From ECONOMIST Magazine
PRODUCTIVITY growth is the closest economics gets to a magic elixir, especially for ageing advanced economies. When workers produce more for every hour they toil, living standards rise and governments have more resources to service their debts and support those who cannot work. As the rich world emerges from the financial crisis, faster productivity growth could counteract the drag from adverse demography. But slower productivity growth could make matters worse.
Workers’ productivity depends on their skills, the amount of capital invested in helping them to do their jobs and the pace of “innovation”—the process of generating ideas that lead to new products and more efficient business practices. Financial crises and deep recessions can affect these variables in several ways. As this special report has argued, workers’ skills may erode if long-term unemployment rises. The disruption to the financial sector and the reluctance of businesses to invest in the face of uncertain demand may also reduce the rate of capital formation, delaying the factory upgrades and IT purchases that would boost workers’ efficiency.
Financial crises can affect the pace of innovation, too, though it is hard to predict which way. Deep recessions can slow it down as firms slash their spending on research and development. But they can also boost the pace of efficiency gains as weak demand forces firms to rethink their products and cost structures and the weakest companies are winnowed out. According to Alexander Field of Santa Clara University, the 1930s saw the fastest efficiency improvements in America’s history amid large-scale restructuring.
Almost every government in the rich world has a spanking new “innovation strategy”. Industrial policy—out of fashion since its most credible champion, Japan, lost its way in the 1990s—is staging a comeback. But mostly such policies end up subsidising well-connected industries and products. “Green technology” is a favourite receptacle for such subsidies.
In 2008 France created a sovereign-wealth fund as part of its response to the financial crisis; it promises to promote biotechnology ventures, though it has also sunk capital into conventional manufacturers that happened to need money. In 2009 Britain followed suit with a “strategic investment fund”. The Japanese too are back in the game. In June the newly invigorated Ministry of Economy, Trade and Industry (METI) unveiled a plan to promote five strategic sectors, ranging from environmental products to robotics. However, past experiments with industrial policy, from France’s Minitel, an attempt to create a government-run national communications network, to Spain’s expensive subsidies to jump-start solar power, suggest that governments are not much good at picking promising sectors or products.
More important, the politicians’ current focus on fostering productivity growth via exciting high-tech breakthroughs misses a big part of what really drives innovation: the diffusion of better business processes and management methods. This sort of innovation is generally the result of competitive pressure. The best thing that governments can do to foster new ideas is to get out of the way. This is especially true in the most regulated and least competitive parts of the economy, notably services.
To see why competition matters so much, consider the recent history of productivity in the rich world. On the eve of the recession the rate of growth in workers’ output per hour was slowing. So, too, was the pace of improvement in “total factor productivity” (a measure of the overall efficiency with which capital and workers are used which is economists’ best gauge of the speed of innovation). But that broad trend masks considerable differences.
Over the past 15 years America’s underlying productivity growth—adjusted for the ups and downs of the business cycle—has outperformed most other rich economies’ by a wide margin (see chart 12). Workers’ output per hour soared in the late 1990s, thanks largely to investment in computers and software. At first this advance was powered by productivity gains within the technology sector. From 2000 onwards efficiency gains spread through the wider economy, especially in services such as retailing and wholesaling, helped by the deregulated and competitive nature of America’s economy. The improvements were extraordinary, though they slowed after the middle of the decade.
The recent history of productivity in Europe is almost the mirror image of America’s. Up to the mid-1990s the continent’s output per hour grew faster than America’s , helped by imports of tried and tested ideas from across the water. Thanks to this process of catch-up, by 1995 Europe’s output per hour reached over 90% of the American level. But then Europe slowed, and by 2008 the figure was back down to 83%. This partly reflected Europe’s labour-market reforms, which brought more low-skilled workers into the workforce. That seemed a price well worth paying for higher employment. But the main reason for Europe’s disappointing productivity performance was that it failed to squeeze productivity gains from its service sector.
A forthcoming history of European growth by Marcel Timmer and Robert Inklaar of the University of Groningen, Mary O’Mahony of Birmingham University and Bart Van Ark of the Conference Board, a business-research organisation, carefully dissects the statistics for individual countries and industries and finds considerable variation within Europe. Finland and Sweden improved their productivity growth whereas Italy and Spain were particularly sluggish. Europe also did better in some sectors than in others; for example, telecommunications was a bright spot. But overall, compared with America, European firms invested relatively little in services and innovative business practices. A new McKinsey study suggests that around two-thirds of the differential in productivity growth between America and Europe between 1995 and 2005 can be explained by the gap in “local services”, such as retail and wholesale services.
