[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 31.10.2007

SEC (2007) 1444

COMMISSION STAFF WORKING DOCUMENT Accompanying document to the COMMUNICATION FROM THE COMMISSION

Raising productivity growth: key messages from the European Competitiveness Report 2007 {COM (2007) 666 final}

TABLE OF CONTENTS

Executive summary 6

Introduction 15

A. General developments 17

1. Key facts about competitiveness developments: growth, employment and productivity 17

1.1. Introduction 17

1.2. Recent macroeconomic developments: the big picture 17

1.2.1. Economic growth and standards of living 17

1.2.2. Employment 19

1.2.3. Productivity 20

1.3. Sources of the productivity gap between the EU and the US 23

1.4. Growth, employment and productivity at sector level 25

1.4.1. Economic growth seen from the sectors 25

1.4.2. Employment 28

1.4.3. Productivity at sector level – recent evolution of the EU-US productivity gap 30

1.5. Globalisation and productivity 36

1.6. Summary and conclusions 43

B. Topical issues on the structural reforms agenda 47

2. Recent microeconomic reforms in the European Union 47

2.1. Introduction 47

2.2. Productivity Growth and Structural Reforms 48

2.2.1. Preconditions for boosting productivity growth 48

2.2.2. Likely effects of structural reforms 54

2.2.3. Structural reforms in the European Union 61

2.3. Spillovers across Member States and Synergies across policy areas in the context of the Growth and Jobs Strategy 73

2.3.1. Reforms leading to skills upgrading 74

2.3.2. Decreasing administrative burdens by cutting red tape 74

2.3.3. Achieving announced R&D intensity targets 75

2.3.4. Labour market reforms leading to the employment target 75

2.3.5. Policy synergies 76

2.4. Conclusions 76

3. Skill problems in European Industrial Sectors 83

3.1. Introduction 83

3.2. General background 84

3.3. Skills and competitiveness of EU manufacturing industries 85

3.3.1. Introduction 85

3.3.2. Skills and competitiveness at the industry level 86

3.4. Skill upgrading in the EU 89

3.4.1. Growth accounting 89

3.4.2. Skill upgrading and employment shifts between sectors 91

3.5. Skill shortages in the EU: case studies 93

3.5.1. Introduction 93

3.5.2. The extent and nature of skill shortages 94

3.5.3. Causes of skill problems 94

3.5.4. Policy responses 96

3.6. Skill gaps in the EU: the role for education and training policies 96

3.6.1. What is a skill gap? 97

3.6.1.1. Skill gap as an adjustment problem 97

3.6.1.2. Skill gap as a non-optimal mix of skills in the economy 98

3.6.2. What is the role for education and training policies to reduce skill gaps? 98

3.7. Summary and conclusions 100

C. Competitiveness at sector level 107

4. Analysis of the performance of European Industries 107

4.1. Introduction 107

4.2. Growth and productivity 110

4.3. Foreign trade 124

4.4. Foreign direct investment 131

4.5. Mutual dependencies and the appropriate economic policies 134

4.6. Conclusions 139

5. The Future of Manufacturing in Europe - a survey of the literature and a modelling aproach 153

5.1. Introduction 153

5.2. Globalisation and international competition 154

5.2.1. Introduction 154

5.2.2. Expected macro-developments: productivity, income and wealth 155

5.2.3. Relocation and international sourcing 157

5.2.4. The emergence of regional and global production networks 158

5.2.5. Globalisation vis-à-vis further regionalisation and regionalism 158

5.2.6. Financial globalisation and financialisation 160

5.2.7. Relocation and the future: possible consequences for European manufacturing 160

5.3. Technological progress and innovation 161

5.3.1. Introduction 161

5.3.2. R&D and innovative capacity 162

5.3.3. Future key technologies 163

5.3.4. Non-technological innovation 164

5.3.5. Knowledge, skills & competencies 165

5.4. Transforming the manufacturing landscape: new manufacturing paradigms and future business models 166

5.4.1. Introduction 166

5.4.2. New manufacturing paradigms 166

5.4.3. New business models: importance and possible ingredients 167

5.4.3.1. Managing global networks, firms becoming ‘orchestrators’ 168

5.4.3.2. (Mass) Customisation 169

5.4.3.3. Services and servation 170

5.5. Society at large: demographics and ageing 170

5.6. Environmental and natural resource concerns 172

5.6.1. Availability of resources 172

5.6.1.1. Energy and energy efficiency 173

5.6.1.2. Other resources 173

5.6.1.3. Recycling 174

5.6.2. Global warming and climate change 174

5.6.2.1. Impact of climate change on manufacturing 174

5.6.2.2. Environmental rules and regulations 175

5.7. Two scenarios for European manufacturing 176

5.7.1. Introduction 176

5.7.2. The macroeconomic variables in the two scenarios 178

5.7.3. The two scenarios at sectoral level 179

5.7.4. The impact of policies 180

5.8. General conclusions 184

D. Statistical annex 196

6. Sectoral Competitiveness Indicators 196

7. Microeconomic Data Country Fiches 211

EXECUTIVE SUMMARY

This is the tenth edition of the European Competitiveness Report since the 1994 Industry Council Resolution established its basis by inviting the Commission to report annually on the competitiveness of European industry. In this Report, competitiveness is understood as a sustained rise in the standards of living of a nation or region and as low a level of involuntary unemployment as possible. At the level of industrial sectors, maintaining and improving the position in the global market is the main criterion for competitiveness.

This concept of competitiveness does not necessarily entail a comparative perspective. However, the use of cross-country comparisons when assessing competitiveness and the frequent use of the US as the reference point can be useful to the extent that the US can be considered to epitomise in many fields the “technology frontier”.

The Report approaches competitiveness issues from the viewpoint of economic theory and empirical research. Its ambition is to contribute to policy making by highlighting relevant trends and developments, and by assessing in an analytical manner the expected outcomes of the various policy options. The Report’s main subject of interest is productivity growth and the factors affecting it.

After a review of recent developments concerning growth, productivity and employment, both at the level of the EU and of the main economic sectors, the Report reviews the state of microeconomic reforms under the Lisbon agenda from the point of view of their potential of raising productivity. It focuses, more particularly, on skills, as a factor for competitiveness. In addition, the Report assesses the relative strengths and weaknesses of European industries with respect to the various dimensions of competitive performance and concludes with presenting a long term vision of European manufacturing so as to put the emerging trends and challenges in perspective and check whether existing policies are consistent with them.

Growth, employment and productivity

Recent developments of the European economy in comparison with the US, confirm that the trend of ever increasing economic growth and productivity gap which could be observed over the last decade has come at a halt. While the reasons underpinning this trend were structural, it is still too early, at this moment, to say whether this change is the product of purely cyclical developments or the first manifestation of a new pattern.

The real growth rates of the EU-27 Gross Domestic Product (GDP) were both in the last quarter of 2006 3.5% year-on-year) and in the whole year (3.0%) the highest since the year 2000.This improvement has been supported by both a higher productivity growth and a stronger employment growth. In this context, it has also to be noted that the enhanced productivity growth is mainly caused by an accelerating growth of total factor productivity, i.e. the part of productivity growth that cannot be assigned to an easily measurable factor such as capital deepening or improved labour quality, but must be attributed to less tangible factors such as technical and organisational progress. In fact, this productivity component grew last year much faster than in previous periods.

These developments and the fact that the EU-27 productivity growth was last year for the first time since 2001 higher than in the US[1], thus closing the EU-US productivity gap, are encouraging. On the face of existing evidence, while the upturn is essentially cyclical in nature, it seems likely that there is also a structural component linked with past structural reforms enacted by the EU Member States, especially in the labour market. Sectoral productivity gains, such as in network industries, and the increase in the skill levels of the work force also support such a view. Such a structural improvement in productivity can be expected to become visible in the future as the effects of recent reforms – particularly those generated through the renewed Lisbon strategy – start feeding through more strongly.

The fact remains, however, that in terms of productivity levels, productivity in the US remains much higher. The main source of the gap is total factor productivity, and secondarily, the quality of human capital, while capital deepening contributes towards closing this gap.

These macroeconomic developments are reflected at sector level. All manufacturing sectors in the EU, with the exception of tobacco, exhibit substantially higher growth rates in 2006, thus contributing to the up-turn in EU growth in the last year. Even textiles and clothing, two sectors with negative growth over the last decade, have improved their performance, although they still show negative growth rates in 2006. However, GDP growth in the EU is concentrated in a few sectors, which account for a large share of total growth. Particularly, the contribution of services sectors to EU growth is substantial. Among manufacturing, only two sectors (electrical and optical equipment and chemicals) can be mentioned, even if their contribution to GDP growth is much lower than the one of the top sectors.

As for the whole of the economy, labour productivity decelerated in nearly all sectors of the economy in the period 2000-2005. However, a change took place in 2006, when growth rates increased significantly in comparison to the period 2000-2005 and even to the period 1995-2000.

Sector level data give some additional insights in the comparison of productivity developments between the EU and US. For instance, they confirm that the lower labour productivity growth in the EU economy in the last decade was due mainly to the poorer aggregated performance in labour productivity growth of EU sectors and not to the sectoral composition of the economy (industry mix), which exerted a slightly positive influence in the results. Here too, the most recent data (available for manufacturing only) confirm that the productivity growth differential in favour of the US becomes negligible at the end of 2006 and has turned positive since then.

Too often, globalisation is associated with job losses - or with some undefined and hypothetical opportunities. The resulting social costs and anxiety are real and call for appropriate policy response to accompany and anticipate transition. However, they should not lead to losing from sight the positive effects that opening up and integration into world markets have in a country’s economic performance, i.e. productivity gains from the resulting specialisation, from scale effects, from the greater competitive pressures that forces less efficient firms out of the market, and from the greater ability to absorb technological advances and new ideas developed in the rest of the world. Taken together, these factors suggest that openness to trade can play an important role in raising the rate of productivity growth of an economy; with the full benefits of openness accruing to economies that can easily redeploy factors of production between firms as well as from declining to growing industries.

