Lorenzo Bini Smaghi: Growth and inflation in the euro area - the
importance of productivity in the services sector
Keynote speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the
European Central Bank, at the Ludwig Erhard Lecture, Brussels, 28 October 2008.
* * *
1. Introduction1
I would first like to thank the organisers for inviting me to give the "Ludwig Erhard Lecture"
this year. It is both a privilege and a pleasure for me to be here today. I would like to discus
an issue - productivity in the services sector - which might seem a bit disconnected from the
pressing economic and financial situation we are currently experiencing. I will try to show
that, on the contrary, the issue is quite relevant for the conduct of economic policies and the
prospects for recovery of our economy.
In my speech today, I'd like first of all to explain why services productivity matters to
monetary policy. Then I'll look at a few facts on labour productivity performance and the links
between productivity and inflation in the services sector. Finally, I'll consider the policy
responses, particularly in the field of structural reforms.
2. Services productivity and monetary policy
Productivity in the services sector matters not only to each and every one of us as
consumers. It is also important for central banks in general, and for the ECB in particular. Let
me mention three key dimensions in this respect. The first two dimensions have to do with
the nexus between productivity and inflation, both from a longer-term and a cyclical
perspective.
Over the longer term, in a world of rising commodity prices other components of inflation
need to grow more slowly, if at all, for overall inflation to be in line with central banks'
objective to maintain price stability. Since energy and food account for over 30% of the
consumer price index in advanced countries, it is simple arithmetic that inflation in
manufacturing and services should increase at a pace well below the definition of price
stability, which in the euro area is close to, but below 2%. For manufacturing goods this has
been the case over the past decade, but not so for services prices. Limited competition and
poor productivity growth have been at the root of services price inflation remaining at a pace
that is not consistent with price stability over the medium term, as I will argue in more detail
later.
Second, from a more cyclical perspective, poor productivity growth may exacerbate the effect
of negative supply shocks and, more generally, tends to intensify growth slowdown. Low
productivity growth reduces potential output growth and makes it more likely, ceteris paribus,
that negative supply shocks will lead to very low growth or even a recession, at least
temporarily. This might, on the other hand, also reduce the equilibrium level of the real
interest rate.
Poor productivity growth also prevents inflation from falling adequately when growth is
slowing, by keeping unit labour costs excessively high. A high degree of nominal price and
wage rigidities slows down the response of the economy to exogenous shocks, thus making
the economy less resilient and the adjustment process less efficient. As a consequence, the
transmission of monetary policy is affected in important ways - mainly by decelerating the
pass-through of nominal interest rate changes to final demand and prices. Poor productivity
growth creates inertia in both wage and price inflation and slows down the process by which
the economy returns to its natural level of activity, thus making the task of monetary policy to
ensure price stability more complicated.
In the presence of structural rigidities, the central bank has to delay monetary easing when
faced with a negative supply shock because of the persistence of inflationary pressures even
during the downturn. We are currently experiencing this problem in the euro area, as the
persistence of strong underlying wage dynamics in nearly all countries, in spite of the
slowdown, has maintained pressure on the underlying dynamics of inflation. In the second
quarter of this year, for instance, in spite of the overall negative GDP growth, nominal wages
have increased by 3.5% and unit labour costs by 3.2%. This has contributed not only to
sustain higher inflation but also to increase unemployment, especially in countries with
indexation.
Finally, differences in productivity growth largely explain the divergences in price and costs
dynamics experienced within the euro area over the last decade. These divergences do not
have a direct impact on monetary policy, since the latter is targeted to the euro area as a
whole, but rather on the ability of some countries to sustain economic growth over time.
Countries accumulating losses of competitiveness, because of lower productivity growth, will
have to catch up over time either through a relative pick up in productivity or through lower
rates of growth of wages, which will have a negative impact on growth. In this respect,
structural reforms may help to reduce cross-country differences in key regulations and
institutions, and thus align adjustment processes across countries. In fact, recent research
on the intra-euro area impact of structural reforms shows that the variance of the responses
of national outputs to an interest rate tightening would be - at the peak and after the
implementation of such reforms - roughly one-sixth of the level that it achieves in conditions
of cross-country heterogeneity in terms of price and wage rigidity.2
3. Key features of past productivity growth
When comparing the euro area's economic performance with that of the US over the longer
term, there is evidence of clear underperformance in output growth. Since 1995, the annual
growth rate for the euro area has averaged 2.2% per year compared with 3.1% in the US.
