European Growth: Myth, Reality and Necessity (Part II)

European Growth: Myth, Reality and Necessity (Part II)


Europe has lower per capita incomes than the US basically because it has traded off its striking productivity gains over the last 30 years for more leisure, rather than for more income. However, such a trade-off is not likely to remain feasible in the future, nor would it be wise for Europe to attempt to continue making it, if the EU wishes to maintain its economic model and make a positive difference in the world.


Despite much more noticeable productivity gains in Europe than in the US over the last 30 years, Europe has failed to close the per capita income gap with the US. Indeed, in the most recent years it has even begun to open. However, while certain aspects of the European economic model may have contributed in a modest way to this phenomenon, the principle explanatory factor has been that Europeans have converted most of their productivity gains into leisure rather than income. Nevertheless, this process appears to have run its course. Future European productivity gains are likely to be converted into increases in per capita income. But Europe would be well advised to finally take seriously further productivity-enhancing reforms, along with improvements in economic governance so as to improve the efficiency of anti-cyclical macroeconomic policy. The single most important key to the future of Europe lies in successfully executing a growth transformation. This would hold out the biggest promise for Europe to someday realize what some have called its ‘Kantian vision’ for itself, if not the world.


The Question of Work and Leisure
The conclusion reached at the end of Part I, however, does pose two interesting questions: first, if there has been no significant divergence in per capita income between the US and the euro zone in three decades, why has there been no convergence? Second, how could convergence be achieved and what would it imply?

To answer the first question one needs to look beyond labour productivity growth (even beyond total factor productivity growth, where again the US has lagged behind Europe over the last 30 years, only overtaking it since 1997) to concentrate on labour use, another factor driving GDP. Oliver Blanchard has recently argued (The Economic Future of Europe, NBER Working Paper no. 10310, March 2004) that there has been no convergence in per capita income gap between the euro zone and the US since the 1970s simply because Europeans have traded away much of their relative growth in labour productivity –which potentially could have contributed to income convergence– for increases in their leisure time. In contrast to Guillermo de la Dehesa’s argument that Europe has failed to catch up with the US –even slipping in recent years– due to a growing divergence in productivity growth (although this is only demonstrably true since 1997), Blanchard’s claim is that since the 1970s, euro zone productivity (measured as GDP per hour worked) has skyrocketed relative to the US (only trailing off slightly since 1997), while average hours worked per person have plunged. Thus, euro zone GDP per person is not lower than that of the US because European workers are less productive. Average GDP per hour worked in the euro zone is now only 5% below that in the US, argues Blanchard, while 30 years ago it was 30% lower. Output per hour is even higher now in Germany and France than in the US.

It is true the fewer people work in the euro zone than in the US, where both the participation rate and the employment rate are higher (77% and 74% versus 70% and 65% in the EU). However, those who do work in Europe, work fewer hours than their counterparts in the US: 257 hours less in 2001, according to the OECD, a difference which has grown from 166 in 1991. Nearly two-thirds of this difference, however, is accounted for by the longer vacations which Europeans enjoy as a result of labour legislation (around 35 days on average of entitled vacation compared with only 16 in the US). The rest, when spread out over the remaining work year, leaves Europeans with an average work week which is about 2 hours shorter than the average work week in the US.

The per capita income gap persists basically because the average person in the US works more hours. The Economist presents a vivid example of this. In France, from 1970 to 2000, average GDP per hour increased by 83%, while hours worked per person fell 23%. French per capita GDP therefore increased only 60% in these 30 years. Meanwhile, in the US, GDP per hour grew only 38% in the same period, while the average number of hours worked per person increased by 26%. US GDP per capita grew by 64%. This small per capita GDP divergence between Europeans and Americans (which has been concentrated in recent years) appears to stem more from a decline in the average number of hours worked in Europe than from faster US productivity growth. Indeed, the stark improvement in euro zone productivity relative to the US has been fully offset by the decline in hours worked in the euro zone.

Now comes another critical related question: Why do Europeans have more leisure time? One possible answer is that Europeans choose to trade higher potential incomes for more leisure (if leisure is a normal good, as we assume it is, at least along certain critical portions of the income scale, then this is perfectly coherent). However, the liberal critics of the European model refuse to accept this version of the story. They argue that many Europeans are forced to work less because of distortions in maximum working hour regulations, forced early retirement, higher taxes, other distortions in the labour market, or simply the economic weight of the welfare state in general.

