Europe risks losing decades

Weakening demographics are preventing investment, although investment is needed to improve productivity to counter demographic decline

Michael Heise

The financial and economic crisis and its aftermath have subdued the European economy since. Now that recovery is taking hold, it is time to look ahead. During the crisis, governments reacted with higher public spending and ever looser monetary policy. But such demand-side policies will do little to address the issues that really matter for Europe’s future growth and prosperity.

The biggest threat to long-term growth stems from the combination of weak demographics and low investment. The combined workforces of the 28 EU countries will shrink by between 12 million and 16 million people in the next 15 years, according to the EU and the OECD. These forecasts already assume a steady inflow of migrants. Further inflows of foreign workers could ameliorate the situation, but they are no solution.

Europe’s only hope for sustained growth is to boost productivity. Here is where it gets worrying: Europe has not seen significant productivity growth for a long time. In the EU-15, the growth rates of labor productivity (output per hour worked) have been declining for decades. Productivity growth stood at a robust 4% in the, declined to 2% in the and dropped below 1% around the turn of the century. Today it crawls forward at about 0.5% a year. Meanwhile, total factor productivity, which takes into account technological innovation, has been stagnant.

WHERE’S THE PRODUCTIVITY GAIN?

The decline in productivity growth in the EU is surprising given the rapid onset of digitalization – often described as the industrial revolution of the 21st century. In Europe, as well as the United States, the technological changes being wrought by smartphones and the Internet are simply not showing up in the productivity data.

Statisticians struggle, for example, to account for how consumers are benefiting from the increased quality and speed of delivery that often results from digitalization. Furthermore, in the digital age, many services are being provided free of charge, which means they are not being counted as consumption at all.

Another factor is that many corporations run the old physical business models parallel to the new digital ones. Adding new IT systems and operating or sales processes to traditional ones can temporarily increase costs and depress productivity, especially if new and old value-added chains are not well connected. As these problems will diminish over time, part of the productivity lull should disappear.

EUROPE’S CATCH-22

A more permanent aspect of low productivity growth may be the depressed level of investment that we have seen in recent years. For Europe as a whole, the ratio of investment to GDP is still below what it was. Long-term economic health will depend, in large part, on whether investment recovers and by how much.

There are reasons to be pessimistic. Weak investment activity partly reflects a gloomy view of the European market. If workforces are stagnating or shrinking and growth is subdued, why spend on boosting output? So here is Europe’s Catch-22: the demographic outlook would require much higher, productivity-boosting investments. But the demographic weakness is causing companies to hold back.

Fortunately, there is much that can be done. A renewed push to integrate European markets for services, digital goods, capital markets, and energy, would remove barriers to business and bring new incentives to invest.

The Transatlantic Trade and Investment Partnership that the EU is currently negotiating with the US would also create a larger market, with less burdensome regulation and more competition. On a national level, reform drives like those carried out in Ireland, Portugal and Spain could improve business conditions and competitiveness across Europe. Finally, all European countries should redouble their efforts to educate and train their citizens to excel in the digital age.

An improved business environment could also help companies reap productivity benefits from digitalization. While some companies excel at the technological frontier, there are too many laggards. More open and larger markets and a well-trained workforce would encourage and allow companies to scale up.

Official forecasts assume that productivity growth will recover to make up for the demographic decline. The OECD and the EU Commission, for example, predict that Europe’s medium-term potential growth rate exceeds 1%. But such meager growth will only materialize if investment and productivity growth recovers to well above the levels we have recently seen. Otherwise the reduction of the workforce will lead to stagnation or even decline.

Productivity improvements are possible, but they require policies that support investment, innovation and skills. In a world where workers and companies grapple with ever-faster change and powerful global competitors in winner-takes-all markets, this is becoming all the more urgent.

Monetary and fiscal policies will do nothing to fix demographic problems and low productivity growth, and they will hardly stimulate investment in the long run. But stronger growth is needed in economies being held back by the legacies of the financial crisis. The time to act is now. Otherwise we in Europe risk losing decades.

Europe risks losing decades

Weakening demographics are preventing investment, although investment is needed to improve productivity to counter demographic decline

Michael Heise

Europe risks losing decades

Weakening demographics are preventing investment, although investment is needed to improve productivity to counter demographic decline

Michael Heise

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