GROWTH - Milken Institute · 2014-04-01 · W 20 The Milken Institute Review otto steininger while the problems facing the u.s. economy are diverse and complex, we believe that one

in both the united states and europe, recovery from recession remains fragile. In-deed, there is real concern that decisions to tackle budget deficits while both economies are limping could slow or even abort a return to prosperity.

But a challenge of a different sort also looms – the medium-term challenge of returning to the vigorous pace of growth that both econo-mies need to sustain prosperity at home as well as to maintain leadership in the global

economy. And seemingly modest differences could change everything. If, for example, the United States could reclaim the 3.3 percent growth rate that it averaged over the last half-century, GDP would double in a bit more than two decades. If, however, the economy only manages a 1.5 percent average – not far from the predictions of many analysts – the doubling would take close to 50 years. The difference

18 The Milken Institute Review

GROWTH

The Possible Dream

19Second Quarter 2011

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might well prove decisive in determining whether these industrialized economies have the will and the way to provide a decent retire-ment for their older citizens, even as they tackle challenges ranging from global warm-ing to health care.

While there are vital distinctions to be drawn between the economies of the United States and Europe, the key to success in both is increasing productivity in the teeth of unfa-vorable demographic headwinds. Recent re-search by the McKinsey Global Institute, Mc- Kinsey & Company’s business and economics research arm, offers agendas for long-term growth – ones that reflect the different start-

ing points of these huge economies as well as their distinct cultural preferences. On both sides of the Atlantic, there is room to boost the role that labor plays in growth, and major op-portunities to boost productivity through technological change. But both economies also need to face up to difficult structural im-pediments if they are to reach their long-term growth potential.

[A Tale of Two Continents]

W20 The Milken Institute Review

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while the problems facing the u.s. economy are diverse and complex, we believe that one key change would go a long way to-ward meeting a host of challenges: America needs to boost productivity growth to a rate not seen since the 1960s. Moreover, that pro-ductivity growth needs to come from both improved efficiency in managing existing economic resources and from technological innovation.

Over the past two decades, the economy

delivered productivity growth of 1.7 percent annually, compared with 1.2 percent in the EU-15 and 1.1 percent in Japan. As a result, U.S. labor productivity was 24 percent higher than in Europe in 2009 and a remarkable 48 percent higher than in Japan. However, the United States must do much better than even this stellar performance if the economy is to match historical rates of GDP growth. Fortu-nately, there are good reasons to believe that the engine has not run out of steam – that the

Retooling America’s Economic Engine

1.

By James Manyika, David Hunt, Scott Nyquist, Jaana Remes, Vikram Malhotra, Lenny Mendonca, Byron Auguste and Samantha Test


U.S. economy has the potential to achieve the required productivity acceleration to equal, or even surpass, historic GDP growth rates.

the growth challengeFor half a century, healthy increases in both the size of the nation’s labor force and its pro-ductivity have powered U.S. growth. Labor grew rapidly as the baby boom generation came of age and as women streamed into the workplace – many as second household earn-ers. As a result, labor has contributed an aver-age of 1.6 percentage points to annual GDP growth since 1960. Meanwhile, productivity rose at the aforementioned rate of 1.7 percent, as business-management techniques evolved and new technologies emerged. Together, they contributed in nearly equal proportions to robust annual GDP growth of 3.3 percent.

However, as the baby boomers retire and the female participation rate plateaus, the U.S. economy will enjoy significantly less lift from labor force growth. It must therefore rely in-creasingly on productivity to fuel GDP growth. In the first decade of the 21st century, productivity increases contributed a full 80 percent of total growth, and the evidence sug-gests that this shift is permanent.

Note the problem here. If the labor force grows as currently projected and productivity increases at the rate of the past two decades, GDP growth would decline to 2.2 percent per year. Accordingly, Americans (who must sup-port a burgeoning population of oldsters) would experience slower gains in living stan-dards than their parents and grandparents did.

It’s thus a matter of arithmetic: If the United States is to sustain the GDP growth rate of the last two decades, the economy ei-ther needs to add labor or to boost productiv-ity. We believe that the United States could comfortably increase the size of the work-force by encouraging older Americans to con-

tinue to work longer, by expanding immigra-tion, and by increasing the participation rates of women and youth. Together, workforce ad-ditions could add as much as one percentage point to annual GDP growth.

The other means to the same end is to in-crease productivity growth from 1.7 percent per year to 2.3 percent – an acceleration of one-third. In theory, the necessary acceleration in productivity could come either from efficiency gains or by increasing the volume and value of outputs through technological change. The United States will need to see both kinds of productivity gains in order to experience bal-anced, sustainable growth.

Efficiency gains are important not only for competitiveness at the company, sector and national levels, but also for facilitating the movement of labor and capital to new and growing sectors. By reducing costs, efficiency often leads to price declines that leave house-holds and businesses with more to spend elsewhere. Yet productivity is not just about efficiency writ small. It is as much about ex-panding output through innovations that im-prove the quality of goods and services.

The GDP growth that the United States en-joyed in the second half of the 1990s was pow-ered by solid gains in both sources of produc-tivity. Two sectors – large-employment retail and very-high-productivity semiconductors and electronics – collectively contributed 35 percent to that period’s acceleration in pro-ductivity growth. This helped the private sec-tor boost its productivity growth from 1.0 percent from 1985 to 1994 to 2.4 percent from 1995 to 1999. At the same time, these two sec-tors added more than two million new jobs.

In contrast, the largest productivity gains since 2000 have come from sectors that have managed to squeeze more value out of fewer workers. Computers and related electronics, the rest of manufacturing and information


technology sectors have contributed around half of overall productivity growth since the turn of the century, but at the expense of 4.5 million jobs. The sectors that added the most jobs during this period were generally the ones with lower productivity – notably health services.

