Originally Publised in THE FINANCIAL TIMES

THURSDAY June 28, 2001


A productivity divide: US economic performance will rebound but Europe risks being left behind,
argues Martin Feldstein

The recent deceleration in US productivity growth - including a fall in the first quarter of this year - has raised important doubts about the nature and sustainability of the econ-omic performance on both sides of the Atlantic.

During the second half of the 1990s, output per employee hour in the US rose by 3 per cent annually, twice the rate of the previous 25 years. Faster-growing productivity translated into faster overall economic growth, bringing with it higher profits, rising stock markets and swelling tax revenues that turned budget deficits into substantial surpluses.

Expectations of continuing productivity growth have caused economists and government officials to predict further rapid growth in gross domestic product and large budget surpluses in the decade ahead. Although Europe has not experienced a similar rise in productivity growth, many analysts believe the same technological forces will eventually cross the Atlantic. All of this is now being questioned.

I believe that the doubts are unwarranted: the US productivity decline is a temporary cyclical setback; productivity growth will return to a trend level that is significantly above that of previous decades. But without fundamental changes in its economies, this favourable performance will fail to spread to Europe. If so, there will be a widening gap between US and European standards of living.

To assess the likelihood of this outlook, ask three questions. Why did US productivity growth increase sharply? Why did Europe not experience a similar productivity improvement? And why is the US likely to return to faster productivity growth?

The revolution in information technology was the primary reason for the increase in US productivity growth. The communication and control made possible by the internet and by corporate intranets is changing the way that companies operate. A general rise in business investment also contributed to faster productivity gains but careful studies imply that the increased investment accounts for only about a quarter of the extra productivity rise. The remaining pure technology gain was about 1.2 per cent a year.

This productivity rise was not achieved on the factory floor but rather among the more numerous staff in purchasing, sales, product design, marketing, accounting and other management activities.

Technology has made possible the reduction of layers of management and support staff. The work of 100 employees in one year can be done by 99 in the next - the essence of a 1 per cent productivity rise.

Europe has failed to share in this productivity gain because its employment practices limit companies' ability to use information technology. American companies can readily change the tasks of existing employees to take advantage of new technology, unimpeded by regulations, white-collar unions or an employee culture that resists change. US employers can also dismiss workers made redundant by the productivity gains, something that is much harder to do in Europe.

American companies have also been more successful in adopting the new technology because the widespread use of incentive compensation at all levels motivates managements to make the sometimes difficult and painful changes that increase productivity rather than continuing with the more comfortable status quo.

I am convinced that future US productivity growth can substantially exceed the historic 1.5 per cent annual trend, even if total investment is lower than it has been in the past few years.

There are still many un-exploited opportunities for companies to use currently available information technology and existing equipment to raise output per employee.

New ideas, software and technology will keep coming at a rapid rate, opening yet further opportunities for productivity gains and profitable investments. The information technology revolution has just begun.

The sharp productivity decline in the first quarter of this year was cyclical, reflecting the fall in out-put triggered by a dramatic reversal of inventory accumulation. Output per employee decreased because companies did not reduce their employment by nearly as much as they cut production, believing that the slowdown would be short and shallow.

This confidence was supported by the fact that total final sales (GDP excluding inventory investment) increased in the first quarter by an annualised 4.4 per cent, in essence the same rate as in the previous four years. When the cyclical slowdown in production ends, overall productivity will bounce back.

In Europe, fundamental changes in employment practices, labour markets and management incentives are necessary to encourage rapid adoption of new technology that can raise productivity while increasing employment. Without such changes, the gap between US and European incomes will continue to widen.

The writer is professor of economics at Harvard University

Copyright: The Financial Times Limited