Jean-Claude Trichet: Productivity in the euro area and monetary policy
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, for the Special
Lecture at the 22nd Annual Congress of the European Economic Association, Budapest,
27 August 2007.
* * *
Introduction
I would like to start with a thank you to the organisers and to the President of the European
Economic Association for inviting me to participate in this conference. It is a privilege for me
to be here today, to discuss the recent productivity developments in the euro area and their
implications for monetary policy. I know that you represent la crème de la crème of the
profession. As an open-minded practitioner in front of so many distinguished scholars, I am
looking forward to learning a lot from your comments on my talk.
The slowdown in productivity growth in recent years represents one of the most important
economic developments in the euro area, a matter for concern for economic policy in
general, but also an important feature of the environment in which monetary policy operates.
I am going to begin my talk with an illustration of key elements of the European
developments since the mid-1990s, which are disappointing especially when viewed against
the benchmark of the strong U.S. performance over the last ten years. Various hypotheses
have been put forward to explain the missing productivity acceleration in Europe, in spite of
the similar diffusion of new technologies, especially Information and Communication
Technologies, on both sides of the Atlantic. I will discuss some of these tentative
explanations. Next, I will review the most recent productivity developments in the euro area,
which in the eyes of some might signal the possibility of an inversion of trend. Nevertheless,
the future remains shrouded in uncertainty and future developments are ultimately what
matters for monetary policy. In the last part of my talk I will discuss the challenges that
monetary policy faces in this context and the important role that other economic policies must
play.
Productivity growth: past trends
The facts
When comparing European and U.S. labour productivity growth over the post-WWII period,
measured by real GDP per hour worked, three phases can be identified (Figure 1).
In the first phase, immediately following the War, productivity growth was strong in both
economic areas, but especially so in Europe where it remained on average almost 3
percentage points above the 2.4 percent level in the U.S.. Thanks to this prolonged period of
catching-up growth, the large negative productivity gap separating the European economies
from the U.S. immediately after the War was substantially eroded in a couple of decades.
This period of strong growth in both output and productivity was interrupted in the early
1970s after the occurrence of - and according to some because of - the first oil shock. Once
again, however, the slowdown was a common trend across the Atlantic, and Europe
continued to perform better on average, with labour productivity growth rates of almost 3
percent over the period from 1974 to 1994, compared to just over 1 percent in the U.S.. As a
result, the catching-up process continued and the productivity gap was almost closed in the
first half of the 1990s, according to available estimates.
Over the past decade, however, euro area productivity growth has been disappointing. From
an average of 2.7% in the 1974-1994 period, it declined to just 1.3 percent in the years from
1995 until 2006. At the same time, the rate of productivity growth in the U.S. increased
strongly, from 1.4% to 2.1%, boosting significantly overall economic growth in the same
period.
By construction, labour productivity growth is the difference between the rates of growth of
output and the labour input. Euro area real output growth remained approximately constant
at around 2.2% between the 1974-1994 and the 1995-2006 periods, while U.S. output growth
rose from 2.9% to 3.3%. In light of the unchanged real output growth, the decline in euro
area average labour productivity growth is mainly due to a switch in the growth rate of total
hours worked from -0.4% in the 1974-1994 period to +0.9% in the years from 1995 to 2006.
This contrasts with a decrease in the growth rate of U.S. total hours worked from 1.6% in the
former period down to 0.9% in the latter. Faster output growth and slower labour input growth
have jointly contributed to increase measured labour productivity growth in the U.S..
These recent developments are in stark contrast to the rest of the post-WWII experience.
First, they represent a break in the process of European catching-up and a resumed
widening of the productivity gap with the U.S.. Second, the broad tendencies across the
Atlantic are no longer aligned, so we cannot explain them with the occurrence of a worldwide
adverse shock, such as oil in the 1970s. The roots of the European productivity slowdown
must be found within Europe.
I will discuss three main hypotheses. The first one is that European firms are not sufficiently
present in high-tech sectors. The second one is that firms in all sectors have not exploited
the benefits of the new technologies to their full extent. The third one is that the aggregate
euro area picture is misleading, because important differences exist across countries.
