Labour productivity
(essay)
Abstract
The analysis in this paper dismisses the notion of a genuine trade-off between employment and productivity growth. Obviously, misguided policies to exploit such a trade-off have to be avoided. However, there are no reasons to think that structural labour market reforms boosting employment will typically entail negative implications for longer-term productivity growth. The dynamic response of productivity to positive labour supply and wage shocks may entail a temporary reduction in productivity growth rates, which, in principle could be considered as benign; anyway, the size of a negative effect of this type is estimated to be fairly small. In particular, this paper reaches the following conclusions: (i) The increase in employment since the mid 90s has indeed been to a significant extent the result of such positive labour market shocks, with about one half of the additional jobs attributed to structural improvements; (ii) Positive employment shocks can only account for a very small fraction of the observed productivity slowdown; consequently, the decline of labour productivity growth must be considered as predominantly caused by other factors and probably not just a temporary phenomenon.
Introduction
The so-called Lisbon strategy involves efforts on several fronts both to improve labour market performance and to raise productivity growth in the EU. This twin aspiration is neatly summed up in the phrase ‘more and better jobs’, which implies higher employment rates but also more productive, higher-quality employment.
The strategy sets explicit targets for ‘more jobs’: an employment rate of as close as possible to 70% and a female employment rate of over 60% by 2010. The Stockholm summit a year later added a further target of an employment rate of 50% for older working-age people. Given the rate of employment growth required to meet these targets, the Lisbon conclusions also established an implicit target for productivity growth with the statement that – if the recommended measures were implemented against a sound macroeconomic background – it should be possible to achieve 3% GDP growth.
These targets have met with criticism in some quarters on several counts. Some regarded them as over-ambitious, particularly since the European Council (as opposed to individual Member States) lacks full control of the necessary instruments to meet its objectives. There were doubts about whether a credible strategy had been set out, or even whether EU leaders realised the extent of the reforms that would be required. Others pointed to the risk of policy distortions – there are many ways to raise employment rates, for example, but not all of them are fully consistent with raising economic welfare. On the other hand, the Lisbon targets appeared to score an initial public relations success, being widely interpreted as a signal that the EU was taking economic reform seriously. (Even then, however, it was noted that this might damage the credibility of similar exercises were the targets to be missed by a wide margin.)
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Two clear advantages of the Lisbon strategy, and especially the employment rate targets, are often overlooked in these discussions. First, the commitment to raising employment rates (i.e. raising labour force participation as well as reducing unemployment) represents a clear rejection of an idea that has been one of the great weaknesses of European employment policy in recent decades, namely that high unemployment can be cured by discouraging labour supply. If this seems obvious today, it is not so long ago in some countries that married women were discouraged from working, while older workers were actively encouraged to quit the labour market through early retirement schemes, partly in response to high unemployment. Even more recently, governments in some EU Member States were entertaining a similar notion – that employment in persons might be boosted by means of regulatory restrictions on hours worked.
Secondly, the Lisbon strategy embodies the idea that structural improvements in the functioning of markets are required for a sustained increase in employment rates and higher productivity growth. Clearly, at any given moment, output and (un-)employment are determined by real demand in the economy. However, over the longer term, real demand will generally tend towards a level consistent with stable inflation, this level being determined by overall supply conditions in the economy. By focusing on the functioning of labour, product and capital markets, as well as investments in R&D and human capital, the Lisbon strategy seeks to raise employment and growth potential in a sustainable manner.
In addition, while one may ask whether the employment rate is the ideal variable to target, there is no doubt that low employment rates in several EU Member States are a symptom of poor labour market performance, and that improving labour market performance would lead both to higher employment rates and to greater economic welfare. The benefits of higher employment rates for the sustainability of the public finances (at least in the short-to-medium term) were also noted.
Against this background, this paper focuses on a crucial question for the strategy of ‘more and better jobs’: whether and in what sense there are trade-offs between employment growth and productivity growth. Concern has been raised in some quarters that raising the employment rate in the EU will result in lower productivity growth. Indeed, there is a grain of truth in this: a rising employment rate implies that productivity growth will be temporarily below full potential, simply because the number of workers per unit of capital is increasing. In addition, those who move from unemployment or inactivity into employment are likely, on average, to have a relatively low level of productivity, at least at first.
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However, there are three reasons why this is not a cause for concern. First, the temporary negative effect on productivity growth is estimated to be rather small. Secondly, even if growth in productivity – GDP per employed person – is negatively affected, a higher employment rate unambiguously raises growth in GDP per capita in the short term. Newly employed people clearly contribute more to GDP than they used to, even if their productivity is below average. Thirdly, there are few reasons to think that a higher employment rate has any negative implications for longer-term productivity growth, which is what really matters for the competitiveness and dynamism of the EU economy. These points –important ones for the Lisbon strategy – are supported by two separate pieces of analysis: an econometric analysis of the dynamic response of productivity to structural employment shocks, and a simulation based on the Commission’s macroeconomic model. Thus, there is no genuine trade-off – in the sense of prioritising one of the two – between policies to raise the employment rate and policies to foster productivity growth.
