September 2000
Federal Reserve Bank of Dallas

A New Paradigm in Europe?

About a year ago, Bob McTeer posed the question to the Research Department of why the New Paradigm only seemed to be emerging in the United States and not in any other countries. In particular, why has Europe, with its abundance of highly skilled labor and world-beating firms in many industries, lagged the United States in taking advantage of the new technologies of the Third Industrial Revolution? In answering this question, I advanced a number of explanations for the slow emergence of the New Paradigm in Europe.

In my presentation today I would like to present these explanations to you. Many of them are familiar to the point of being clichés, but I will also argue that there are signs of change. In particular I will argue that the process of European integration that led to the creation of the European Union (EU) has put in place processes that will in time fundamentally transform the economic landscape on the continent. In particular, the Single Market Act in 1986 and the launch of Economic and Monetary Union (EMU) at the beginning of 1999 will help create a domestic market for European firms that will allow them to reap the scale economies and efficiencies that have typically only been available to U.S. firms. I will also argue that the European Commission deserves credit for beginning the process of breaking down barriers to competition in the form of state subsidies to industry. While a lot remains to be done, the upside potential of the EU should not be underestimated.

My presentation will follow a standard three-act format. I will begin by showing just how different the performance of the United States and the EU has been over the past five years. My focus will be on aggregate statistics that provide the most dramatic evidence of the existence of a New Paradigm in the United States. I will then present my arguments for why Europe missed out on the early stages of the Third Industrial Revolution. The essence of my argument will be that the burden of government in Europe, which manifests itself in many ways, in conjunction with fragmented markets, has historically limited competition and stifled the entrepreneurship that is vital to economic growth. However, the recent moves towards deeper integration between the nations of Europe, both economically and politically, will significantly alter the business landscape and provide fertile ground for future economic growth.

The New Paradigm
By the New Paradigm I mean the combination of high growth, low inflation and low unemployment driven by rapid productivity growth that has been a feature of the U.S. economy for the past five years. The basic comparative statistics are shown in Figures 1–4 (see PDF). During the first half of the decade, productivity growth in the United States and in Europe was not dramatically different. The United States experienced the usual spike in productivity associated with recovery from recession in 1992. Europe experienced something similar as it emerged from recession in 1994. In 1995 productivity growth in Europe actually exceeded productivity growth in the United States, but since then the United States has experienced productivity gains at a more rapid rate than Europe. It is the wide and growing gap between U.S. and European productivity growth so evident in Figure 1 that is the basis for the New Paradigm in the United States.

Rapid rates of productivity growth have in turn translated into more rapid real output growth. Since 1995 real output growth in the United States has exceeded real output growth in Europe by an average of 1½ percentage points a year.

Both the United States and Europe experienced declining inflation for most of the 1990s. In the United States the decline in inflation was facilitated by the acceleration in productivity, in conjunction with a series of shrewd interest rate decisions by Federal Reserve policymakers. In Europe, the deceleration of prices was driven by the need to meet the stringent inflation criteria for participation in EMU.

Perhaps the most felicitous consequence of the New Paradigm in the United States is the decline in unemployment to levels not seen in thirty years. After the jobless recovery that followed the 1990–91 recession, unemployment has fallen steadily and we are now experiencing the tightest labor markets in a long time. In contrast, unemployment in Europe has run at rates more than twice the U.S. rate for most of the past decade. While some of this higher unemployment undoubtedly reflects the difficulty of absorbing the former East Germany and some is possibly due to the tight fiscal and monetary policies pursued by most countries in the run-up to EMU, the bulk of it reflects the rigidity of Europe's labor market, a point to which we will return below.

Europeans have noticed and have been voting with their savings. As Bob McTeer has pointed out in a number of speeches, the current account deficit, which is a source of concern to so many U.S. commentators, is simply a reflection of the huge capital account surplus that the United States has been running in recent years. For most of the 1990s, net purchases of U.S. stock by European investors were close to zero. Not any more. Since 1997, Europeans have increasingly been net purchasers of U.S. equities.

