The EU-US productivity gap and Europe's hidden strength

Total hours worked are only part of the story.

The labor “productivity gap” is one of the defining aspects of the economic differences between the European Union and the United States. Traditionally, labor productivity is measured as output of gross domestic product per hour worked. That’s a very flawed metric (not taking into account family care and treating GDP as an all-important economic metric, for example), but it can be a basic starting point for understanding the economic differences and choices made by the EU and US. Labor productivity is defined by graphs like this one from Mario Draghi’s EU competitiveness report. “100” is the US, the blue line is the EU. Europe nearly caught up to America in the 1990s, before falling far behind.

Economists use this data to point to productivity as a key factor in the growing GDP gap between the EU and the US. But the story is more complicated than this, and can be explained by both cultural differences between Europe and America as well as macro-economic policy decisions. Labor productivity is composed of two different factors. First, America has a higher labor productivity because Americans work more hours than Europeans, on average. Second, Americans are more productive per hour in their work, as measured in GDP per hour. This graph, also from the Draghi report, nicely illustrates this:

This gap in labor productivity, caused by both few hours worked and less productive labor by Europeans, has created a growing GDP gap between the EU and US over the course of the 21st century. Again, here’s a figure from the Draghi report that shows this difference:

It’s notoriously difficult to compare economies on a pure GDP basis due to challenges with exchange rates, but the PPP (purchasing power parity) measurement elegantly captures the divergence in consumer spending power between the EU and US, as caused by the labor productivity gap. Significantly, the PPP gap between the EU and US would be even larger, but America has much faster population growth than Europe, meaning the smaller economic pie in Europe doesn’t have to be sliced as much.

This graph from the European Central Bank shows how even accounting for only hourly productivity (which would mitigate the impact of Americans working more hours per year) Europeans are falling behind Americans. This trend is even accelerating since 2022.

Clearly, the US has higher productivity than Europe, leading to long-term differences in GDP per capita at PPP, and the overall economic growth of the two trading blocks, an outcome that could have long-term impacts on living standards, security, and the power relationships within the transatlantic relationship.

Why is America leaping ahead both in terms of labor productivity per person and productivity per hour? Here are 4 reasons why:

1) Americans work more hours than Europeans

This first point is obvious, and is tied to significant cultural differences between the US and EU — Americans work much longer hours than Europeans. Here, Bruegel demonstrates the average annual hours worked gap. It’s significant that the largest EU economy, Germany, is at the bottom of the list in terms of hours worked.

Of course, there’s some nuance here. Germany keeps better statistics on employment hours than the US, and nearly 40 percent of workers there are classified as part-time. The part-time employed number is only 17 percent in the US. The huge number of part-time workers in Germany is primarily due to parents and the retired taking on part-time work in Germany and being classified as such. On the flip side, taking on part-time workers is expensive for American firms who are required to pay health insurance, suppressing those numbers.

However, comparing numbers and cultural factors between the EU and US also suggests that Americans work longer hours because they want to, pushing up the productivity numbers and eventually GDP growth. This is even the case among the richest workers in the US, as Derek Thompson has reported on for The Atlantic.

2) Europe missed the internet revolution of the 1990s

As we saw above, the labor productivity gap is not only because of differences in total hours worked per year. It’s also because there’s greater productivity per hour of labor in America than in Europe. Why?

This is one of the major focuses of Draghi’s competitiveness report, and he distills the per hour productivity gap down to one word: technology. The EU missed the boat on the internet revolution that began in the 1990s in the US. In fact, Draghi shows that almost all of the labor productivity gap between the EU and US can be chalked up to technology. He writes:

“The main reason EU productivity diverged from the US in the mid-1990s was Europe’s failure to capitalise on the first digital revolution led by the internet – both in terms of generating new tech companies and diffusing digital tech into the economy. In fact, if we exclude the tech sector, EU productivity growth over the past twenty years would be broadly at par with the US.”

Technology firms are among the fastest-growing companies in world history. The integration of information technologies from these firms into other industries create productivity improvements in those other industries as well. The European Central Bank also wrote that this early digitization in the US played a central role in productivity improvements there, writing that “Some authors find that the greater ability of the US to create and to use digital technologies in the production process is one of the main drivers of the US-euro area productivity gap.” (China also dominated in information technology in the 1990s, leading to significant productivity boosts there.)

A counterfactual is also helpful here in establishing the importance of integrating new technologies into the economy for long-term growth. The economic miracle in Europe of the 1950s and 1960s was largely driven by new institutions and rebuilding destroyed industries after the war with the newest production technologies.