One of the main reasons for the euro area's disappointing performance is the low trend
growth in labour productivity. Between 1980 and 1995, hourly labour productivity in the euro
area grew on average by 2.3%, and between 1995 and 2007, it grew by only 1.3%. In the US
over the same periods, the figure went from 1.2% to 2.1%.3
Understanding developments in services is crucial to our understanding of developments in
the economy as a whole. Services account for 69% of the euro area economy and 70% of
total employment.4 Private sector services represent roughly half of the economy, and
government-related services make up the rest. And it's the private sector services that mainly
account for the gap in labour productivity growth between the euro area and the US. From
1995 to 2005 their hourly labour productivity in the euro area only grew by 1.0% compared
with 2.9% in the US. Of the private sector services, distribution services, including the
wholesale and retail trade sector, have been the main reasons for the gap, followed by
finance and business services (excluding real estate). In the wholesale and retail trade
sector, for instance, hourly labour productivity grew on average by 1.4% in the euro area,
while it grew on average by 4.6% on the other side of the Atlantic.
What lies behind these labour productivity developments?
Specific policies aimed at increasing employment, particularly in the unskilled segment of the
labour market, have certainly contributed to the slowdown in labour productivity growth,
especially in services, which are usually more labour-intensive. However, developments in
labour supply are only part of the story. To a large extent, the slowdown in labour productivity
growth can be attributed to a marked slowdown in total factor productivity (TFP) growth,
which is generally taken as a measure of technological progress and improvements in the
organisation and overall efficiency of production. Between 1980 and 1995, TFP for the whole
economy grew on average by 1.5%, before declining to 0.8% between 1995 and 2007.5 And
private sector services significantly contributed to this decline. Indeed, TFP growth in these
services slowed down from 0.6% between 1980 and 1995 to -0.1% between 1995 and
2005.6
Several authors, such as Oliner and Sichel (2002), have already highlighted the major role of
innovation and information and communications technology (ICT) in the revival of labour
productivity growth in the US.7 Moreover, it has been argued that the effect of ICT
dissemination, as measured by ICT investment, has been particularly important in explaining
the differences in labour productivity growth developments in some market ICT-using
services sectors between the euro area and the US. Since the early 1980s, investment in
ICT in the United States has been double that of the euro area.8 Basu and others (2003) find,
for instance, that industries with faster growth in ICT capital in the 1980s and early 1990s
had faster TFP growth rates in the late 1990s.9 It seems that the ICT investments in some
private sector services in the US have sparked further innovations in managerial processes,
procedures and organisational structures, and facilitated complementary innovations. The full
benefits of the productivity acceleration however can only be reaped if there are no obstacles
to organisational change.10 In this regard, the structural characteristics of the euro area
economies - as reflected by labour market rigidities and the lack of competition in product
markets - did not allow European firms to exploit the benefits of new technologies to their full
extent.
4. Productivity and the single market
For the ECB, long-term growth prospects matter, but our main focus is of course on inflation
developments. Let me therefore now turn to the role of productivity in shaping inflation
5
Source: European Commission.
6
EU KLEMS database.
7
See Oliner and Sichel (2002), "Information technology and productivity: where are we now and where are we
going?" Federal Reserve Board. See also Jorgenson, D., M.S. Ho and K. Stiroh (2002), "Information
Technology, Education, and the Sources of Economic Growth across U.S. industries", mimeo.
8
ICT investment represented roughly 3% of GDP in the United States compared with 1.5% in the euro area
over the period 1980-2005 (source: OECD productivity database).
9
Basu, S., J. Fernald, N. Oulton, and S. Srinivasan. 2003, "The Case of the Missing Productivity Growth: Or,
Does Information Technology Explain why Productivity Accelerated in the United States but not the United
Kingdom?", NBER Macroeconomics Annual.
10
See for, example, van Ark, Bart and Inklaar, Robert, 2006, "Catching up or getting stuck? Europe's troubles to
exploit ICT's productivity potential", GGDC Research Memorandum GD-79, Groningen Growth and
Development Centre, University of Groningen.
BIS Review 130/2008
dynamics and some characteristics of inflation in services more generally. I will touch on
inflation at an area-wide level, but also - and mainly - on inflation differentials within
Monetary Union.
At an area-wide level, unit labour costs resulting from wage and productivity developments
are a key predictor of inflation. Wage increases not covered by productivity gains push up
production costs, which eventually add to price pressures. When looking at price
developments across sectors, it appears that in the euro area, the prices of services have
increased faster than the prices of goods over the last two decades. Evidence of this inflation
gap can be found by looking at the main HICP components and gross value added deflators.