Periods like the last decade make many Americans suspicious that boosting produc-tivity is an exercise in job destruction. But this does not hold true in the long run. Since 1929, every 10-year period except one has re-corded increases in both productivity and employment. (The only exception, inciden-tally, was 1944 to 1954, a period of displace-ment in the wake of World War II, when inef-ficient war-materials industries were phased out.) And measured even on an annual basis, 69 percent of periods have delivered both productivity and jobs growth.

The United States now needs to return to the balanced-productivity growth that the economy enjoyed in the 1990s. During that time, strong aggregate demand and a shift to products with higher value per unit helped to ensure that employment expanded along with productivity. This reignited the virtuous cycle in which productivity gains spur de-mand, in turn leading to more rapid eco-nomic growth.

the productivity perplexSectors that have historically made large con-tributions to productivity growth still have ample room for more. Manufacturing and other sectors open to international trade will be forced to keep improving their productiv-ity in order to stay abreast of global competi-tors with lower labor costs. Domestic sectors

like retailing will need to do the same, be-cause the Internet, the big-box store and the rapidly changing tastes of consumers guaran-tee there will never be much shelter from in-tense competition.

Nor should it surprise anyone that lagging sectors – notably, government and highly reg-ulated sectors like health care – have the po-tential for dramatic productivity gains. In each, the cumulative impact of improvements within and across enterprises can make a large impact on aggregate economic performance.

The McKinsey Global Institute, which has studied productivity in 20 countries and 30 sectors over the last two decades, estimates that adopting best practices more widely could deliver one-quarter of the targeted pro-ductivity acceleration. Even in retailing, where U.S. business has a strong record on produc-tivity growth, there is potential to do more – for example, by extending lean practices like just-in-time inventory from the stockroom to the storefront. One retailer adjusted schedul-ing so that salespeople were not busy replen-ishing shelves during peak demand at lunch hour. That increased overall staff utilization by 20 to 30 percent and, equally important, improved customer satisfaction by reducing waiting time.

Other sectors have thus far lagged behind in adopting leading-edge operational prac-tices. The U.S. aerospace industry is a major exporter and a global leader by many mea-sures of innovation. But the sector lags in achieving cutting-edge manufacturing effi-ciency. Although there are, of course, differ-ences between constructing a commercial air-liner and, say, building a pickup truck, basic metrics suggest aerospace has room for im-provement. For example, on-time delivery rates in commercial aerospace average less than 70 percent, compared to 95 percent for best-in-class automobile manufacturers.

The authors all hail from McKinsey & Company and the McKinsey Global Institute, its economic-research arm.

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Sectors operating outside competitive markets, like government, health care and ed-ucation, represent more than 20 percent of the U.S. economy. But their low productivity growth has served as a drag on overall eco-nomic growth. Indeed, if the public sector could halve its efficiency gap with private-sector enterprises with similar organizational functions, government productivity would be 5 to 15 percent higher, generating annual sav-ings of $100 billion to $300 billion. Large parts of these sectors could benefit from com-petition with market-driven enterprises, more extensive use of technology and appli-cation of managerial innovations.

In many cases, private-sector examples of best-practice procedures (say, in the process-ing of casualty-insurance claims) could be used as benchmarks for the public sector (as in the processing of tax returns). Health care suppliers have just begun to adopt lean oper-ational principles. Hospitals, for example, have room to improve how nurses allocate

their time. At some, they spend less than 40 percent of shifts with patients; the rest is de-voted to paperwork and other tasks that could be done by computers or personnel with lesser skills. Hospitals could also im-prove their admissions and discharge proce-dures to reduce turnaround times and ex-pand patient capacity.

growth and innovationOver the next decade, many industries will tap into the productivity gains available from a wave of innovations coming onstream. If companies take full advantage of them, the United States could get halfway to the Mc- Kinsey Global Institute’s productivity-growth target. To give a flavor of the opportunities available, we highlight three examples:

Enhanced business operations. U.S. com-panies have already made large gains in sup-ply-chain efficiency, but there is more to come. In retail, integrating physical and on-line supply chains both reduces costs through

BNumbers may not sum due to roundingC2000–8 data used for 2000ssource: U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics; McKinsey Global Institute analysis

WhilE ThE conTRibuTion of PRoDucTiviTy To u.S. GDP GRoWTh hAS bEEn fAiRly conSTAnT, lAboR’S conTRibuTion iS DEclininGconTRibuTionS To GRoWTh in REAl u.S. GDP, comPounD AnnuAl GRoWTh RATE, %

incREASES in vAluE ADDED PER WoRKER

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increasing the scale of inventory management and boosts revenue and value-added by re-ducing the need for markdowns on overstock. Additionally, the declining cost of radio fre-quency identification – systems that use intel-ligent tags to track store inventory – could en-able a new wave of end-to-end supply-chain models. Europe is already beginning to use RFID to better monitor supply chains in meat production, where superior tracking can also greatly enhance the safety of the food supply.

Greater customer responsiveness and en-gagement. Companies have room to increase both revenue and customer satisfaction by re-sponding more rapidly to changing customer preferences. Retailers, for example, could bet-ter tailor targeted promotions and move to-ward self-service checkouts and information kiosks. The health care sector could encour-age e-mail and phone communication rather than demanding frequent face-to-face visits

that inflate outpatient costs and diminish re-sponsiveness to patient needs. Kaiser Perma-nente, the California-based integrated man-aged health care consortium, is a pioneer in this regard. Kaiser reduced outpatient visits by 10 percent by offering its patients online self-service, e-health and tele-health services to address non-urgent issues.