While those like Blanchard find that nearly all of the fall in hours worked in Europe has been voluntary, other studies, like the recent Timbro report, suggest that nearly all of the drop has come from misguided state policies such as higher taxes, which, so the liberals argue, reduce the incentive to work. It is true that marginal tax rates have risen more in Europe than in the US over the last decades, but there seems to be little, if any, correlation between the collapse in hours worked in Europe and the rise in taxes. Blanchard cites Ireland as an example, where average hours worked since 1970 have dropped 25% even though tax rates have risen less than in the US.

Nevertheless, it has been pointed out above that nearly two-thirds of the difference in average hours worked per employee between the US and Europe is accounted for by more holiday time mandated by European legislation. The rest is accounted for by a shorter work week, in many cases also restricted by legislation. The assumption of the defenders of the European model is that such legislation is based on a broad social consensus, meaning that the majority of Europeans have desired the increase in vacation time achieved over the last 30 years and a marginally shorter work week than in the US. However, liberals will still not accept this rationale, and they often point to surveys to prove their point that even in Europe people would prefer more income to more free time.

One such survey was released in June 2000 by Roper Starch Worldwide. In it, 57% of Americans said they would prefer more money to more time off. Only 37% preferred more time off. Furthermore, the same survey found that well over 50% preferred more money to more time off in four major European countries (France, Germany, Italy and the UK –63% in the case of France–) and Canada. The presumed conclusion is that people everywhere would prefer higher incomes to more leisure time. This would leave European welfare state intrusions, forcing ‘leisure’ on Europeans, as the main culprit behind the per capita income gap.

But there is more than meets the eye in these numbers. First, in Europe workers have already achieved a significant improvement in their leisure time over the last 30 years –something that has not occurred in the US–. The current European preferences referred to above demonstrate only that Europeans no longer generally desire to continue making the same trade-off: that is, dedicating new labour productivity gains to leisure instead of income. Given that Europeans have achieved what they consider to be the optimal level of leisure, they are now ready to resume dedicating new productivity gains to improvements in per capita income. The survey figures do not suggest that Europeans would prefer to trade away portions of their current level of leisure for increases in income, irrespective of productivity gains.

Second, the survey figures for US preferences tell us little about the different income, work and leisure contexts in the US and Europe. A corollary of the question asked above of Europe should be asked of the US: Why do people work more? Is it simply to make more income? Are they really making the same choice as their European counterparts today? Income distribution is far less equal in the US than in Europe. The Gini coefficient in the US is nearly 50% while in the euro zone it is under 30%. This implies that those in the middle and lower income strata in the US have less room to make such a choice than their European counterparts. Most of these income earners in the bottom 60% of the US scale face a higher marginal utility for income than for leisure, even if they might also like to have more vacation time in the absence of such an intense budget constraint. European workers are perhaps now –after having achieved sufficient leisure from the productivity gains of the past decades– returning to a position on the income scale where the marginal utility of income is higher than that of leisure. In addition to the greater income inequality, fewer social benefits, less public infrastructure, and the more ‘flexible’ labour market in the US, there are more single-parent families and double-income families in the US than in Europe, where often there is a family member capable of remaining outside the workforce, working at home. This means that even if low and middle-income workers in the US had more time off, much of it would be eaten away by domestic chores.

The tentative conclusion would be that the supposed superior economic performance of the US relative to the euro zone has been exaggerated. Productivity has grown just as fast in the euro zone, excepting the modest reversal in recent years which is very possibly accounted for by a relatively faster uptake of employment in Europe. Even if growth in GDP per capita has been slightly slower in Europe, this has been primarily due to a welcome increase in leisure, to say nothing of the particular struggles of post-reunification Germany. According to some estimates, like that of Northwestern economist Robert Gordon (‘Two Centuries of Economic Growth: Europe Chasing the American Frontier,’ October 2002), European living standards are only 10% lower than those of the US, if one factors in the US’s harsher climate and higher crime rate (along with the associated economic costs), as well as the welfare value of Europe’s public transport systems.

In short, the only clear period of ‘superior’ US performance has been the epoch since 1997, during which the US traded off a sharper economic boom and a more muted recession for the accumulation of several threatening imbalances –a trade-off the Europeans, for whatever reason, did not make– which could still extract a heavy price. The problem for Europe is that, unless it can renew its former stronger productivity growth, it will likely be forced to shoulder some of the economic costs of any instability ultimately produced by the US macroeconomic overhangs –like a potential dollar crisis or significantly slower US growth–. Europe needs to become an alternative engine of growth for the world economy once again. If that happens, arresting the recent divergence with the US, and finally beginning the process of convergence, will no longer be an issue.