For instance, when using the GDP deflator at factor cost, inflation in private sector services
has been on average 0.8 percentage points higher than in the manufacturing sector.11
Similar developments have been found for the US and other industrialised economies, but
the gap in the euro area has been more persistent than in the US. The persistent divergence
between services and goods inflation in the euro area clearly reflects a weakness in
productivity growth in services activities.
Turning to individual euro area countries, several ECB studies show that the differences in
unit labour cost developments across individual euro area countries have also clearly been
associated with differences in their HICP inflation rates over the last ten years.12 Countries
such as Greece, Ireland, Italy, Luxembourg, the Netherlands and Spain, which, over the
period, had above-average unit labour cost growth rates also recorded higher-than-average
inflation rates. When looking more closely at the contribution of wages and productivity, at
the aggregate level, to the cross-country differentials in cost competitiveness - as captured
by unit labour costs - we see that much of it can be explained by developments in
compensation per employee. However, in several cases which have experienced major
competitiveness losses, lacklustre productivity growth has been an important factor
contributing to this loss. This holds as well for sectoral cost competitiveness. For instance,
over the last ten years, the gap in labour productivity growth between manufacturing and
private sector services has been more than twice as high as the gap for the average growth
in compensation per employee. The stronger increase in unit labour costs in private sector
services relative to the manufacturing sector has therefore been largely driven by the relative
weakness of labour productivity growth in those services in the euro area.
Inflation differentials across sectors and countries have of course a number of causes and
cannot entirely be attributed to productivity gaps. One important element is the degree of
competition to which a sector is exposed and its impact on prices. In this respect, remaining
institutional restrictions on services sector competition not only go hand in hand with low
productivity performance, but also with higher profit margins and more price stickiness. For
instance, even though caution is required when interpreting mark-ups, it is worth mentioning
that over the last 20 years (1981-2004) mark-ups in private sector services, defined as the
price to marginal cost ratios, were 1.56 in the euro area compared with 1.36 in the United
States and 1.18 in manufacturing and construction sectors in the euro area and 1.28 in the
US.13
Finally, extensive empirical research on price flexibility and inflation persistence shows that
the frequency of price changes in a given month in the euro area is considerably lower than
in the United States. Prices change infrequently in the euro area and with notable differences
across sectors. In the services sector - which is my main focus tonight - less than 6% of all
retail prices change every month, a fact which points to a frequency of price adjustments that
is lower than in every other sector of our economy, and less than half of the comparable
frequency in the United States. Of course, this lack of flexibility in euro area services prices is
probably a faithful reflection of the relatively low degree of competition and integration,
implying that the burden of adjustment in response to an unfavourable shock falls
disproportionately on changes in output, income and employment.
Having pointed out these features of productivity, inflation and competitiveness
developments, I'd now like to consider how long-term economic performance can be
improved.
5. The policy responses: strengthening structural reforms for long-term growth
Structural rigidities are widely held to be the main reason for Europe's weaker productivity
performance compared with the United States and with some other advanced industrialised
economies. Let me point to three key policy areas where further reforms could help to spark
medium to long-term productivity growth.
First of all, Europe needs more flexible labour markets. Indeed, in a context of rapid
technological change, it is essential to ensure that human capital can be adjusted to labour
market needs, so that the labour force remains employable and flexible. A high level of
employment protection legislation may have a particularly strong negative impact on
industries experiencing rapid technological change, since it may prevent the efficient
matching of workers to jobs.
Second, increasing competition by establishing efficient and well-functioning product markets
is also fundamental. Many studies point to the potential of competition to boost productivity
trends by improving production efficiency and enhancing the incentive to invest and innovate.
Nicoletti and others (2006)14 find, for instance, that restrictive product market regulations
slow the process of adjustment through which best practice production techniques spread
across borders and new technologies are incorporated into production processes. This
suggests that remaining cross-country differences in product market regulation can partially
explain the recently observed divergence of productivity in OECD countries.
In this respect, the Single Market has already yielded major benefits for the European
economy.15 In telecommunications, for instance, now largely or fully open to competition,
labour productivity growth has significantly accelerated, from 4.4% between 1980 and 1995
to 7.4% between 1995 and 2005 and telephone prices charged by the former monopolies for
national and international calls were reduced by more than 40% on average in Europe
between 2000 and 2006. The extension and deepening of the internal market remains
however a priority as regards the pursuit of effective competition in the energy market, the
implementation of the Services Directive and further financial market integration.
Third and finally, to fully exploit productivity potential, the labour and product market reforms I
have mentioned need to be accompanied by policies which unlock business potential, by
action to support innovation through higher investment in research and development, and by
measures aimed at improving human capital.
