Behind the cross-Atlantic productivity gap

For most of the second half of the 20th century, France and Germany progressively narrowed their labor productivity gap with the United States. That changed in the 1990s, however, as U.S. productivity growth pushed ahead and growth in Europe slowed. By 2000, labor-productivity gaps with the United States had widened again, to 5 percent for France and to 15 percent for Germany. One cause is clear: Both France and Germany have smaller information technology (IT)-manufacturing sectors than does the United States, where IT generates 2.3 percent of the country's gross domestic product (GDP). U.S. productivity in this sector--boosted by more powerful and easier-to-assemble computers from advances in microchips and from a spike in demand--rose sharply in the late 1990s. Indeed, studies show that the sector accounted for about a quarter of the annual U.S. productivity growth during this period.

Meanwhile, in France and Germany, where IT manufacturing generated only 1.3 and 1.5 percent of GDP, respectively, the sector contributed less than a fifth of total productivity growth. But this difference explains only a third of the gap in productivity growth between the two European countries and the United States since the mid-1990s.

Many observers blame the remaining productivity gap on the lower levels of IT spending in Europe. In aggregate, French and German companies do spend less on technology than do U.S. companies, but low IT investing isn't the root cause of lower productivity growth; it is necessary to ask why companies in the two European nations invest less in technology. Besides, spending money on IT doesn't guarantee higher productivity. It can, however, play a valuable role in developing innovative products, services, and processes that raise productivity, especially if deployed in highly consolidated sectors or in transactions involving high volumes per customer, so that the benefits can be spread across a larger customer or sales base.

But IT spending can also yield disappointing results, as many retail banks found after investing in customer-relationship-management systems.

It is only through an examination of productivity at the sector level that the true drivers and barriers emerge. In 2002, the McKinsey Global Institute compared six sectors--automotive, retail banking, retail trade, road freight, telecommunications, and utilities--in France, Germany, and the United States--to see how the two European countries could increase their rate of productivity growth. The analysis provided a mixed picture.

While productivity had grown strongly in almost all sectors studied, the details were starkly different. In most sectors in France and Germany, productivity was 10 or more percent behind U.S. levels. Some European sectors, such as retail banking, continue to close the gap; others, such as retail trade, are falling further behind. In the mobile-telecom industry, productivity levels and growth rates are much higher in France and Germany than are those in the United States.

What accounts for these disparities? The sector studies underpin our belief that differences in IT spending have not been the cause of the differences between productivity of the United States and that of France and Germany. Rather, it is inappropriate regulations that distort the competitive environment and stifle innovation in the two European countries.

The adoption of innovative products, services, and processes--which may or may not involve the use of IT--has played a critical role in raising productivity in France and Germany as well as in the United States. Although consolidation too plays a part, in the longer term, the only sustainable source of rising productivity is innovation. That means new products and services, such as mobile telephony, which gave rise to a fast-growing new business. It also means new (and often IT-enabled) processes, such as back-office automation, which allow financial institutions to process a high volume of transactions with little added cost for each one.

Blame inappropriate regulation
Innovations can be expensive and may require changes in the way managers run their businesses. Without intense pressure from competitors that exploit best-practice processes, managers thus often shy away from adopting them. Zoning laws, for example, protect French food shops, whether hypermarkets or small traditional providers, from new competition.

It is only through an examination of productivity at the sector level that the true drivers and barriers emerge.

By slowing down growth in the number of retail-food outlets, these regulations have lifted capacity utilization, thereby raising productivity to levels higher than those prevailing in Germany or the United States.

However, in this environment, French food retailers, including the large operators, have been slow to adopt best-practice innovations, such as collaborative supplier relationships that create greater efficiencies by reducing inventories and keeping shelves stocked with popular items. Productivity growth in the retail-food sector is now slower in France than in the United States, and without a more rapid adoption of best-practice innovations, the French advantage in this sub-sector will slip away.

Conversely, France's automotive sector demonstrates how deregulation and competitive pressure can spur innovation and raise productivity. The Japanese first introduced lean manufacturing--aimed at eliminating waste and reducing assembly time--in the automobile industry during the 1970s. But in France, as elsewhere, tariffs protected national carmakers from cheaper imports. Shielded against competition, French companies maintained the operational status quo.