The financial-services industry, which faces a shifting regulatory environment, is looking to new products as a source of future growth. For example, retail banks are focusing on more effective management of personal finance. We can see this in the use of analytical tools that aggregate information across multiple ac-counts. One example of the latter is SmartyPig, a Web-based application that allows users to establish specific savings goals (e.g., to pay for a vacation to Cancun). The service offers dis-counts with retailers and allows family and friends to contribute to the savings accounts.

source: U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics; McKinsey Global Institute analysis

PRoDucTiviTy DiffERS SiGnificAnTly AcRoSS u.S. REGionS

PRoDucTiviTy GRoWThcomPounD AnnuAl GRoWTh RATE, 2000–8, %

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Service and product innovation. Compa-nies could boost productivity through inno-vation in the sorts of products and services they offer. They could supplement traditional products – an office supply company, for ex-ample, could provide comprehensive procure-ment services. Retail banks and payment com-panies could pioneer ways to serve the nearly one-quarter of Americans who lack accounts or access to credit.

Some retailers have thrived in uncertain times by staying ahead of the curve in just this way. For example, the pet-supplies industry has enjoyed double-digit growth since the onset of the recession by offering an array of new services with a focus on pet health and well-being. Petco and PetSmart aimed at afflu-ent households by marketing dog training and day care. Meanwhile, the wireless communi-cations equipment market seems almost reces-sion-proof as it introduces a dazzling array of smartphones.

structural issuesIndividual companies could achieve three-quarters of the productivity acceleration we’ve targeted on their own initiative. The remain-ing quarter would require a coordinated ef-fort by the public and private sectors to ad-dress the systemic barriers to growth. We group them in seven categories.

1. Drive productivity in government and gov-ernment-regulated sectors. Enterprises that largely operate outside the market, like those in health care and education, represent more than 20 percent of the output of the econ-omy. Hence their low productivity growth is a major drag on economic growth.

Reforms are needed here on a variety of fronts. The current lack of transparency is striking: The U.S. government itself has not reported its own productivity outcomes since 1994. And even when performance informa-

tion is released, it is often inadequate. In health care, outcome data on physicians is very difficult to acquire – yet, this is the point at which patients could make informed choices. In education, standardized tests were designed in part to help in the evaluation of schools, but many fail to measure the contri-bution of individual teachers.

Accountability and incentive structures fall short as well. Performance reviews and bud-get allocation are often structurally separate – the timing of reviews and funding may not be aligned. In health care, the dominant system of pay-per-service for physicians creates in-centives for increasing procedures and office visits. A more efficient system would probably mix fee-for-service, pay-for-performance and flat payments per covered patient. Getting the right mix would require a period of experi-mentation in which international experience may provide some guidance.

2. Reinvigorate innovation. As we can’t em-phasize too strongly, innovation is vital to de-livering the balanced productivity gains that not only improve efficiency but also boost the quality of goods and services. While the United States remains the global leader in R&D spend-ing, others are catching up. This is particularly true in new cutting-edge industries like alter-native energy. In 2009, China surpassed the United States for the first time in clean energy investments, spending $34.6 billion, com-pared to $18.6 billion for the U.S. Government has a role to play here, in large part by provid-ing market-based incentives (in particular, tax breaks) for private companies to expand their U.S.-based R&D activities.

3. Develop the talent pool. The U.S. needs to work on multiple fronts to address skill short-ages, notably by removing barriers to older workers staying on the job. Increasing the me-dian retirement age by 18 months – from 62.6 today to 64.1 by 2015 – could add more than


$12 trillion to GDP over the next three decades. International experience suggests this goal is realistic. In Finland, for example, coordinated government and business action helped to in-crease the average retirement age by four years within a decade.

But to get from here to there, the United States would need to overcome a variety of dis-incentives affecting both employers and older workers. For instance, although Medicare cov-ers retirees at 65, it pays for little of the health care costs of older Americans who stay on the job. And since the elderly are far more expen-sive to insure, employers are reluctant to hire them. In addition, many older workers are willing to work if they can do so part-time, but businesses have been reluctant to accommo-date such flexibility. In contrast, Abloy Oy, a lock manufacturer in Finland, gives addi-tional benefits to workers over 55 (more time off and free fitness club membership), to en-courage them to remain in their jobs.

The participation of women could also be increased. After decades of growth, the por-tion of women in the labor force appears to have leveled off – and at a lower level than in some other developed countries. In Sweden, participation began to rise after the govern-ment reduced taxes on second earners and gave working women priority in subsidized day care programs. The United States should consider removing the marriage-tax penalty and encouraging the provision of child care, transportation and remote working options to facilitate greater choice for families in how they balance home and work life.

Overall, if the United States were to in-crease participation of women and seniors and decrease youth unemployment, it could boost GDP by up to 1 percent. That’s not small change in a $15-trillion economy.

The United States might also consider the

elimination of barriers to the immigration of skilled workers. Immigrants account for a high percentage of entrepreneurs and technol-ogy start-up leaders, and a large share of PhDs from American universities. Yet the country uses a quota-based immigration approach emphasizing family ties, while other devel-oped countries – most recently, Australia and Britain – have adopted points-based systems that emphasize skills. Australia changes the re-quirements annually to reflect shifting work-force needs. The United States, for its part, makes exceptions for skills in short supply, which leads to extra processing and related de-lays. The United States should consider easing the process to acquire green cards, increasing the number of H-1B visa quotas granted for temporary employment of skilled workers, and replacing quotas with a points-based sys-tem that rewards educational attainment.

4. Modernize infrastructure. Infrastructure drives productivity both directly and by acting as a platform to allow for economies of scale. To capture more of these opportunities, the United States needs to implement best prac-tices in infrastructure development and to use demand-management techniques, like conges-tion pricing for roads and airport runways, to ease the strain on overburdened infrastructure.