Before going into further details, however, I would like to underline the difficulties of
measuring productivity developments exactly and of comparing them across countries. Most
of the data I will discuss for the euro area have recently been made available in the so-called
EU KLEMS Growth and Productivity Accounts database, which was published on 15 March
2007. This database includes the first results of a two-year collaborative effort by researchers
based at 16 institutions across the EU to produce long and internally consistent time series
for output growth, employment, capital formation and total factor productivity, or TFP, at a
disaggregated industry level. This database, together with others developed under the
leadership of the Groningen Growth and Development Centre, provides extremely valuable
information for assessing structural trends in real output and labour productivity growth.
Nevertheless, the database remains subject to a number of caveats, as suggested by the
fact that it has not yet been clearly endorsed by national statistical institutes. More
specifically, international comparability across some dimensions remains difficult, for
example concerning measures of hours worked in the total economy. These difficulties are
magnified when discussing TFP, whose measurement is uncertain due to data limitations
which concern all factors of production, but are particularly severe for the capital input.
Measurement difficulties should be kept at the back of our mind when drawing conclusions
from the data.
First remark: Europe has less innovative firms
Given that the U.S. productivity performance has been ultimately linked to rapid technological
progress and the role of new information and communication technologies, the first
hypothesis to entertain as an explanation of the disappointing European performance is that
firms in the old continent have been lagging in the development of new technologies. In other
words, the U.S.-Europe difference in productivity should be found mainly in the
ICTproducing sectors, which have been driven by technological improvements at breakneck
pace in the U.S., and characterised by less innovative firms in Europe.
This hypothesis has some intuitive appeal. After all, industry giants such as Microsoft and
Google are in the U.S.. U.S. firms such as Apple are often viewed as epitomising
innovation,1 and the U.S. hosts some of the world's best brains in its top universities. There
is also evidence that, in spite of its small share in total production, the IT-producing sector in
the U.S. did contribute to a non-negligible extent to the post-1995 increase in aggregate
labour productivity growth, due to its double digit productivity growth rates.2
On a more general note, there are other signs of a worse innovation performance of average
EU countries compared to the U.S.. The European Commission, under the Lisbon Strategy,
has been monitoring the innovation performance of the EU Member States, compared to
other countries, for a number of years. Innovation performance is summarised in a composite
indicator, called Summary Innovation Index, which includes inputs ranging from the structural
conditions required for innovation and investment in R&D activities, to measures of results
achieved in terms of successful know-how. The latest report does indicate Danish, Finnish,
German and Swedish firms as world innovation leaders, with both high and fast-growing
scores in terms of the Summary Innovation Index.3 The performance of U.S. firms is slightly
below the leaders and at par with other European countries including France and Belgium.
That being said, on average EU countries do lag behind both the U.S. and Japan. And this is
true also in terms of a number of other crucial indicators.4 For example, Japanese
expenditure in R&D in 2004 was, in percent of GDP, twice as big as in the EU; in 2003, the
share of population with tertiary education was 38 percent in the U.S., compared to 23
percent in the EU and 30 percent in the Scandinavian countries; venture capital investments,
again as percentage of GDP, were in the U.S. in 2002 more than three times larger than in
Europe in 2005; finally, both the U.S. and Japan show a vastly superior performance in terms
of number of patents granted compared to the EU.
Nevertheless, differences in the ICT-producing sectors appear to be insufficient to explain
the bulk of the cross-Atlantic gap in aggregate productivity growth. There is a view, which I
will turn to next, that ICT-using sectors have also played a fundamental role in determining
productivity improvements in the US.
Second remark: U.S. firms are better able to exploit new technology
Over the years from 1996 to 2004, the labour productivity differential between the euro area
and the U.S. has characterised above all the standard, non-ICT-producing manufacturing
sector, and especially market services, including distribution, financial and business services
(Figure 2-3). These are also the sectors driving the decline in labour productivity growth in
comparison with the 1980-1995 period.
In the U.S. case, the increase in labour productivity growth over the 1996-2004 period was
more broad-based. With a few exceptions, most U.S. sectors show labour productivity growth
rates that are very significant, above 2% per year, and higher than in the 1980-1995 period.