In the 1990s, trade barriers gradually fell at a time when the western European car market was stagnating. French carmakers found themselves losing market share. In response, they moved to adopt industry best practices, including lean manufacturing, which made labor productivity rise more rapidly in the French sector than in its German counterpart and narrowed the productivity gap between French carmakers and U.S. and Japanese ones. The partial privatization of Renault, and management changes there and at PSA Peugeot Citro?n were also important milestones in promoting the adoption of lean-manufacturing techniques.

A lack of competitive pressure to adopt best practices quickly wasn't the only problem. The others included inappropriate regulations as well as ownership structures that support fragmented markets and hinder consolidation.

Scale plays a significant role in increasing productivity by spreading fixed costs, including fixed labor, across a broader customer base and by helping companies take full advantage of innovation, thereby encouraging further improvements in productivity. But in Germany, small state-owned and cooperative retail banks, for example, are ubiquitous, and since their owners are not answerable to the capital markets, they have little incentive to consolidate. The country's banking sector pays a heavy price in productivity for this fragmentation.

By contrast, the deregulation of the European road freight industry sparked a wave of consolidation, and French and German trucking companies have profited from the resulting increase in capacity utilization and productivity. These networks are now large enough to let French and German road freight companies efficiently deploy tools, such as route optimization systems, that further raise their productivity. Using such tools would have made little sense for small operators.

Productivity disadvantages caused by distorted patterns of competition put a heavy burden on governments to continue and even accelerate the trend toward deregulation, though in sectors such as utilities and telecommunications, where heavy fixed costs naturally limit competition, it will be necessary to craft smart regulations that create dynamic incentives to improve productivity.

In our study, we found many examples of companies that enjoyed higher productivity growth in the aftermath of regulatory changes, but in many sectors there is still room for further change to promote consolidation and the more rapid dispersal of innovation.

France and Germany--indeed, all of Europe--lie on the brink of a demographic shift.

When the competitive environment is right, businesses in France and Germany will not only quickly adopt innovations that promote productivity but will also invest in the IT systems that will enable or enhance them.

Demand differences and productivity
A part of the lagging productivity growth in the two European countries is explained by the nature of their consumer demand as compared with that of the United States and by their lower income per head. Like the scale effects resulting from consolidation, greater aggregate demand improves the utilization of fixed assets. Demand for higher-quality goods can raise productivity as well, since consumers usually pay premium prices for branded or luxury products.

Differences in demand can reflect structural factors such as climate and geography as well as individual preferences. U.S. households, for instance, spend twice as much time on long-distance calls over fixed-line networks as do French households, though prices in both countries are similar. The fixed-line grid in the United States thus has much higher utilization and productivity. In networked sectors such as utilities, telecom and banks, with their branches and ATMs, productivity is especially vulnerable to low utilization resulting from low demand.

Varying income levels can also affect demand, since relatively prosperous people tend to buy more (and higher-quality) goods and services than do relatively poor ones. Average annual incomes in both France and Germany are 30 percent lower than those in the United States. The difference is the result of lagging productivity in Europe and lower labor inputs in Germany and France: A smaller proportion of the working-age population labors for fewer hours a week in France and Germany than in the United States, partly because workers in Europe prefer longer vacations, shorter work weeks and earlier retirement to higher income.

Previous MGI studies have shown that labor market rigidities too are a significant factor in Europe's lower labor inputs. The higher minimum wage in France and Germany, for example, raises unemployment and keeps down the number of jobs for low-skilled workers and, consequently, income per head.

The automotive sector gives a clear example of how demand affects productivity. In recent years, U.S. demand for sport utility vehicles and other light trucks has boomed, and they now account for more than half of the vehicles sold in the United States. These light trucks are easy to make and deliver 30 percent more value per hour worked. By contrast, in France and Germany, there is more demand for small, fuel-efficient cars, which generate lower value added per hour worked. In this sector, the nature of demand in the two European markets explains a third of their productivity gap with the United States.

The need to increase productivity in Germany and France goes beyond any theoretical race with the United States. France and Germany--indeed, all of Europe--lie on the brink of a demographic shift: In a few decades, the population will have aged considerably, putting a much larger burden on the work force. Today, for example, Germany has 2.3 people of working age for every pensioner, but by 2030 that ratio will have shrunk to 1.4. The working population will therefore be forced to support a larger group of pensioners. Short of the unexpected--increased immigration or longer working hours--the only way to maintain or improve today's standard of living in France and Germany will be to push forward productivity improvements as quickly as possible. Both countries could in fact do so.

For more insight, go to the McKinsey Quarterly Web site.

Copyright © 1992-2003 McKinsey & Company, Inc.