The quality of concrete and steel infrastruc-ture, from transportation to water supply, has been in relative decline. According to the World Economic Forum, the United States ranks 23rd out of 139 countries on overall quality, behind France, Germany, Canada and Japan. (In 2000, by contrast, it ranked seventh.) One obvious shortfall is in road transport, where demand has increased by 3 percent an-nually over the past two decades while capacity has increased by only 1 percent a year. Road congestion already costs more than $85 billion a year in pollution and wasted time and fuel, with an average cost per traveler exceeding

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$1,000 a year in large urban areas.Broadband penetration is also becoming a

central issue for all economies. The United States lags here, with 27 subscribers per 100 inhabitants compared to 41 per 100 in Swe-den. This limits innovative economic activity. In retail, for instance, low broadband pene-tration is curtailing efforts to reap the pro-ductivity advantages of moving online. The United States also appears ill-prepared for the next generation of online commerce on net-worked mobile devices. It ranks 71st out of 139 countries in mobile-phone penetration.

There is considerable room for the United States to implement leading-edge practices, beginning with how it selects projects in the public sphere. One model currently in place in Canada creates an investment arm of the

government to allocate funds to infrastruc-ture projects. Some countries have also made progress in designing effective public-private infrastructure partnerships: Canada’s pri-vately operated Highway 407 toll road, which bypasses congested public roads in the To-ronto area, is often cited as a model. Britain has experimented widely with some successes, notably in education and health care.

The United States should consider ways of harnessing financial innovations to bridge the infrastructure-funding gap. Users of public infrastructure resist paying for it, exacerbat-ing the challenge of providing revenue streams sufficient to meet the returns required by eq-uity investors. Current funding approaches (e.g., municipal bonds) are not scalable to the degree that would be needed for high quality

ThE RElATivE quAliTy of u.S. infRASTRucTuRE hAS DEclinEDquAliTy of ovERAll infRASTRucTuRE

source: World Economic Forum, Global Competitiveness Report, 2010-2011.

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public infrastructure, which would cost an es-timated $2.2 trillion to fund.

Adding to its problems, the United States is well behind best practices in construction. Pro-ductivity in the U.S. construction industry has at the very least stagnated – and perhaps even declined – over the past three-plus decades.

Finally, the United States should consider ways to enhance demand-management tech-niques, including congestion pricing. Such pricing plans can drive more productive use of badly overburdened infrastructure and draw attention to the places investment is likely to yield the highest societal returns. Again, the United States should study best practices being adopted elsewhere.

5. Enhance the business environment. The relative competitiveness of the U.S. business environment is declining because of overreg-ulation – and at a time when many other countries are aggressively streamlining regula-tion to attract new investment. Washington should consider ways to reduce the complexity of regulations and simplify the process of re-solving disputes. Policymakers also need to as-sess corporate taxes with an eye toward mak-ing rates competitive with other countries. The United States could also go further in eliminating barriers to competition. For ex-ample, the United States does not permit big retailers to sell pet medicines. In the auto in-dustry, rules curbing online distribution limit opportunities for customizing products and raise costs.

6. Embrace the energy productivity chal-lenge. Increases in global demand for energy will likely accelerate over the next 20 years, with developing economies accounting for 85 percent of that growth. This will impose in-creasing environmental costs and could strain supply, limiting long-term growth prospects. And while we’ve mostly focused on sourcing

new supplies, there is considerable scope for using existing supplies more efficiently.

The United States has lagged behind other countries in efforts to use less energy per unit of GDP. Indeed, with no change in policy, the nation will remain the most energy-intensive developed economy in 2020, as well as the country with the highest energy consumption per capita. However, there are enough oppor-tunities (using existing technologies with an internal rate of return of 10 percent or more) to boost energy productivity by the equivalent of 11 million barrels of oil per day. Capturing these opportunities would enable the United States to cap annual energy consumption and carbon dioxide emissions at their current lev-els for another decade.

Tangible changes in policy, like tougher fuel-economy standards, would encourage the adoption of existing energy-saving technolo-gies and spur the development of new ones. If the United States were to match Europe’s and Japan’s plans in this regard, the average fuel economy of U.S. vehicles could improve by five miles per gallon by 2020, cutting demand for oil by some four million barrels per day.

More generally, action to make consumers aware of the consequences of their energy choices could have a significant impact. Utili-ties could accelerate installations of smart meters for residents and small businesses that permit time-of-day pricing. When customers realize that they are paying premium prices for peak-time power, they are more likely to shift consumption toward off-peak times.

In recent years, a number of states have re-vived energy-efficiency resource standards that set targets for reducing total electricity consumption. These are typically mandated through utilities and can’t be implemented well unless the utilities are compensated for success. The evidence suggests that when util-ities have an incentive to overcome a variety

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of barriers to higher productivity, they have been able to generate savings of around 1 per-cent of energy consumption.

7. Thinking globally, acting locally. Cities and regions in the United States have mark-edly different growth and productivity trajec-tories, yet all too often fail to share information gleaned from trial and error. This is unfortu-nate, since their experience could yield rich data with the potential of revealing best prac-tices. For example, experiments with welfare reform suggest what works and what doesn’t.

States and localities have also failed to ex-ploit opportunities for cross-regional alli-ances. This could include projects in which private partners coordinate work across re-gions with differing strengths in different pieces of the supply chain (e.g., design in one state, manufacturing in another).

• • •The United States has a superlative record

as the global productivity leader, and possesses

the tools to retain that edge. Corporations are emerging from the recession with more-effi-cient operations and healthier balance sheets, putting them in a strong position to take on the next wave of productivity challenges.