The Report illustrates the positive relationship between aggregate productivity and globalisation, using trade openness as a proxy for the later, and summarises empirical findings on the causal relationship between productivity and globalisation. While the direction of causality can go both ways, of course, it is clear that with increases in the tradability of services and with a growing fragmentation of production processes, companies can reconfigure their production networks to boost overall productivity and hence competitiveness.

Microeconomic reforms and productivity

Raising the long-term economic growth potential by increasing productivity growth is one of the fundamental objectives of the renewed Lisbon strategy and an important response to the challenges of globalisation, ageing, the rapid pace of technological progress, the global increase in the demand for high-skilled labour and the need to combat climate change. If the European Union wants to sustain its social model in the future, strong productivity growth is one important precondition for being able to do so. Reforms in pursuit of this objective are being undertaken mainly in the microeconomic policy pillar of the integrated strategy. Among the policies most relevant to TFP growth are those designed to foster increased investment in R&D and innovation, the use of ICT, competition and product markets reform but, also, the quality of human capital and better regulation.

Thus the rationale for structural reforms rests in the role specific policies can play in raising productivity growth and potential output. How the respective roles look like and how effective they are remains the subject of an ongoing debate, although some conclusions can already be drawn:

- Investment in R&D and innovation is conducive to boosting productivity, the more so if the elements of the knowledge triangle, R&D, innovation and education and training, are well integrated.

- ICT investment has high returns in terms of productivity growth when accompanied by appropriate organisational changes, which ensure that ICTs are used efficiently.

- Increased competition on better regulated markets tends to have positive effects on productivity and employment by improving allocative efficiency (static), productive efficiency (work organisation), and dynamic efficiency (innovative products and processes) even though the effect on innovation is more ambiguous depending on market structures and on the distance of market participants to the technological frontier. Competition is of particular importance for the countries and industries close to the technological frontier for maintaining their edge.

- Significant increases of output and consumption can also be achieved by reducing the administrative burden and thereby freeing resources for more productive uses. In addition, well-designed tax policies may provide the correct incentives to better achieve the objectives of growth-enhancing policies.

An assessment of recent reforms by Member States in product and services markets as well as on the field of better regulation reveals that, in general, reforms in these areas have made notable progress, even if this progress is not yet fully reflected in the data measuring performance.

For instance, Member States have been strengthening their Better Regulation policies in recent years thus improving the quality of regulation and cutting back on red tape. The promotion of excellence in education and research is also pursued vigorously by many Member States together with sustained efforts to increase spending on R&D. Finally, Member States have made considerable progress in reducing start-up costs for SMEs by facilitating procedures and setting up one-stop-shops.

The coordination of national reform policies in the EU is an important aspect of the Growth and Jobs Strategy. There are several reasons why the coordination of Member States’ economic reforms may bring additional benefits. While countries can learn from each other, joint efforts are stimulating to carry on reforms and coordination can also help to overcome national resistance against reforms. Most importantly, coordinated implementation may create benefits which would be absent, had reforms been pursued unilaterally.

The empirical analysis of spillovers from reforms confirms that coordinated action in the areas mentioned above produces, in many cases, benefits substantially superior to those of acting alone. For instance, roughly half of the potential increase of GDP generated by Member States' achievement of their R&D intensity targets would result from cross-border knowledge spillovers. Additional benefits are accruing from policy complementarities. As an example, increasing skills and R&D raises real wages, which in turn should increase participation rates. Also, the reduction of administrative burdens, through lower mark-ups, has strong synergies with the employment target as it works through a reduction in equilibrium unemployment.

Skill problems in European Industrial Sectors

Educational attainment shows an upward trend in the EU countries, as well as in most other countries across the world. A better educated work force is conducive for a country’s economic performance. Human capital not only augments the efficiency of labour, it can also help to create absorptive capacity so that firms can more easily adopt technologies developed elsewhere. Both mechanisms would foster productivity and international competitiveness. For example, empirical research indicates that raising the average duration of schooling by one year would increase productivity by 8 to 10% in the long run.

The rising educational attainment and its contribution to competitiveness is also reflected at sectoral level. Skills upgrading is under way in all economic sectors, even in low-skill ones. Also, empirical analyses reveal that sectors employing a larger share of high skilled or medium skilled workers exhibit higher productivity growth while the share of low skilled workers in a sector is associated with a negative impact on productivity growth. Furthermore, skills matter for the speed of convergence towards the technology frontier. As might be expected, convergence is faster in high skill intensive industries.

The importance of skills can also be identified within a growth accounting framework. In most countries, changes in the skill composition of labour input are responsible for more than half of the gross changes in the composition of labour input measured in terms of the difference between the indices of hours worked and of labour services supplied, where the latter takes into account age, gender and skills. This shows that skill upgrading made a relevant contribution to labour demand shifts and implies that there is a substitution process towards higher quality types of labour.

The same can generally be said for individual industries. Here the analysis demonstrates that the upgrading process within industries contributes more to the increasing demand for highly skilled workers than shifts of overall employment between sectors or industries. Nonetheless, there is also a general shift of employment away from low-skill intensive industries towards medium- and high-skill intensive industries, and this shift occurs across all groups of EU countries.

Against this background, skill gaps can be seen, firstly, as an adjustment problem, arising after an increase in demand for (or fall of supply of) a certain skill. In such a situation the government’s role could be to smooth the transition process. Secondly, skill gaps can also be due to a non-optimal mix of skills in the economy. In this case government intervention might be needed to correct market failures or to improve institutions which prevent the economy from reaching an optimal mix of skills.

Case studies for six selected EU Member States on skill shortages in two of their industries, textiles and clothing, and mechanical engineering, show that skill shortages vary considerably across Member States, both in terms of their scale as well as in terms of rates of change, but greater problems are evident in the mechanical engineering industry. Skill shortages are usually most pronounced for technically skilled staff, and more acute for operatives than for ancillary staff. The causes of skill shortages in the mechanical engineering industry seem to be of a structural nature, often related to qualitative discrepancies on labour markets. The textiles industry, by contrast, is confronted with a low level of education among many of its employees, which limits the sector’s adaptability and the capability of workers to learn new skills.

The performance of European industries

In order to obtain a full picture of European competitiveness, an in-depth analysis of sectoral competitiveness for 52 sectors is undertaken. This analysis covers the relative strengths and weaknesses of European industries with respect to various dimensions of performance such as the growth of value added, employment, labour and Total Factor Productivity, international trade, and foreign direct investments.

All in all, the competitive performance of European industries is highly variable, both across countries and between sectors. More specifically, competitiveness differs greatly depending on which dimension of performance is investigated. For the period since 1995, the EU exhibits relatively low performance in terms of value added growth, labour and Total Factor Productivity growth, while appearing quite healthy in terms of sectoral profitability and trade performance. Incidentally, the latter stands in sharp contrast with the US which lost market shares in almost all of its manufacturing industries.

Assessing the relative strengths and weaknesses by sector, the mining sector and the production of leather and footwear, clothing, textiles, nuclear fuel and tobacco show a persistent decline in terms of value added and employment. Conversely, almost all industries with the highest rates of value added growth in the European Union are associated with the new information and communication technologies, i.e. communication equipment, office machinery and computers, as well as telecommunications and computer related services.

Compared to the US, the biggest gap in sectoral performance can be found in the manufacturing of office machinery and computers, wholesale and retail trade, air transport, and the financial services. The latter three services sectors all appear to be rather sensitive to economies of scale and are likely to benefit from larger integrated markets in the US. Conversely, the EU shows pockets of higher growth in selected areas of high-tech manufacturing, particularly pharmaceuticals, and the network industries, such as electricity, gas and water supply, water transport, and telecommunications, which are apparently undergoing substantial restructuring processes.

Addressing the dynamics of labour productivity growth, the data confirm a tendency of general catching-up, including many service sectors. This implies that countries with lower initial levels of labour productivity have on average achieved higher growth, whereas countries initially ranking at the top of productivity performance found it more difficult to maintain high growth rates. However, pharmaceuticals and the computer industry are exceptions to this rule. They are characterised by dynamic specialisation, where given competitive strength not only persists but tends to be reinforced. Consequently, certain countries with an initially high level of productivity in these industries also enjoy higher rates of labour productivity growth at a later stage.

An analysis of structural relationships among different performance indicators highlights the trade-off between the growth of employment and labour productivity in the short to medium term. This trade-off touches upon the choice between policies which are primarily directed at raising the labour intensity of growth, and policies aiming at raising productivity growth. Overall, among the variables investigated, Total Factor Productivity growth appears to be the central driver of sectoral performance. It exerts a positive impact on the growth of value added and labour productivity, inward FDI, and gains in international comparative advantage.

Decomposing the entire variation in average sectoral performance between countries and industries shows that a relatively small portion of about 12% is accounted for by fixed country effects, i.e. differences in purely macro-economic conditions and the general business environment with equal impact on all industries. Conversely, fixed industry effects explain almost one third of the total variation in performance. These effects refer to intrinsic differences between industries and are as such not likely to respond to different policies. However, fixed industry effects do point toward the importance of structural change and the policies that enable it by raising the ability of labour and capital markets to reallocate resources efficiently.

The majority of variation, then, is explained by country-industry interaction effects, i.e. by the particular performance of a country and an industry. This fact is testimony to the heterogeneity in performance and the variety of causative factors. It calls for an integrative policy approach, where horizontal and vertical perspectives are combined in order to adjust the business environment to the particular characteristics and needs of the respective industries. And it confirms the validity of the integrated approach to industrial policy put forward by the European Commission in recent years, comprising as it does a wide-ranging work programme of both horizontal and sectoral initiatives. The Lead Market Initiative that the Commission is currently developing serves as an example of such an integrated approach.

The Future of Manufacturing in Europe

While structural adjustment and relocation have been linked to manufacturing for decades, the character and speed of adjustment and its potential longer-term consequences appear to have taken on new dimensions in the current wave of globalisation. This fact has invigorated the discussion on how the manufacturing landscape will manifest itself in the near and longer-term future and which challenges may result for policy makers in Europe.

