US and European productivty

The McKinsey Global Institute has released a new study which examines the gap in productivity between the US and Europe, 70 percent of which it says can be attributed to European underperformance in the service sector. While productivity may sound like a dry economic concept, it is perhaps the most important single metric for evaluating economic health, as production dictates consumption and standard of living (one can't consume more than what one produces). 

As shown by this graph, the difference between U.S. and European productivity levels is pronounced -- and widening:

I'll note that there is reason to think that this graph may actually understate the difference in productivity levels. In The Power of Productivity -- a book I can't recommend enough -- author William Lewis, a former director of the McKinsey Global Institute, noted that labor restrictions in some European countries discourage the hiring of low productivity workers, such as grocery store baggers, which are common in the US. Thus, because Europe has fewer such workers, it skews the productivity numbers upwards. 

In any case, if Europe is to move closer to US productivity levels the McKinsey report says that it must pursue an agenda of deregulation and market liberalization:

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.

This is something to keep in mind as our elected leaders continue to warn against the alleged evils of deregulation and many on the left urge further moves towards the European model. It may sound attractive in the abstract until one fully grasps what it means: reduced prosperity.