Before turning to consider the foundations of the New Paradigm, it is worth asking what exactly happened in 1995 that so dramatically transformed the U.S. economy. Some students of the U.S. productivity point to two key developments that year. First, there was a noticeable acceleration in the rate of decline of computer prices. From the late 1980s through the middle of the 1990s, computer prices declined at an average annual rate of about 15%. However, since 1995 computer pries have declined at a rate closer to 30% a year. The key factor precipitating the more rapid rate of decline in computer prices was a dramatic shortening of the time Intel took to get new chips from development to market. Moore's Law, which previously stated that the capacity of semiconductors doubled every eighteen months, was reformulated to state that capacity doubled every twelve months. The second key development that year was that Dell, Cisco and Amazon all began to make extensive use of the Internet for commercial transactions, marking the beginning of the e-commerce revolution.

Why The Difference?
So what factors underlie the emergence of the New Paradigm in the United States and account for the failure of Europe to reap similar gains to date? I've listed five: burden of government, the competitive environment, entrepreneurship, access to capital and the use of technology. The items listed are not mutually exclusive or exhaustive, but are intended more as a focal point for discussion.

It is well known that the burden of government in Europe is greater than in the United States. One simple measure of this burden is government spending as a fraction of GDP. Government spending in Europe typically amounts to close to half of GDP, compared with about one-third in the United States.

The quid pro quo of high government spending is high taxes. According to recent estimates, the average tax rate on labor in France is nearly 50% and includes, in addition to income tax, a myriad of "social charges" (including a literal payroll tax). The average tax rate on labor in the United States is just over 20%.

It's not just labor that's taxed heavily. European countries rely much more on consumption taxes of one sort or another to finance spending than does the United States. The average tax rate on consumption in the United States is currently only about 5%, while in most European countries it is in the 15%–20% range, largely because of Value Added Tax.

Along with a heavy burden of government, firms in Europe have traditionally faced a less competitive environment than their United States counterparts. For some, this reflected the small size of their domestic markets. For many, the lack of competition was due to government intervention in markets both internally, in the form of regulation and nationalization, and externally, in the form of tariff and non-tariff barriers to trade. Until quite recently, many key industries in Europe were directly owned by the state or heavily regulated. State aid to failing firms was commonplace, delaying much needed restructuring.

Within Europe, tariffs and nontariff barriers to trade between countries have been effectively eliminated. However, the common external tariff of the European Union still affords European firms a greater degree of protection than their American counterparts.

A third key difference between Europe and the United States has to do with levels of entrepreneurship and social and cultural attitudes towards entrepreneurs. If the business of America is business, no one has ever been quite sure what Europe's business is. The differences in the rates of entrepreneurship between the United States and Europe reflect a variety of more fundamental factors. Regulatory obstacles are the most obvious. It is considerably easier to register a company and file a patent in the United States than it is in the EU. Bankruptcy law needs to strike the right balance between protecting the needs of investors who supply risk capital and encouraging innovation and risk taking. Businessmen in Europe complain that existing legislation errs too much in the former direction and excessively penalizes failure. Entrepreneurship is also hindered by difficulties in raising capital and barriers to the provision of stock options. Finally, the culture in most European countries has not accorded the entrepreneur the same status enjoyed in the United States.

Finance is the fuel that feeds the flame of innovation. Without capital to nurture them through their infancy, most ideas soon die. Europe's financial structure differs in important ways from what we are familiar with in the United States. Financial institutions, particularly banks, have traditionally played a much more important role in channeling funds from lenders to borrowers than has been the case in the United States. The heavy reliance on bank funding posed a particular problem for business startups, which typically do not have much in the way of collateral to offer. Until two years ago, national capital markets were fragmented and cross-border investment carried significant exchange rate risk. Large and persistent government deficits absorbed a significant amount of such capital that was available, crowding out investment in business enterprises.

A comparison of how private individuals save gives us some sense of the difficulties faced by European entrepreneurs. On average, Americans hold just under half of their savings in the form of mutual funds or securities, and less than one-fifth in the form of bank deposits. In contrast, Europeans hold about one-third of their savings in the form of securities or mutual funds, and nearly half in the form of bank deposits or life insurance.

These differences between the United States and Europe manifest themselves in the low rates of utilization in Europe of the new Information Technologies that are the driving force of the New Paradigm. The United States leads in the production of hardware, the development of software, invests more in new technologies and has a labor force with a skill mix better suited to the New Paradigm. Almost all U.S. white collar workers use a PC, while only slightly more than half of European workers do. R&D spending averages just under 3% of GDP in the United States, as opposed to just under 2% in Europe.