The economy could achieve three-quarters of the productivity-growth acceleration it needs to match the growth rates of the last half century if best practices were widely ad-opted and companies tapped into the poten-tial of emerging innovations. To get the rest of the way to the productivity growth target – and perhaps even top historic rates – the United States needs to make structural changes, including boosting labor-market participa-tion to counter the natural aging of the popu-lation and changing incentives to make mar-kets more efficient. For all the talk of decline, America has the means to ensure that the next generation enjoys the same pace of rising prosperity as their parents and grandparents did.

© 2011 CREDIT SUISSE GROUP AG and/or its affiliates, subsidiaries and branches. All rights reserved.

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B30 The Milken Institute Review

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by most accounts, the obstacles to returning post-recession Europe* to the growth path needed to meet its social and de-mographic challenges are daunting. House-holds in some parts of the continent are over-leveraged and preoccupied with paying back debts rather than with investing or consum-ing. But there is little scope for governments to continue using public money to offset en-

feebled private demand; public debts and def-icits are just too high.

Still, there are grounds for optimism. The structural reforms needed to boost produc-tivity (and to help companies innovate and grasp new market opportunities) are under

beyond Austerity:2. Renewal in Europe

*In this article, we use “Europe” as shorthand for the EU-15 – Austria, Belgium, Britain, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain and Sweden.

By Charles Roxburgh, Jan Mischke, Baudouin Regout, Davide Archetti, Alexandre Chau, Paolo D’Aprile, Akshat Harbola, Harald Proff, Dirk Schmautzer, Manuela Thomys and Andreas Weber


way in some parts of Europe, contradicting the conventional wisdom that Europeans aren’t willing to make the tough choices. Moreover, Europe doesn’t need to import so-lutions from Asia or the United States: the re-gion is peppered with examples of good prac-tices. Indeed, we estimate that if all European countries were to emulate the reforms already adopted by some of them, Europe could close the current 24 percent gap in per capita GDP with the United States.

recapturing prosperityThe threat to growth posed by the lingering effects of the financial meltdown in the EU-15 is not likely to dissipate in the next year or two, or even five. The deleveraging process that has followed nearly every major financial crisis since World War II has typically been long and difficult. Indeed, there is reason to believe that, this time around, deleveraging may prove especially painful since past epi-sodes involved fewer national economies.

Intensifying these headwinds against growth, Europe’s dependent population is ex-panding. In the 1980s, changes in the age mix made a positive 0.3 percent contribution to the annual growth rate of GDP per capita, be-cause additions to the labor force more than offset population growth. Now, the demo-graphic machinery has reversed: by 2030, aging will impose a 0.4 percentage point drag on per capita GDP growth.

Thus, merely to maintain past rates of growth, Europe would need to increase labor inputs beyond current projections or to ac-celerate productivity growth by about one-third over historic levels. Productivity growth would have to pick up the pace by even more in order for Europe to close the per capita GDP gap with the United States, which now amounts to more than $11,000 per person in terms of purchasing power.

To get from here to there, Europe needs bold reforms.

labor-force participation Europe has experienced a quiet revolution in labor markets in recent decades. The portion of the population of working age that’s actu-ally in the market has risen by six percentage points in 20 years. And, contrary to the popu-lar perception that Europe has a poor record on employment opportunities, the EU-15 created 24 million new jobs between 1995 and 2008 – more than the United States did in the same period.

But labor utilization still lags significantly behind that of the United States. In 2008, the labor force contributed 733 hours of work for every man, woman and child in the EU-15, compared to 913 hours in the United States.

Fully half of the difference can be chalked up to Europeans’ preference for longer vaca-tions and more paid leave, which now totals five weeks more per year than in the United States. The fact that women work only part-time, even after child-caring activities are completed, accounts for another 18 percent of the gap; lower participation in the labor force by older workers explains 15 percent. Europe’s much-discussed sclerotic unem-ployment situation – its inability to bring joblessness down to acceptable levels even during economic booms – explains a rela-tively modest 6 percent of the difference.

We estimate that, without challenging the societal choice for longer absences from the workplace, the EU-15 could add 2 to 9 percent to per capita GDP simply by matching best practices in raising labor-force participation and in lowering structural unemployment. These labor-market reforms, it’s worth noting, are best attempted when there are reasonable prospects for job creation through comple-mentary reforms elsewhere in the economy,


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The authors all hail from McKinsey & Company and the McKinsey Global Institute, its economic-research arm.

or when the region is in a cyclical upswing.

Boosting labor-force participa-tion among older workers. Participation in Europe’s labor force by adults aged 55 to 64 stands at 51 percent, compared with 65 per-cent in the United States. But there are wide variations among countries. Italy’s participa-tion rate is only 37 percent; Sweden’s, by con-trast, is 74 percent, higher than the United States by a large margin. If Europe could raise older workers’ participation rate from the

EU-15 average to Sweden’s, total labor market participation would increase by six percent-age points.

To manage this, Europe needs to restruc-ture pension programs. One high-priority change: eliminating regulations that set lower retirement ages for women than for men. Or, as Sweden has done, governments could en-courage longer working lives (without forc-ing them) by allowing workers to add pen-sion credits for each additional year they work over the age of 61.

On the demand side, governments could adopt anti-age-discrimination statutes and extend the subsidized training-age limit for displaced workers. They could also provide older people with job-search support and de-

sign more flexible ways of setting wages for older workers that take ac-count of their potentially lower productivity.

Reducing adult and youth unemployment. In the EU-15, the average unemployment rate for workers over 25 was 6.5 percent from 2004 to 2008 – years of relatively brisk eco-nomic growth. But it was much higher in some countries. The more successful econo-mies have deployed a range of policies to re-duce employment. One is letting markets set wages at rates that reflect differences in pro-

Swedenwomen in the workforceOne important way to get more from a labor force is to get women to work full-time. And here, Sweden has succeeded spectacularly. In 2008, 88 percent of women aged 25 to 54 were part of the workforce. More striking, though, was the fact that just 14 percent of women worked part-time, compared to 39 percent in Germany. The higher incidence of full-time work in Sweden meant that, on average, women worked 35 hours a week, compared to 30 in Germany.

