A question of structure: Explaining the divergence of growth in the OECD area

A gap appears to have opened up between the economic growth performances of North America on the one hand and Europe and Japan on the other, with the US in the lead. This divergence may be a more serious issue than some believe. It is time to act.

Searching for the sources of growth is a never-ending activity. But it has recently gained a lot more importance for policymakers across the OECD. We are now at the end of a long and exuberant business cycle. The dust is settling. And many Europeans are now coming to the full realisation that, yes, economically speaking, North America and continental Europe may be growing apart. For large European countries, GDP per capita stopped converging to US levels in the 1980s. And it probably backtracked during the 1990s. The same conclusions apply for Japan (see graph).

It also appears that within Europe, starting in 1995-96, growth differentials between big countries have become relatively wide, not so much in manufacturing, but in the non-traded sector. In addition, Nordic countries have tended to forge ahead of their major European neighbours.

At the OECD, we find these developments rather disturbing. Why? Because we think this diversity of performance stems primarily from costly policy failures in some OECD countries, failures that, if allowed to persist, would undermine growth and prosperity.

It is the OECD’s core mission, our raison d’être, to spread success and good practice. To nudge “reform-shy” countries into reform mode and help them unblock potential and improve their economic performances. So, we have been working hard at answering some key questions. What’s driving the good performers? And, what is holding back the others? Indeed, the OECD has spearheaded a vast research effort to address these issues over the past few years. The exercise culminated in March with the publication of a book, The Sources of Economic Growth in OECD Countries (see references).

The main messages are straightforward.

1) At the OECD, we strongly believe that growth differentials over the past decade have been deeply structural in nature. The key culprits have been: diverging demographics stemming from ageing and immigration and the stalling over the 1980s and 1990s of the process of convergence in GDP per capita that began after the Second World War.

In many OECD countries, convergence has been impaired by the inability to achieve both full employment and optimum productivity levels. This diagnosis is becoming increasingly consensual, though acknowledgement has been slow to come and in the meantime many good opportunities have been lost.

It would be an extreme exaggeration to say that the Europeans and Japanese have forgotten about structural issues over the past decade or so. Nordic European countries are, for instance, star performers, awash with the latest information and communication technologies, good jobs and innovative companies. And all of this combined with a willingness to modernise and strengthen the welfare state. In many European countries, good progress has also been achieved in raising employment rates.

But too often macroeconomic issues have overshadowed other concerns. Quite understandably, Europeans have been absorbed by discussions of fiscal and monetary issues in the run-up to monetary union, and again during the current slowdown, with a view to determining whether in Europe macro policies were flexible enough.

These considerations are important and legitimate. Insufficiently flexible macro policies can help explain to some extent why the euro area has over-reacted to the US slowdown. Europe, which was only mildly overheating at the peak of the cycle, should not have followed the US downturn so closely. But from a long-term growth accounting perspective, it appears that over the past decade, the growth gap between the US and Europe has not had much to do with cyclical issues. Indeed, ten years ago, Europe and North America shared the same cyclical position. And this will be the case again in 2003.

To explain the growth divide between the two sides of the Atlantic we therefore have to rely on long-term factors. The same conclusion applies also to the transpacific gap that divides Japan and the US. To underscore the magnitude of these long-term growth differentials, I usually cite the 3-2-1 rule: 3% trend annual growth for the US; 2% for Europe; and 1% for Japan.

There is, of course, nothing wrong in theory with different growth rates, provided they reveal a kind of social optimum. Preferences for leisure or risk-taking might be different, for instance, between Europe and North America. To give an example, Europeans may well prefer more free time to higher incomes. But our research suggests that the current state of affairs is very often suboptimal and largely reflects misguided policies.

Better policies could actually increase welfare and restart lagging economies. If Europeans were, for instance, to correct the highly skewed incentives that govern their pre-retirement and pensions systems, the future of welfare and employment would both be greatly improved.

2) Where should the action take place? In Europe, the priority should be to allow employment rates to rise, while in Japan productivity should be enhanced. Europeans should not be too complacent about productivity either, since their good productivity figures often reflect the fact that less productive workers have been priced out of jobs. In many European countries, more competitive product markets would provide a boost to productivity through better innovation and the diffusion of IT.

3) The OECD’s contribution to the policy agenda is both rigorous and level-headed. Structural policy is easy to advocate, but often costly to execute. So, if you want to challenge the status quo, you have to show that inaction, too, has a cost. Actually, a better title for our book on the sources of growth may well have been “The Cost of Inaction”.

At the OECD we have worked hard to connect policy and growth, not only through solid analysis, but also through actual numbers. Orders of magnitude are useful tools of persuasion. In other areas, we have tried to be innovative and push back the frontiers of research.

More concretely, The Sources of Economic Growth has two dimensions: the first dimension is a growth-accounting exercise, to provide a broad overview of how the main components of growth have developed over time; the second dimension consists of a large-scale econometric analysis, using panel data, that looks at three successive layers: aggregate national data, industry level data, and firm level data.

One major contribution was the construction of a set of indicators to measure the stringency of the regulatory framework on product and labour markets. These data were then ready to be injected into our econometric analysis, to see whether structural policies had an impact on productivity growth, and assess its magnitude.

We first estimated the effects of macro policies on economic performance: stable and low inflation, lower taxes, and openness to trade are all found to have a significant impact on long-term growth.

At the industry level, we tried to see how regulatory stringency in product and labour markets affects productivity and growth outcomes. And we found that, yes, having a light regulatory touch and allowing competition to develop were good for growth. We found, for example, that the liberalisation of product markets could increase productivity by as much as 10% in those sectors which lag behind.

Finally, we have our firm-level analysis. Here we find that new firms in the US start small compared with Europe. But the successful US start-ups grow very quickly. As we all know, administrative set-up costs in the United States are relatively low, while labour market regulations are relatively light. Thus, it is comparatively easy to start a business. And, for successful ventures, the cost of expanding the workforce is lower.

Of course, we should not be too glowing about US entrepreneurship. The current downturn is exposing past excessive exuberance. It is also clear that US corporate governance is not perfect. However, we should not forget the contribution US-style entrepreneurship has made to innovation and the diffusion of technology in recent years.

The OECD has a long-standing commitment to economic reform dating back to the Marshall Plan. Today we would like good growth performances to spread a lot more widely across the Atlantic and the Pacific.

We are all well aware of the diplomatic frictions OECD countries are currently experiencing. It would be unfortunate if another decade of diverging economic fortunes were to add to this geo-strategic divide. We could end up in a situation where we don’t even share the same kinds of economic problems as each other.

But our current difficulties should not be a source of discouragement. On the contrary, they should lead us to intensify our dialogue in order to promote a common agenda for growth, both at the OECD and the G8. Indeed, let our work of restoring convergence begin in late April, when OECD economics and finance ministers set about trying to close the gaps. Our common economic futures depend on it.

References

OECD (2003), The Sources of Economic Growth in OECD Countries, available from the OECD bookshop and online (see links below), where more on the OECD’s extensive work on the sources of economic growth can be consulted.

The OECD’s new “Policy Agenda for Growth”, together with related presentations by Jean-Philippe Cotis, is available online (see link below).

©OECD Observer No 237, May 2003




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