The Challenges Facing the European Model
So how can the euro zone arrest this recent divergence, and how can it begin to at least partially converge with the US? Faster growth can come from either higher productivity growth, or through a reduction in leisure (either of the large voluntary segment or of the residual –perhaps some 30%, according to more cautious studies– which is forced). Certainly there is some room for improvements in productivity growth. Given that the relative productivity spurt of the US against the euro zone since 1997 also coincided with faster employment creation in Europe (8% versus 6% in the US) and an improvement in the euro zone’s unemployment rate relative to the US (a drop from 10.4% to around 8% in Europe compared with an increase in the US from 4.9% to 5.6%), one could easily conclude that a key underlying factor behind the recent lag in euro zone relative productivity growth has been Europe’s recent uptake of employment (this seems to be particularly true of Spain). After all, during the periods previous to 1997, when the euro zone’s productivity growth has higher than the US’s, it tended to perform more poorly on employment and unemployment. Because there has been some labour market reform in Europe in recent years, helping to stimulate employment increases, one could conclude that Europe will soon experience at least a modest upturn in productivity growth sometime soon.

But Europe should also encourage even more productivity growth (and especially of the all-important total factor productivity) through more reforms, particularly those of the Lisbon Agenda. Such reforms could possibly have the additional effect of reducing the residual of forced leisure (ie, some of the difference in the participation and employment rates and in the length of the work week between Europe and the US). There are some signs that this is already beginning to happen: recent reforms in Germany have already begun to increase the work week –even without additional compensation–. What is not needed is an attempt to increase hours worked by cutting back on average vacation time in Europe. Assuming that these current levels of voluntary leisure would not decline unless per capita income was to actually fall, any other scenario in which voluntary leisure might decline would imply a net loss in welfare. Given the current European marginal preferences for more income versus more leisure, presented in the Roper survey cited above, we would conclude that a resurgence of productivity growth in Europe would be matched by a resurgence of growth in per capita income.

Clearly, we cannot be complacent about Europe’s future –even if we can set the record straight about the past and the present and be clear about the economic success that European integration has represented to date–. Unemployment remains high, and reform is threatening to stall in Germany, France and Italy, which together make up some 70% of the euro zone’s GDP. But the biggest looming challenge is demographics. Europe’s labour force (already small relative to the US) will soon begin to decline as a share of the population, making it more difficult for Europe to maintain even its current pace of growth in GDP per capita, and therefore harder to finance pension systems. Without faster growth –ideally coming from faster total factor productivity growth and some additional flexibility in the labour and product markets (which might help increase Europe’s lower participation and employment rates)– Europe will simply be unable to afford its welfare system (See Ricard Sandell, Ageing Populations: An Opportunity for Public Policy Reform, Real Instituto Elcano, Madrid, Working Paper 20/2003, July 21, 2003).

Even the achievement of balanced budgets by 2005-06, with growth converging at 1.75% by 2030, according to the OECD, public debt ratios will be 300%-400% of GDP in France and Germany by 2050. Faster growth alone cannot solve this demographic challenge –it will need to be supplemented by significant reforms of European pension systems– but faster growth can certainly help mitigate the social opposition, and navigate through the political divisions, that pension reform will certainly provoke.

The European model is certainly not dead, but the fact that Europe has been able to afford both leisure and welfare in the past does not mean it can in the future, particularly given the long-term structural challenges mentioned above (demographics and pensions) and the goal of most Europeans to create meaningful common foreign, security and defence policies.

Furthermore, the experience on the Continent in recent years suggests a fundamental ‘law’ which is hard to circumvent by even the most able policy-maker: it is possible to operate with a public sector which is relatively great in proportion to GDP and still keep an acceptable growth rate in the economy, provided labour and product markets are competitive and free of intervention. The most obvious example of this is provided by the Scandinavian countries. It is also probably viable to operate with less flexible markets if the public sector is relatively small in proportion to GDP and, ideally, relatively efficient. The clearest example of this is pre-unification Germany.