This evidence is broadly in line with the hypothesis that information and communication
technologies have the largest impact on productivity growth indirectly, namely by sparkling
further innovations in managerial processes, procedures and organizational structures, and
by facilitating complementary innovations. For example, ICT reduces communication costs
and allows for more flexible and decentralized organizational structures. However, the full
benefits of the availability of new technologies can only be reaped if computers are adopted
as part of mutually reinforcing organizational changes.5 One of the slogans of the
organisational reengineering wave of the U.S. in the 1990s was: "Don't Automate,
Obliterate", to convey the need for breaking away from old business processes, rather than
just trying to speed them up.6
These effects are particularly difficult to measure at the aggregate level, but some studies
have suggested that the contribution from the use of information technology capital -
including computer hardware, software and communication equipment - accounts for almost
50 percent of U.S. labour productivity growth in the second half of the 1990's.7 This
contribution is associated with both increased real investments and declines in their
qualityadjusted prices.
The crucial role of ICT-using sectors is also confirmed by the analysis of TFP, which in
theory represents a pure measure of disembodied technological progress associated with the
use of all factor inputs. Table 1 reports a decomposition of euro area and U.S. value added8
growth for the market economy concept.9 The key factor behind the increase in real output
growth over the 1996-2004 period, compared to the years from 1980 to 1995, is in fact TFP
growth. In the 1980-1995 period, euro area annual TFP growth, at 0.4%, was not markedly
below the 0.7% level in the U.S.. The gap became much larger in the 1996-2004 period,
when euro area TFP growth increased only marginally to 0.5%, while U.S. TFP growth rose
dramatically to 1.6%. The euro area sectors in which TFP growth has declined most,
between the 1980-1995 and 1996-2004 periods, are manufacturing (excluding electrical
industry), distribution services, and financial and business services. The ICT-producing
sector is one of the few in which TFP growth exhibited a better performance in 1996-2004
compared with 1980-1995.
Third remark: it is important to analyse cross-country differences
The euro area is a large economic area made of many different countries. One may therefore
conjecture that the aggregate figures I have discussed so far conceal important
crosscountry differences, which should be taken into account for a correct interpretation of the
facts.
Once again, the EU-Klems project provides valuable information in this respect (Table 2). At
least with reference to the largest four euro area economies, namely Germany, France, Italy
and Spain, one can gauge to what extent developments in individual countries have
contributed to the labour productivity slowdown in the euro area as a whole.
Labour productivity growth for the total economy slowed down significantly in all four of these
euro area economies over the 1996-2004 period compared to the years from 1980 to 1995.
Over the 1996-2004 period, annual labour productivity growth ranged from a maximum of
1.7% in Germany and France to a minimum of 0.3% in Spain, but it remained in all cases
significantly below the 2.4% level in the U.S.. This downward trend has been particularly
marked in Italy and Spain, where labour productivity grew significantly below the euro area
average. When looking at the two components of labour productivity growth - real gross
value added and total hours worked - the figures reveal additional cross-country differences.
In Germany, the productivity slowdown has been driven by a significant reduction in real
output growth, while in France it mainly reflects a rise in labour input growth. In Italy, the
productivity downturn has been driven by both a significant drop in real gross value added
growth and a strong increase in labour input growth. In Spain, the slower pace in labour
productivity growth has been dominated by a stronger increase in labour input growth than in
real output growth.
By and large, while different EU countries have had somewhat different experiences, the
overall pattern is common. This conclusion remains valid looking at a sectoral breakdown.
For example, the labour productivity differential in favour of the U.S. has been larger in
market services than in manufacturing, even if in the case of France the deceleration was
rather modest, with annual labour productivity growth in manufacturing over 1996-2004 even
slightly exceeding that observed in the U.S. (3.3% in France compared to 3.1% in the U.S.).
The tendency towards a labour productivity slowdown in distribution services and financial
and business services is also common, although the deceleration was mild in the former
sector in the case of Germany - still exhibiting a labour productivity growth rate above 2% in
1996-2004 period. The ICT-producing industries in Germany, France and Italy failed to
exhibit a decline in labour productivity growth over the years from 1996 to 2004 compared
with 1980-1995 period, but a slowdown did occur in Spain.
Similar observations can be made for national developments in TFP, whose deceleration
between the 1980-1995 and 1996-2004 periods was broad-based across the four largest
euro area economies, even if more noticeable in Italy and Spain, where TFP growth turned
negative in recent years.
