The assertion that Europe is not experiencing a significant productivity lag behind the United States, as recently argued by Nobel laureate economist Paul Krugman, relies on a metric that obscures a more concerning reality: the widening economic divergence between the two economic powerhouses. While current purchasing power parity (PPP) calculations may suggest relative stability in output per hour over the past quarter-century, a deeper analysis using more appropriate economic indicators reveals a starkly different picture, indicating that the productivity gap is, in fact, expanding, with profound implications for Europe’s future economic competitiveness and global influence.
Krugman’s analysis, disseminated through a series of posts on his Substack platform, challenges the prevailing narrative of European economic stagnation. He contends that when adjusting for the relative cost of goods and services between the US and European economies – the essence of PPP – the output per hour worked in Europe has remained remarkably consistent when compared to its US counterpart for approximately 25 years. This perspective, if accepted at face value, would suggest that fears of a significant European productivity decline are overblown, and that the continent is not falling critically behind the economic engine of the United States.
However, economists Philippe Aghion, Antonin Bergeaud, and Luis Garicano, in their commentary, strongly contest this interpretation. They argue that Krugman’s chosen metric, current PPP, is fundamentally ill-suited for accurately assessing long-term productivity trends and international competitiveness. Their contention is that while PPP is useful for understanding the relative living standards and the purchasing power of individuals in different countries at a specific point in time, it fails to capture the nuances of economic growth, innovation, and the structural shifts that drive productivity in advanced economies.
The Limitations of Purchasing Power Parity
Purchasing Power Parity (PPP) is an economic theory that attempts to measure the value of currencies through a "basket of goods" approach. It posits that in the long run, exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services in any two countries. For instance, if a Big Mac costs $5 in the US and €4 in Germany, the PPP exchange rate would be $1.25 per euro. This method is valuable for comparing living standards because it accounts for the fact that prices for many goods and services differ significantly across countries. A dollar might buy more in a country with lower living costs than in a country with higher living costs, even if the nominal exchange rate is different.
The issue, as highlighted by Aghion, Bergeaud, and Garicano, is that current PPP rates are often influenced by the prices of non-tradable goods and services, such as haircuts or restaurant meals, which are heavily dependent on local wage levels. As European economies have generally maintained lower nominal wages than the US, the prices of these services tend to be lower in Europe. When these lower prices are used to "inflate" European output to US dollar equivalents, it can artificially boost the apparent output per hour, masking underlying weaknesses in the creation of higher-value, tradable goods and services that are the true drivers of long-term economic growth and innovation.
A More Revealing Metric: Real GDP Per Hour Worked at Constant Exchange Rates
The alternative metric proposed by the critics, and one that is more standard in rigorous economic analysis of productivity and competitiveness, is the comparison of real Gross Domestic Product (GDP) per hour worked using constant, rather than current, exchange rates or, more precisely, by focusing on output in a common currency using a consistent, often chain-weighted, measure. This approach effectively removes the distorting effects of fluctuating price levels and differing inflation rates between economies, and crucially, it focuses on the actual volume of goods and services produced, adjusted for purchasing power in a stable, base year.
When this more robust methodology is applied, the narrative shifts dramatically. Data from institutions like the OECD (Organisation for Economic Co-operation and Development) and Eurostat consistently show that while the US has experienced sustained growth in labor productivity over the past few decades, many European countries have lagged behind. The productivity gap, measured in this manner, has not remained flat; it has demonstrably widened.
Supporting Data:
According to OECD data, for example, in 2000, the United States’ labor productivity (GDP per hour worked) stood at approximately $45 (in constant 2015 US dollars). In the same year, the average for the Euro Area was around $35. This represented a gap of roughly 22%. By 2022, US labor productivity had grown to over $70, while the Euro Area average had only reached about $48. This widening divergence means the gap has increased to approximately 31%. While specific figures can vary slightly depending on the exact methodology and base year used by different statistical agencies, the overarching trend of a growing productivity gap between the US and Europe is a consistent finding across reputable sources.
This disparity is often attributed to several factors, including differences in investment in research and development (R&D), the pace of technological adoption, the flexibility of labor markets, and the dynamism of the business environment, particularly in high-growth sectors like technology and digital services. The US has generally demonstrated a stronger capacity to foster innovation and translate it into productivity gains, especially in the digital economy.