What is not tenable –and this continues to be a key fallacy in the present-day European policy-mix– is to have both relatively inflexible markets and an ever higher demand on public services, with a public sector taking up a sizeable part of overall economic activity. This is probably true even in the context of a closed economy, but even if it were not, ever intensifying globalization and demands from the developing world for access to western domestic markets will make sure that such a ‘law’ ultimately enforces itself. The implications of this are clear. While the European model should be maintained, it should be streamlined through pension reform, deeper and freer integration of product and services markets, and further reform and rationalization of the labour markets. Despite past European successes in the pre-globalization and pre-EMU periods, the goal should continue to be faster productivity growth and faster potential output growth.

But the long-term structural challenges to potential growth are not the only problems confronting Europe’s economy. The euro zone in particular has been suffering from a weakness of domestic demand. The insufficiencies of euro zone economic governance –made vivid in the controversies surrounding the Stability and Growth Pact and the ECB’s monetary policy– have left the European economy very dependent on external demand, and ultimately that of the US. According to the OECD, the output gap this year –a measure of excess capacity– will be 3.3% of potential GDP in Germany and 2.3% in the euro zone. In the US and the UK it will stand at a mere 0.3% and 0.1%, respectively. The left tends to argue that this is due to the innate conservatism of the ECB, but it is just as likely that, once European monetary authorities begin to witness more product and labour market reform, the ECB will feel freer to become more active in the pursuit of anti-cyclical policy.

The upshot is that, due to long-held and entrenched fears of excessive inflation and debt build-up, Europe’s EMU has structured its policy instruments and economic governance framework in a way which leaves it too rigid and inflexible in policy terms to be capable of contributing new demand to world growth in the short run at times when it is most needed.

Finally, the so-called problem of an appreciating Euro is really a false dilemma. Without action to redress the above mentioned policy and market rigidities, a stronger euro does indeed pose important cyclical limitations on Europe. However, with appropriate action, a stronger euro becomes a beneficial tool for facilitating stronger domestic demand and purchasing power.

The Necessity of Europe
It is imperative that the European economy begins to grow faster, both in the short run and sustainably into the future. This is the case because the world economy is in desperate need of an alternative engine of growth capable of contributing demand to the world economy. This imperative is particularly acute at moments when the US economy –currently the world’s only independent engine of growth– finds itself facing an increasingly binding external constraint and the need to unwind its current account deficit –along with its domestic private and public debt overhang– through more reliance on external demand.

The world economy is currently facing such a situation, which only promises to become increasingly unstable so long as another independent source of demand does not emerge. Even China –now providing significant demand to the economies of East Asia and Latin America, particularly those of the Pacific Rim and the Southern Cone (see Luís Esteban Gonzalez Manrique, El “síndrome China” se extiende por América Latina, ARI, June 3, 2004)– is still ultimately dependent upon the demand of the US consumer. While China has growing deficits with most of its trading partners (generated primarily by the importation of raw materials and intermediate goods), its large trade surplus with the US (over US$100 billion, based mainly on the export of consumer goods) still offsets, and supports, its demand-exporting deficits. China may have become a powerful slingshot for the world economy, but the supply of stones still comes from the US.

If the anticipated rise in US interest rates places even a mild brake on Chinese exports –to say nothing of the possibility that the domestic Chinese investment bubble could easily burst sometime soon– the incipient export-led recoveries of Japan, the rest of Asia, the Southern Cone and, ultimately, Europe will be threatened.

A significant increase in European economic growth would also appear to be a prerequisite for Europe to achieve and exercise greater political influence in the world. The quest for an efficient and effective common foreign and security policy, currently plagued by perceptions of conflicting national interests, would only be facilitated by a transformation of Europe’s growth rate. If for no other reason, the perception of a more vibrant economy is probably the only practical carrot that Europe has to seduce the UK into a deeper and more permanent commitment to participating fully in the European project, including EMU. Ultimately, the perception of more vibrant growth is the only historically known antidote to political divisions of the kind still impeding further EU political union.

Furthermore, Europe can only hope to become a truly alternative pole of investment attraction for world savings if its economy is perceived to be more efficient and profitable. Again, the solution is to be found in more rapid and sustainable European growth. In addition, if the euro were to achieve a position of true rivalry with the dollar for international currency uses, the macroeconomic flexibility which has underpinned the US’s capacity to influence (or obstruct) the international agenda would begin to accrue to Europe, thus making European political divisions more susceptible to possible compromises (see Paul Isbell, The Internationalization of the Euro: State of Affairs and Critical Aspects, Real Instituto Elcano, Working Paper 25/2003, September 12, 2003). Indeed, the dream of many Europeans to use the European model of political and economic integration as an attractive resource for shaping a truly multilateral international system will remain just that –a dream– if Europe fails to increase its growth rate in a sustainable fashion.