Possible interpretations
Overall, many causes probably contribute to explain the disappointing labour productivity
growth performance in euro area economies in comparison to the U.S.. A gap is visible in the
ICT-producing sectors, where U.S. productivity growth has increased at an especially fast
pace. However, the particularly poor labour productivity and TFP growth performances of
some ICT-using sectors, such as distribution services, and financial and business services,
appear to play a crucial role in determining aggregate outcomes.
Given the broad diffusion of ICT hardware and software in Europe, this evidence suggests
that the presence of structural rigidities prevents, or slows down the process of exploitation of
all the advantages of the new technologies in the lagging industries. Conversely, the more
flexible structural characteristics of the U.S. economy - a more flexible labour market, a
higher degree of competition in product markets and lower barriers to entry for new firms as
well as a more efficient capital market - have proved to be better suited for the challenges
and opportunities of technological innovation.
This intuition has been confirmed by a few studies of sectoral developments using a set of
indicators that measure differences in the regulatory restrictions of non-manufacturing
sectors of OECD countries.10 By and large, these studies find that highly regulated
environments tend to be associated with lower investment and productivity growth.11 A
simple way to illustrate the link is to relate differences between rates of growth of productivity
pre and post 1995 in various countries to an index of regulatory reforms. An obvious choice
is to focus on the OECD's "inward oriented" index of product market regulation, which
includes information on the degrees of "state control" and "barriers to entrepreneurship," but
abstracts from "barriers to trade and investment" (Figure 4). This simple, aggregate analysis
is nevertheless suggestive of the association between an anti-competitive regulatory
environment and poor labour productivity growth. More sophisticated studies based on these
data point out that the negative impact of regulation on productivity growth comes through
distortionary effects on investment and innovation, rather than merely through the
administrative costs it may entail.
We can therefore conclude that the degree of market regulation plays an important role to
explain the euro area performance. However, there are indications that it does not provide a
complete explanation. For example, it is not immediately consistent with evidence that firms
placed in the same regulatory environment have superior productivity performance, when
U.S.-owned.12 More importantly, the evidence of a negative influence of regulation on
productivity growth may appear to be inconsistent with a number of basic facts: a more
regulated environment did not prevent the superior European productivity growth
performance prior to the mid-1990s; the recent trend in Europe has been towards
deregulation; some of the countries which do not register an outstanding productivity
performance, such as the UK, have reached a stage of deregulation comparable to that of
the United States.
I believe that these apparent inconsistencies can be reconciled if we realise that the recent
productivity decline is a peculiar result of the coexistence of regulation and technological
innovation. While regulation has probably become less stringent in more recent years, it has
become more costly for firms in an era of rapid technological progress driven by ICT. Studies
have found a strong negative correlation between anti-competitive regulation and the
contribution of ICT-using services to productivity growth.13 The effect could come through
larger barriers to entry, which reduce competition and the incentive of incumbents to
innovate.14
Regulation may also have interacted with the tax system. An influential view on the poor
European performance builds on the observation I made at the beginning of my talk, that the
productivity slowdown is mostly associated with a sharp increase in the growth rate of hours,
for an unchanged growth rate of output. The rise in hours worked since 1995, and its
previous decline, have been relate to gradual increases in labour taxes until 1995, and to
reductions over the more recent period. According to this view, lower taxes on labour and the
introduction of labour market reforms since the mid-1990s have provided incentives for firms
to hire a larger number of lower skilled workers.15 This hypothesis would also help explain
the faster labour productivity growth in the European Union until 1995 in spite of the high
regulatory environment.
especially in the long run. G. Nicoletti and S. Scarpetta (2003), "Regulation, productivity and growth,"
Economic Policy, April, find that various measures of anticompetitive product market regulations significantly
reduce TFP-growth at the industry level.
12
N. Bloom, R. Sadun and J. Van Reenen (2007), "Americans do I.T. better: U.S. multinationals and the
productivity miracle," NBER Working Paper No. 13085.
13
G. Nicoletti and S. Scarpetta (2005), "Regulation and economic performance: product market reforms and
productivity in the OECD," OECD Economics Department Working Paper No. 460.
