Tigers, tortoises and textbooks

Until around 1995, postwar labour productivity grew much faster in Europe than in the United States. But since 1995, Europe’s productivity catch-up ground to a halt and then reversed. The ratio of EU-15 relative to US average labour productivity, using 1995 PPP exchange rates, was 77% in 1979, reached 94% in 1995, and by 2004 had slipped back to 85%. About half of this reversal was from the US surge in productivity growth, which has been much analysed. But the other half of the story, Europe's productivity slowdown, hasn't.

Ian Dew-Becker and Robert J. Gordon from Northwestern University examine what caused this retardation in a new paper to be presented today at the Macroeconomics and Productivity Workshop in Boston, part of week two of the NBER Summer Institute 2006. The paper, The Slowdown in European Productivity Growth: A Tale of Tigers, Tortoises, and Textbook Labor Economics (PDF), argues that increasing taxes on European labour in the period up to 1995 encouraged more capital-intensive production - raising growth but reducing employment rates. Labour market reforms over the past decade have cut labour taxes, but at some cost to productivity growth:

One of the exogenous driving forces in this was an increase in labor taxes before 1995 and a reduction after 1995. We show that a substantial portion of the post‐1995 turnaround in the growth of European hours per capita can be explained by a reversal in the previous regime of ever‐increasing tax rates. We conclude that Europe must accept slow productivity growth as a consequence of labor market reforms that have achieved a desirable turnaround in growth of hours per capita.

The paper contains an extensive analysis of the industry decomposition of European productivity growth, based on a decomposition of Europe’s fastest‐growing “Tigers,” its slowest‐growing “Tortoises”, and a Middle group. The decline in tax rates and turnaround in the growth of hours per capita is distinctly more important in the Tortoises than in the Middle group, adding to the case that changes in the cost of labor are driving both the positive turnaround in hours and negative turnaround in productivity in the EU compared with the US.

Note: Also worth reading is the authors' December 2005 NBER working paper on US productivity growth, Where Did the Productivity Growth Go? Inflation Dynamics and the Distribution of Income, which found that "only the top 10 percent of the income distribution enjoyed a growth rate of real wage and salary income equal to or above the average rate of economy-wide productivity growth." (See The Economist's coverage). You can find a free version of the paper here; a revised version is forthcoming in Brooking Papers on Economic Activity, 2005, no. 2.

Update: Dave Altig at Macroblog links to this post (thanks), and presents Bernanke's views on productivity: The Chairman Speaks: Why Don't Rising Productivity Tides Raise All Boats (Equally)?

Bernanke's explanation is that "the United States has done a lot better at using those [ICT] technologies than a lot of other industrialized countries." He also cites competitive pressures as an important driver of firm productivity - something i absolutely agree with.

On the Dew-Becker and Gordon paper itself, Dave muses:

My instinct is to side with some version of the Bernanke explanation. But there is rarely a single factor that provides a fully satisfactory explanation of any particular set of facts, and I haven't read the paper cited by TNE.  So I'll leave it as an open question.

Comments

[spencer]

Thanks for the link to the Gorden-Becker paper. It certainly is thought provoking. It is going to very interesting to watch the debate it generates.

[A. PERLA]

Gordon: Yet there has been a turnaround in European hours per capita as well, as this ratio has grown since 1995 both in absolute terms and relative to the US (where hours per capita in 2006 are below the level of 2000).

I don’t understand this statement at all.

In the early 1990's France mandated the 35-hour week (reducing it from 39.5 hours worked). This is one indication of where one European country reduced hours worked.

This was done supposedly to negotiate with management to make more supple work hours in multiple shifts, which turned out to be an absolute fallacy.

Information published by the Economist a few years ago shows hours worked declining across all major industrialized nations, more so in Europe than in the US admittedly.

I'm puzzled by their conclusions.