Europe needs more new and dynamic firms willing to reap the benefits of opening markets
and to pursue creative or innovative ventures with a view to large-scale commercial
exploitation. Notably, it is new and smaller firms, rather than large ones, that are the job
creators. An entrepreneur-friendly economic environment would imply less red tape for small
and medium-sized enterprises, and help them to develop at home and abroad, as well as
easier access to the finance they need. Europe is significantly lagging behind in this field; its
venture capital financing, for instance, remains only a fraction of that in the US, relative to the
size of its economy.
Research and development as well as human capital make also valuable contributions to
total factor productivity growth. Moreover, meeting the challenges of innovation and its
dissemination as well as ensuring the labour force's employability and flexibility requires
improved education and training, as well as lifelong learning. However, investment in human
capital in Europe is still clearly inadequate for a "knowledge-intensive" economy. Europe still
needs to enhance the quality and efficiency of its schools and universities as well as to
increase incentives for all relevant parties, including firms, to invest in human capital.
In this connection, let me now focus more specifically on the financial services sector which
is, within the services sector, probably the most important and, in some sense, problematic
component. For the ECB, financial integration is essential, given its relevance to the conduct
of the single monetary policy. And it is gradually taking place across Europe, with
considerable progress having already been made. The degree of integration, however, varies
across market segments, and integration is generally more advanced in those market
segments which are closer to the single monetary policy. While the euro area banking
markets for wholesale and capital market-related activities have shown clear signs of
increasing integration since the introduction of the euro, the retail banking segment has
remained more fragmented, leaving European firms and consumers unable to take full
advantage of Economic and Monetary Union (EMU) and the Single Market. The current
extraordinary conditions in financial markets should provide a unique opportunity for
overhauling the architecture of financial markets not only worldwide, but also within the EU
and EMU.
Many would argue that embarking on such reforms is probably easier said than done. And
European policy-makers, notably in the euro area, seem to take for granted that the
electorate will punish them for bold reform in product and labour markets. This may explain
why progress in the euro area has been comparatively limited. However, a recent paper from
the Commission (Buti et al. 2008)16 suggests that fear of electoral backlashes may be
unfounded. Moreover, as I argued earlier, without reforms the economic costs in terms of
output and job losses will be increased, and monetary policy will be forced, sooner or later, to
react more forcefully to continued upward price pressures. Renewed efforts to raise
productivity - also in the services sector - can reduce inflationary pressures, raise real
income and strengthen the resilience of our economies to the global shocks in the financial
system and commodity prices which we are experiencing.
5. Concluding remarks
Ludwig Erhard was prized for his courageous policies, which were based on the principles of
free competition, flexible prices and open markets. On many occasions he stressed the
importance of price stability. In my view, these principles still act as guideposts, helping
Europe to cope with the shocks facing the global economy by maintaining sound and stable
macro-economic policies, to support flexibility and innovation, and to continue with structural
reforms. In this respect, the thoughts I have shared with you here today confirm that his
ideas remain valid for our times. Europe must strive to deliver growth, jobs and low inflation
consistently over time under the Lisbon Strategy for Growth and Jobs, which aims to make
Europe fit for the future.
One might be tempted to think that this long term agenda may not fit quite well with the
shorter term challenges that we are currently facing, which is to get out of the current crisis. It
would be a mistake. We have seen that some of the causes of the current crisis lie in the
inappropriate functioning of certain markets, notably the financial sector. We also noted that
the rigidities in the labour and product markets weigh on the ability of economic policies to
effectively address some of the shocks that we are currently experiencing. In particular,
monetary policy in the euro area is constrained by the rigidities in the labour markets that risk
dis-anchoring expectations of price and wage setters. This is the reason why, even in the
current deteriorating economic conditions, monetary policy has to continue to be framed
within the established ECB strategy in which the primary objective of monetary policy is price
stability. If this was not the case, monetary easing could be perceived to be the result of a
change in priorities by the ECB, in favour of economic growth or financial stability rather than
price stability. Economic agents could expect that monetary policy would now be ready to
accommodate higher inflation expectations, under the form of higher nominal rates of return
or higher wages. This would lead to much worse macroeconomic results over the short and
medium term.
Going forward, the stance of monetary policy will continue to be adapted on the basis of the
primary objective of price stability - a rate of inflation close but less than 2%. The stronger is
the underlying growth of productivity, especially in the services sector, the higher are the
prospects to achieve such a target, the greater the room for manoeuvre for monetary policy
to adapt to the weakening of economic conditions. The current economic difficulties do not
justify any stop, or reversal of reforms. On the contrary, it's time to accelerate them.
Thank you very much for your attention.