Is Europe Suffering From Productivity Paralysis?

Why can't Europe be more productive? That's a question investors, executives, and politicians are asking with increasing urgency. Boosting labor productivity is the key to creating higher profits, improving living standards, and keeping prices stable. For decades after World War II, Europe kept pace or even surpassed the U.S. in productivity growth. But since 1995, Europe has trailed America in this vital metric.

The gap is even widening. This year the U.S. should record productivity gains of 3.3%, according to Eurostat, the statistical agency of the European Union. That's almost twice the rate of France and Germany and well above the British rate (yes, even dynamic Britain is struggling in this area). Europe now has an hourly output per worker some 20% below American levels.

The productivity numbers have become so alarming that European Central Bank boss Jean-Claude Trichet warned about the problem in a July 1 speech. The Dutch, who have seen their once-robust economy stumble, are getting worried. "Future economic growth will require a substantial increase in our productivity," says Economic Affairs Minister Laurens Jan Brinkhorst. Patricia Hewitt, the British Secretary of State for Trade & Industry, has made improving productivity a top priority: It's the only way Britain can close a still-considerable gap in living standards between British workers and their U.S. counterparts.

But what exactly is wrong? The short answer is that Europe is not seeing the same productivity bang from information technology that the U.S. has enjoyed over the past decade. The long answer is that uniquely European factors -- from stiff job-protection codes to hidden barriers against competition -- amplify the problem. There is no simple fix.

Start with the issue of info-tech spending. A key to productivity increases is using IT to get the most out of workers and plants -- whether it's customer-relationship software in a sales office, process-control technology in a factory, or inventory-tracking systems in a store. European companies have ample access to all this knowhow from U.S. and Asian tech providers, not to mention from other European firms such as software giant SAP (SAP), industrial powerhouse Siemens (SI), or mobile-phone maker Nokia .


But this is where the differences between Europe and the U.S. become stark. European executives have invested much less in IT than have their U.S. counterparts. According to the Organization for Economic Cooperation & Development, in France, spending on information and telecommunications technology accounted for 1.97% of gross domestic product in 2002. U.S. IT spending accounted for 4.42%. That partly reflects differences in mind-set, says Roger Fulton, an analyst in the British office of IT researcher Gartner Inc. (IT) "The U.S. is a 'just do it' society, whereas Europe has more of a 'let's think about it' society." That results in a greater hesitancy to buy into the benefits of IT and, therefore, to lower IT spending.

There's also a chicken-and-egg problem with IT investment in Europe. Heavy spending can help a company produce more with fewer workers -- often making layoffs inevitable, even desirable. "But the labor market is less flexible in Europe than in the U.S.," says Kasper Rorsted, managing director for Hewlett-Packard Co. (HPQ) in Europe, the Middle East, and Africa. "Employees in Europe are seen as more of a fixed cost -- not something you can easily trim." With the cost of laying off a worker so high in Europe, companies hesitate to spend on labor-saving information technology in the first place. Rorsted is so concerned about low IT spending in Europe that he confers monthly with policymakers in Brussels on crafting investment incentives and loosening regulation.

Europe also simply doesn't have as large a tech sector as the U.S. That matters because fast-growing technology companies are themselves major contributors to productivity growth. According to McKinsey & Co., the IT sector generates 2.3% of total GDP in the U.S., but only 1.3% and 1.5% in France and Germany, respectively. McKinsey says that the U.S. tech sector accounts for more than a quarter of the entire economy's productivity growth. (Some studies suggest it is much higher.) In contrast, a smaller IT sector generates less than 20% of productivity growth in Europe.

At the same time, says Dirk Pilat, senior economist at the OECD in Paris, fewer new businesses -- most of which generate strong productivity growth if they survive -- are created in Europe. "You just don't get the same productivity impulse from new companies here," he says.

Europe also spends less on research and development -- about 2% of GDP, vs. nearly 3% in the U.S. Spending on R&D usually boosts productivity, too, as new processes and easier-to-make products flow from the labs to the assembly line. And many of the big European R&D spenders, such as Novartis (NVS), are shifting more of their R&D to the U.S. to be closer to their biggest market. German-based BASF (BF), for example -- the world's largest chemical company -- is not only trimming R&D spending but also deciding whether to move its genetically modified crop research across the Atlantic. Such moves mean that the U.S. economy benefits more than Europe does from any productivity payoff that comes from R&D.

Even if IT and R&D expanded dramatically in Europe, it's not clear whether they would have the intended effect. The biggest psychological impulse to boost productivity is the survival instinct: the drive to be smarter, faster, bigger. In Europe, numerous barriers to competition mute that instinct. "Europe seems to be covered in a warm blanket, which protects the average but smothers the excellent," says the Netherlands' Brinkhorst.

Take Germany. The legal separation of commercial, savings, and cooperative banks in Germany means that there has been little financial sector consolidation. German banks have invested heavily in information and communication technology and developed highly efficient payment, customer-relations, and online-banking systems. But without the chance to exploit the economies of scale that come with consolidation, they can't derive maximum productivity benefits from it. The average German bank's productivity is 13% lower than its U.S. counterparts as a result.

There are even productivity-busting restrictions in Britain, the fastest-growing big economy in Europe. British retailer Tesco PLC (TSCDY) over the past 10 years has spent heavily on IT. Retailing analysts estimate that Tesco's labor productivity growth has been about 1% a year higher than the recent British average for the past five years. "Their distribution systems are as tight as they can be," says Nick Isles, associate director at the Work Foundation, an independent research consultancy in London. That benefits Tesco's efficiency because it delivers the right goods at the right time.

Yet for all its success, Tesco hasn't been able to chalk up as many productivity gains as it could. One reason, say industry experts: Tough British planning laws make it harder to open large new supermarkets than in the U.S. That means Tesco can't fully benefit from productivity gains by setting up new shops and achieving the economies of scale it would in a less regulated environment.

Could Europe have a productivity spurt? Yes. Take what happened in the German electricity and gas market when it was liberalized in 1998. Wholesale prices fell, forcing power generators to improve their traditionally low productivity levels by investing heavily in IT -- $5.6 billion in 2000 alone. Annual productivity in the sector has risen 3.5% since. By contrast, Electricité de France, a state-owned virtual monopoly, has invested just a fifth as much in IT in recent years as has the German power sector. One result, say consultants: Labor productivity growth at EdF is less than a sixth of German levels.

Europe wide deregulation helps, too. When the regulations governing commercial trucking were harmonized in the late 1990s, managers were able to reduce red tape and invest in bigger, more efficient vehicles. Some European companies and countries even outperform their U.S. rivals. European mobile-telephone operators tend to be far more productive than most U.S. providers. Low-tax, well-educated, high-tech Ireland boasts productivity growth rates on a par with or above U.S. levels. Britain is improving manufacturing output per worker by stressing training. What's missing is that systematic surge in IT spending, coupled with serious labor-market reforms, that would change the dynamic in all of Europe. Until that happens, progress will come in fits and starts.