Historical Context and the Evolution of the Debate
The debate over Europe’s economic performance relative to the US is not new. For decades, economists have grappled with understanding the structural differences between the two economic models. Following World War II, Europe embarked on a path of integration and the creation of a social market economy, prioritizing social welfare, worker protections, and a strong public sector. This model, while successful in fostering stability and reducing inequality in many respects, has at times been criticized for potentially stifling entrepreneurial dynamism and innovation compared to the more market-oriented, less regulated US economy.
In the late 20th century and early 21st century, particularly after the dot-com boom and the subsequent rise of the internet and digital technologies, the US economy experienced a surge in productivity growth fueled by technological advancements. Europe, while also benefiting from these advancements, has often been perceived as slower to adopt and integrate them across its diverse economies. This has led to ongoing discussions about whether Europe is destined to be a perpetual follower in terms of technological and economic progress, or if it possesses the inherent strengths to close the gap.
Krugman’s intervention in this long-standing debate, by focusing on current PPP, appears to be an attempt to inject a more optimistic note into the discourse, suggesting that the perceived gap is less dire than often portrayed. However, the counterarguments from Aghion, Bergeaud, and Garicano suggest that this optimism might be misplaced if it leads to complacency regarding the structural challenges Europe faces in boosting its productive capacity.
Implications of a Widening Productivity Gap
The implications of a persistent and widening productivity gap are far-reaching for Europe:
- Reduced Economic Growth: Lower productivity growth translates directly into slower overall economic expansion. This can limit the growth of real incomes, job creation, and the capacity for public investment in areas like infrastructure, education, and healthcare.
- Diminished Global Competitiveness: In a globalized economy, countries with higher productivity are generally more competitive. They can produce goods and services at lower costs or with higher quality, making them more attractive to international markets. A widening gap can lead to a decline in Europe’s share of global trade and investment.
- Challenges for Public Finances: Slower economic growth puts a strain on government finances. Lower tax revenues can make it harder to fund social programs, manage national debt, and respond to economic shocks.
- Impact on Innovation and Technological Leadership: Productivity growth is intrinsically linked to innovation. If Europe is not matching the US in productivity, it suggests it may also be falling behind in the development and adoption of cutting-edge technologies, potentially ceding leadership in critical future industries.
- Social and Political Stability: Persistent economic underperformance relative to peers can lead to social discontent and political instability, as citizens question the effectiveness of their economic policies and institutions.
Towards a More Robust Economic Framework
The core of the disagreement between Krugman and his critics lies in the choice of measurement. While Krugman’s use of current PPP aims to illustrate a stable standard of living relative to the US, Aghion, Bergeaud, and Garicano argue that for understanding the engine of economic growth and future potential, a metric that focuses on the volume of output and its underlying drivers is essential.
The authors’ call for using more appropriate metrics is not merely an academic quibble; it has profound policy implications. If the productivity gap is indeed widening, European policymakers need to address the structural impediments to growth. This could involve:
- Boosting Investment in R&D and Innovation: Encouraging greater private and public investment in research and development, particularly in areas with high growth potential like artificial intelligence, biotechnology, and green technologies.
- Fostering Entrepreneurship and Start-up Ecosystems: Creating an environment that is more conducive to the creation and scaling of new businesses, including simplifying regulations, improving access to finance, and supporting innovation hubs.
- Accelerating Digital Transformation: Ensuring that businesses across all sectors adopt digital technologies and that the workforce is equipped with the necessary digital skills.
- Enhancing Labor Market Flexibility: While maintaining social protections, exploring ways to make labor markets more adaptable to changing economic conditions and technological advancements.
- Promoting Education and Skills Development: Investing in education and lifelong learning to ensure that the European workforce can adapt to the demands of a rapidly evolving economy.
In conclusion, while Paul Krugman’s analysis using purchasing power parity offers a potentially optimistic interpretation of Europe’s economic standing relative to the US, the counterargument posited by Philippe Aghion, Antonin Bergeaud, and Luis Garicano, which emphasizes the significance of real productivity measures, presents a more sobering and, arguably, more accurate picture. The evidence suggests that the productivity gap is not static but is instead widening, posing significant challenges to Europe’s long-term economic health and its position on the global stage. Addressing this divergence requires a clear-eyed understanding of the underlying economic realities, moving beyond metrics that may mask deeper structural issues and focusing on policies that can reignite robust productivity growth across the continent.
