By Jan Švejnar, Yuriy Gorodnichenko, Debora Revoltella and Christoph Weiss
On 28 and 29 November, the European Investment Bank and the European Central Bank, in cooperation with the Massachusetts Institute of Technology, Columbia University and SUERF (the European Monetary and Finance Forum) will co-organise a high-level conference on ‘Investment, Technological Transformation and Skills’.
Falling productivity growth in the EU can be explained by distortions in the allocation of capital and labour across firms in the different countries and sectors of the single market. This is a relevant issue for policymaking, after years of economic readjustment. Many (more or less formal) barriers continue to keep resources from flowing to the most productive and efficient firms in Europe. Policy design should work towards eliminating frictions in EU product and labour markets that allow the persistence of resource misallocation. A better harmonization of the business environment—and thus easing the reallocation of resources—across countries and industries will increase firm productivity and aggregate economic growth in the EU.
Our paper (Gorodnichenko, Revoltella, Švejnar and Weiss, 2018) 1 focuses on misallocation of resources in Europe. The conceptual framework is straightforward. If the key objectives of the EU—the creation of a single market—were truly achieved, one ought to observe that resources are allocated efficiently and marginal products for firms in all 28 countries are equalized. This is obviously a tall order. A less demanding proposition would be to ask whether, after decades of economic integration, the dispersion of marginal products across firms in the EU is close to the dispersion found in the United States.
Europe productivity dispersion cut would boost GDP
We show that the allocation of resources in Europe is far from efficient. We develop a dynamic theoretical framework of firm optimisation behaviour and, using EIB’s Investment Survey (EIBIS) of firms in the 28 EU countries, we estimate that reducing the EU dispersion in marginal revenue products to US levels—a change that would be likely to require many significant policy reforms—could increase the EU’s GDP by more than 20 percent. By reallocating capital and labour to firms that perform better, EU economies could significantly increase productivity and output.
We also explore why firms have different marginal products. We show that removing barriers across countries and industries in the EU could increase GDP by at least 18 percent. This implies that the EU common market is rather fragmented.
In terms of labour allocation, firms are more segmented across countries than industries. Differences in levels of marginal products of labour are higher across countries than across industries. This suggests that moving a worker from one country to another is “costlier” than moving the worker from one industry to another within the same country, or that quality differences across workers are larger between countries than between industries. The opposite is true for the use of capital: the interpretation is that moving a unit of capital from one country to another is cheaper (or easier) than moving it from one industry to another within the same country or that quality differences in capital are smaller between countries than between industries. National regulations and language barriers could play an important part in these inefficiencies of resource allocation within the EU.
Raw dispersion and productivity gains
We also note that while the dispersion of marginal products may reflect barriers and distortions, some dispersion may reflect optimizing behaviour of firms (e.g. compensating differentials in the labour market), which would be economically rational from the standpoint of the firms and could even be optimal for social welfare. Which of these phenomena is consistent with the data is thus a key question.
We also explore the extent to which firm characteristics predict the variation in marginal products. When we constrain the effects of firm-level characteristics to be the same in all EU countries, they can explain 11 percent of the variation in the marginal product of capital and 27 percent of the variation in the marginal product of labour, a sizeable part of total dispersion. When we allow the effects of these variables to differ across countries, so that for instance the effect of a rise in capacity utilization is permitted to influence the productivity of a German firm differently than an Italian firm, these effects explain most of the variation in marginal products.
Based on this analysis, we reach two important conclusions. First, the raw dispersion in marginal products is likely to overstate the extent of misallocation, since some variation could be driven by heterogeneity in the quality of inputs. Second, distortions are likely to be substantial and removing them may lead to significant gains in productivity.
We also use the Machado-Mata decomposition to construct counterfactual distributions of marginal products for each country. This decomposition exercise helps us to understand better whether the observed variation in marginal products is caused by:
- differences between countries in firm characteristics or
- differences between countries in how the business, institutional and policy environment guides the allocation of resources across heterogeneous firms, i.e. how regression coefficients on characteristics are “priced” into outcomes.
We find that variation between countries in the dispersion of marginal products is largely driven by differences in a country’s business, institutional and policy environment rather than by differences in firm characteristics per se. This result is important because it provides large-scale microeconomic evidence that institutions can explain the variation in marginal revenue products across EU firms.
The policy implications of this research are clear. Policymaking can increase firm productivity and economic growth in the EU by creating incentives to better allocate capital and labour across firms in different countries and industries. Improving the business environment consists in addressing frictions in EU product markets and labour markets that support the persistence of resource misallocation.