[Ian D-B]

I posted the following comment at macroblog:

"In that paper, I don't think we so much disagree with Bernanke's explanation as argue that there is more to the story (as you say). If you break the LP growth gap into TFP and capital deepening, TFP accounts for the majority -- that's what Bernanke is referring to. The problem is, TFP is pretty tough to talk about -- it;s just a residual.

"When Bob and I talk about the effects of tax rates, we're referring to capital deepening. It's also important to note, as have other papers recently, that capital deepening in the US recently has been driven by low hours worked, rather than high investment -- slightly troubling."

Also, Perla, you're right, hours in the EU did decline in the early 90's. And you're also right, in France, Germany, the UK and other countries we call the "middle", hours continued to fall. But in the countries with the lowest growth of labor productivity, i.e. benelux, Spain and Italy, hours per capita grew at the fastest rates in Europe. We see this as an important clue -- declines in hours are associated with higher LP growth, growth in hours is associated with low LP growth.

[A. PERLA]

"... in France, Germany, the UK and other countries we call the "middle", hours continued to fall. But in the countries with the lowest growth of labor productivity, i.e. benelux, Spain and Italy, hours per capita grew at the fastest rates in Europe."

For years I have been emphasizing that it is intrinsically erroneous to compare apples and oranges. If you want to compare the US with a demographically equivalent economy, then compare it with the EU-aggregate.

I would not dare do the reverse - compare the EU-aggregate with California and Massachusetts and then try to derive a plausible conclusion.

The comparison may not be necessarily wrong ... but neither is it necessarily right.

Wadaya think?

[Ian D-B]

You're right, demographic corrections are important. So when looking at the *level* of hours per capita, you can't compare Europe and the US. Over the short run though, the age composition of the work force changes slowly enough that you can compare *changes*. So if we look at a 3 year span and see employment rates rise and labor productivity slow in one country, and the opposite in its neighbor, then we believe we can make a connection. That is, we're arguing that short run changes in employment rates and hours worked are more unlikely due to demographics simply becase demographics don't change very quickly.

That, however, then brings up issues of different business cycle effects across countries, which is something Bob and I need to grapple with for our next draft.

[A. PERLA]

"That is, we're arguing that short run changes in employment rates and hours worked are more unlikely due to demographics simply becase demographics don't change very quickly."

But, they do not have to "change" over a cycle. It is sufficient that they be different from the onset.

Consider, for instance, the fact that, in France, the tendency is for educated people (the major part of those economically active in an economy that has exported unqualified-labor jobs) to go to work at around 27 years of age. In the US, the same college graduate will want to enter the workforce at around 23. The difference of about 5 years is significant in terms of overall productivity, I would think.

But, to detect that difference, it is necessary to consider statistically a very lonnnngggg period of economic activity. Many decades, I suggest. At least fifteen years.

Methinks. (Since, this is not at all my area of expertise.)

Thank you for the exchange nonetheless.

PPS: I must admit that I do not like, at all, the present work done in comparing rates of productivity internationally. I find that neither the data nor the manner in which it is collected sufficiently homogenous (either within Europe or between Europe and the US) to generate believable conclusions. For instance, in Europe, with its high-rate of social overhead, as much as 20% of economic activity is “off the books”. At one time, in Italy, it was thought that a third of economic activity was underground (i.e., it did not show up in official statistics.

PPS: But, admittedly, I seem to be the only one with those concerns.

[Arthur Eckart]

I agree, controlling the supply of labor can artifically increase productivity and capital deepening. Also, European employers may have been more cautious hiring workers, because of favorable laws for employees. There may be two significant factors why U.S. productivity was low in 1965-95. From 1965-80, the demographics of the U.S. labor force shifted to a smaller proportion of "prime-age" workers. Then, from 1980 to 1995, the growth of U.S. emerging industries expanded, which initially are less productive than older industries. So, lower hours worked can mean emerging industries are becoming productive at faster rates, while capital deepening increases. I think, Japan would be an interesting study.

