September 14, 2000
© Peterson Institute for International Economics
1. New economy capacity. Based on recent U.S. experience, the new economy is capable of delivering sustained 3-4% annual GDP growth (based on productivity growth of 2-3%) in a mature industrial economy.
2. Key ingredients. The new economy has four key ingredients: (a) new technology, especially information technology; (b) very low barriers to foreign trade and investment; (c) social acceptance of intense competition in all markets; and (d) continued restructuring of firms and the workplace with a view to increasing productivity.
3. U.S. vs. EU growth. Faster U.S. adoption of these ingredients has led to a decade of faster U.S. GDP growth rates by comparison with Europe (Figure 1). The consequence, since 1995, is faster GDP per capita growth in the United States (Figure 2).
4. Manufacturing productivity. Manufacturing is the sector where it is easiest to measure productivity. U.S. manufacturing productivity growth has exceeded European rates by more than one percent per year since the mid-1990s (Figure 3). The rate of change in unit labor costs is about the same in the U.S. and the EU, reflecting faster U.S. wage growth (Figure 4). In my view, the IMF projections of U.S. manufacturing productivity growth for 2000 and 2001 are too low.
5. Unemployment. U.S. unemployment in the 1990s has dropped faster and flattened out at a much lower level than European unemployment (Figure 5). Both the OECD and the IMF see little prospect that European unemployment can be brought below 6.5% compared to 4% in the United States. Their argument: after a decade of high unemployment, many European workers have effectively lost their skills and left the labor force. In my view, the official outlook for EU unemployment is too pessimistic. An important reason that productivity growth has been so high in the United States is that high employment has encourage workers and compelled managers to accept more productive ways of work. Correspondingly, as unemployment falls in Europe, managers will stress productivity, and work force dropouts will regain their skills.
6. Rates of return. As far as can be measured, U.S. rates of return on business capital (plant and equipment) have persistently exceeded European rates of return (Figure 6). Comparable rates of return figures are hard to calculate; however, the persistent net inflow of direct investment into the United States supports the view that U.S. rates of return on business capital exceed European rates. In 1999, EU firms placed $228 billion direct investment in the United States, whereas U.S. firms placed $58 billion of direct investment in Europe. As the new economy reaches Europe, rates of return will rise and direct investment flows will become more balanced.
7. Capital depth. Two other comparisons about business capital are worth making. Gross fixed capital is a somewhat larger share of GDP in Europe than in the United States (Figure 7). And the capital income share in Europe is larger (Figure 8). In other words, Europe has a deeper, but less productive, capital stock than the United States. Again, the new economy will raise the productivity of capital in Europe.
8. Inflation and interest rates. U.S. CPI inflation since 1995 has been a little higher than EU CPI inflation (Figure 9). U.S. short-term interest rates are also somewhat higher (Figure 10). But these similarities mask an important difference. Low U.S. inflation is largely the result of sharp competition in virtually all product markets. Low EU inflation owes more to tight monetary policy (tight relative to the depressed EU economy) and high unemployment.
9. Technology application. U.S. firms apply technology more energetically than European firms. Three comparisons are worthwhile. U.S. expenditures on R&D (mainly development outlays) as a percent of GDP are persistently higher than European expenditures, and there is no narrowing of the gap (Figure 11). Internet usage is cheaper and denser in the United States (Figure 12). The U.S. has more information technology companies (Figure 13). The number of U.S. billionaires has increased much faster than in Europe (Figure 14). These four indicators should be watched as harbingers of the new economy in Europe.
10. How open? In terms of broad aggregates, the European and U.S. economies are open to foreign trade and investment to about the same degree. EU merchandise imports and exports (excluding intra-European trade) in 1999 were about 26% of GDP, compared to 19% for the U.S. Cross-border M&A coming into the U.S. in 1998 was 2.5% of GDP ($221 billion), compared to 2.4% of GDP into the EU ($201 billion). An open economy can be a high-pressure, low unemployment economy: instead of breeding inflation, low unemployment can stimulate productivity growth.
11. Labor practices. However, labor practices are much more rigid in Europe. Job descriptions are far less flexible. It is harder for firms to downsize their workforce when demand is weak, and accordingly they are less willing to hire when demand is strong. The underlying reason that workplace rules and traditions remain so durable is that unemployment has been persistently high for more than a decade. In Europe, if you have a job, you put your personal and political energy into protecting that job. Lower unemployment rates, resulting from traditional macroeconomic stimulus, are the key to more flexible European labor practices, and faster growth in labor productivity.
12. Corporate restructuring. Corporate restructuring is going forward in Europe. Hostile takeovers are becoming more familiar, but an enormous amount of restructuring remains to be done. Obstacles are becoming less severe year by year. In 1999, European M&A transactions reached about three-quarters of the U.S. level (Figure 16). A continued high rate of M&A activity is critical for the new economy to reach Europe.
13. Government size and tax rates. Tax competition is just erupting in Europe. Germany and France have both announced modest steps toward corporate tax relief. The success of Spain and Ireland are getting notice. Still, average tax burdens in Europe are about 15 percentage points of GDP higher than in the United States (Figure 17). Not only do higher taxes diminish incentives, they also mean that a larger portion of the EU economy is essentially non-competitive (social services like health, education and welfare, as well as postal services and utilities, are provided by monopoly suppliers—public agencies).
14. The path to the new economy. In my judgment, the EU path to the new economy has five steps:
15. The time line. Here's my optimistic scenario. Within three years, with traditional macroeconomic stimulus, and growth rates of 3%+, European unemployment drops toward 5%. Labor rigidities begin to melt. Meanwhile, IT makes major inroads into the European economy. Within five years, EU manufacturing productivity growth rises to 2% annually. The new economy has finally arrived! However, the larger European public sector may keep EU productivity below U.S. levels.