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Fri Oct 28 14:20:15 PDT 2005

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CLOSING THE GROWTH GAP
Oct 27th 2005  

A theory to explain why Europe has fallen behind America, and how it
might catch up

IN THE past ten years, the economies of what is now the euro area have
grown by around 2% a year. America has managed a full percentage point
more. Lots of reasonable explanations of the gap are on offer: America
has freer markets than Europe; it is better at finding and using new
technology; its fiscal and monetary policies have been more supportive
of growth; and so forth.

You might expect such explanations, and a bundle of policy
recommendations, to tumble out of theories of growth--the branch of
economics concerned with the medium- and long-term fortunes of
economies. You'd be disappointed. Growth theory is good at explaining
why rich countries are rich and poor ones poor, but much less so at
divining why some rich countries (eg, America) grow faster than others
(eg, much of Europe) and telling the laggards how to catch up.

A recent paper*[1] by Philippe Aghion, of Harvard University, and Peter
Howitt, of Brown University, attempts to fill the spaces between fact,
theory and policy. One branch of theory emphasises the role of capital
accumulation in generating growth: save more, is the implication. This
might help to explain why, say, East Asia sped past Latin America in
the last part of the 20th century, but not why Europe has been trailing
America: Europe, after all, has a higher saving rate. Another line of
thought holds that good "institutions"--the rule of law and all
that--are essential. This can account for much of the chasm between
rich and poor, but not the fine variations among rich countries with
sound legal and political systems. A third angle identifies innovation
as the fuel for economic advance. Messrs Aghion and Howitt argue that
models of this type have hitherto had little to say about how economic
laggards catch up and then keep up (or not) with the latest
technology--and thus about why Europe, having grown faster than America
for 30 years after the second world war, stopped closing the gap and
fell farther behind.

Technological advance, though, is at the core of their own approach. In
essence, a given industry in a given country can use either the best
technology available or an older, less efficient version. In countries
already at the cutting edge, innovation is the source of growth. Those
not at the frontier advance by implementing existing, but still better,
methods of production.

>From this, two observations follow. The first is that the institutions
and policies best suited to countries at the leading edge need not be
the right ones in less advanced places. Education, say Messrs Aghion
and Howitt, is a case in point. The closer a country is to the
technological frontier, the more growth depends on having a highly
educated workforce. Further back from the frontier, education still
matters; but university degrees matter relatively less and good primary
and secondary education count for relatively more. Evidence from
different countries and from American states appears to bear this out.
And what does this imply for the transatlantic growth gap? America
spends around 3% of its GDP on tertiary education; the European Union
only 1.4%. More than a third of Americans have degrees; fewer than a
quarter of Europeans do. Against that, many EU countries are considered
to have stronger secondary education than America does. Europe may
therefore have been well equipped for its post-war decades of chasing
the United States, but did not adopt the policies needed to push back
the technological limits.

The second observation is that, whereas most theories of growth laud
the accumulation of capital, it is sometimes good to see it destroyed.
Growth is likely to be higher if markets are open to new entrants,
which either drive less efficient incumbents out of business or scare
others into investing, updating their technology and seeing off the
raiders. Again, this is likely to matter more the closer countries are
to the limits of technology. And again, the destructive process appears
to have a freer rein in America than in Europe. For example, say the
authors, half of all America's new pharmaceutical products are
introduced by firms less than ten years old; the proportion in the EU
is only 10%.

BUDGETING FOR GROWTH
More controversially, Messrs Aghion and Howitt also turn their
attention to macroeconomic policy. Most economists think that budgets
and interest rates ought to be geared mainly to the short-run course of
the economy. Not necessarily so, say the authors: countercyclical
budgetary policy can be aimed at long-term growth, and the case is
stronger in Europe than in America.

If capital markets are well developed, they argue, sound companies can
borrow to tide them over in recessions; if those markets are thin, good
businesses will sink. And where capital markets are less
well-developed, policies that dampen the business cycle can help more
good firms to survive. Econometric tests suggest that well-targeted
fiscal policy--investment, rather than government consumption--might
work. Because Europe's capital markets are less deep than America's
(its ratio of private credit to GDP, for example, is much lower),
budgetary policy ought to lean against the cycle more in Europe than in
America. In recent years, however, the opposite has been true.

When Mr Aghion proposed this idea last month, at the annual conference
of the Centre for Economic Policy Research and the European Summer
Institute in Frankfurt, he met a fair bit of scepticism. It is easy to
see why. Countercyclical policy is much harder to get right on purpose
than by accident. And, as one economist there remarked, America's
growth rate has actually been more volatile than Europe's--implying
that Europe has less need to smooth out cycles to encourage growth.
Still, Mr Aghion and Mr Howitt have produced some provocative research.
More--and more arguments--will surely follow.

* "Appropriate Growth Policy: A Unifying Framework." Available at
post.economics.harvard.edu/faculty/aghion/papers/Appropriate_Growth.pdf[2]

-----
[1] http://www.economist.com/#footnote1

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