This graph, again from the European Central Bank, nicely captures the role technological uptake plays in the productivity question. TFP, or total factor productivity, measures how well an economy uses inputs to generate income. In short, better use of inputs leads to a higher income and a higher TFP, measuring the economy’s efficiency.

The graph shows how EU TFP spiked in the post-war period, as new factories with new technologies came online. At the same time, US TFP rose slightly during the first internet revolution in the 1990s, as they took advantage of new technologies. Europe experienced no boost in TFP in the same period, showing how European firms failed to embrace the IT revolution.

3) Europe protects workers, America protects employers

This is an overly simplistic heading, but at its core its true and was most clearly exemplified by the radically different ways the EU and the US responded to COVID-19. US firms funded unemployment benefits and lending to sustain employers even if it led to job cuts, while the EU supported short-time-work programs, in effect preventing job losses. The Fed Reserve Bank in San Francisco wrote that:

The EU’s short-time work programs during the pandemic recession preserved employment relationships by subsidizing workers’ wages. U.S. policy instead has focused on income support to households through, for example, expanded unemployment insurance programs under the CARES Act.

This graph also illustrates the extent to which difference in EU and US labor policy led to radically different outcomes:

EU firms preserved working relationships, while US firms severed theirs, indicative of the stronger role of labor and a pro-worker orientation in the EU. However, the longer term impact of this difference between EU and US policy is increasing US labor productivity, as the lowest skilled workers are laid off. This is not the first time this has happened. A similar dynamic occurred during the Great Recession in 2008, as open US labor policy meant workers were quickly fired, allowing firms to reallocate towards different roles and technologies. EU support for keeping employees employed could also be leading to the “zombiefication” of firms that no longer play an efficient role in the economy, according to the European Central Bank.

4) America has a stronger innovation policy than Europe

At all stages, America invests significantly more in high productivity businesses than Europe and has a stronger innovation policy. This is illustrated by one central statistic: the shockingly low number of tech giants within the EU. The Draghi report highlights that at the time of its writing, there was no homegrown from scratch European company with a market capitalization over 100 million euros that had been set up in the past 50 years, while the US has scores of such companies. A brief look at market caps show that the largest European companies are behind dozens of American and Chinese firms:

Furthermore, the EU doesn’t invest in research and development to the same extent as the US. (However, it’s unclear how this may be shifting with recent Trump cuts to federal research budgets.)

Here’s a graph from CEPR on the same issue. Research funding in American technology is at sky-high levels compared to European firms:

The European Central Bank puts it such:

“We argue that, despite Europe's clear potential due to its market size, quality universities, and leadership in deploying green innovation and regulation to tackle climate change, the issues that plagued Europe after the 1970s—namely its inadequate innovation policy—continue to hinder its ability to derive productivity gains from global technological revolutions.

Artificial intelligence is only the most recent manifestation of the EU falling behind the US on a technology — and the productivity benefits it will bring. Only three European companies were included in a Forbes list of top 50 AI firms in the world. Mistrial, the one frontier AI firm in Europe, is far behind the American companies, with a valuation that’s just a fraction of AI giants like OpenAI.

Europe’s hidden strength

Luckily for Europe, productivity and economic growth is not everything. (Even if it does have longer term impacts on living standards.) The EU and individual European countries have made a series of choices that limit productivity in favor of leisure, health, respecting worker’s rights, and full employment. A few examples:

• Europeans choose to work less and enjoy leisure time

• European countries refused to allow firms to fire workers during COVID-19, instead supporting short-term-work programs

• More European public funds are poured into health and social service programs than into industrial research compared to the US

These cultural and macroeconomic choices have had real dividends for Europe versus the US. As pointed out by Matt Yglesias, Europeans are living increasingly longer lives, while Americans are living shorter ones. Isn’t it a no-brainer for an industrialized country to be choosing health over wealth?

On the flip side, Europe is still in a strong position to change the story on the productivity front. As laid out by the European Central Bank, Europe still has strong economic fundamentals that could lead to an explosion in productivity with a few policy tweaks, such as a large market, rich and educated population, top universities, and a leading position in many green innovations. Ken Rogoff, an economist at Harvard and former chief economist of the IMF, is bullish on European growth too, which he says could be caused by a spike in defense spending, instigating a catch-up to the US.

The productivity gap between the EU and US displays the extent to which specific cultural and macroeconomic factors can generate remarkably different productivity and health outcomes — a natural experiment in the outcomes of different labor choices. European countries are in a strong position to shrink the productivity gap with few impacts to health, if they’re able to pull a few key policy levers and integrate new technologies quickly into their economies. However, the EU’s path may not be one of maximum output — but it could prove to be a more sustainable model for growth, health, and dignity in the 21st century.