Europe's Problem Isn't Just Debt, It's Productivity

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At an October protest in Paris, a man holds up a sign that in English reads “Listen to the people’s anger.” Charles Platiau / Reuters-Landov

Europe’s economy is weak and growing weaker. Many households will be trying to pay back debts rather than spending, and aging populations will bear down on consumption too. Austerity has replaced stimulus as the watchword of governments seeking to pay down deficits.

The real problem behind the debt, however, is productivity. Europe’s per capita GDP is 24 percent lower than that of the United States, a gap that amounts to a total of $4.5 trillion in annual income. While Europe has made a societal choice of more leisure time over more work, the major reason for slower growth is a widening productivity gap. Even when Europeans do work, they work less productively. The only way to unleash the dynamism and growth Europe needs to pay its debts is a new wave of structural reform.

Europe’s productivity had been catching up with that of the United States for decades, but the gap has been widening since the mid-1990s. New research by the McKinsey Global Institute finds that Europe would need to accelerate productivity growth by about 30 percent (or opt to work more) just to maintain past GDP growth—and by much more to start catching up to the U.S.’s per capita GDP.

Skeptics will argue that Europe has long balked at tough reform, and its reluctance is peaking in these austere times. Look at the public protests that erupted when the French government proposed raising the retirement age. But the skeptics may be wrong.

Europe has undergone a quiet revolution over the past 10 to 15 years. Easing labor-market rules has led to a 6 percentage-point increase in labor-market participation in 20 years, with many more women and seniors working. Contrary to popular perception, Europe has become a more dynamic job machine than the United States, creating 24 million jobs between 1995 and 2008, compared with 20 million in the United States.

Europe is reforming in its own style, not by importing ideas. In less than 20 years, the share of employment accounted for by seniors has gone up 24 percent in the Netherlands and 21 percent in Germany as a result of new incentives, training, and protection from ageism among employers. Sweden has brought 88 percent of women into the workforce—the highest share of any developed economy—by providing affordable child and elder care. By tying parental-leave benefits to earnings, and day care to jobholding, Sweden provides a strong incentive to work. In addition, only 14 percent of Swedish working women are in part-time jobs, a very low share that is due in large part to smart tax incentives. So reform is underway. The challenge is to push it forward. Action on three fronts is vital: further labor-market reform, boosting the productivity of service sectors, and investing in innovation.

Despite recent strides, Europe still lags the United States on most key indicators of labor-market competitiveness. It has fewer seniors ages 55 to 64 in the workforce (by 51 percent to 65 percent), a higher unemployment rate (averaging 2.5 percentage points higher over the past 10 years), more women working part time, and vacations and other paid leaves that average five weeks more per year than in the United States. If all of Europe were to match European best practices in key labor-market policies, it could raise its rate of labor utilization by 9 percent—without touching vacation or increasing hours worked per week.

Service industries account for two thirds of the productivity-growth gap with the United States. Retailing, for instance, suffers from rules that make it difficult to open new stores when and where it makes the most sense. Dutch towns still have the power to prevent furniture stores from selling televisions. Yet when Sweden liberalized zoning rules in retail, the result was a big boost to productivity. If Europe could spread best practices across the regional service industry, it could add 20 percent to overall productivity. The third front—investing in R&D and innovation—would lay a foundation for growth in emerging economies and industries, like clean tech.

Europe mustn’t use tough times as an excuse to delay reform. The model is Sweden, which responded to an economic crisis in the 1990s with a wave of reform from which it still benefits today. Europe should seize this crisis as an opportunity to transform the entire region.

Roxburgh is the London-based director of the McKinsey Global Institute, McKinsey & Co.’s business and economics research arm.

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