Although opinions vary, a considerable degree of consensus appears to exist on which drivers can be expected to shape the future of manufacturing. These drivers encompass increasing international competition, the rapid pace of technological change, major socio-demographic trends such as the ‘greying’ of most of the industrialized world, salient environmental developments such as climate change and, last but not least, the regulatory environment and the values of the public. It is worth noting in this context that long term projections generally confirm the role of Total Factor Productivity as the most important source of growth.

In terms of international competition, global markets will further integrate for both goods and services, and new competitors are likely to enter, thereby intensifying competition and posing new challenges for incumbents. However, the emergence of developing countries such as China or India also offers new opportunities due to larger markets and even more scope for specialisation for individual companies. And while the per capita income gap between Europe and these countries will remain substantial, steep rises in income in some developing countries will clearly have implications for the types of the goods and services which consumers demand.

As a consequence, relocations of production are likely to continue as companies endeavour to harvest the benefits of increasingly global production networks. But also new opportunities emerge for European manufacturers once the quality of the product as well as the quality of the supplier is of greater importance for customers. Against this background, close user-producer relationships, the available pool of high-skill labour and low political risks become major reasons for staying in, or even coming to, Europe.

Financial markets too are becoming more integrated and the influence of financial markets and shareholders on corporate governance and corporate behaviour will increase, possibly favouring as some have argued short-term financial goals at the detriment of strategic objectives and long-term competitiveness. But the jury is still out on whether these developments are on balance positive or negative, given that the necessary restructuring of underperforming firms may sometimes be facilitated by new people at the helm.

In terms of technological change, its rapid pace and the need of staying competitive in a globalising and increasingly knowledge-based world requires firms to focus even more on science, technology and innovation in order to master the transition from resource based to knowledge-based manufacturing. Enabling technologies such as information and communication technologies, micro-systems, advanced materials, and bio-technologies and nano-technologies, will play a crucial role in maintaining technological leadership for Europe. Key is in particular the pervasive diffusing capacity of these technologies, which potentially affects future competitiveness across a wide array of sectors.

The transition from resource-based to knowledge-based manufacturing will also make knowledge and skills absolutely crucial to future growth and competitiveness. Among these, particularly soft-skills become more and more important as organisations are progressively globally networked while non-technological innovation, predominantly organisational innovation, bears added significance on maintaining and improving competitiveness, both as an enabler and facilitator of technological innovation and in its own right.

In response to these challenges, new manufacturing paradigms are emerging, not only in Europe but also in Japan, on how manufacturing can transform and reinvent itself so as to face the future in a sustainable way. These paradigms often call for fundamentally different ways of production in view of an increasing scarcity of non-renewable energy and natural resources as well as climate change. In addition, these paradigms champion the adoption of mass customisation, more and better quality services, more networking and collaboration and embracing globalisation.

On the shop floor, the new manufacturing paradigms will call for, and be transposed into, new or modified business models, for which four major trends can be identified. Firstly, large businesses become less vertically integrated as they increasingly manage global production networks (e.g. car manufacturers). Secondly, together with mass-customisation a transition from products to services is observed, with manufacturing firms increasingly providing add-on services to their traditional products (e.g. photocopier manufacturers). Thirdly, firms increasingly diffuse intellectual property (IP) beyond company and even country boundaries, as innovation becomes more open (e.g. ICT companies and open innovation leaders). Lastly, in particular small businesses have to compete in manufacturing networks and collaborate openly to address market challenges.

Future societal developments and consumer behaviour will also significantly shape the setting for industries and firms. Thus an aging society is likely to induce demand shifts for both public and private goods and services. Furthermore, the decline of the labour force may induce skill shortages at a time when there is a growing need for skills. Environmental concerns are likewise important for the future of manufacturing in that the regulatory framework will have to respond to these concerns by becoming more stringent.

Much will depend on the ability of European manufacturing firms to capitalise on the opportunities that global challenges, such as ageing and climate change, represent. Since Europe needs to address them early on, there is a real opportunity for establishing lead market positions in products linked to health care, convenience, leisure and entertainment. While the global response to climate change remains uncertain, energy efficiency and recycling potential will be important value attributes. More generally, technologies that permit to operate within much stringer environmental constraints than today will offer lead market opportunities.

It is possible to push the analysis further by feeding the trends and drivers identified in the review of the foresight literature into more quantitative, model based scenarios. The value of the latter is purely indicative as the number of possible scenarios is infinite, however, considering alternative futures permits to be better prepared for unforeseen circumstances. By using a general equilibrium model to build the scenarios, those are made internally consistent. More importantly, this approach permits to evaluate the impact of policies that aim at improving the general framework conditions for competitiveness and their relative importance.

The two scenarios discussed differ across all the drivers of change discussed above; to summarise them, scenario I is characterised by slower globalisation and technological progress processes and a slower growth of manufacturing production than in scenario II. It results in a relatively larger European share in global production while in scenario II the geographical centre of global manufacturing production shifts to Asia.

The policies considered are:

- upgrading skills

- better regulation and less administrative burdens for firms

- R&D and innovation policies

- A strong competitive Single Market, including competition

- environmental policies

Their individual impact on GDP by 2025 is in the range of 0.5-0.6% (skills[2]) to3.0-3.5% (R&D), with the other structural policies in-between. Their cumulative impact amounts to around 8% (scenario I) to 9% (scenario II).

If the differences between the two scenarios in the macro effects of the individual structural policies are minor, the same cannot be said for their at sector level impact. As globalisation is an important driver that affects particular industries in different ways. The sectors which are already most open for international trade are also the ones mostly affected. These include textiles and wearing apparel, wood and other manufacturing, chemicals, rubber and plastics, electronic equipment, transport equipment and other machinery and equipment. Overall, the sectors food products and pulp, paper and publishing are less influenced. These are sectors which are more domestically oriented, less R&D intensive and face less technological progress. Europe has no comparative advantages in textiles and wearing apparel, electronic equipment and basic metals. Chemicals, rubber and plastics, transport equipment and other transport and equipment will be the important manufacturing sectors in Europe.

Of the structural policies fed into the model, improving skills, reducing the administrative burden and increasing energy efficiency, have the least impact on manufacturing. R&D and innovation policies and strengthening the internal market on the other hand have the strongest and most positive impact on manufacturing. In the coming decades Europe’s share in global manufacturing production and trade will decrease more slowy. The structural policies decelerate further the relative decline trend of manufacturing in Europe, such that in some manufacturing sectors such as chemicals, rubber and plastics, and combined machinery and equipment sectors the trend is almost cancelled out. In terms of the EU share in world production, in the absence of structural policies, under both scenarios, there is no sector where EU maintains its relative importance by 2025. In the presence of policies (i.e. achievement of targets) sectors such as transport equipment, wood and other manufacturing, energy carriers, Research and development services, chemicals, rubber and plastics; transport services and other business services maintain or almost maintain, their global share.

All in all, the analysis suggests that the European manufacturing industry will still play a major global role in a context where the crucial assets will be knowledge and the skills to manage it. Indeed, many sectors will be able to maintain their global share in this, much bigger than today, market. While the negative trends concerning manufacturing employment and the share of manufacturing in the total economy will certainly continue, these trends must not be confounded with stagnation or decline as new opportunities emerge and are exploited.

INTRODUCTION

This is the tenth edition of the Commission’s European Competitiveness Report since the 1994 Industry Council Resolution that established its basis. Competitiveness in this Report is understood to mean a sustained rise in the standards of living of a nation or region and as low a level of involuntary unemployment as possible. Maintaining and improving its position in the global market is the main competitiveness criterion at the level of an industrial sector.

As in previous years, the Report approaches the issues from the point of view of economic theory and empirical research and its ambition is to contribute to policy making by bringing to attention relevant trends and developments and by discussing analytically the likely outcomes of the various policy options. Its main subjects continue to be topics related to productivity, as the most reliable indicator for competitiveness over the longer term, developments regarding manufacturing industry and other microeconomic issues of the Strategy for Jobs and Growth.

Recent developments bring some good news, such as the end of the trend of an ever widening productivity gap with the US, taken as a benchmark of frontier productivity performance (Chapter 1). In addition, although hardly a new development, convergence among Member States in the form of productivity catching up continues. Reviewing trade performance brings in more good news: in spite of sometimes gloomy perceptions. Europe has, in general held its own in global markets. In addition, there is a positive relation between market openness and productivity growth, a message that merits to be underlined.

However, when levels of productivity are considered, Europe has still a long way to go. Taking into account the sectoral dimension confirms that this is not so much a question of economic structure but of lower productivity in some important sectors such as air transport and retailing. The sectoral analysis also underscores the central role of Total Factor Productivity (TFP) in explaining this gap, i.e. the part of productivity growth which must be assigned to factors such as technical and organisational progress, and cannot be attributed to improved labour quality or increase capital intensity.

The policies most directly relevant to TFP growth are those covered by the microeconomic pillar of the Lisbon strategy (Chapter 2): those fostering technological progress, the use of ICT, competition and product markets reform and infrastructures but, also, the quality of human capital. Coordinated action in these areas produces, in most cases, superior benefits to acting alone as an empirical analysis of spillovers from reforms confirms. In general, Member States have made notable progress in engaging reforms in the microeconomic pillar, which adds to the good news, even if these reforms are not yet fully translated in the data that measure performance.

Against this background, it is worth noting that skills contribute directly to international competitiveness and productivity (Chapter 3) while skills upgrading is under way in all economic sectors, even in low-skill ones. Incidentally, the latter is good news too, because it points to higher competitiveness and higher real incomes. However, imbalances such as skill shortages may occur in the short term, indicating that policies also have a role to play to smooth transition.

Competitiveness is a multifaceted target for which no single and fully comprehensive measure exists. To form a comprehensive picture, the Competitiveness Report assesses the relative strengths and weaknesses of European industries with respect to the various dimensions of performance, such as the growth of value added, employment, labour and multifactor productivity, international trade, and foreign direct investments (Chapter 4).