[A. PERLA]

"So, lower hours worked can mean emerging industries are becoming productive at faster rates, while capital deepening increases."

Indeed, this may be true.

But, look again. When you talk about "emerging industries" you also talk about hi-tech companies that very often offshore thier manufacturing.

If this is true, your capital "deepening" (your word) or "thickening" (my word) is not only happening in the US, but it is happening abroad. So, one should be looking at FDI to see where the capital thickening is going.

This component is certainly not showing up all that much in the US figures. And, if you went looking for those figures, you'd be tasked to find them. When a billion dollars goes abroad to build a sophisticated silicon wafer plant in Korea, it is not tagged as such. All FDI figures, I'll bet are in the aggregate, whether reported by the outgoing country or the incoming country.

[Arthur Eckart]

Yes, capital deepening is taking place globally. Bernanke suggested U.S. firms employ inputs more efficiently than firms in other countries, which help explain why U.S. firms had double-digit profit growth over the past 17 consecutive quarters. Consequently, this capital creation adds to global capital deepening. To balance the balance of payments, U.S. current account deficits must be offset by U.S. capital account surpluses. So, foreign investment in the U.S. far exceeds U.S. investment abroad. Much of the foreign investment is in U.S. Treasury bonds, which is the safest investment in the world. Consequently, there's a low rate of return (currently, the 10-year bond yield is below the Fed Funds Rate), and net foreign capital inflows keep U.S. interest rates low. U.S. firms use inputs more efficiently to compete with foreign firms, e.g. because of cheaper imports. So, U.S. firms are highly productive, which often requires fewer workers, e.g. in some Information-Age firms.

[A. PERLA]

"Some people call it "lifestyle arbitrage" - as globalization continues, expect to see more of it."

"To balance the balance of payments, U.S. current account deficits must be offset by U.S. capital account surpluses."

In theory, yes. In practice, when is the last time we saw US exports in balance with US imports? In the early 1950s?

The US is the world's economic motor, for as long as it continues its chronic trade imbalance and for as long as countries are willing to buy T-notes. And, as long as the budget can service T-note payments, without raising taxes thereby stifling consumption.

"Much of the foreign investment is in U.S. Treasury bonds, which is the safest investment in the world."

What makes you think this? Blind faith?

Should the Chinese/Russians decide to dump T-notes, it will be like a Tsunami on foreign exchange markets and the dollar will go into free-fall.

Have you seen the perennially rising amount of Euros that are employed as a part of world currency reserves? Elucidating ...

"So, U.S. firms are highly productive, which often requires fewer workers, e.g. in some Information-Age firms."

US firms ARE highly productive, no doubt. But, not all employment in the US is by Fortune 500 companies. In fact, do you know how much of total employment these firms represent? Very minor percentage.

Most of American employment is in small to medium sized industries where your "capital thickening" is a far less dominant force for productivity enhancement. In fact, these companies are more concerned with minimum wages. Why?

Because the US is outsourcing its mid-level (read, "skilled labor") manufacturing jobs to the Far East. The move towards service industry jobs is inexorable. But, what percentage of service jobs benefit from "capital deepening" - only information worker jobs.

All the rest are in menial activities that cannot be outsourced, some of which can be none-the-less lucrative due to thier increasing scarcity. I don't know anyone going to Bombay or Shanghai for a haircut, do you?

I know of few plumbers, electricians, gardeners who are on the dole for lengthy periods of time. And, were it not for immigrants, who would be serving you at the local restaurant? The list of low-skilled ljobs is endless - and the people working in them is great.

What am I trying to say. Your "capital deepening" is great, it's fine, it reads well in today's media hi-tech hysteria. But, it is NOT the Holy Grail of economics. And it certainly does not describe the ENTIRE economic/busines picture. Not by a long shot.

Don't get overly fixated by high-tech productivity enhancement. It comes and goes, and can very easily evaporate like the morning dew.

