meant a high real interest rate for Germany. The Maastricht limits on deficit and debt/GDP ratios have curtailed Germany's ability to use fiscal policy to stimulate domestic demand. Germany has painted itself into a corner in which traditional monetary, fiscal, and exchange-rate policies are no longer available to offset competitiveness or cyclical difficulties, making painful structural reforms the only way out of its economic malaise.

The underlying weaknesses of the European economy are also apparent in its productivity record. After nearly two decades of roughly comparable performance, during the past six years, the growth of real GDP per hour worked increased in the U.S., but it declined in France, Germany, and Britain. What explains this divergence in productivity growth? There is mounting evidence that differences in information-technology investment rates have played a role. A recent study shows a significant pickup in productivity growth rates in IT-using sectors in both manufacturing and services in the U.S. and a decline or stagnation in productivity growth rates in comparable sectors in Europe between the first and second half of the 1990s. The sectors producing IT equipment in both Europe and the U.S. enjoyed a significant improvement in productivity growth over this period. But U.S. productivity growth rates in these sectors were higher, and overall U.S. productivity growth benefited from the fact that IT output accounts for a larger share of total output in the U.S. than in Europe.

Another study by the Board of Governors of the Federal Reserve finds a correlation between changes in IT investment and changes in productivity growth rates during the 1990s, suggesting that lower IT investment rates in Europe were partly responsible for its slower productivity growth. This study also finds that both regulatory constraints on employment practices and regulatory barriers on startups have discouraged investment in IT and dampened productivity growth in Europe.

Recent industry and company studies by McKinsey Global Institute conclude that competition is a key determinant of productivity growth and that competitive intensity in most product markets is weaker in Europe than in the U.S. When competitive intensity is high, companies are forced to seek greater efficiencies by investing in new technologies. Thus, a lower level of competitive intensity is one of the reasons behind the lower rates of IT investment in Europe compared with the U.S.

If Europe is to realize the potential of an enlarged integrated market, it must hasten labor and product market reforms to intensify competition. In this respect, 2002 has been another disappointing year for the European economy.

By Laura D'andrea Tyson

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