Taking the long view (Chapter 5) indicates that Europe, whilst still among the richest regions on a GDP per capita basis, will most probably be passed by some of the emerging economies in terms of size. By 2050 Asia will most likely have become the most important market and pole of growth. It is worth noting that long term projections, as speculative as they may be, likewise confirm the role of TFP as the most important source of growth. Moreover, the future holds the promise that the European manufacturing industry will still play a major global role in a context where the crucial assets will be knowledge and the skills to manage it. Indeed, many sectors seem to be able to maintain their global share in this, much bigger than today, market. However, the negative trends concerning manufacturing employment and the share of manufacturing in the total economy will continue. These trends must not be confounded with stagnation or decline. To a certain extent, they result from normal developments and reflect the effect of different productivity growth rates and income elasticities of demand for goods and services.

Of real concern, over the longer term, would be a growing differential in productivity growth with our main competitors. While such a gap persists today compared to the US, it is not a fatality. In fact, policies count and haven proven to do so. For instance, achieving the Lisbon targets in R&D, skills, administrative costs or making the Internal Market more effective, under alternative scenarios about the future, consistently brings in more favourable outcomes in terms of wealth generation and international competitiveness. At the same time, these results are in line with the improved performance of the European economy that we can currently observe and that, most probably, can in part be attributed to recent reform efforts.

A. GENERAL DEVELOPMENTS

KEY FACTS ABOUT COMPETITIVENESS DEVELOPMENTS: GROWTH, EMPLOYMENT AND PRODUCTIVITY

Introduction

This chapter reviews recent developments of the European economy. The main point is the confirmation of the encouraging signs already seen in last year's report. The following section (Section 2) gives the big picture, the evolution of the main economic variables at country level that describe the current momentum of the European economies, i.e. growth, standards of living, employment and productivity. Section 3 focuses on the sources of the productivity gap between the EU and the US. Section 4 examines the sectoral dimension of these variables at EU level, presenting the contribution of the different sectors of the economy to the main macroeconomic developments. Finally, Section 5 explores some aspects of the relationship between globalisation and productivity.

Recent macroeconomic developments: the big picture

Economic growth and standards of living

The EU remains since mid 2005 on a brisk growth path, after having overcome a severe slow-down in 2002 (see Graph 1.1). The real growth rates of the EU-27 Gross Domestic Product (GDP) were both in the last quarter of 2006 3.5% year-on-year) and in the whole year (3.0%) the highest since the year 2000.

Graph 1.1: GDP, employment and productivity growth in the EU-27 |

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Note: Growth compared to the same quarter of the previous year. Source : Eurostat 25/05/2007 |

GDP per capita is a common indicator of the standards of living. In 2006, the growth rate of GDP per capita was higher in the EU-27 (2.6%) than in the United States (2.3%, see Table 1.1). In 2006 growth accelerated in 22 of the 27 Member States, compared to the period 2000-2005, bringing the EU's per capita growth at a rate which was nearly as high as in the period 1995-2000 (2.7%).

Within the EU, GDP per capita corrected for differences in price levels, through using purchasing power standards, vary from less than 40% of the EU-average in Romania and Bulgaria to 270% in Luxembourg. Average GDP per capita in the EU is about two thirds of that in the US. Most of the economies which have a GDP per capita level below the EU average continued in 2006 their catching up process in terms of higher-than-average GDP per capita growth.

Table 1.1: GDP per capita growth & per capita GDP level |

EU-27 | Average annual growth rate of GDP per capita * | 2006 GDP per capita (in pps; EU-27=100)** |

1995-2000 | 2000 - 2005 | 2006 |

Austria | 2.8 | 0.9 | 2.7 | 127.8 |

Belgium | 2.5 | 1.0 | 2.6 | 122.7 |

Bulgaria | -0.2 | 6.7 | 6.6 | 36.4 |

Cyprus | 2.5 | 1.4 | 2.1 | 91.9 |

Czech Republic | 1.6 | 3.7 | 5.9 | 78.9 |

Denmark | 2.4 | 1.0 | 2.9 | 126.9 |

Estonia | 6.7 | 8.6 | 11.6 | 67.6 |

Finland | 4.5 | 2.3 | 5.0 | 117.5 |

France | 2.4 | 0.8 | 1.4 | 111.0 |

Germany | 1.9 | 0.6 | 2.8 | 114.5 |

Greece | 2.9 | 4.1 | 4.0 | 88.5 |

Hungary | 4.3 | 4.6 | 4.1 | 65.8 |

Ireland | 9.2 | 3.4 | 3.4 | 145.3 |

Italy | 1.9 | 0.1 | 1.4 | 103.4 |

Latvia | 6.4 | 8.9 | 12.5 | 55.4 |

Lithuania | 5.4 | 8.3 | 8.1 | 57.0 |

Luxembourg | 4.7 | 2.2 | 5.2 | 267.3 |

Malta | 3.9 | -0.3 | 2.3 | 74.3 |

Netherlands | 3.4 | 0.7 | 2.7 | 130.5 |

Poland | 5.6 | 3.1 | 5.9 | 53.3 |

Portugal | 3.7 | 0.1 | 0.9 | 73.2 |

Romania | -1.0 | 6.5 | 7.9 | 37.4 |

Slovakia | 3.3 | 4.6 | 8.2 | 62.6 |

Slovenia | 4.4 | 3.3 | 4.8 | 86.9 |

Spain | 3.6 | 1.7 | 2.3 | 101.4 |

Sweden | 3.1 | 2.0 | 3.8 | 120.7 |

United Kingdom | 2.9 | 2.0 | 2.2 | 121.7 |

EU-27 | 2.7 | 1.4 | 2.6 | 100.0 |

US | 2.9 | 1.4 | 2.3 | 153.4 |

Note: * The GDP per capita measured is in prices of 2000. The figures represent the average annual growth rates between the GDP levels of the first and the last years. **pps = purchasing power standards. Source: Ameco, May 2007. |

Employment

GDP per capita growth is determined by total population growth, employment growth and labour productivity growth, with the last two components playing the major part. As regards employment growth in the EU, the developments since 2000 confirm the usual time lag of several quarters between overall economic growth and employment growth: while a strong recovery has taken place since the beginning of 2006, a slight upward trend had already been visible since early 2003 (see Graph 1.1). Employment growth in 2006 (1.6%, see Annex Table 1.1) was significantly stronger than the average during the previous years (0.7% between 2000 and 2005 and 1.0% in the period 1995-2000).

Countries which are catching up in terms of GDP or GDP per capita are not generally performing better than average in terms of employment. In 2006, five out of the twelve new Member States recorded employment growth at rates below the EU-average. Half of last year's real GDP growth rate of 3.0% in EU-27 was generated by the increase in employment and the other half by productivity growth. This contrasts with the previous periods 1995-2000 and 2000-2005 where the contributions from employment were clearly lower than those from productivity. This development seems to reflect a change in terms of the employment content of growth. Under unchanged policies it will however not be sustainable, given the growth dampening impacts of the long-term demographic developments.

The largely positive developments in employment are also reflected in an improving employment rate, which reached in last year 64.4% in EU-27 (in EU-15 it amounted to 66%, see Graph 1.2 and Annex Table 1.1). It is particularly the increase by one percentage point between 2005 and 2006 which is promising, while the improvement between 2000 and 2006 by only 2 percentage points is rather moderate and indicates that reaching the EU's 70% target by 2010 is unlikely. Due to the simultaneous decrease by around 2 percentage points of the US employment rate since the year 2000, the gap between the EU and the US could be significantly reduced from about twelve to seven and a half percentage points.

Graph 1.2: Employment rates in the EU |

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Note: Employment rates are defined as the number of persons in employment aged 15-64 as a percentage of the population of the same age. EU-15 and EU-27 data for 2005 and 2006 are provisional. Source: Eurostat Labour Force Survey, 2007. |

Productivity

The growth of labour productivity i.e. output per person employed – the other main component of GDP per-capita growth - picked up in the EU and in the majority of the Member States in 2006 compared to the first half of this decade (1.5% vs. 1.2%, see Table 1.2 and Graph 1.3). Productivity and employment growth accelerated simultaneously in 2006 for the first time since 1997. On a quarterly basis, a distinct upswing of productivity growth can be noticed since mid 2005, and a slight upward trend since mid 2002 (as shown by Graph 1.1). The recent increase is taking place in a context of positive investment growth and continued structural reforms in the Member States. It has to be noted also that the enhanced productivity growth is underpinned by an accelerating growth of total factor productivity, i.e. the part of productivity growth that cannot be assigned to an easily measurable factor such as capital deepening or improved labour quality, but must be attributed to less tangible factors such as technical and organisational progress. In fact, the total factor productivity component grew last year by 1.1%, which represents an increase compared to previous five-year averages 2000-2005 (0.6%) and 1995-2005 (0.9%).

Graph 1.3: Average annual labour productivity growth per person employed |

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Note: For the period 2000-2005 the average annual growth rate is presented. Source: AMECO, May 2007. |

These developments and the fact that EU-27 productivity growth was last year for the first time since 2001 higher than in the US[3] are encouraging. In terms of productivity levels, productivity in the US remains much higher. Expressed as GDP per employed person, US productivity is 38.6% higher than in the EU. The productivity gap is lower when expressed in terms of GDP per hour worked (26% in 2005). Importantly, nearly all Member States with relatively low GDP per capita and productivity levels and all new Member States are catching up in terms of productivity growth, which indicates an improvement in their competitiveness. While productivity growth accelerated much more in Germany than in the other five large EU economies, growth rates of more than 3% were recorded only in the new Member States and Finland. However, the level of productivity per hour worked (the data for Romania are not available) is still particularly low in Bulgaria (30% of EU-25 average), the Baltic States (between 40 and 45%) and Poland (45%).

