Why Europe lags behind the United States in

productivity
Europe has made considerable economic progress in the past 15 years, but its per
capita GDP is still $11,250 lower than that of the United States—$4.5 trillion in all. A
preference for leisure time is one reason, but a widening productivity gap between
Europe and the United States is the major culprit. What accounts for it? The answer is
underperforming service sectors. Local services (such as retailing) alone account for two-
thirds of the productivity shortfall. But Europe, boasting examples of best practice across
service sectors, could reduce the gap. The trick would be for companies to emulate these
examples in their own industries and for governments to help them do so by removing
regulatory hurdles.1
The opportunity to improve Europe’s lagging service sectors is one of the major themes
addressed in Beyond austerity: A path to economic growth and renewal in Europe, a
new report from the McKinsey Global Institute (MGI).2 The report analyzes Europe’s
strides in reforming labor markets, cutting unemployment, and fueling growth in per
capita GDP; the many pressures bearing down on growth; and how to build an effective
pro-growth agenda using recent reforms as a platform. Given high debt and deficit levels,
little scope remains to spur growth through short-term stimulus spending. Europe must
therefore embrace structural reform—and boosting the performance of service industries
is a critical part of this effort.
In Europe, service sectors account for a lower share of overall economic activity than
they do in the United States. Across the Atlantic, 19 percentage points of gross value-
added growth were accounted for, from 1995 to 2005, by local services,3 business
services,4 and professional and financial services. In the EU-15, these added only 10
percentage points (Exhibit 1).
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From the 1960s to the mid-1990s, Europe steadily closed its productivity gap with the
United States. But then the gap started widening again—and one important reason was
that Europe’s service sectors underperformed their US counterparts (Exhibit 2). While
productivity is not an end in itself, it is a critical means to an end: per capita GDP,
competitiveness, and productivity move in lockstep. If Europe is to close the per capita
GDP gap with the United States, it will therefore have to boost productivity, particularly
that of services. US productivity grew by 22 percent between 1995 and 2005, and local,
business, and professional and financial services together contributed half of that
expansion. In Europe, productivity grew by 15 percent, of which only one-quarter came
from these service industries.
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Many policy makers in Europe are maintaining the traditional focus on technology-
intensive and manufacturing sectors, reflecting their strong role in productivity growth
and the exposure of the region’s economies to global competition. But the fact remains
that as the number of manufacturing jobs has declined in the EU-15, only the service
sectors have increased their levels of employment. It is the service sectors that offer
Europe the major potential for job creation.
How to raise European service productivity
A range of regulatory and market barriers stand in the way of higher productivity in
European services, which suffer from relatively low scale in many operations and from
product, land, and labor market regulations that inhibit competition. MGI sees two
important areas to address. It will also be necessary to ensure that enablers for growth,
including infrastructure and skills, are in place.
Injecting competition
The liberalization of monopolistic industries in Europe has consistently led to dramatic
increases in productivity. Coupled with standardization, regulation to heighten
competition has made a success story of telecommunications, for example. GSM—the
Global System for Mobile Communications—was initially deployed in seven European
countries, in 1992; today the system has more than four billion users worldwide. In the
road freight industry, the relaxation of price controls and the removal of barriers to
cross-border trade led to a 15 to 25 percent drop in tariffs and 5 percent-plus annual
productivity gains throughout the 1990s in France and Germany.
Despite such examples, many other service industries, including postal services, rail
transport, and professional services (such as law and accounting), continue to receive
regulatory protection from competition. Entry barriers are still common. Many
European countries limit the number of pharmacies, for instance, in effect creating
regional monopolies on retail sales of medicinal products. Some European countries set
price ceilings or floors—for architects and lawyers in Italy and Germany, among others.
France and Spain prohibit advertising for notaries. Some countries have abolished such
advertising and price restrictions in recent years, apparently without damaging these
markets. But regulation remains high overall. In professional services, the 2008 product
market regulation index of the Organisation for Economic Co-operation and
Development (OECD) is nearly twice as high for Europe as for the United States.
Deregulation
Regulation not only hinders competition in Europe’s service sectors but can also
compromise the efficiency of operations. Retailing, for instance, still suffers from
restrictive land and product regulations. Zoning laws that limit the size and density of
stores put bigger, more efficient formats like hypermarkets at a competitive
disadvantage: in France, the introduction of more restrictive rules on the size of retail
outlets during the 1990s halted the sector’s productivity growth—opening new stores
larger than 6,000 square meters became virtually impossible—and the restrictions
eventually had to be eased. In the United Kingdom, the number of new stores opening
has slowed because of insufficient reform to planning laws. In the Netherlands,
individual municipalities have the power to prevent retailers from selling televisions in
furniture stores.
Strict labor laws, which often encourage informality, are another barrier to productivity.
Businesses have an incentive to stay smaller to avoid a higher level of regulatory
scrutiny, and this stratagem prevents companies from achieving scale in fragmented
industries, including construction. (In Portugal, informal labor accounts for more than a
quarter of the hours worked in residential construction.) In retailing, Dutch labor
legislation typically requires stores to pay their employees 30 percent more for evening
work.
Operational barriers remain rife too. In land transport, standardized road freight
containers that could boost productivity have not achieved widespread use. In the
construction industry, the complex way projects are set up compromises productivity:
traditionally, there are separate tenders for design, engineering, and actual construction.
That undermines coordination and inefficiency—for instance, contractors are rarely
involved in the design phase to discuss cost-efficient construction specs and materials.
Since the public sector accounts for 33 percent of all construction in Germany and for 25
percent in the United Kingdom, if governments changed their procurement and
tendering processes, they could directly help to institutionalize best practices.
Emulating best practice
European service sectors could vastly increase their productivity and growth. Take food
retailing. If the EU-15 as a whole achieved the productivity levels of its top-quartile
countries in this sector—admittedly not an easy task in many places—it could achieve a
44 percent boost in productivity. This would translate into a 21 percent increase in the
productivity of retailing in general, or a 0.75 percent increase in the value added
generated by the entire EU-15 economy. (These figures assume that the hours freed up as
a result of improved productivity will be reallocated to the rest of the economy at current
sector productivity levels.)
In road freight, emulating best practice would boost the productivity of land transport by
50 percent, adding 0.4 percent of incremental GDP to Europe’s economy. Reaching best
practice in construction could boost its productivity by 12 percent, for a 0.5 percent
increase in the value added generated by the European economy overall.
Europe’s low-key revolution in reforming its product and labor markets fueled a
relatively solid economic performance before the global crisis hit. But in the early
aftermath of the global recession, Europe is battling to revive the headwinds of growth—
with little scope to prime the pump, given high debt and deficits. If it is to sustain robust
growth in the coming years, structural reform is no longer optional, and freeing service
industries to compete is a vital component of that change.