Productivity, defined as the ratio of output to input, is crucial for long-term economic well-being and at the core of any economic activity and governance. It measures how efficiently inputs like labor (e.g., number of hours worked) and capital (e.g., machines employed) are used in production for a given level of output.

Without productivity growth, a modern society that has both an 8-hour workday and an increasing supply of consumer goods would be impossible. In short, productivity growth provides the foundation for the high quality of life in Europe as we know it. Especially in aging societies with declining labor force participation, welfare gains can no longer be achieved without productivity growth.

In recent years, we have observed a decline in productivity growth in Europe and elsewhere in the world. This is puzzling as the ongoing digital transition is expected to fuel the drivers of productivity growth, namely technological progress and utilization of innovation. The overall weak productivity growth is even more worrisome as it is spread unevenly across European regions.

If it further concentrates primarily in large companies in metropolitan regions, it will sooner or later hamper economic convergence. This, in turn, will foster social and political tensions within the EU. Thus, it is not only important to increase the aggregate growth rate of productivity, but also to ensure ‘inclusive productivity’ by disproportionate higher growth rates in regions currently lagging behind.

The green transition adds another challenge for productivity growth. Economic output should remain at least constant while required inputs like fossil energy decrease drastically or are even fully replaced. This changes the focus of productivity from labor and capital usage to the sparing usage of natural resources and minimizing pollution. Russia’s invasion of Ukraine clearly demonstrated the high importance for Europe to improve the productivity of natural resources.

In this blog post, we shed light on Europe’s position in productivity, the diffusion of productivity across European regions, the role of productivity in the green transition and policy implications to foster inclusive productivity growth.

Productivity is key for keeping up with the rest of the world

Productivity determines the competitiveness of an economy. High productivity implies low inputs for producing a given amount of output. This allows firms to offer their products and services at lower prices than firms in other regions and countries. In contrast, low productivity implies wasteful usage of labor, capital or other inputs to produce a certain output and leads to higher production costs and, ultimately, higher prices.

Many European countries are exhibiting a prolonged slowdown in productivity growth. When it comes to labor productivity, a key indicator, countries like France, Germany or Italy had annual growth rates between 3 and 9 percent until the mid-1970s. Since then, growth rates have declined substantially and are well below 2 percent since the year 2000. Explanations for this phenomenon range from a slowdown of technological progress and diffusion to a structural shift of economies towards lower productive services, restrained investment activity since the financial crisis and mere measurement difficulties. Some believe that the big productivity boost from digitization is yet to come.

So far, Europe is not alone in this problem. A similar development can also be seen in other industrialized countries like the USA and Japan. This trend, however, does not necessarily have to continue. On the one hand, there are also country-specific causes behind the slowdown. For example, in Germany, a large part of the productivity paradox can be explained by strong labor market development and structural change. On the other hand, the global distribution of innovative strength as a key driver of productivity development is shifting.

While international rankings like the Global Innovation Index still find the US and European countries leading in innovative strength, the “performance of South East Asia, East Asia, and Oceania (SEAO) has been the most dynamic in the past decade, and is the only region closing the gap.” There is evidence that Europe is losing ground on patents in key technologies too.

 

At the same time, research shows that technological progress becomes more and more unevenly distributed on a regional level. Between 1995 and 2014, the share of patents held by the top 10% of OECD cities rose from an already remarkable 61% further to 64.5%. Among leading global cities regarding patenting, only one is located in Europe: Paris. Since innovation is a basic condition of productivity and thus income growth, this concentration process has fundamental implications for welfare distribution within Europe.

Productivity is key for cohesion in Europe

Productivity determines long-term prosperity. Equally distributed prosperity across European regions is important to avoid economic imbalances that undermine cohesion, an important political aspiration of the European Union. Therefore, to reduce economic imbalances, it is crucial that less-developed regions in the EU improve their productivity. In order to catch up to already productive regions, these regions must achieve even higher productivity growth.

But how are European regions doing? Between 2007 and 2017, labour productivity, measured in output per worker, developed very unevenly across European regions. Most regions with an already high level of productivity in 2007 grew at a below-average speed.