2. More and better jobs – an example of goal inconsistency?
Background considerations
At the moment, EU GDP per capita in purchasing power parities is around 70% of the US level, with 1/3 of the gap due to productivity differentials and 2/3 due to a lower labour input (i.e. a lower employment rate and hours worked compared with the US). Consequently, improving the EU’s productivity performance and raising employment is fundamental to increasing the long-term growth potential of the EU economy[1]. However, several observers have argued that the twin goals of raising both employment rates and productivity growth may be difficult, or even impossible to pursue simultaneously, given a perceived negative trade-off between employment and productivity.
The basic argument for the existence of a negative relationship between employment and productivity is derived from straightforward comparative-static reasoning. For any standard production function, average factor productivity will decrease with rising output as the expansion of production will require the bringing in of less and less productive factors into operation – less fertile soil, older and less efficient equipment and machinery, workers with lower abilities and skills, etc. Then, obviously, higher employment will inevitably be associated with lower output per worker and vice versa. Thus, in such a comparative-static setting it is easy to construe a situation where, for example, regulations and restrictions excluding low productivity workers from employment result in a higher level of actual labour productivity, but it will come at the price of lower employment; similarly, reform efforts to price back low productivity workers into employment will mean more jobs, but this will be associated with lower overall productivity.
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In comparing labour productivity levels across countries, such considerations of a comparative-static nature can be useful. There appears to be widespread agreement that measured labour productivity in Europe relative to the US may be upwardly biased as a result of the exclusion of more low productivity workers. Indeed, the EU employment rate falls short of the US level by some 10 percentage points, with lower participation rates and higher unemployment rates disproportionately affecting low skill workers. In a similar vein, the capital-labour ratio appears to be typically higher in the EU than in the US, driving up measured labour productivity in Europe. Thus, both economic theory and a quick inspection of a few aggregate figures suggest that one should control for these effects in productivity comparisons. Obviously, in consequence, a Europe at full employment may well see a significantly larger labour productivity gap vis-à-vis the US than the current actual figures suggest.
By how much could the productivity gap rise? A simple calculation could be performed focussing on comparisons of total factor productivity levels, using the following relationship:
(1)Y/L = (K/L)1-α. TFP
where Y/L denotes measured labour productivity, TFP is total factor productivity, K/L is the capital intensity of production and 1-α is the capital-elasticity of output in the constant-returns Cobb-Douglas case. For the calculation, GDP and the capital stock in PPP are taken from AMECO. Employment is civilian employment (LFS). Hours worked come from the GGDC (Groningen Growth and Development Centre). The results of this simple exercise suggest that the productivity gap between the euro area and the US, shown in the graph below, may be some 6 percentage points wider than the actual figures indicate.
Graph 1: TFP and labour productivity gap
Source: Commission services
However, the notion of a negative relationship between employment and productivity levels emerging in comparative-static considerations should not be confused with a genuine trade-off between employment and productivity in a long-run dynamic sense. One of the “big” stylised facts in economics is that in the long run technical progress is neutral with respect to employment. History has told us that the process of capital accumulation and technological innovation has not meant the “end of work” and despite notions of “factories without workers”, it is clear that from an overall perspective workers have not been replaced by machines. In standard economic growth theory this long-run neutrality proposition has been captured by the concept of labour-augmenting technical progress[2]. Along this balanced growth path, labour productivity, real wages and the capital intensity of production grow at the same rate, driven by (exogenous) technical progress. Technical progress is called total factor productivity growth, indicating that this concept should not be seen in a narrow “engineering” sense. Given that TFP determines our standards of living in the long run, clearly policy makers want it to grow faster than in recent years.
Actual labour productivity growth can of course deviate from the balanced labour productivity growth rate over the short-to-medium term due to capital-labour substitution; faster than “balanced” productivity growth indicates labour shedding, and a shortfall of actual relative to “balanced” productivity growth is a characteristic of what is loosely called labour-intensive growth. Obviously, then, the employment neutrality hypothesis will not hold over the short-to medium term[3]. In consequence, pressing ahead with labour market reforms may entail a temporary reduction in measured productivity growth below full potential, but this should not be regarded as a trade-off in any sense. A higher employment rate implies an unambiguous increase in GDP per capita with no negative implications for the long-run productivity growth of the existing workforce. Thus, there is no inherent problem to act on both fronts simultaneously, raising the “balanced” rate of productivity growth using all the available instruments to stimulate TFP growth, whilst at the same time encouraging the labour-intensive growth in the medium term that is needed to move towards full employment[4].