14
E.g. P. Aghion, N. Bloom, R. Blundell, R. Griffith and P. Howitt (2005), "Competition and innovation: an
inverted U relationship," Quarterly Journal of Economics 120, pp. 701-28.
15
I. Dew-Becker and R. J. Gordon (2006), "The slowdown in European productivity growth: A tale of tigers,
tortoises and textbook labor economics", presented at NBER Summer Institute Macroeconomics and
Productivity Workshop.
BIS Review 94/2007
Despite the large number of papers published in recent years, more research efforts are
needed to better understand the sources of the European productivity performance in the
past decade. These difficulties are magnified when trying to gauge future trends.
Productivity growth: current trends
In conjunction with the cyclical recovery, euro area labour productivity growth per person
employed has been gradually increasing since 2005. From a trough of 0.2% year on year in
the first quarter of 2005, it slowly climbed to 1.2% in the third quarter of 2006, then to 1.7% in
the first quarter of 2007. A notable feature of these recent developments is that the increase
in productivity growth occurred at the same time as an increase in employment, which
contrasts with the average experience of the 1995-2006 decade and might, in the eyes of
some, be a first sign of structural improvement.
At the sectoral level, the recent, favourable labour productivity performance has been mainly
driven by positive cyclical developments in industry excluding construction. In this sector,
labour productivity growth has steadily increased since 2004, reaching 4.1% year on year in
the first quarter of 2007. In contrast, annual labour productivity growth in services has not
improved as much, even if it also rose slightly.
These encouraging signs must be weighted against the fact that data based on productivity
per hours worked show a less spectacular improvement in 2006. Since only yearly data on
hours are available for the euro area, we will need time to understand whether changes in
working time distort the interpretation of quarterly data on productivity per employed person.
The problem at this point in time is to determine whether the recent improvements in
productivity growth do, or do not, represent the beginning of an inversion of the declining
trend observed of the last decade. Let me just note, incidentally, that once again these
developments are taking place out of phase compared to the U.S., where the growth rate of
labour productivity in the non-farm business sector has since 2004 been slowing down from
the exceptionally rapid pace of the previous decade. In spite of its deceleration, however,
labour productivity seems to have continued to benefit importantly from investment in new
technologies, even if the contribution from capital deepening has been smaller in recent
years than it was during the capital investment boom of the late 1990s. This is one of the
reasons suggesting that the recent U.S. slowdown in labour productivity may be, at least
partly, a cyclical response to the moderation in the pace of economic activity in 2006, rather
than a meaningful downshift in the longer-run trend.
Recent developments: structural or cyclical?
Identifying changes in trend productivity growth is always difficult in the midst of an
expansion, because productivity growth is well-known to be subject to cyclical variations: it
tends to be below its longer-term trend when the economy is contracting and above that
trend when the economy is in the early stages of an expansion.
This property can be described more concretely with reference to the euro area experience
during the cyclical upswing of year 2000. After years of sluggish performance compared to
the U.S., many conjectured that the euro area economy would also experience a revival in
trend productivity growth. These conjectures led international institutions to revise upwards
their estimates of potential output growth in the euro area.
With hindsight, that assessment was overoptimistic. The revisions in the first available
projections for the years 1999 to 2004, typically published one to two years ahead by the
OECD and the European Commission and one to five years ahead by the IMF, were always
negative and on average equal to between -0.3% and -0.4%. Moreover, for 1999 to 2002, the
ranges of first available projections published by the Commission, the IMF and the OECD do
not overlap with the ranges of the latest estimates by the same international organisations
(Figure 5).
From the viewpoint of this recent experience, it is only natural to be cautious about the future.
After all, we attribute a lot of the discrepancy between the European and U.S. performance in
labour productivity growth to different rates of growth of TFP, namely of an unobservable
factor whose evolution over time is particularly difficult to forecast. Are the structural reforms
carried out in past years sufficient to at least stop the European productivity decline, if not to
foster a technological revival? Have European firms learned to exploit the potential of the
ICT-revolution to its full extent?