Europe’s service markets are smaller than America’s, fragmented along national lines and heavily regulated. The OECD has tracked regulation of product and services markets across countries since 1998. It measures the degree of state control, barriers to competition and obstacles to starting a new company, assigning a score to each market of between 0 and 6 (where 0 is the least restrictive). Overall the absolute level of product regulation fell between 1998 and 2008, and the variation between countries lessened. America and Britain score joint best, with 0.84. The EU average is 1.4. But when it comes to services, the variation is larger and Europe has made much less progress.
In professional services, the OECD’s score for Europe is fully twice as high as for America (meaning it is twice as restrictive). As the McKinsey report notes, many European countries are rife with anti-competitive rules. Architects’ and lawyers’ fees in Italy and Germany are subject to price floors and ceilings. Notaries in France, Spain and Greece and pharmacies in Greece are banned from advertising their services. Such restrictions limit the ability of efficient newcomers to compete for market share, cosseting incumbents and raising costs across the economy.
In Japan productivity growth slumped after the country’s asset bubble burst at the start of the 1990s. One reason, as an earlier section of this report has described, was the failure to deal decisively with the bad loans clogging its banks, which propped up inefficient “zombie” companies rather than forcing them into liquidation. That meant less capital was available to lend to upstart firms. Another problem was the lack of competition. Japan’s service sector, unlike its world-class manufacturers, is fragmented, protected from foreign competition and heavily regulated, so it failed to capture the gains of the IT revolution.
Over the years Japan made various efforts at regulatory reform, from freeing up the energy market and mobile telephony in the mid-1990s to liberalising the financial sector in the late 1990s. These have borne some fruit. Japan’s total factor productivity growth, unlike Europe’s, began to improve after 2000. But coupled with the continuing weakness of investment, the reforms were too modest to bring about a decisive change in the country’s overall productivity prospects.
Sweden offers a more encouraging lesson. In the aftermath of its banking bust in the early 1990s it not only cleaned up its banks quickly but also embarked on a radical programme of microeconomic deregulation. The government reformed its tax and pension systems and freed up whole swaths of the economy, from aviation, telecommunications and electricity to banking and retailing. Thanks to these reforms, Swedish productivity growth, which had averaged 1.2% a year from 1980 to 1990, accelerated to a remarkable 2.2% a year from 1991 to 1998 and 2.5% from 1999 to 2005, according to the McKinsey Global Institute.
Sweden’s retailers put in a particularly impressive performance. In 1990, McKinsey found, they were 5% less productive than America’s, mainly because a thicket of regulations ensured that stores were much smaller and competition less intense. Local laws restricted access to land for large stores, existing retailers colluded on prices and incumbent chains pressed suppliers to boycott cheaper competitors. But in 1992 the laws were changed to weaken municipal land-use restrictions, and Swedish entry into the EU and the creation of a new competition authority raised competitive pressures. Large stores and vertically integrated chains rapidly gained market share. By 2005 Sweden’s retail productivity was 14% higher than America’s.
The restructuring of retail banking services was another success story. Consolidation driven by the financial crisis and by EU entry increased competition. New niche players introduced innovative products like telephone and internet banking that later spread to larger banks. Many branches were closed, and by 2006 Sweden had one of the lowest branch densities in Europe. Between 1995 and 2002 banking productivity grew by 4.6% a year, much faster than in other European countries. Swedish banks’ productivity went from slightly behind to slightly ahead of American levels.
All this suggests that for many rich countries the quickest route to faster productivity growth will be to use the crisis to deregulate the service sector. A recent study by the Bank of France and the OECD looked at 20 sectors in 15 OECD countries between 1984 and 2007. It found that reducing regulation on “upstream” services would have a marked effect not just on productivity in those sectors but also on other parts of the economy. The logic is simple: more efficient lawyers, distributors or banks enable firms across the economy to become more productive. The size of the potential gains calculated by the Bank of France is stunning. Getting rid of all price, market-entry and other competition-restricting regulations would boost annual total factor productivity growth by one percentage point in a typical country in their sample, enough to more than double its pace.