For regions with a low level of productivity in 2007, a bipartite picture emerges. While Eastern European regions grew predominantly above average, most of the Southern European regions grew at a below- average rate. Hence, the overall gap between regions with high productivity and regions with low productivity did not close in the last decade. Put differently, the productivity divide between Southern and Northern Europe did not shrink.

Current disparities in productivity levels across European regions will change in the future. Three trends will determine the future of the productivity landscape in Europe:

Productivity is key for shouldering the green transition

Traditionally, productivity is calculated on the use of labor and capital relative to GDP. This leaves out advances in the usage of natural resources or the amount of pollution, where European firms place heavy emphasis. Leaving out natural resource usage and pollution leads to biased results of productivity growth resulting in overestimation or underestimation. An overestimation occurs if output growth relies on depletion of natural capital or on heavily polluting technologies. An underestimation does not consider the investment in more efficient use of (domestic) natural resources or in pollution abatement.

Part of the puzzling decline in productivity growth can be attributed to a non-consideration of natural resources and pollution. Especially until the 1970s, environmental policies were weak, resulting in an overestimation of productivity growth. In contrast, in recent years, environmental regulations are strict, requiring firms to focus on cutting down natural resource usage and pollution alike leading to an underestimation of productivity growth.

Given the goals of Europe’s Green Deal strategy to combat climate change, GDP growth needs to be decoupled from natural resource inputs and CO2 emissions. Reducing fossil energy consumption, cutting down carbon emissions and expanding the circular economy involves drastic transformation processes leading to fundamental changes in the way inputs are used to produce the current level of output. Without using inputs more efficiently and scarcely, the transformation into a greener Europe is not possible. Doing so means higher productivity, but with a focus on natural resources and energy rather than on labour and capital productivity.

What can be done?

Europe needs to foster productivity to remain competitive with other global players like China and the US, but also to master the green transition. To meet these challenges, productivity needs to improve in all European regions, but especially in those persistently lacking behind. Without inclusiveness in productivity growth, regional inequalities will prevail and continue inflicting economic and political cohesion.

To move ahead, it is more important than ever that regional and structural policy focusses stronger on regions left behind to make them more productive and thus reduce disparities in prosperity in the long run. In the end, it is not relevant whether the impulse for productivity gain is created in Sicily or Lapland if all European regions can benefit from it. It is technology diffusion that needs to be enhanced.

Productivity can be fostered by innovation. The key for innovation is investment in R&D activities with a clear focus on their contribution to overarching policy goals. This requires strengthening human capital by modernizing education. But more is needed: The EU has to work on open (digital) markets which are interoperable and a modern capital stock in the form of functioning business-related infrastructure regardless of a region’s current productivity position. More public investment in (cross-border) infrastructure and research would improve framework conditions, enhance planning security for companies and send an important signal for private investors to follow.

European regions with a high dependency on fossil energy sources today will have to shoulder the highest burden in the green transition. Without the support of economically stronger member states, this can hardly be accomplished. By contrast, a carbon-neutral and more circular European economy can only be achieved in solidarity. Here, the EU can offer a decisive advantage not only through financial compensation, but also through coordination, better transnational energy infrastructure and common trade policy.

Reaching European climate goals and implementing the Green Deal through higher resource and energy productivity would, in fact, also reduce dependency on foreign resource imports from countries such as Russia, which we urgently need to avoid for geo-strategic reasons.

Finally, we must rethink our understanding of productivity as such. We need to consider natural resources and energy rather than labor on the input side and greenhouse gas emissions on the output side. Doing so requires both a unified methodology of measuring resource productivity and ambitious targets continuously monitored. With the ongoing green transition to a more sustainable economy, this becomes increasingly relevant.

About the authors

Thomas Schwab is Project Manager for the Europe’s Future Program at the Bertelsmann Stiftung. He applies a data-driven approach to economic analysis by employing data science and econometric methods.

Marcus Wortmann is a Project Manager at the Bertelsmann Stiftung. He deals with various topics of economic and monetary policy in Europe as well as international economic relations. Prior to this, he worked as a research assistant at the Chair of International Economic Policy at Georg-August-Universität Göttingen. After completing his Master’s degree in International Economics, he earned his doctorate with the thesis “Convergence or Divergence in the EMU?”.

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