Table 1.2: Growth of real labour productivity per person employed & 2006 levels of GDP per person employed (ppe) and GDP per hour worked (phw) |

EU-27 | Average annual labour productivity growth per person employed | GDP ppe 2006 (EU-27=100) * | GDP phw 2006 (EU-25=100) ** |

1995-2000 | 2000 - 2005 | 2006 |

Austria | 2.2 | 1.0 | 1.9 | 120.3 | 97.8 |

Belgium | 1.6 | 0.9 | 1.9 | 134.0 | 127.5 |

Bulgaria | -0.6 | 3.9 | 3.6 | 34.5 | 30.3 |

Cyprus | 2.6 | 0.1 | 2.3 | 84.3 | 68.0 |

Czech Republic | 2.3 | 3.4 | 4.7 | 70.4 | 52.5 |

Denmark | 1.8 | 1.3 | 1.3 | 108.2 | 100.3 |

Estonia | 8.2 | 7.2 | 5.5 | 63.1 | 45.0 |

Finland | 4.3 | 4.0 | 5.8 | 112.6 | 95.5 |

France | 1.5 | 0.8 | 1.1 | 122.7 | 115.9 |

Germany | 2.2 | 1.4 | 2.3 | 106.6 | 108.5 |

Greece | 2.8 | 3.3 | 2.7 | 103.3 | 74.6 |

Hungary | 2.9 | 4.1 | 3.0 | 75.1 | 55.1 |

Ireland | 4.4 | 2.2 | 1.7 | 134.1 | 119.7 |

Italy | 1.1 | -0.1 | 0.2 | 108.7 | 88.2 |

Latvia | 5.9 | 6.4 | 7.0 | 52.2 | 40.3 |

Lithuania | 5.9 | 6.8 | 5.7 | 57.6 | 45.3 |

Luxembourg | 1.9 | 0.0 | 2.4 | 171.3 | 162.0 |

Malta | 3.8 | -0.5 | 2.0 | 86.4 | 72.9 |

Netherlands | 1.5 | 1.5 | 1.8 | 113.6 | 120.0 |

Poland | 5.8 | 3.6 | 2.4 | 61.6 | 45.1 |

Portugal | 2.2 | 0.4 | 0.5 | 66.4 | 58.8 |

Romania | 0.6 | 6.4 | 4.7 | 41.5 | #N/A |

Slovakia | 4.8 | 3.0 | 4.0 | 70.0 | 58.4 |

Slovenia | 0.6 | 6.4 | 4.7 | 83.3 | 69.6 |

Spain | 0.3 | 0.5 | 0.8 | 99.6 | 87.1 |

Sweden | 2.4 | 1.7 | 4.0 | 110.0 | 101.5 |

United Kingdom | 2.4 | 2.0 | 2.6 | 112.5 | 98.8 |

EU-25 | 1.9 | 1.2 | 1.5 | 103.6 | 100.0 |

EU-27 | 2.1 | 1.2 | 1.5 | 100.0 | #N/A |

US | 2.1 | 2.1 | 1.4 | 138.6 | #N/A |

Note: * The relative levels of GDP per person employed and per hour worked have been calculated on the base of purchasing power standards. ** Dta for Romania, the US and EU-27 are not available. Source: AMECO. May 2007. |

Graph 1.4 shows that the trend decline in productivity growth which could be observed since the second half of the 1990s stopped in the second half of the year 2003. While the reasons underpinning the widening of the EU-US productivity gap over the last decade were structural, it is still too early to say whether this recent change is the product of purely cyclical developments or the first manifestation of a new pattern.

Analysis by the Commission services[4] indicates that, while the upturn is essentially cyclical in nature, it is likely that there is also a structural component linked with past structural reforms enacted by EU Member States, especially in the labour market. Sectoral productivity gains, such as in network industries, and the increase of skill levels in the work force would also support such a view.

Graph 1.4: Productivity growth in the EU-27 |

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Note: GDP per person employed. Growth compared to the same quarter of the previous year. The line represents a moving average of 2 periods. Source : Eurostat 25/05/2007. |

Sources of the productivity gap between the EU and the US

As seen above, the productivity per person employed is about 39% higher in the US than in the EU. Regarding productivity per hour worked, the latest available comparable figures for the US (2005) indicate a gap of 26%. The gap per person employed is higher than the one per hour worked, because the number of hours worked per person employed is on average higher in the US than in the EU. This now raises the question of the sources regarding the gap in terms of productivity per hour worked.

A productivity gap per hour worked can be broken down[5] into differences with respect to capital intensity, labour quality and total factor productivity: while capital intensity measures the capital stock per hour worked, the quality of labour is captured by the educational attainment of those employed and total factor productivity (which indicates progress in terms of technological progress, knowledge and organisational changes) is a residual between total hourly labour productivity and the first two components. The computation of such a breakdown reveals that the EU has a negative gap compared to the US with regard to labour quality and total factor productivity, with the latter much more important than the former, whereas capital intensity contributes towards closing the gap. The relatively high contribution of capital accumulation in Europe is reflecting to a certain extent its underutilisation of labour.

It is of high relevance for the EU economic policies to know that most of the labour productivity gap is caused by total factor productivity, while the quality of labour play a significant but secondary part. Although there is no need to catch up quantitatively in terms of capital stock, more developed analysis is required to analyse the "quality" of capital stock and the possible existence of quality gap with the US.

In order to complete the picture on the sources of the EU productivity growth gap to the US, the considerations on the respective levels and their sources need to be complemented by a comparison of the respective growth rates and their components. In this regard, it has first to be observed that the growth rates of hourly productivity were in the period 2000-2005 on average 0.6 percentage points lower in the EU than in the US, as illustrated by Graph 1.5, so that the existing gap regarding the hourly productivity has obviously even widened since the year 2000. The growth gap is overwhelmingly generated by total factor productivity (growth gap of 0.8 percentage points) while the growth difference in terms of capital accumulation is only slightly negative and the one on labour quality is even positive (which shows a catching up process of the EU in this field).

While the absolute numbers in a growth accounting framework depend heavily on the specification chosen, there is no doubt that the EU has a comparative deficit regarding the level of total factor productivity and that this deficit has even significantly widened between 2000 and 2005 . On the positive side, the acceleration of total factor productivity growth in the EU in 2006 (see Section 1.2.3) and the catching-up process in terms of the quality of labour provide some encouraging signals.

Graph 1.5: Decomposition of average hourly productivity growth 2000-2005 |

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Source: Mourre (2007), using data from ECFIN-AMECO, US Bureau of Labour Statistics and Eurostat. |

The economic policy implications deriving from these observations are that the EU policies tackling total factor productivity, such as ICT, research, innovation, competition, product market reform and better regulation policies, should be prioritised. They have obviously a high potential impact on overall labour productivity and the room for improvement regarding this component is particularly high, as shown by the comparison to the US.

Growth, employment and productivity at sector level

The objective of this section is to review the contribution of the different sectors (from agriculture through non-market services) to GDP, employment and labour productivity growth, over the period 1995-2005 and to look into some aspects of the labour productivity differential between the EU and the US. Contrary to Chapter 4 of this Report, which carries out an in-depth analysis of the performance of European manufacturing over the same period, the emphasis of the present section is on the latest developments.

Economic growth seen from the sectors

As seen in Section 2, the EU economy decelerated in 2000-2005 relative to the second half of the 1990s. This deceleration is common to all sectors, with a few exceptions: health and social work; electricity, gas and water supply; construction; and education (Graph 1.6). In 2006 a change seems to take place, as growth, employment and labour productivity show a recovery relative to the previous years.

Graph 1.6: EU-27 value added growth 1995-2005 |

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Source: calculated with Eurostat data. |

GDP growth in the EU is concentrated in a few sectors, which account for a large share of total growth (Graph 1.7). Particularly, the role of services sectors in EU growth is substantial. Among manufacturing, only two sectors (electrical and optical equipment and chemicals) can be mentioned, even if their contribution to GDP growth is much lower than the one of the top sectors. The uneven contribution of manufacturing and services to GDP growth, and particularly the modest contribution of manufacturing sectors, is explained, to a large extent, by the substantially lower share of these sectors in the economy.

Graph 1.7: Contribution of sectors to EU GDP growth, 2001-2005 |

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Source: calculated with Eurostat data. |

As indicated above, all manufacturing sectors, with the exception of tobacco, exhibit substantially higher growth rates in 2006, thus contributing to the up-turn in EU growth in the last year (Graph 1.8). Even textiles and clothing, two sectors with negative growth over the last decade, have improved their performance, although they still show negative growth rates in 2006[6].

Graph 1.8: Annual growth rate of production of manufacturing sectors, 2001-2005 and 2006 |

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Source: calculated with Eurostat data. |

Employment

Although positive, EU employment growth in 2000-2005 was lower than in 1995-2000 (Section 2). At sectoral level, most of the employment growth is explained by the performance of a small number of sectors (Graph 1.9). Business services, health and social work and wholesale and retail trade account for more than 80% of total employment growth over 1995-2005. Manufacturing sectors contribute negatively, with the only exception of transport equipment.

Graph 1.9: Contribution of sectors to total employment growth rate 2001-2005 |

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Source: calculated with Eurostat data. |

The latest employment developments by sector, including 2006, can be measured only for manufacturing sectors. Contrary to what is seen in value added growth, employment shows a mixed picture, with much variation across sectors and time. However, in 2006 employment in manufacturing improves, with higher growth rates than in the previous five years (2000-2005) and even positive growth rates in sectors like instruments, metal products, electrical and non-electrical machinery, and recycling (Graph 1.10).

Graph 1.10: Manufacturing employment annual growth rate 1995-2000 and 2006 |

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Source: calculated with Eurostat data. |

Productivity at sector level – recent evolution of the EU-US productivity gap

As for the whole of the economy, labour productivity decelerated in nearly all sectors of the economy in the first have of the 2000s but recovers in 2006[7], in which growth rates are significantly higher than in 2000-2005 and even than in 1995-2000 (Graph 1.11). In general, the strongest growth in labour productivity takes place in manufacturing sectors. The services sectors that have above-the-average growth rates in 2000-2005 are electricity, gas and water supply, financial intermediation, and wholesale and retail trade (data for all sectors can be found in Table 4.1, Chapter 4, for the period 1995-2004).

