The Draghi Report – or, was it a mistake for the EU to leave the UK?

"Productivity isn't everything, but, in the long run, it is almost everything. A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker." – Paul Krugman (The Age of Diminished Expectations, 1990).

Let's think about that. The author – one of the smartest people I've met – is saying that to raise living standards, we have to raise output per person, or productivity. But living standards are often defined in terms of GDP per capita – that is, output per person. So Krugman is essentially saying that to raise output per person, we need to raise output per person. What sounds initially like a profound statement is a tautology. He isn't saying anything at all. Living standards and productivity are two sides of the same coin.

I am not being mean. Krugman's comments are typical of the well-meant but ultimately unhelpful things macroeconomists say when asked how to improve our collective wellbeing.

The early sections of Mario Draghi's 400-plus page report for the European Commission, "The future of European competitiveness", published earlier this month, fall prey to similar circularity. They note for example that the gap between US and EU per capita GDP can be largely explained by lower EU productivity. Lower productivity effectively is the gap.¹

The point, of course, is: what can be done about it? How should a country or region go about becoming more productive?

We don't know for sure. The countries which historically have been most successful in this sense – the US, Switzerland – did not deliberately and explicitly set out to be so. There were no productivity symposiums back in the day at Plymouth or on the Rütli.

Unquantifiable and unpredictable characteristics such as culture, ethics, law, politics – markets and government, government and markets – must have played a big role. Likewise physical and human geography – ease of travel, natural resources, learning.

In modern times, economic development has become more routinely part of the political agenda, and governments have indeed often set out deliberately to achieve faster growth – but with mixed results.

Initially, the focus was on macro variables and the demand side, things like (real) exchange rates and credit policy. But in the last few decades the competitiveness debate has revolved around micro variables and the supply side, with Harvard's Michael Porter being particularly influential. In this regard some countries and regions have delivered stunning success.

Ireland, for example, is now ranked alongside the US, Switzerland and others as one of the most prosperous countries in the world.²

And in this respect the Draghi Report gets more interesting. It does eventually dig more deeply, and more frankly, into the potential obstacles to a more productive EU than other official reports I've seen.

It locates much of the productivity shortfall versus the US in the technology sector, and identifies an ‘innovation gap’. Acknowledging that returns to (US) scale will likely keep the US out in front in key areas (such as cloud computing), it suggests other areas (such as robotics) where the EU may have an edge.

Amongst the other obstacles it identifies are: a shortage of EU venture finance, and relatively low investment relative to savings; still-fragmented markets and governance; a skills shortage (including, perhaps surprisingly, one-fifth fewer STEM – science, technology, engineering, and mathematics – graduates per million than in the US). It bemoans a lack of energy security, and relatively high energy costs; and poor access to CRMs (critical raw materials). It also talks of the "rising weight of regulation" in the round – too much complex EU legislation.

The report's Part B is a relatively detailed review of around a dozen sectors and industries, and of half a dozen ‘horizontal’ policy headings such as innovation, skills, competition. Remarkably for an official EU report, it asks if EU competition policy has been too ‘vigorous’, and perhaps "conflicts with European companies' need for sufficient scale to compete with Chinese and American superstar companies".

The sectoral focus in particular confirms the impression that Draghi ‘gets it’. What we (or the EU) make ultimately matters more to our prosperity than what we spend or what we get paid, yet macroeconomists so often choose to focus on the spending and income sides of national accounts rather than on output (arguably, even monetarists default to a Keynesian demand-led view). This has led to an over-emphasis on aggregate demand, and race-to-the-bottom views of competitiveness. The goal instead surely is to make things and services that people want, largely irrespective of price and cost. Competitive success is a high-wage economy, not a low-wage one.

Acknowledging the importance of the product cycle is one thing, of course, but second-guessing the products which are indeed going to lead is quite another. America's genius lies in its uncanny ability to spot – invent? – what consumers will want next, from mass-produced autos to rock 'n' roll to smartphones. And reinforcing successful local clusters may work for a region or small country, but for a continent?

For what's worth, though, I am impressed with the report overall – with both its depth, that focus on output; and its candour, its willingness to acknowledge that Europe needs to do better, that it faces an ‘existential challenge’ if it is to continue to finance its social model.

It is emphatically not – as some have suggested – the ‘same old same old’.

The report also offers proposals to tackle many of the issues it identifies, including (contentiously) the greater use of EU-wide borrowing – the issuance of common debt, or EU bonds – to help create a deeper capital market for growing, innovative businesses, and to help finance what it sees as extra investment spending needed of around 4-5% of GDP annually.

We shall see whether EU political leaders are ready to act. Arguably, the EU's ‘social model’ may be part of the political problem: measures designed, with the best of intentions, to promote equality and protect jobs, may have inadvertently helped to stifle growth and deter employers from hiring.

The report notes that "… the US has pulled ahead of the EU owing to its stronger position in breakthrough technologies, yet it displays higher levels of inequality". In that sentence, the word "yet" carries a significance that the report's author may not appreciate: for some analysts, it could be replaced by "and" or even "because".

Finally, as a Brit digesting the report I was struck by two things in particular. First, if EU red tape is indeed such a problem, perhaps it shouldn't have left the UK (which, incidentally, is not only growing less slowly than Germany, but trading more with the EU now than when it was in it: Project Fear, and perhaps those ‘doppelganger' models, was misguided).

But second, and more seriously, why don't we talk more about the ‘what’ here in the UK? Where is the UK's industrial review?

Citations

[1] Fellow anoraks will note we are cutting a few small corners here. Labour productivity is output per unit of labour input, and this can only mirror GDP per capita if the proportion of the population in work, and its working hours, are constant. In practice they are variable – so labour utilisation can affect the wider population's average living standards. But neither Krugman nor Draghi are urging laggards to work more.
[2] Declaration of interest: as a sell-side economist I wrote the ‘Celtic Tiger’ report on Ireland's economy in 1994 – it has done better even than I'd dared imagine. Currently I help advise the Cardiff Capital Region in Wales on how best to foster regional growth.