Euro-zone economy holding its own compared to achievements of US

Analysis: European workers have used their productivity gains to boost both their income and leisure time; Americans have increased their income only, writes Kevin Daly.

There is a widespread belief in financial markets, and among some policymakers, that continental Europe is a persistent underperformer relative to the United States - a "basket case", as some have put it. The US, it is pointed out, is richer than the euro zone and the gap is increasing.

In 2003, income per head in the euro zone - adjusted for price differences - was around 30 per cent less than in the US. Over the past 10 years, US gross domestic product (GDP) has grown, on average, 1 per cent a year faster than in the euro zone.

Those who view continental Europe as an economic failure are also in no doubt as to why the United States is richer and has grown faster: the advent of the "new economy" has resulted in technology-driven productivity gains in the US.

Europe, with its bureaucratic, over-regulated economies, has been slow to develop or take advantage of new technologies.

However, there's one problem with this conventional wisdom - it is contradicted by the evidence.

Through the use of a simple accounting framework, one can shine a light on the real sources of income and growth: a higher level of GDP per head can be due either to higher productivity (GDP per hour worked) or to higher labour utilisation (total hours worked per head of population).

Over the past 10 years, the euro zone's "problem" has been one of low labour utilisation rather than productivity.

The level of euro-zone productivity, when defined as output per hour, was only 4 per cent less than the US in 2003, slightly better than the position 10 years ago.

Labour utilisation (total hours worked per head of population), on the other hand, was 28 per cent lower in the euro zone in 2003 than in the US. Euro-zone employees worked 15 per cent less hours than their US counterparts in 2003, accounting for one-half of the gap in labour utilisation.

The remaining gap was accounted for by a smaller proportion of people in employment. This is partly a function of higher structural unemployment (accounting for around one-quarter of the lower employment rate) but it is primarily a function of low labour participation, particularly among women.

Similar results are obtained when looking at growth rates over the past 10 years. Almost all of the US outperformance has been due to demographic factors. Population growth in the US averaged 1.2 per cent a year compared with 0.5 per cent a year in euro zone.

GDP per head has grown at virtually the same rate in the euro zone as the US - 1.7 per cent a year versus 1.8 per cent. The remaining difference is explained by a small decline in the proportion of the population of working age.

It seems odd to talk of the euro zone's relative economic failure given that, over the past 10 years, GDP per head has risen at virtually the same rate in the euro zone as in the US and euro-zone productivity growth and the rise in the employment rate were slightly faster than in the US. (I consider a whole economy measure of productivity. The commonly quoted US non-farm, business productivity data suggest faster growth because, once one strips out two large sectors - farming and the government - where productivity growth is low, productivity growth in the remainder of economy seems quite high).

To maintain the same growth in GDP per head, US workers have had to work longer hours than their euro-zone counterparts.

To put it another way, Europeans have used their productivity gains to boost both their income and leisure time; Americans have increased their income only.

The finding that Europe's underperformance has been driven by demographics rather than productivity has important implications for policymakers and financial markets.

In March 2000, the EU Council of Ministers set a strategic goal for the decade ahead - the so-called Lisbon Agenda - "to become the most competitive and dynamic knowledge-based economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion... An average economic growth rate of around 3 per cent should be a realistic prospect for the coming years."

According to the analysis here*, there is little prospect of the euro-zone achieving an average growth rate of 3 per cent a year over the next decade unless there is a marked change in demographic trends. For this to occur, the European Union would need to seriously reconsider its approach to immigration.

Europe could always do better, of course, and structural reforms are important to pursue. But structural reforms will not result in US-style growth rates as suggested in the original Lisbon agenda. In some cases, they may actually depress growth for a time.

In many areas, where policy can have a meaningful impact - raising productivity and employment - the euro zone's underlying performance is already on a par with the US.

For financial markets, the key insight is that slower euro-zone GDP growth driven by weaker labour force growth should not result in a lower return on eurozone assets. With open capital markets, the risk-adjusted rate of return should converge across economies.

But even in the absence of open capital markets, many economic models imply that the rate of return is dictated by productivity growth rather than labour force growth.

The euro zone's return on capital compares favourably with the United States and total equity returns have been as good in the euro zone as in the US over the past 10 years.

The same is likely to be true over the next 10 years, despite slower GDP growth.

*This article summarises the findings of the study Euroland's Secret Success Story, Goldman Sachs Global Economics Paper, No 102, January 2004.

Kevin Daly is an economist at Goldman Sachs investment bank