[Arthur Eckart]

The balance of payments must balance. To pay for trade deficits, debt must be issued. Foreigners typically buy U.S. Treasury bonds to offset U.S. trade deficits. U.S. Treasury bonds are the safest investment in the world, because it has the least inherent risk. If foreigners sold their holdings of U.S. Treasury bonds, their currencies would appreciate and interest rates would rise in the foreign country, which would lower output and exports. Both the U.S. current and capital accounts would shrink. Consequently, countries that depend heavily on exports may fall into recessions, while the U.S. may have an acceleration of inflation, on the consumer level (demand-pull inflation). So, foreigners have to invest heavily in the U.S. to maintain output. Yes, the largest U.S. firms are the most productive. Also, firms in the Agricultural Revolution produce more than enough food to feed the entire country with less than 3% of the U.S. workforce. Firms in the Industrial Revolution continue to produce more with less. Only 11% of the U.S. labor force works in manufacturing. Without productivity gains and capital creation in those two economic revolutions, there wouldn't have been an Information Revolution, which is becoming more productive and freeing-up resources for the Biotech Revolution and other emerging industries.

[Arthur Eckart]

Also, I may add, it's a value judgment whether it's more important to keep a meaningless job or to outsource that job to increase per capita output (equals income). Nonetheless, there are many driving forces that make increasing per capita output inevitable. One force is consumers want high quality goods at low prices. Another force is producers must at least earn an accounting profit even when competition is fierce. The disapproval is really about income distributions, mostly by people with low or obsolete skills, particularly since U.S. income inequality is at a high level. There are excellent opportunities for Americans to acquire skills, and about one-third of American adults have a four-year college degree. However, for those without skills, the marketplace offers mostly relatively decreasing lower-paying jobs. Some of those jobs are filled by illegal immigrants, who are willing to work harder for less.

[A. PERLA]

"Consequently, countries that depend heavily on exports may fall into recessions, while the U.S. may have an acceleration of inflation, on the consumer level (demand-pull inflation). "

And, the US would avoid a recession? Bollocks.

The dollar would nosedive, increase import costs, namely oil and therefore energy that would permeate throughout the economy. Not to mention the price of oil that is priced no longer according to the dollar exchange rate but a basket of currencies, namely the euro.

This indirect taxation would hit the consumer right in the wallet. The US economy would be in very deep sneakers, a situation unseen since before you were born.

"So, foreigners have to invest heavily in the U.S. to maintain output."

Oh, in a recession, foreigners would invest in the US? Yeah, right.

"Only 11% of the U.S. labor force works in manufacturing. Without productivity gains and capital creation in those two economic revolutions,"

Productivity is maintained only because entitlements and social subventions (namely, health) are so poor, meaning manpower costs are artificially low. Which is why the menial services sector is burgeoning, because only immigrants on survival pay will work them - and, these people don't show up in your 11%. It's clearly double that amount.

"Economic revolutions"? Oh my God. Kiss the flag, genuflect when passing the Fed building.

Over and out.

[Arthur Eckart]

A Perla, I suggest you at least study the Mundell-Fleming model for further instruction. I've explained that the U.S. current and capital accounts would shrink, along with some implications, if foreigners stopped investing in the U.S. If inflation accelerated, the U.S. would not necessarily fall into recession. However, given U.S. major trading partners are relatively weaker, they'd more likely fall into recessions. U.S. incomes are high, because productivity is high (U.S. per capita income will be over $43,000 in 2006). Technological improvements, greater competition, education, training, etc. increase productivity, which raise living standards. The objective is to maximize the value of output, given limited inputs. Not pay workers more than they're worth to buy goods that won't exist.

[Arthur Eckart]

Also, I may add, higher luxury taxes would change the mix of output, although I suspect it would be small. Currently, there's a negative income tax for low income workers, i.e. an incentive to earn less. In fairness, low income workers should pay some income tax.

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