Breaking Down Barriers to Growth

• Author: Martin Neil Baily and Diana Farrell
• Position: Senior Fellow at the Institute for International Economics, was Chairman of the Council of Economic Advisers during 1999-2001/Director of the McKinsey Global Institute

Encouraging competition is key to reviving stalled industrial economies

How best to rekindle growth is a subject of intense debate in most of Europe's developed economies and in Japan. Over the past decade, these countries have experienced a slowdown of economic growth at the same time as lengthening life spans have caused their pension and health care costs to mount. Some economists have recommended lifting restrictions on competition in the many sectors where they remain and reforming labor market regulations. But such moves are resisted by those who fear they will lead to mass unemployment and destroy social safety nets. Others recommend more investment in research and development (R&D) and education to equip workers with the skills to perform higher value-added tasks as more low-value jobs are automated or migrate to lower-cost economies.

Who is right? In exploring the debate, this article focuses on supply-side barriers to growth (demand-side macroeconomic policies have been examined extensively elsewhere). After a decade of research comparing productivity in private sector industries in the world's major economies, our conclusion is that the key to boosting productivity and thus growth is a policy framework promoting competition in all sectors.

Productivity is paramount

Rates of economic growth among developed economies have varied over the past 15 years, creating quite significant changes in relative GDP per capita (see Chart 1). As the chart shows, GDP per capita can be broken into GDP per hour worked (a rough measure of productivity growth) and hours worked per capita (labor utilization). Productivity growth is clearly the main source of GDP per capita growth, so policymakers should make promoting it a top priority. However, overall growth has been curtailed in a number of economies because of substantial declines in hours worked per capita. Accordingly, creating jobs is vital, too.

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Our research on six major European economies, the United States, and Japan shows that regulatory reforms resulting in greater competitive intensity within an industry will improve overall productivity within that industry. The more sectors that improve their average productivity, the greater GDP growth in that economy will be.

Look at Europe. In each of the six countries we studied, there is a significant gap between the labor productivity levels of most companies in any industry and those of world-class companies. In France and Germany, for instance, labor productivity is lower in most industries than in the same industries in the United States (see Chart 2), with food retail in France and mobile telecoms in both France and Germany as the only exceptions.

[ SEE THE GRAPHIC AT THE ATTACHED ]

While several European industries closed the productivity gap with the United States during the 1990s, just as many fell further behind. What prevents Europe's labor productivity from reaching its potential? The gap in some industries has structural causes. In European retailing, for example, small, proprietor-owned stores-less productive than either large discount retailers or chains of small specialty stores-are much more common than in the United States. Similarly, in Japan, mom-and-pop stores have a large share of the market. In other industries, productivity gaps arise because national industries introduce more productive innovations at different times. French automakers, for instance, adopted lean manufacturing in the 1990s, igniting a jump in the sector's labor productivity, from just 42 percent of the U.S. level in 1992 to 72 percent in 1999. German auto companies, in contrast, began the decade in a dominant position and felt little pressure to change. As a result, their productivity levels fell behind those of French companies, from 59 percent in 1992 to 69 percent of the U.S. level in 1999.

We found that where European industries had retained structures and processes that impeded productivity growth, the underlying cause was a lack of competitive...