Graph 1.11: Labour productivity annual growth (%) 2000-2005 and 2006 |

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Source: calculated with Eurostat data. |

Sector level data from the EU KLEMS data set[8] give some additional insights in the comparison of productivity developments between the EU and US. For instance, they confirm that the lower labour productivity growth in the EU economy in the period 1995-2004 and the two sub-periods considered, is due mainly to the poorer performance in labour productivity growth in EU sectors and not to the sectoral composition of the economy (industry mix), which exerts a slightly positive influence in the results (Graph 1.12)[9].

Graph 1.12: Decomposition of the EU-US differential in labour productivity growth between sectoral performance and sectoral composition (structure) of the economy, 1995-2004 |

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Source: calculated from EU KLEMS data. |

The use of average annual growth rates in the two periods 1995-2000 and 2000-2005 is to a certain extent dictated by data availability regarding the EU. By focusing on manufacturing alone, one can obtain a finer view of developments over time and an indication of what might be happening in the near past by using short term indicators.

Graph 1.13 presents the evolution of the EU-US productivity level gap in industry, estimated with monthly production data, between January 1995 and June 2007[10]. It can be seen that the deterioration of the gap had already started at the beginning of the period but seems to have stabilised since 2003.

Graph 1.13: EU labour productivity in industry(*) (US = 100), January 1995 - June 2007 |

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Note: (*) Mining, manufacturing and energy. Source: calculated with data from Eurostat and O’Mahony and van Ark (2003). |

Manufacturing accounts for a small part of the EU total economy (17%). Yet the productivity performance of manufacturing is of interest in tracking developments in the whole economy. Indeed, Graph 1.14 shows the labour productivity growth in manufacturing and in the economy at large exhibit a similar profile (smoother for the whole economy, although productivity growth rates are, in general, higher in manufacturing. Manufactured goods are more tradable than services; the sector is more exposed to international competition, and more intensive in R&D. Therefore, productivity developments in manufacturing are a good indicator for capturing the capacity of the economy to react and adjust to globalisation challenges. This should not, however, shift the attention from the fact that productivity increase in services industries (72% of EU GDP) is crucial to improve competitiveness of the EU economy as a whole.

Graph 1.14: Labour productivity growth in manufacturing and the whole economy |

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Source: Calculated with data from ECFIN-AMECO. |

Growth rates (Graph 1.15) explain this development in EU-US industry productivity: since 2003 labour productivity growth rates in the US have been decreasing, while they were increasing in the EU[11]. Although labour productivity growth is still higher in the US, the relative performance of the EU improves steadily during these years. In other words, the growth differential in favour of the US decreases and becomes negligible at the end of 2006.

However, this does not necessarily show a structural change in the EU performance relative to the US. As a matter of fact, US labour productivity growth leads EU’s and the lag in EU’s productivity growth explains partially the convergence in growth rates observed in the second half of the Graph. Yet, there is some persistence in labour productivity growth in the EU, which, nevertheless, might have attained a maximum at the beginning of 2007[12]. The influence of the business cycle on the relative labour productivity developments is shown in Graph 1.16, which presents the growth differential[13] in GDP and manufacturing labour productivity between the EU and the US, where, with the exception of the period 2001-2003, the differential in GDP growth is mirrored closely by the differential in labour productivity growth. The correlation coefficient between the two series is 0.32.

Graph 1.15: EU and US industry labour productivity growth |

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Source: calculated with data from Eurostat |

Graph 1.16: Growth differential between EU and US |

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Source: calculated with Eurostat national accounts and short-term indicators data. |

Globalisation and productivity

Openness increases productivity. By expanding exports, firms learn new technologies to compete in foreign markets and they could reduce unit production prices from the expansion in production resulting from exports. Imports expose domestic firms to greater competition and forces less productive firms out of the market. More competitive firms can then better compete in international markets. Access to foreign inputs also improves the product mix of intermediate inputs raising productivity at the firm level. Foreign inputs could furthermore be of superior quality relative to domestic inputs resulting in another channel through which imports impact productivity. Imports could in addition provide an important access to new technology embodied in goods and services. The increase in productivity improves a country’s international competitiveness in price and quality boosting its exports.

Although not a new phenomenon the current wave of globalisation has enhanced the role of international competition, i.e. competition from abroad and competition abroad, in determining a country’s prosperity measured by its productivity growth. The acceleration of globalisation in the last decades is illustrated by Graph 1.17, presenting the increases of trade openness across countries and regions between 1995 and 2005 and Graph 1.18 presenting Foreign Direct Investment stocks compared to GDP. Trade openness has increased by 8 percentage points in the EU-15 despite its size, and in the EU-10 by 34.5 pp. The figure shows the brisk pace of China’s integration into the world economy, doubling its trade openness in only ten years. In fact, China's contribution to world-wide growth in the more recent past has been impressive. China's share in global output has risen from 1.7% in 1990 to 5% in 2005. Since 2000, the country has contributed about one third to overall worldwide GDP growth.

Graph 1.17: Trade Openness, 1995-2005 |

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Note: Exports and imports over GDP. China excludes Hong Kong. (*) EAC is East Asian Countries. Source: Data from IMF DOTS, WEO, IFS. |

The increasing trade openness has been accompanied by a strong rise in foreign direct investment (FDI)[14]. Graph 1.18 shows the increasing stocks of inward and outward FDI stock as a share of GDP for selected countries and regions. The high degree of internationalisation of the EU economy (both as a home and as a host region) is striking when compared to that of the US. Interestingly, in comparison to the large inward FDI stock into China, outward FDI stocks from China are still small[15]. But the rising intensity of outward investment activities by Chinese enterprises signals a new stage in China’s integration to the global economy as Chinese tries to reduce its dependence on multinational corporations and is becoming a more proactive player[16].

Graph 1.18: FDI stocks over GDP, 1990-2000-2005 |

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Note: China excludes Hong Kong. EU figures include intra-EU activity. Source: UNCTAD World Investment Report. |

Given the growing size of globalisation, its effects on a country’s performance are of the utmost importance. The positive relationship between aggregate productivity and globalisation is depicted in Graph 1.19. The data, covering OECD countries, reveal that trade openness and labour productivity tend to move together[17]. A word of caution is needed here since while openness may increase productivity, the reverse also seems likely. Box 1.2 below summarises selected empirical findings on the causal relationship between productivity and globalisation.

Graph 1.19: Openness and Productivity |

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Note: Openness is exports and imports over GDP. Labour productivity is real GDP per worker. Sample includes Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Japan, Netherlands, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, United Kingdom, and United States. For most countries 10 years averages are calculated (1960-1970; 1970-1980; 1993-2003). Source: Summers-Heston data set, Version 6.2. |

The same positive relationship is found when looking in detail at more disaggregated sectoral data. Graph 1.20 plots labour productivity growth in manufacturing sectors in the EU against openness, defined as the ratio of imports to the value added of the sector, over the period 1995-2004[18]. A fixed effects panel regression of the labour productivity annual growth rate on the annual growth rate of the openness of each sector (lagged one period) shows a positive significant coefficient for the variable openness[19]. On average, a 1% increase in the openness of the economy, as measured by the ratio imports to value added, results in an increase of 0.05 percentage points in the labour productivity growth rate in the following year. These results should be taken only as a preliminary indication of the effect of the openness of the economy on sectoral productivity performance, as other determinants of labour productivity are not included in the regression and higher productivity might also lead to more openness[20].

Graph 1.20: Labour productivity growth and openness in EU manufacturing sectors |

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Source: calculated from EU KLEMS and COMTRADE databases |

Too often, globalisation is associated with job losses - or with some undefined and hypothetical opportunities. The resulting social costs and anxiety are real and call for appropriate policy response to accompany and anticipate transition. However, they should not lead to losing from sight the positive effects that opening up and integration into world markets have in a country’s economic performance, i.e. productivity gains from the resulting specialisation, from scale effects, from the greater competitive pressures that forces less efficient firms out of the market, and from the greater ability to absorb technological advances and new ideas developed in the rest of the world. Taken together, these factors suggest that openness to trade can play an important role in raising the rate of productivity growth of an economy; with the full benefits of openness accruing to economies that can easily redeploy factors of production between firms as well as from declining to growing industries.

Gains through more efficient production

With the increase in the tradability of services and fragmentation of production processes, companies can reconfigure their production to boost their overall competitiveness. This has led to global production systems and the development of international production sharing. While the range of activities suitable of international outsourcing has widened, the economic logic of these activities are similar to the well-known process of declining transportation costs which is contributing to increasing the range of goods subject to import competition. Once reduced to national dominion, the playing ground for relocation has now become a world wide ground.

Now it is easier for firms to move parts of their production to foreign locations-a process referred to as offshore outsourcing or, more simply, offshoring. Numerous studies have shown the positive impact of outsourcing and productivity (see Box 1.1).

But although international production-sharing is an increasing phenomenon, the scale of offshoring compared to the economy as a whole is still quite limited[21]. However, trends across regions differ markedly. China, and to a lesser extent the new EU Member States and South East Asia, are an important part of this process. The share of intermediate imports (goods) as a share of total imports in China has gone up from around 55% in 1992 to almost 75% in 2003. For the EU-10 the increase has not been as impressive but it reached almost 5 pp to around 60% during the same period. In fact, intermediate goods are the largest component of trade by stage of production both in China and in the NMS-10 (exports of intermediates represented 38% of total exports in 2003 in China and 54% in NMS-10); and trade deficits in intermediates has gone up to 8% and 5,7% of GDP in China and NMS-10, respectively. In contrast, the share of intermediate goods in imports has been decreasing continually in Japan, the US and EU-15 (for the EU-15 by 4pp to 50% in 2003)[22] [23].

