July 24, 2002
Boomtime in Europe

FT.com / Comment & analysis | Boomtime in Europe | by J. Bradford DeLong | July 23, 2002 |

...some socially unproductive investments were made during the Nasdaq bubble; some European companies have held back on investment plans because of slack demand; others have held back on investment plans because of various obstacles to economic flexibility; and there are important differences between US and many European statistical systems in their ability to track economic growth.

Yet I cannot help but be reminded of America just a decade ago, when commentators and analysts speculated that all the investment in high-tech equipment was wasteful and dissipative. People in Washington, DC, observed the ferment of innovation in Silicon Valley but dismissed the possibility that it would have a big macroeconomic impact. After all, steadily and rapidly increasing computer power had already been at work for three decades without having any effect on aggregate productivity.

What the conventional wisdom of a decade ago in the US missed was that you do not expect growing sectors - even rapidly growing ones - to have an impact on aggregate statistics until they achieve critical mass...

Financial Times
Comment and Analysis
Boom-time in Europe

By Bradford DeLong
Published: July 23 2002 20:11

The second half of the 1990s saw an astonishingly large productivity boom in America. Moreover, the boom did not end when the recession began: the unemployment rate has risen by 2 percentage points over the past six quarters, yet production has risen by 2.4 per cent.

But why was the boom in productivity so tightly confined to the US? There is, after all, nothing in the air or water that makes high-technology equipment work better in San Francisco or New York than in Frankfurt, Lyons or Edinburgh.

In the past four years analysts have puzzled over slow relative growth outside the US - particularly in Europe.

Some analysts from the Bundesbank suggested that it was the result of different ways of calculating production in Europe but this would fail fully to explain the component of the US productivity acceleration, found not in computer-making but in computer-using industries.

The US Federal Reserve moved towards a consensus that the real problem was too much European red tape: that businesses invest heavily in high-tech equipment only when they can smell immediate productivity gains from reorganisation and restructuring; and that western Europe's steps towards economic reform and liberalisation have so far been too small for businesses to be confident that they will be allowed to reorganise and restructure.

Keynesians offered an opposed diagnosis: that businesses invest heavily in high-tech equipment only when they need to satisfy increased demand; and European central bankers unwilling (as Alan Greenspan, chairman of the Fed, was in the 1990s) to take risks on the inflation side in order to expand employment have slowed the transformation.

Still others said the boom was oversold - that because of the Nasdaq bubble the US had pushed employment too high and invested too much in telecommunications infrastructure and computer equipment that would never be very useful. According to this thesis, the US boom was only a boom in production, not an increase in economic welfare.

It would be unlikely if any of these stories were completely false: some socially unproductive investments were made during the Nasdaq bubble; some European companies have held back on investment plans because of slack demand; others have held back on investment plans because of various obstacles to economic flexibility; and there are important differences between US and many European statistical systems in their ability to track economic growth.

Yet I cannot help but be reminded of America just a decade ago, when commentators and analysts speculated that all the investment in high-tech equipment was wasteful and dissipative. People in Washington, DC, observed the ferment of innovation in Silicon Valley but dismissed the possibility that it would have a big macroeconomic impact. After all, steadily and rapidly increasing computer power had already been at work for three decades without having any effect on aggregate productivity.

What the conventional wisdom of a decade ago in the US missed was that you do not expect growing sectors - even rapidly growing ones - to have an impact on aggregate statistics until they achieve critical mass. This is an old lesson, first taught by the observation that historians of technology think Britain's industrial revolution took place between 1780 and 1830 (when its key inventions were made) while social historians think it took place between 1830 and 1870 (when the new industries of steam, iron and mass production achieved critical mass and turned Britain from a nation of shopkeepers into one of factory workers and industrialists).

Indeed, a decade ago Daniel Sichel of the Federal Reserve pointed out that it should have been no surprise that back then the aggregate impact of the computer revolution was small: it was, after all, proportional to how fast computer prices were declining, multiplied by the share of national income spent on high technology, multiplied by the share of total production attributable to the use of high tech. None of these numbers was very big (although they were growing rapidly) and the product of three not very big numbers will be a small number.

However, as computers and communications equipment continued to spread throughout the economy, expenditure on high tech and the share of income attributable to it continued to grow and did achieve critical mass. The result was the productivity boom that is still continuing.

Much of western Europe is in the same situation as the US in the early 1990s, simply waiting for the next turn of the business cycle and the continued diffusion of technology to achieve the necessary critical mass. The computer and communications revolution is already transforming the economies of Finland, Sweden, Ireland, Australia. My money is on western Europe's revolution being relatively close behind.

The writer is professor of economics at the University of California at Berkeley

Posted by DeLong at July 24, 2002 08:16 AM | Trackback

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... and this could be compounded by a return of some offshore investment money back into the EU. The appreciation of the Euro could help (although, I agree that it wouldn't be necesseralu rational) and is also, to a degree, a reflexion of this swing. I would also expect the Eastward expension of the EU to be a strong force for growth during this decade.