Getting rid of all anti-competitive regulation may be impossible, but even the more modest goal of embracing “best practice” would yield large benefits. The IMF has calculated that if countries could reduce regulation to the average of the least restrictive three OECD countries, annual productivity growth would rise by some 0.2 percentage points in America, 0.3 percentage points in the euro area and 0.6 percentage points in Japan. The larger gains for Europe and Japan reflect the amount of deregulation left to be done. In both cases the productivity gains to be achieved from moving to best practice would all but counter the drag on growth from unfavourable demography.
Even in America there would be benefits. But, alas, the regulatory pendulum is moving in the opposite direction as the Obama administration pushes through new rules on industries from health care to finance. So far the damage may be limited. Many of Mr Obama’s regulatory changes, from tougher fuel-efficiency requirements to curbs on deep-water drilling, were meant to benefit consumers and the environment, not to curb competition and protect incumbents. Some of the White House’s ideas, such as the overhaul of broadband internet access, would in fact increase competition. The biggest risk lies in finance, where America’s new rules could easily hold back innovation.
An unlikely role model
The country that is grasping the challenge of deregulation most energetically is Greece, whose debt crisis has earned it a reputation for macroeconomic mismanagement. Under pressure from the IMF and its European partners, the Greek government has embarked on one of the most radical reforms in modern history to boost its productive potential.
Again, this involves freeing up an historically cushioned service sector. So far the main battleground has been trucking. Before Greece descended into crisis, its lorry drivers required special licences, and none had been granted for several decades. So a licence changed hands in the secondary market for about €300,000, driving up the costs of everything that travelled by road in Greece. But under a reform recently passed by the Greek government, the number of licences is due to double. Greek lorry drivers went on strike in protest, but the government did not budge. Lawyers and pharmacists too are slated for deregulation.
If Greece can stick to its plans, it will, like Sweden, show that crises can offer valuable opportunities. Without the country’s brush with default and the conditions attached to the resulting bail-out, its leaders would have been unlikely to muster the necessary political will.
The sluggish progress of reform elsewhere underlines this point. Germany, which ranks 25th out of 30 OECD countries on the complications of its licence and permit system, approaches deregulation on tiptoes: it recently reduced restrictions on price-setting by architects and allowed chimney-sweeps easier market access.
Two French economists, Jacques Delpla and Charles Wyplosz, have argued that incumbent service providers should be paid off in exchange for accepting competition. They reckon that compensating French taxi drivers for deregulation would cost €4.5 billion. But buying off the losers from reforms may not hold much appeal.
Boosting European integration could be another way to cut through national resistance to deregulation. As Mario Monti, a former EU competition commissioner, pointed out in a recent call for action, 70% of the EU’s GDP is in services but only 20% of those services cross borders. The EU’s Services Directive, which is supposed to boost cross-country competition in services, has proved fairly toothless.
How governments can help
Activism on the part of governments is not always misguided. Their investment in basic research is important. The grants doled out by America’s National Institutes of Health, for example, generate the raw ideas that pharmaceutical firms turn into profitable medicines. America’s Defence Department created the beginnings of the internet. Public spending on building and maintaining infrastructure also matters, though economists argue about how much. Governments can encourage private R&D spending with tax credits and subsidies, and the evidence suggests that more R&D spending overall boosts growth. Other research shows that firms which spend more on R&D are also often quicker to adopt other innovations.
But these traditional ways of encouraging innovation may be less relevant now that research has become more global and more concentrated on software than on hardware. Since the mid-1990s China alone has accounted for a third of the increase in global spending on research and development. Big firms maintain research facilities in many countries. Dreaming up new products and services, as well as better ways of producing old ones, increasingly involves collaboration across borders and companies. As Mr Jorgenson of Harvard University puts it: “Think Google, not lab coats.”
In this more fluid world the old kind of government incentives, such as tax credits and subsidies, may do less to boost innovation than more imaginative inducements, such as offering firms prizes for breakthrough innovations. Bigger efforts to remove remaining barriers to collaboration, from limitations on high-skilled immigration to excessively rigid land-use rules, should also help.
A smart innovation agenda, in short, would be quite different from the one that most rich governments seem to favour. It would be more about freeing markets and less about picking winners; more about creating the right conditions for bright ideas to emerge and less about promises of things like green jobs. But pursuing that kind of policy requires courage and vision—and most of the rich economies are not displaying enough of either.