BOX 1.1: Empirical evidence on the link between Globalisation and Productivity There are plenty of studies analysing the relationship between productivity and different forms of globalisation. A growing body of empirical work has documented the superior performance characteristics (including productivity) of international firms (i.e. FDI firms, outsourcing firms, exporters, but also importers) relative to only-domestic firms. The issue is whether good firms choose to go international or whether globalisation improves firm performance. Both theory and empirical evidence show that causality goes both ways. Empirical evidence showing that firms exposed to international competition are different as there seems that more productive firms self-select into exporting and outsourcing include, among others, Bernard and Jensen (1999) who show that good firms become exporters (but that the benefits of exporting for the firm are less clear). Antrás and Helpman (2004) also show how high-productivity firms source overseas by engaging in FDI while low-productivity firms acquire domestic intermediates. Kurz (2006) finds that outsourcers are “outstanding” performers –larger and more productive organisations. Similarly, Tomiura (2007) also shows that international firms in general (FDI firms, outsourcers and exporters) are more productive than domestic firms. Muuls and Pisu (2007) find that a process of self-selection applies also to importing firms. Overwhelming empirical support is found in the literature for the positive effects that globalisation can bring to a country in terms of productivity. Using trade as a proxy for globalisation many studies have found the significant benefits of international trade on productivity (e.g. Alcalá and Ciccone (2004), Miller and Upadhyay (2000)). A number of studies have focused on outsourcing and its effects on productivity. For a sample of EU countries Egger and Egger (2006) find a long-run positive impact between international outsourcing of goods and low-skilled workers productivity. Amiti and Wei (2006) find that service outsourcing has a significant positive effect on productivity in the manufacturing sector. Similar results have been found regarding the productivity impact of outsourcing on the Irish electronics industry by Görg et al. (2007). Mann (2003) analyzes the role played by international outsourcing of IT hardware in stimulating productivity growth during the last decade. She advocates a similar model of global competition for IT software and services that will deliver more cost-effective IT services and will prompt the next wave of productivity growth. ECB (2007) shows that changes in the sectoral shares in value added are related to changes in intermediate imports (from low-cost locations) for the EU area. This result is consistent with the story that industries that outsource production inputs could have beneficial effects in terms of value added. Positive results are found particularly for machinery and equipment, vehicles, and electronic and communications equipment sectors. Finally, many studies have looked at the positive effects of globalisation on productivity via technology spillovers. Egger and Pfaffermayr (2001) find that the transfer of production know-how improves overall productivity of FDI-receiving firms and to some extent also that of the other firms due to spillovers. Buckley et al. (2002) also finds that the presence of multinationals generates spillovers to locally-owned firms. Coe and Helpman (1995) estimates indicate that foreign R&D has beneficial effects on domestic productivity, and that these are stronger the more open an economy is to foreign trade. Moreover, the estimated rates of return on R&D are very high, both in terms of domestic output and international spillovers. Sinani and Meyer (2004) disentangle the positive effect of technology transfer on the productivity of domestic firms from that of competition. They find that the size of the spillover effect depends on the characteristics of incoming FDI and of the recipient firm. Spillovers have a positive or negative impact on the productivity of local firms depending on whether the negative competition effect outweighs the positive effect of demonstration and imitation, the training of employees, and the positive effect of backward and forward linkages. |

Gains through technology spillovers

The relocation of production activities also has benefits for the host or insourcing economy. The beneficial effects for the host economy occur through a number of channels: imitation via the adoption of new production methods or management practices; higher competition in the domestic market due to the entrance of foreign firms; human capital spillovers; “export-spillovers” through collaboration or imitation with the foreign firm so that domestic firms learn how to penetrate export markets. Graph 1.21 depicts the change in the foreign direct investment inward output ratio and the change in the labour productivity for a sample of selected new Member States (the Czech Republic, Hungary, Slovakia, and Slovenia) and the significant robust correlation with a coefficient of 0.51 (p-value of 0.02).

Graph 1.21:Relationship between the change in labour productivity and change in the FDI inward capital stock in selected new Member States |

Note: Sample includes Czech Republic, Hungary, Slovakia, and Slovenia. Source: WIIW FDI database, Eurostat (New Cronos). |

One of the main channels for productivity increases in the inshoring country come from technological spillovers. Empirical evidence shows that foreign-owned firms tend to be more technologically advanced than domestic firms and have a higher propensity to innovate[24]. As shown in Graph 1.22 for a sample comprising Czech Republic, Latvia, Estonia, Hungary, Lithuania, and Slovakia, the share of innovative sales is higher for foreign-owned firms than for domestic ones. For these NMS countries, estimates from a probit model on the probability that a firm introduces a new product or production process show that foreign-owned firms are significantly more likely to innovate than domestic firms[25]. Some studies suggest that the positive technology spillovers are stronger on a vertical, not horizontal level (thus associated with intermediate trade and outsourcing). A possible explanation for this is that multinationals are able to “hide” their new technology from competitors in the same industry but their (vertical) suppliers profit from their technology (Gorg and Greenaway, 2004; Smarzynska 2004). Box 1.1 above provides a selected summary of empirical studies corroborating the positive effects of globalisation via technology spillovers.

Graph 1.22. Share of innovative sales between foreign-owned and domestic firms |

[pic] |

Notes: Sample includes manufacturing sectors in CZ, EE, HU, LT, LV and SK. Number of observations is 6349. The category “new products” represents new (or significantly improved)-to-firm products (but not necessarily new to the market). The category “new market products” are new (or significantly improved) not only to the firm but also to the market. Source: Community Innovation Statistics (CIS) 3 micro-aggregated data. |

Summary and conclusions

In 2006, the EU had its best economic growth performance since 2000, supported by a simultaneous acceleration of employment and labour productivity growth. At the same time, the productivity growth differential vis-à-vis the US, which had bottomed out in 2003-2004, turned positive. These very encouraging results, which are also reflected at the sector-specific level, should n distract from the fact that there is still a very large productivity gap vis-à-vis the US, taken as a benchmark of the technological frontier.

The main source of this gap is total factor productivity, i.e. the part of productivity growth that cannot be assigned to an easily measurable factor such as capital deepening or improved labour quality, but must be attributed to less tangible factors such as technical and organisational progress. The policies most directly relevant to total factor productivity are those covered by the microeconomic pillar of the Lisbon strategy: those fostering technological progress (through more investment in – but also better uptake of the results of - R&D), the use of ICT, competition and product markets reform and infrastructures. The fact that the recent productivity upswing in the EU was fuelled also by an acceleration of TFP and that it was widespread across setters, including the services, leads to the suggestion that these reforms are starting to bear fruit. However, it is too early to be able to confirm the structural nature of this development.

In this context, it is worth noting that trade openness and competitiveness go together. While the causality link might be ambiguous, there are well visible productivity gains associated with the resulting specialisation, the scale effects, the greater competitive pressures that forces less efficient firms out of the market and the greater ability to absorb technological advances and new ideas developed in the rest of the world.

These results suggest that both increased intra-EU trade as a result of improving the Single Market and ambitious external policies – such as concluding the Doha Development Agenda, the new generation of bilateral free trade agreements, rebalancing the trade relationship with China, removing barriers to EU exports and a stepped-up market access strategy – hold out the potential of significantly contributing to productivity growth in the EU.

References

Alcalá, F., and A. Ciccone (2004): “Trade and Productivity,” Quarterly Journal of Economcis, 119.

Amiti, M., and S. Wei (2006): "Service Offshoring, Productivity and Employment: Evidence from the US", CEPR Discussion Paper No. 5475

Antràs, P., and E. Helpman (2004): “Global sourcing”, Journal of Political Economy 112.

Bernard, A., and B. Jensen (1999): “Exceptional exporter performance: cause, effect, or both?,” Journal of International Economics , 47, 1 .

Buckley, P., J. Clegg, and C. Wang (2002): “The impact of inward FDI on the performance of China’s manufacturing firms”, Journal of International Business Studies , 33(4).

Coe, D., and E. Helpman (1995): “International R&D Spillovers,” European Economic Review , 39, 5.

Egger, H., and P. Egger (2006): “International Outsourcing and the Productivity of Low-Skilled Labour in the EU,” Economy Inquiry , 44, 1.

Egger, P., and M. Pfaffermayr (2001): “A note on labour productivity and foreign inward direct investment”, Applied Economics Letters , 8.

European Commission (2006): “Global Trade Integration and Outsourcing: How Well is the EU Coping with the New Challenges?” DGECFIN Economic Papers 259.

Görg, H.; A. Hanley, and E. Strobl (2007): “Productivity Effects of International Outsourcing: Evidence from Plant Level Data”, CEPR Discussion Paper 6361.

Gorg, H., and D. Greeaway, D. (2004): “Much Ado About nothing? Do Domestic Firms really Benefit from Foreign Investment?” World Bank Research Observer, 19, 2.

Gorg, H. and E. Strobl (2001): “Multinational Companies and Productivity Spillovers: A Meta Analysis”, Economic Journal, Vol.111.

International Monetary Fund (2007): World Economic Outlook, Washington DC.

Kurz,C. (2006): “Outstanding Outsourcers: A Firm- and Plant-Level Analysis of Production Sharing”, Federal Reserve Board, Washington DC.

Mann, C. (2003): “Globalization of IT Services and White Collar Jobs: The Next Wave of Productivity Growth,” International Economics Policy Briefs , Dec., Institute for International Economics, Washington DC.

Miller, S., and M.Upadhyay ( 2000), “The Effects of Openness, Trade Orientation, and Human Capital on Total Factor Productivity,” Journal of Development Economics , 63(2).

Mourre, Gilles (2007):"What are the main sources of income differentials and what are the key components of economic growth in Europe? A detailed GDP accounting exercise", Brussels, European Economy Economic Papers , forthcoming.

Muuls, M., and M. Pisu (2007): “Imports and Exports at the Level of the Firm: Evidence from Belgium,”CEP Discussion Paper 801.

O’Mahony, M. and B. van Ark (2003) EU productivity and competitiveness: An industry perspective. Can Europe resume the catching-up process? European Commission, Luxembourg: Office for Official Publications of the European Communities.

Sinani, E., and K. Meyer (2004): “Spillovers of technology transfer from FDI: the case of Estonia,” Journal of Comparative Economics , 32, 3.

Smarzynska, B.K. (2004): “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers through Backward Linkages,” American Economic Review , 94, 3.

Tomiura, E.(2007): “Foreign outsourcing, exporting, and FDI: A productivity comparison at the firm level,” Journal of International Economics, 72, 1.