To achieve such a growth transformation, the European Union will at least have to resolve the problems currently plaguing the economic governance of the union and undertake a major push to achieve the kinds of structural reforms envisioned in the Lisbon Agenda.

European Leadership’s Date with Destiny
This is an enormous challenge that will submit Europe to its most important test to date. The idea of Europe –and, here it must be admitted, there is not only one– that has developed incrementally since WWII is about to come face to face with destiny. Will it show up at the appointment? And, if so, how can it rise to the occasion?

Both Europe’s traditional Right and its traditional Left must now embrace reform with equal enthusiasm. Unfortunately, both sides of the political spectrum in Europe continue to resist reforms in their own way, and typically for motives inconsistent with their own closely-held big-picture visions of what the world should look like.

On the left, political forces continue to obstruct even timid Social Democratic attempts to push a rationalizing reform agenda. Yet rarely does a credible Social Democratic leader frame the argument that reforms are essential in terms of achieving other larger goals of the European left: like gaining more credibility and influence for Europe on the world stage –the only way that European Social Democracy will ever to able to help effectively craft an international system which reflects the values of multilateralism and international law which Europe shares with so much of the world–. The anti-war, anti-reform left in countries like Germany and France –and even Spain– might think twice about their opposition to ‘liberal’ reforms if they could see how a stronger, more vibrant and united Europe might have been capable of influencing world events in such a way as to successfully avoid what has now become the disastrous denouement of the Iraq affair –rather than simply contributing to the international acrimony and chaos which fed the current crisis–. They might also think twice if it were to be made painfully clear to them that the mid-run choice is between a new, streamlined, more rationale version of the European model or no European model at all. Now is the time for a Social Democratic president to become truly ‘reformist’ in a visionary way, consistent with the broader objectives of the left.

On the right, the dynamic is obviously different. Nationalism, status and prestige are all central motives driving national rivalries: it is always one or more of the other European partners who are dragging their feet on reforms, or attempting to wrest power and privilege at the expense of one’s own vital national interests –in short, someone else is always using the European Union as a tool to wrench concessions from weaker partners and free-ride at their expense–. But rarely do Conservative leaders frame the argument for European cooperation on economic reforms –through the complicated process of trade-offs and give-and-take typical of the European process– in terms of how such reforms, in their own right, are ultimately in the best interest of their respective nations, regardless of what the other European partners do or fail to do. Ultimately the power and prestige of any country in Europe rests upon its capacity to produce and perform economically, and to generate stable livelihoods for its citizens. Conservative electorates are swayed by economic success; they could also be swayed by the possibility of a strong and internationally-influential Europe (whatever they think it should do). If only a powerful Conservative leader would lock hands with Social Democrats to push for more reform and roll up their sleeves to engage in sincere pedagogy with their electorates.

But the necessary reforms of the European model are not only of a microeconomic nature. Sooner or later the macroeconomic economic governance of the euro zone will need to be deepened –that is, infused with more efficient mechanisms for deeper fiscal policy coordination, or even more sovereignty sharing–. Although this is still a very broad generalization, increasingly it is the European right which opposes deeper macroeconomic policy integration, on the grounds of defending national sovereignty in the face of the all-consuming eurocrats. However, if the Right hopes to achieve further microeconomic reform, it might be politically necessary to attend to the growing demand for enhanced macroeconomic governance, possibly including the ceding of further fiscal policy competences to the EU.


Europe has been a great economic success to date, but the configuration of possibilities and limitations defining the future potential of the EU has changed. If Europe does not rise to meet its short-term cyclical economic constraints, to say nothing of its long-term structural challenges, it could easily relegate itself to secondary status in a rapidly changing world, surrender its potential leadership and influence in the world system to the US and Asia, and fail to generate the essential breath of fresh air that the European Union needs to break through its many current impasses. This will be only more true if the US and Asia actually take the initiative to sort out their own inefficiencies and imbalances, while Europe remains passive and hopes only to benefit from the external demand provided by those economic regions.

On the other hand, if Europe manages to surprise us all –and perhaps even itself– then the sui generis model for international cooperation that it has long been attempting to build for itself, and even offer to the world, could become of such transcendental historical significance for the world as that other sui generis project which played a key role in transforming Europe’s historical dynamic: the original American experiment with democracy.

Paul Isbell
Senior Analyst, Real Instituto Elcano