The United States has more Internet hosts per capita than any other country, largely because of the low cost of Internet access here. The New Paradigm has not repealed the Law of Demand. We could look at many other dimensions of the new technologies, but we would see essentially the same thing.

Signs of Change
Is Europe doomed? It is my contention that the process of European integration, which began shortly after World War II and really got under way with the signing of the Treaty of Rome in 1957, is creating an environment that in the not too distant future will allow Europe to reap many of the benefits of the New Paradigm that the United States has been enjoying for the past five years. The two most significant developments in this regard are the Single Market Act of 1986, which eliminated all remaining obstacles to the free movement of goods, services, labor and capital, and the launch of Economic and Monetary Union last year, which will deepen and strengthen the single market through the sharing of a single currency. EMU will provide additional benefits over time, by creating an environment of price stability that few countries outside of Germany have enjoyed for most of the past fifty years. And the fiscal discipline required by the Maastricht Treaty, as elaborated by the Growth and Stability Pact, will constrain the free-spending impulses of many governments.

Few would deny that the large domestic U.S. market provides an ideal environment in which U.S. businesses can refine their products and business practices before taking them to the global marketplace. The emerging single market in Europe is providing a similar environment for European firms. This market exceeds the domestic U.S. market by about 100 million consumers, all with per capita incomes that are about two thirds those of their U.S. counterparts. As I mentioned earlier, tariff barriers have essentially been eliminated (except for some recent entrants), and nontariff barriers are becoming a thing of the past. Language differences will always be something of an obstacle, although even here many businesses are facing the reality that English is the global language of business and are making it the official language for internal business purposes.

Europe's common currency will be used by about 300 million consumers from the start of next year, and depending on the outcome of the referendum in Denmark later this month, may rapidly become the sole currency of all European nations in a couple of years. By eliminating exchange rate risk, the single currency will deepen and strengthen the single market. It has already facilitated the development of a pan-European capital market which hitherto did not exist, and is driving a flurry of M&A activity in a number of sectors. The fiscal discipline required by EMU will manifest itself in lower taxes and less capital being absorbed by the public sector. Just last month, Germany announced a major package of tax cuts, and France recently followed suit.

A little-noticed provision of the Treaty on European Union limits the ability of national governments to provide aid to ailing firms or industries. This provision has been increasingly invoked by the European Commission to limit the ability of governments to bail out bankrupt companies (most recently in the case of the Philipp Holtzmann construction company in Germany). It has also served as a spur to privatization of formerly nationalized industries and deregulation of formerly regulated ones. Some of the most dramatic changes have been in the telecommunications sector, formerly the exclusive province of state-owned monopolies. Deregulation of this sector in recent years has been accompanied by price declines, and as competition increases, the scope for further declines will grow.

And these reforms are bearing fruit. Europe does have the lead in several emerging information technologies, especially mobile telephony. The existence of a single standard for wireless communications in Europe has accelerated the adoption of mobile phones. In some of the Scandinavian countries, penetration rates are close to two-thirds of the population. Europe is also leading the way in the development of third-generation mobile phones and applications such as m-commerce. Finally, a recent survey of emerging centers of Internet activity listed 16 European cities, as opposed to 14 in the United States.

A Success Story
Before concluding, I'd like to draw your attention to one dramatic success story that has interested Bob McTeer for some time. For much of its history, the Republic of Ireland pursued the same statist policies that were the norm in Europe. High taxes paid for generous welfare benefits and foreign investment was discouraged. After a public-spending binge in the late 1970s and early 1980s, the country found itself in a crisis, with unemployment close to one-fifth of the labor force and the specter of emigration once again raising its ugly head. A fierce fiscal retrenchment followed, with the result that by the end of the 1990s Ireland looked less like the typical European county in terms of the burden of government and more like the United States.

And the payoff? Real GDP growth rates that earned the country the sobriquet of the Celtic Tiger and a level of GDP per capita greater than the large island to its east that was once its colonial master.

—Mark A. Wynne

About In Depth This article is based on a presentation by Mark A. Wynne, policy advisor and research officer, Research Department, Federal Reserve Bank of Dallas. The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System.