In these circumstances, I have been surprised to see that Europeans bourses have tanked at least as badly as Wall Street. This is not a new phenomenon, and it makes sense in that a slumping American market is bad news for European exporters.

And yet, I would have expected worrying investors to diversify into European equity on the ground that they are not the object of accounting scandals and that European accounting practices are not nearly as creative as their American counterparts. We shall see what happens when the panick subsides...

Posted by: Jean-Philippe Stijns on July 24, 2002 09:16 AM

Jean-Philippe,

Unfortunately, diversification does not work all that well in bear markets. Correlations between different national markets are known to be higher in times of negative returns.

As to European accounting practices being less creative than American ones, I beg to differ. Not only are they more creative (in praticular, when it comes to smoothing earnings), they are legal, too (the pre-Chrysler Daimler, which for years published its reports according to both U.S. GAAP and German Commercial Code, used to be the darling of comparative accounting researchers; there was no better way to show how well earnings smoothing works under German accounting standards).

Worst of all, the very notion of financial accounting has not taken root yet; financial reports are still required to conform to tax rules. It's definitely getting better (thanks in no small part to IASC efforts), but for the most part, depreciation schedules are still set by tax authorities... Or am I hopelessly out of date?

Posted by: Nikolai Chuvakhin on July 24, 2002 11:39 PM

Nikolai: Everyone talks about German Commercial Code as if it were typical of European accounting and it isn't. The market capitalisation of the EU is dominated by UK, plus Netherlands, plus France, all of which have GAAPs which I would defend as being better than US.

Furthermore, the "smoothing" of profits under GCC is actually conservatism plus accruals. I can't think of a single instance of major overstatement or anticipation of revenues under GCC, and would be interested if you could.

GCC balance sheet accounting also massively errs on the side of conservatism; the issue is much more about hidden reserves than unrealised losses.

Posted by: Daniel Davies on July 25, 2002 03:15 AM

My sense is that, while there is adoption of technology in Europe, it is painfully slow: the UK has the lowest broadband connectivity in the G8.

The real issue is that Europe is still not organised to take advantage of modern technology. Starting new companies is hard (it can take months to get a new company registered in Germany), tax and regulation vary widely between countries, increasing costs. Labour laws, immigration permits, etc. are hugely restrictive. Hiring a Continental European usually means taking on a huge financial commitment: at a minimum a year's salary if you choose to make them redundant.

It can take months, or years, in the UK to find a suitable premises. Planning is extraordinarily tight: redeveloping a factory can take years. Leases are typically long (more than 5 years, and 15-25 is the norm) and have fixed (upward only) rents. Therefore, rental prices do not drop as much as they should when the market is in disequilibrium: Central London is crowded with empty offices, but no one is offering them dirt cheap, the landlords simply keep them off the market.

It would be almost impossible to build a 'European distribution centre': the red tape and transport delays, for an area much smaller than the US, are too large.

Differences in accounting practices and business ethics mean acquisitions in Germany or Italy or France are fraught with peril. In France, the general attitude in business is if you are not French, then stealing from you is entirely legitimate. Most local enterprises operate in a web of corruption and backhanders with local authorities.

Holidays are long, and working hours are short. Trying to get anything done after noon on Friday in most European cities is an impossibility.

The informal sector is huge, because of the high levels of social security and value added taxes. The government service sector is phenomenally unproductive in many countries: Italian civil servants retire at 50, having done little or no productive work in their lives.

While some European industries (Germany in machinery, Ireland in IT technology) have productivity approximating US or Japanese levels, the service sector in particular has very poor productivity.

Therefore, much of the new technology and new ways of doing business offers huge opportunities for productivity improvement, but Europe is not poised to employ them. Ireland, easily the most open industrial economy in Europe (Dell, Intel and any number of US companies manufacture there), might have industrial productivity levels which approach American ones, but in general it just doesn't happen in Europe.

The new rightist movements in Europe are unlikely to make this better. Their fundamental aspirations are xenophobic and collectivist. The most dynamic groups in the European economies, often the immigrants from the old East Bloc, or from Turkey or India or the Far East, risk economic and social marginalisation.

The free market liberal parties in Europe are in retreat. The German Free Democrats cling to electoral relevance. The French liberal democratic presidential candidate gets c. 3% of the vote (I cannot remember his name). Berlusconi signs deals with the Mafia in Sicily to protect his electoral base. Meanwhile in the UK a growing percentage of the Opposition party simply wants out of Europe.

The Common Agricultural Policy remains a total farce. Basically Europe is a giant slush fund for coddling French farmers. When the Poles join Europe, the problem is going to be compounded.

What Austria is to Europe, Europe is fast becoming to the world. Demographically old, its politics and large industries divided between the ruling parties, quaint and charming but half asleep. The euro is a sign of Europe's fundamental defensiveness, a circling of wagons against a tougher, more competitive world, rather than a sign of confidence and growth.

Posted by: john on July 26, 2002 02:42 AM
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