Annex

Annex Table 1.1: Employment growth and 2006 employment rate |

EU-27 | Average annual employment growth | 2006 Employment rate: Employment as percentage of population 15 to 64 years. |

1995-2000 | 2000 - 2005 | 2006 |

Austria | 0.7 | 0.3 | 1.4 | 70.2 |

Belgium | 1.1 | 0.6 | 1.1 | 61.0 |

Bulgaria | -0.3 | 1.5 | 2.4 | 58.6 |

Cyprus | 1.3 | 3.0 | 1.5 | 69.6 |

Czech Republic | -0.8 | 0.3 | 1.6 | 65.3 |

Denmark | 1.0 | 0.0 | 1.9 | 77.4 |

Estonia | -2.0 | 1.1 | 5.5 | 68.1 |

Finland | 2.3 | 0.9 | 1.4 | 69.3 |

France | 1.4 | 0.6 | 0.8 | 64.8 |

Germany | 0.8 | -0.2 | 0.7 | 67.2 |

Greece | 0.6 | 1.3 | 1.5 | 68.6 |

Hungary | 1.2 | 0.2 | 0.7 | 57.3 |

Ireland | 5.7 | 2.9 | 4.2 | 63.0 |

Italy | 1.0 | 1.2 | 1.7 | 58.4 |

Latvia | -0.5 | 1.7 | 4.6 | 66.3 |

Lithuania | -1.1 | 1.7 | 4.6 | 63.6 |

Luxembourg | 4.1 | 3.1 | 3.9 | 63.6 |

Malta | - | 0.9 | 0.7 | 54.8 |

Netherlands | 2.6 | 0.2 | 1.2 | 74.3 |

Poland | -0.4 | -0.6 | 3.3 | 54.5 |

Portugal | 1.9 | 0.8 | 0.7 | 67.9 |

Romania | -1.9 | -0.3 | 2.8 | 58.8 |

Slovakia | -0.8 | 0.6 | 2.3 | 59.4 |

Slovenia | -0.4 | 0.5 | 1.2 | 66.6 |

Spain | 3.9 | 3.2 | 3.3 | 61.0 |

Sweden | 0.8 | 0.3 | 1.8 | 73.1 |

United Kingdom | 1.3 | 0.9 | 0.8 | 71.5 |

EU-27 | 1.0 | 0.5 | 1.6 | 64.3 |

US | 2.0 | 0.5 | 1.9 | 71.5 |

Source: National accounts (EUROSTAT) for employment growth and structural indicators (EUROSTAT, Labour force survey) for the employment rate. Status: July 2007. |

B. TOPICAL ISSUES ON THE STRUCTURAL REFORMS AGENDA

RECENT MICROECONOMIC REFORMS IN THE EUROPEAN UNION

Introduction

The renewal of the Lisbon Strategy in 2005 as the Partnership for Growth and Jobs focused the efforts of the European Union on more effective responses to the challenges of demographic change and globalisation. The National Reform Programmes and the Community Lisbon Programme designed to carry this reform effort over the three-year cycle 2005-2008 aim at increasing employment rates and productivity growth at the same time. This combined effort to act on labour supply and productivity growth should help ensure that the European Union will continue to have the wherewithal to sustain its social model and to secure the prosperity to which Europeans have grown used over the decades, and which in good measure has been the fruit of European integration, in particular the single market.

Raising the long-term economic potential by increasing productivity growth is one of the fundamental objectives of the renewed Lisbon strategy. Reforms in pursuit of this objective are being undertaken mainly in the microeconomic policy pillar of the integrated strategy, although reforms in the macroeconomic and employment policy pillars also impact productivity growth. It is in the microeconomic policy area where Member States identified the largest number of key challenges in their 2005 National Reform Programmes. This chapter aims to provide a broad assessment of whether the types of reforms engaged by Member States since 2005 are likely to have the desired effects on growth in total factor productivity, given what is known about the relationship between microeconomic structural reforms and productivity growth[26].

The results of productivity-enhancing structural reforms can rarely be captured in the short term and the measurement of their effects is complex. In view of that, the relaunch of the Lisbon strategy in 2005 is too recent to allow for a quantitative assessment of progress in the microeconomic pillar of the strategy. However, based on the literature on the relationship between structural reforms and productivity growth, it is possible to determine whether Member States and Community level are engaged in the right kinds of activities in the pursuit of productivity growth. This chapter finds that the priorities identified and the reforms pursued by Member States and at Community level under the Community Lisbon Programme in their majority target higher productivity growth. There is clear progress with the key reforms under the microeconomic pillar of the strategy. While it is too early for quantitative assessments, the most recent data on productivity developments presented in chapter 1 seem to be consistent with a positive view of the structural reform effort to boost productivity growth.

Section 2.2.1 presents a literature review of the links between structural reforms and productivity growth and in Section 2.2.2 estimates found in the empirical literature on the likely quantitative impacts of certain types of structural reforms across the microeconomic pillar of the Growth and Jobs Strategy. In the light of these findings, Section 2.2.3 looks at reform measures taken by Member States and at the Community level and assesses to what extent they promise an increase in productivity growth in the European Union in the years ahead. Section 2.3 considers the role of spillovers between reforms pursued by Member States individually as compared to joint reform action by all Member States in this context. Section 2.4 concludes.

Productivity Growth and Structural Reforms

Preconditions for boosting productivity growth

Europe's underperformance vis-à-vis the United States over the last decade or so in terms of per capita income and the question of how this underperformance can be overcome has been the subject of a considerable body of literature focusing on the role which structural reforms can play in raising potential output and productivity growth in European economies[27]. Differences in total factor productivity are generally regarded as the main variable for explaining differences in par capita income across countries with similar capital intensity and labour input[28]. As the residual in the growth accounting equation, total factor productivity growth captures the overall increase in efficiency achieved through technological progress and the improvement in production processes that cannot be attributed to capital deepening[29].

The analysis of factors explaining cross-country differences in productivity growth provides an important point of reference for any reform agenda aiming to raise the long-term growth performance. Europe's competitiveness over the long term can only be ensured through stronger and sustained productivity growth. To achieve higher productivity growth is therefore a key objective of the renewed Lisbon strategy, the partnership for growth and jobs. The empirical literature on structural reforms has produced numerous quantitative estimates of the potential impact of "Lisbon-type" reforms[30] on productivity, economic growth, and employment. While productivity growth depends also on macroeconomic stability and well functioning labour markets, its immediate foundation is the quality of the microeconomic business environment and the sophistication with which firms operate.

Michael Porter et al. (2006) present the microeconomic business environment of the firm as the interplay of four elements: factor conditions (human and capital resources, administrative, scientific and technological infrastructure, natural resources), context for firm strategy and rivalry, demand conditions (sophistication of demand), and related and supporting industries (quality suppliers, presence of clusters). Increasing productivity growth can be achieved to varying degrees by influencing these elements of the business environment through appropriate policy measures, but it ultimately depends on the sophistication of the companies.

Catching up with the United States on productivity growth – past trends

The basic types of policies required to boost growth and employment in Europe have changed considerably over time, and the recent widening of the gap between the United States and the European Union in terms of productivity growth are in part a reflection of an insufficiently rapid adaptation of policies in Europe. This becomes clear when looking at the broad trends over the past 50 years. Aghion (2006) points out that Europe's success in achieving sustained economic growth during the post WWII era was associated mainly with policies of capital accumulation and the imitation or adaptation of innovations made elsewhere[31]. The economic institutions of the time were well suited to support this catching up process through incentives based on limited competition in product markets, a focus on education below the tertiary level, and labour market arrangements favouring the accumulation of experience within firms rather than labour mobility.

Once the catching up process was complete by the 1980s, capital deepening and the imitation of innovations produced elsewhere were no longer sufficient to boost growth, and home-grown innovation was needed. Michael Porter et al. (2006) describe such transitions in more general terms as moving from the investment-driven phase of economic development to the innovation-driven phase. They attribute an economy's difficulties in making such transitions to the "wholesale transformation of many interdependent aspects of competition" that is required to advance to the next level and to the complication that previously successful strategies may no longer be efficient under the new circumstances.

The role of efficient ICT use

The widening of the gap in productivity growth between the United States and Europe since the mid-1990s has been attributed to a large extent to innovations in the ICT sector and their rapid spread across the entire economy in the following years. Contrary to the United States, Europe has not been able to keep up with regard to the production but also with regard to the use of ICT across all sectors of the economy. The services sector in particular has lagged behind in Europe vis-à-vis the US in terms of productivity growth since the late 1990s[32]. Van Ark (2005) has shown that the productivity gap in ICT using sectors has widened sharply since 1995.

It is however interesting to note, that capital deepening in ICT has accelerated in all the 26 OECD member countries investigated in van Ark (2006), even in those countries where productivity growth remained slow. This seems to suggest that increases in ICT investment as such do not guarantee stronger total factor productivity growth, but that general framework conditions, such as the degree of competition prevailing in a market and the general conditions for restructuring the productive sector, are likely to be of more fundamental importance for the innovative capacity of an economy.

This view is supported by Crespi et al. (2007) who have analysed the relationship between productivity growth, ICT investment and organisational change based on firm-level panel data for the United Kingdom. While the authors present a note of caution in view of measurement and data issues, their findings are consistent with previous studies which have shown that ICT investment has high returns in terms of growth accounting, when organisational change is omitted from the equation[33]. These returns fall sharply once organisational change is taken into account. The authors also find that periods of above-average ICT investment tend to be associated with slowdowns in TFP growth in the short run. These results are consistent with the suggestion that ICT investment and organisational change together boost productivity and that in the absence of organisational change higher ICT investment would imply a slowdown in measured TFP growth.

The relationship between competition and innovation

Europe needs to boost its innovative capacity continuously in order to raise productivity growth and to be able to sustain its standard of living in the face of the challenges posed by globalisation, ageing societies, as well as changes in technology and skill composition of demand for labour and climate change. The empirical literature on structural reforms and productivity supports the view that the focus of public policy on areas crucial for future productivity growth - such as