Why the big difference? Taxes and benefits. Women’s participation soared after 1971, when Sweden switched from joint to individual filing of income taxes, greatly reducing marginal tax rates on second earners. On the benefit side, affordable, high-quality care both for children and the elderly, along with generous parental leave, have smoothed the way to full-time employment. But Sweden uses sticks as well as carrots as incentives: parental-leave benefits depend on previous earnings, and access to subsidized day care generally requires parents to be in the labor force.


ductivity between regions and industries. An-other is loosening employment-protection laws to make them less of a disincentive for employers to take on additional workers.

The Netherlands had the lowest average unemployment rate (3.3 percent) in the 2004-2008 period. If the rest of the EU-15 were to match that average – which would require the creation of around five million jobs – labor utilization would increase by 2.6 percentage points.

Youth unemployment presents a very dif-ferent challenge. Between 2004 and 2008, the average EU-15 unemployment rate of work-ers aged 18 to 24 was a miserable 15.6 percent, with large variations by country. One reason for the variation is the failure of some coun-tries to deter young people from leaving school early, with insufficient training to fit into a modern labor force. In 2009, dropouts ranged from around 10 percent in Finland and Denmark to more than 30 percent in Spain and Portugal. If the rest of the EU-15 could match the Netherlands’ 6.8 percent rate of youth unemployment from 2004 to 2008, Europe would increase labor utilization by around one percentage point. Note, too, that improvements here would save considerable sums in social benefits and provide young people with the opportunities they deserve.

Easing the transition to full-time work for women. Thirty-one percent of women in the EU-15 work part-time. But, again, there are huge variations: the figures ranges up to 60 percent in the Netherlands. Many women would be willing to work longer hours, but it is not economically attractive to do so, be-cause the added income (after taxes and loss of benefits) is very low.

According to the OECD, the gap between Europe and the United States in average hours worked by women could be closed if European countries were to align their marginal taxes on

EuRoPE vS. u.S.

900

850

800

750

700

01990 2005 2010

yEAR

source: Conference Board; International Monetary Fund; OECD; McKinsey Global Institute analysis

Eu-15 lAboR inPuT, houRS WoRKED PER cAPiTA

U.S.

EU

$484644424038363432302826

01990 2005 2010

source: Conference Board; International Monetary Fund; McKinsey Global Institute analysis

Eu-15 PER cAPiTA GDP, 2009 ($, ThouSAnDS, PPP)

U.S.

EU

$60

55

50

45

40

01990 2005 2010

source: Conference Board; International Monetary Fund; OECD; McKinsey Global Institute analysis

Eu-15 PRoDucTiviTy, 2009($ PER houR WoRKED, PPP)

U.S.

EU


second earners in households to those in the United States. We estimate that the EU-15 could increase overall labor utilization by about two percentage points simply by bring-ing countries at the low end up to the current average. Note, moreover, that this boost could be achieved without challenging European workers’ penchant for long holidays.

Bringing working hours per employee up to the level of the United States could increase labor utilization far more – but at the price of paring holiday and leave entitlements. We therefore did not include such a policy initia-tive in our estimates of the EU-15’s growth potential.

productivity As in all high-income economies, service in-dustries have accounted for all of the net job growth in recent decades. But Europe’s pro-ductivity growth in services lags far behind the United States. Local services, including hotels, restaurants and both retail and whole-

sale distribution, accounted for five out of a total seven percentage points of the difference in productivity growth between the EU-15 and the United States from 1995 to 2005.

Boosting service productivity in the lag-ging countries to the EU-15 average would increase the region’s productivity by 3 percent. Boosting productivity to European best-prac-tices level could add a remarkable 20 percent. While growth at the top end of this range may prove unattainable in so diverse a mix of eco-nomic cultures, it nevertheless serves to illus-trate the scale of the room for improvement. Because of the domestic nature of many ser-vices, governments could play a decisive role in generating gains. Four broad categories of action would yield dividends:

Increasing competition in services. Many European service industries lag in productivity due to insufficient competition. Take profes-sional services. The OECD calculates a “prod-uct market regulation index” designed to cap-ture “the extent to which policy settings

A SiGnificAnT GAP REmAinS in TERmS of PARTiciPATion RATES

source: OECD

AvERAGE AnnuAl WoRKinG houRS, 2008

1,7721,7461,7271,7181,604 1,7962,256

EU-15 Australia Canada NewZealand

Japan U.S. SouthKorea

PARTiciPATion RATE, 2009

80.178.377.973.869.9% 80.7 81.0

SouthKorea

EU-15 U.S. Australia Canada NewZealand

Japan

AvERAGE unEmPloymEnT RATE, 2004-08

4.24.85.16.5

7.6%

3.9 3.5

EU-15 Canada U.S. Australia Japan NewZealand

SouthKorea


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promote or inhibit competition in areas of the product market where competition is viable.” In 2008, this index for professional services in the EU-15 was nearly twice as high (implying far less com-petition) as it was in the United States. This is due to regulations that effec-tively create region-wide monopolies (e.g., for notaries and pharmacies), price-fixing (Italy and Germany have price ceilings and floors for architects and lawyers, respectively) and restric-tions on (or even the prohibition of) ad-vertising and marketing. The rationale is generally consumer protection, but in practice the regulations mostly just limit competition and protect incumbent producers.

Monopoly power in firms that function within network indus-tries constitutes another major constraint on pro-ductivity. At one end of the spectrum, a combination of consistent technical stan-dards, market liberalization and regulations deterring collusion has made the telecommu-nications sector one of Europe’s productivity success stories. But several sectors, notably postal services and rail transport, are not yet fully open to competition.

