Europe’s competitiveness trap

A flawed understanding of what drives economic growth has emerged as the gravest threat to recovery in Europe. European policymakers are obsessed with national “competitiveness,” and genuinely appear to think that prosperity is synonymous with trade surpluses. This largely explains why Germany is routinely cited as an example of a strong, “competitive” economy.

But economic growth, even in traditionally export-led economies, is driven by productivity growth, not by the ability to capture a growing share of global markets. While imports must, of course, be financed by exports, the focus on trade competitiveness is drawing attention away from Europe’s underlying problem – very weak productivity growth. And this is as serious a problem in the economies running trade surpluses as it is in those running deficits.

The idea that economic growth is determined by a battle for global market share in manufactured goods is easy for politicians to grasp and to communicate to their electorates. Economies running external surpluses are regarded as “competitive,” regardless of their productivity or growth performance. The trade balance is seen as a country’s “bottom line,” as if countries were firms. In fact, they have little in common – the trade balance is simply the difference between domestic savings and investment or more broadly, between aggregate spending and output – but referring to Deutschland AG, or UK plc, is conceptually attractive and seductively easy.

Governments obsessed with national competitiveness are likely to pursue damaging economic policies. If economic growth is seen as being dependent on the cost competitiveness of exports, governments will focus on things that might make sense for exporters, but not for their economies as a whole, such as labor-market policies aimed at artificially holding down wage growth, which redistributes income from labor to capital and exacerbates inequality.

Indeed, the secular decline in the proportion of national income accounted for by wages and salaries over the last 10 years in nearly every EU economy is a major obstacle to a recovery in private consumption. And the flipside of the decline in wage and salaries – a steep rise in the proportion of national income accounted for by corporate profits – has not resulted in booming investment.

This should come as no surprise. An individual firm can cut wages without undermining demand for whatever good or service it produces. But if all firms cut wages simultaneously, the resulting weakness of overall demand undermines companies’ incentives to invest, in turn depressing productivity growth.

In short, cutting the proportion of national income accounted for by wages, accepting a secular rise in inequality, and boosting the proportion of national income accounted for by corporate profits is no way to deliver sustainable economic growth. But that is precisely what happens when governments believe that economic salvation lies in winning a growing share of export markets.

It doesn’t. There is a very strong correlation between rising labor productivity and economic growth, which holds for countries with trade surpluses as well as those with deficits. So the European Union’s rate of productivity growth, not the size of its trade surplus, will largely determine its economic prospects.

Unfortunately, productivity growth is declining across Europe, from around 3.5% annually in the 1970’s to barely 1% in the 2000’s. And productivity growth has been almost as weak in the eurozone’s core as in its troubled periphery.

Governments throughout the EU should focus on raising productivity – not just in the most internationally exposed sectors, like manufacturing, but also in less tradable sectors, such as services, which now account for around two-thirds of economic activity. Without stronger productivity gains there, economic growth will prove elusive.

But improvement presupposes diagnosing why Europe’s productivity performance, with a few notable exceptions, has been so bad. There are two core problems. The first is inadequate skills levels, aggravated by complacency. Some countries – Scandinavia and the Netherlands, for example – do well. But the picture elsewhere is patchy at best. Germany has good vocational training, Britain more than its fair share of top universities, and France good technical education. Other countries, especially in the south, perform poorly in most areas.

The second problem is inadequate competition. In too many sectors, incumbents are protected. This is justified in terms of upholding “social justice” or defending “national champions.” But it merely fuels rent-seeking – the ability of particular groups in society to extract disproportionate rewards for their work. Where this tendency is strongest, productivity levels are weakest.

While Europe’s economic growth prospects may be poor, this has little to do with what is happening elsewhere. Europe’s leaders will find that improving education and training – and throwing open hitherto protected markets – is a long and arduous task. But, unlike the obsession with “competitiveness,” such reforms would lead Europe onto the path of sustainable growth.