At the same time, one should not extrapolate the recent past indefinitely and fail pray of the
view that the European countries are ultimately doomed, because definitely unable to cope
with the challenges of globalisation and technological innovation. After all, the U.S.
productivity revival appeared late in the cycle, years after the beginning of the expansion of
the 1990s. The overall expansion did not appear to conform to previous cyclical norms. The
rate of growth of GDP and investment in non-residential structures increased very slowly in
the initial years of the 1990s compared to previous, prolonged expansions, in the 1960s and
1980s. Investment in information technology also took a while to accelerate, even if it then
reached levels far above those of other European countries.16
In practice, we base the real-time assessment of trend versus cyclical components in
productivity growth on a wide set of indicators, including time-series techniques, which
attempt to filter from the data the unobservable time-varying trend in productivity growth, and
other relevant information.
All methods tend to suggest that the recent pick-up in productivity growth is probably not
erratic. It has proved to extend also to the services sector, which had remained particularly
sluggish in the past. Survey measures also appear to be supportive of the hypothesis of a
somewhat improved outlook for future productivity growth, even if their results have turned
less optimistic over 2006.17
At the same time, the recent rate of growth of labour productivity is not exceptionally high
compared to previous cycles. Similar growth rates were observed during cyclical peaks in
1997-98 and in 2000. Recent estimates of TFP-growth are also not particularly buoyant and
the contribution to labour productivity growth from capital deepening has been non-negligible
over the 2004-2006 period. This pick-up in investment activity is often interpreted as a sign in
favour of the view that the improvement in labour productivity growth is associated with
cyclical developments.
According to time-series estimates, the trend component of the rate of growth of output per
hour stabilised in the last few years, after a steady decline from the high levels of the
seventies. There are, however, no clear signs of improvement in the trend, and one needs to
bear in mind that these measures are surrounded by considerable statistical uncertainty.
At this stage, all taken into account, my provisional assessment would be that the most
recent pick up in labour productivity remains of a cyclical nature and that it is too early to
judge whether, on top of this cyclical improvement, we are starting to observe a structural
change that will be sustained over many years to come. That is not to say that I exclude this
possibility: the creation of the single market for goods and services, the implementation of
financial integration, the completion of the reforms that are part of the Lisbon agenda and the
pursuit of the reengineering of production processes associated with ICT investments and
globalisation should all foster labour productivity and total factor productivity in the euro area.
They should! But we do not have evidence yet that substantiates this hypothesis.
Policy implications
I have so far discussed possible determinants of past trends in euro area productivity growth
and the outlook for future productivity developments. Yet, to what extent are these
developments relevant for monetary policy?
At the European Central Bank we can provide a very clear answer. Our mandate is to
maintain price stability over the medium term and we have clarified that price stability is to be
interpreted as a rate of increase in the Harmonised Index of Consumer Prices for the euro
area below but close to 2 percent. Hence, developments in productivity growth are relevant
for the monetary policy of the ECB to the extent that they have an influence on medium term
deviations from price stability in the HICP for the euro area.
What are the potential risks to price stability in the medium term coming from productivity
developments? Some would give very simple and straightforward replies. One view would
suggest that the simple quantity equation tells us that trend money growth should be
adjusted so as to accompany the changes in output growth, whether up or down, triggered
by the change in productivity developments. All other things equal, the monetary policy
stance should be, according to this view, looser if there is an increase in trend productivity
growth and tighter in the reverse case.
Another view would stress that standard growth theories tell us unambiguously that, in the
long run, equilibrium real interest rates move proportionally to trend productivity growth.
Assuming that long run inflation expectations are firmly anchored, changes in equilibrium real
rates should spill over one-to-one into changes in the equilibrium nominal interest rate. Other
things equal, the policy interest rate will eventually move up, if there is an increase in trend
productivity growth, and down in the reverse case.
A naïve interpretation of the suggestions for policy action stemming from these two views
would come to the conclusion that they are somewhat contradictory. Let us see how we
should reason as a policy maker in practice.
Monetary policy implications of a known change in productivity growth
As is often the case in economics, matters become particularly complex when we move to
analyse higher frequencies. In the short run, whether productivity developments exert
positive or negative pressure on inflation will depend on their net effect on aggregate
demand and aggregate supply.
A productivity slowdown will in fact tend to produce two competing effects. The first effect,
which can be denoted as supply effect, derives from the lower potential output growth
associated with the productivity slowdown. For a given level of aggregate demand, the fall in
potential output will tend to be such that actual output