Smarter regulation. According to OECD measures designed to capture the administra-tive and regulatory burdens on the economy, the EU-15 have gone a long way toward clos-ing the gap with other major OECD coun-tries in recent years. But some European mar-kets remain hobbled by regulation.

In retailing, where EU-15 productivity lags behind that of the United States by fully 30 percent, zoning laws that limit store size and density put more-efficient stores, like hyper-

markets, at a competitive disadvantage. After Sweden liberalized its regulation of the retail sector, productivity jumped by 50 percent – putting it 14 percent above U.S. retail produc-tivity in 2005! Strikingly, the greater efficiency

Swedenrevolutionizing retailing

Swedish retailing had the highest productivity

growth in Europe between 1995 and 2005 (4.6

percent annually) and by the end of that period

outperformed the vaunted U.S. retail sector by

14 percent. The revolution began with the eas-

ing of zoning laws in the 1990s that reduced

the power of municipalities to prevent new

store openings and led to a doubling of the

average size of new food markets between

1990 and 2000. This boost in store size was

part of a broader transformation in the struc-

ture of retailing that included an expansion in

the number of shopping centers and a trend

toward integrated chains like Ikea and H&M,

which could exploit scale advantages in pur-

chasing, supply chain and store management,

and marketing.

That, together with an influx of discounters

and the rise of new channels like Internet shop-

ping, intensified competition. Meanwhile, the

rise in the use of private labels has increased

margins by eliminating relatively unproduc-

tive components in the supply chain, like the

manufacturing sales force. Finally, greater

use of information technology by deep-

pockets retailers has yielded efficiencies in

a variety of areas.


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did not come at the price of employment, which rose 15 percent in the wake of reforms.

Labor-market regulation poses another

barrier to productivity. In the Netherlands, for instance, collective labor agreements typi-cally include clauses calling for 50 percent higher wages after 9 p.m.

All that said, European retailers do bear part of the blame for lagging productivity; many have yet to grab opportunities to cut costs by investing in more information tech-nology for managing supply chains, inven-tory and shop operations.

Government as productivity catalyst. Al-though private enterprise largely drives inno-vation, governments can play a crucial role

in this arena. They can coordinate the strategic direction of sectors like tour-ism, where the whole is greater than

the sum of the parts. (Think, for instance, of transportation, lodging and restaurants.) Gov-

ernments can also manage technical standards, as they have done by ensuring that Europe – in contrast to the United States – would oper-

ate on a single standard for mobile communications. And

governments are among a coun-try’s largest procurers, particularly in construction, allowing them to drive productivity by the requirements they set on training and the room for innovation they allow.

Then there is the very traditional – but often vital – role that government plays in physical infrastructure. Be-coming an attractive tourist destina-

tion – tourism is a huge European industry – requires the construc-

tion of efficient airports and of roads to get people to hotels and restaurants. By the same token, freight transport depends on a dense road and rail infrastructure.

The Netherlandstackling youth unemploymentUnemployment among workers under 25 is a chronic problem throughout Europe. Between 2004 and 2008, the average youth unemploy-ment rate was 15.6 percent. But there were large variations: the highest rate was in Greece, at 24.6 percent; Belgium, France, Italy, Spain and Sweden also had average rates exceeding 20 percent. By contrast, the rate in the Netherlands was just 6.8 percent.

How did the Netherlands do so much bet-ter? In 2003, it launched a program with the goal of halving the number of people leav-ing school with insufficient qualifications, and offering training or jobs to those who did drop out before they were unemployed for six months. The public-private effort included:

Training. Every young person who receives social assistance benefits past the six-month mark gets an internship of three months. Trainees retain their benefits, while the employ-er pays a wage of d450 (about $625) a month. Employers, in turn, get a tax break and can make use of training funds from a pool pro-vided by their industries.

Work first. Those asking for social assistance are put to work in low-paid subsidized jobs as soon as possible after applying. The idea is to create incentives for them to look for better jobs; noncompliance leads to the loss of at least part of the benefits package.

Keeping dropouts in sight. Centers within each municipality keep track of those who exit early from secondary schools. The government also requires schools to stay in contact with young people until they have made the transi-tion to work or another school.


Knowledge-intensive business services like software and IT services require reliable elec-tricity and telecom systems, as well as a pool of talent nurtured by public education.

Crossing borders. Cross-border competi-tion in services is anemic in Europe: only 20 percent of services operate in two or more countries. The potential gains from integrat-ing national markets is quite large: harmoni-zation of regulation for trucking that allowed the industry to achieve economies of scale led to annual productivity gains of more than 5 percent throughout the 1990s in Ger-many and France.

innovationEurope needs to pursue policies that encour-age growth in a handful of key sectors. Indeed, if European companies could capture global growth opportunities in these areas, the per capita GDP gap with the United States might be closed over the next decade or two.

Exports to emerging markets. Rapid growth

in the economies of Asia and Latin America offer vast opportunities for European enter-prises. Education, for example, can be ex-ported through a host of channels, including the creation of satellite campuses, the sale of educational consulting services and – most important – the education of foreign stu-dents in Europe. We estimate that in Britain alone, revenue from international students could exceed £10 billion (roughly $15 billion) by 2030 if the country built enough capacity to maintain its existing share of the foreign-student market.

Cleantech. Clean technology solutions, in-cluding renewable energy and energy-effi-cient vehicles, buildings, machinery and elec-tricity-distribution systems, are expected to have a global market potential of €2 trillion (about $2.8 trillion) annually in 2020. And Europe is in a strong position to win sales. Germany’s Siemens, for example, already generates almost a third of its revenue from clean products.

EuRoPE’S PRoDucTiviTy GAP iS mAinly DRivEn by SERvicE SEcToRS,buT AlSo by PRimARy RESouRcES AnD mAnufAcTuRinG2005 PRoDucTiviTy lEvElS AnD GAP

PRoDucTiviTy PPP/houR, 2005 $ PRoDucTiviTy

GAP, PERcEnT

conTRibuTion To PRoDucTiviTy GAP,

$/houREu-15 u.S.SEcToR

Primaryresources

Manufacturing

Infrastructure–utilities

Infrastructure–construction

Infrastructure–transport

Localservices

Businessservices

Finance

Health,educationandotherpublicgoodsRealestate

Average

source: EU KLEMS; McKinsey Global Institute analysis Total gap = $4.50/hour. Sector mix effect accounts for an additional $0.70/hour gap

18

41

88

32

7

4

19

51

48

418

39

54

49

99

32

35

30

34

66

34

413

44

42

1

2.9

0.1

-66

-17

-11

-2

-23

-21

-43

-23

-12

-1.7

-1.4

-0.2

-0.1

-0.4

-1.7

-1.0

-1.1


Advanced technologies. Over the next de-cade, annual growth rates of 30 percent in biotech products and 20 percent in nanoma-terials are expected. In the pharmaceutical/biotech sector, five of the nine leading firms are based in Europe. Europe is also in a good position in nanotechnology research, with 420 patents registered in 2007, compared with 465 in the United States. The crucial step here will be to facilitate translation of R&D into viable products and services.

structural issuesBold reforms in labor-force participation, productivity and innovation are only part of the solution. While Europe can boast of some remarkable successes, it still suffers from in-stitutional and structural weaknesses that need to be addressed.

Prioritizing funding for innovation. Euro-pean governments still allocate one-third of their subsidies to preserving low-productivity

industries, notably agriculture and coal min-ing. Only 8 percent goes to R&D or to other activities directly related to innovation. And the private sector does not make up the shortfall: In 2008, Europe spent, all told, only 1.9 percent of GDP on R&D, compared with around 2.7 percent in the United States. Real-locating just one-third of the subsidies cur-rently spent on agriculture to R&D would vault Europe’s government-financed R&D spending (as a percentage of GDP) to the level of the United States.

Developing larger-scale high-tech clusters. European clusters are much smaller than their North American counterparts because of na-tional fragmentation, deliberate government policies (some European governments favor spreading around the benefits), and restric-tions on land use. But there are important ex-ceptions that others could emulate. Finland developed a world-class mobile telecoms cluster around the remote University of Oulu based on investment commitments from Nokia and the Finnish government – though, as the recent decline of Nokia suggests, the cluster now faces the challenge of renewal.

Linking academia and business. The ties between the EU-15’s academic institutions and its industry tend to be weak compared with those in the United States – or Switzer-land, for that matter. The OECD has long ar-gued that Europe needs to reconsider the po-tential of universities as drivers of innovation and to grant them more autonomy. Again, Europe can boast of some success stories. For example, the University of Sunderland in Britain participated in an alliance that made Nissan’s local car plant the most productive in Europe.

Fostering an entrepreneurial mindset. The share of the European population interested in becoming entrepreneurs is eight percent-age points smaller than in the United States,

Eu-15 SPEnDinG on R&D iS loWER ThAn in mAny DEvEloPED EconomiES% of GDP, 2007

1.9

1.4

2.3

2.7

0.6

0.4

0.6

0.8

0.2

0.1

0.2

0.1

1.1 1.0

1.51.8

oThER

GovERnmEnT- finAncED

inDuSTRy- finAncED

note: Numbers may not sum due to roundingsource: OECD

EU-15 China OECD U.S.


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and the share of Europeans who actually start businesses is just half that in the United States. But Europe has potential, and it is worth gov-ernment effort to encourage business start-ups in the host of ways employed in the United States.

• • •The European economy has some major weaknesses to overcome. But that is less a rea-son for pessimism than evidence of untapped potential. Indeed, the widely differing na-tional economic environments offer natural

experiments in what works and what doesn’t. The great recession has shaken Europe

badly and made Europeans aware of the fra-gility of many of their economic and financial institutions. But the crisis could also serve as a catalyst for far-reaching reforms, refuting the conventional wisdom that the EU-15’s best days are in the past. Indeed, there is rea-son to believe that Europe can close the pro-ductivity gap with the United States, the global productivity leader – and in the pro-cess generate the income needed to fulfill the expectations of diverse interests. m

Denmarkreducing structural unemploymentBetween 1993 and 2008, Denmark’s unemployment rate among adults fell from 8.9 to 2.5 percent, a reduction that dwarfed the 2.2 percentage point cut (to 6.1 percent) achieved by the whole EU-15. A series of labor-market reforms in the 1990s led to that big drop.

Decentralization of negotiations. Denmark modified centralized wage bargaining to permit regional and individual variations in compensation. In 2000, 85 percent of contracts allowed for individual adjust-ments or left wages to negotiations between employer and employee. Wage dispersion duly increased, in particular at the high and intermediate levels within firms. It is noteworthy that despite the large decline in unemployment, the average annual growth of real wages was a reasonable 1.9 percent from 1993 to 2001.

Benefits reform. Denmark tightened unemployment benefits, but without reducing allowances. Instead, it cut the duration of the entitlement from seven years to four and limited the period in which recipients were not obligated to look for work to one year. At the same time, Denmark limited eligibility for benefits to those who had worked regularly for at least one year in the previous three.

Supply-side policies. Denmark focused on upgrading the skills of the unemployed. And it took the effort seriously, spending 1.3 percent of GDP on the effort.

Taxation. The government modestly reduced marginal tax rates on labor. And though rates remained high, they fell at a time when many EU countries were increasing the marginal tax rates on earnings.

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