Far too many policymakers in Europe have a confused vision about the policy conditions required for Europe to grow its digital economy. Their habits of thought – a sense of what is reasonable, necessary and inevitable – are now deeply embedded in the EU’s endeavours of digital policymaking. Digital underperformance, as frequently ascribed to Europe, is argued to be a consequence of the superior performance of U.S. technology companies. In this paper, we will diagnose Europe’s economy from the viewpoint of digital expansion, and analyse the economics of slow growth in the digital economy. We are focusing less on the digital economy in itself because it is arguably not the essential component in the quest of understanding the EU’s problems. Like other innovative sectors, the digital economy is more interesting for its general effects on productivity and competition in the wider economy rather than what it directly produces. It is a general-purpose sector and its dominant contribution to the economy will come through new competition in other sectors. A dynamic digital economy will force labour, capital and other production factors in the economy to adapt to new and, as a general rule, more productive economic behaviour.
We will argue that the EU’s most pressing structural impediment for digital businesses to develop and reach scale is regulatory heterogeneity in non-digital industries. Due to fragmented regulatory frameworks for many goods and most services sectors, it is difficult for any digital business to contest traditional industries by digitalising old-economy business models.
Powerful incumbents that have successfully adopted to national laws and regulatory procedures often prevent regulatory change. Regulatory heterogeneity and incumbency protection are intertwined. Both can be major sources of inefficient resource allocation in many industries – irrespective of whether they find themselves in primary sectors, manufacturing or services industries. It follows, therefore, that the paramount task for policymakers should be to reduce the non-digital barriers that hold digital business models back from transforming European economies faster to become more competitive and to facilitate economic convergence.
2. Europe’s Productivity Problem
Productivity growth is the major driver of economic development and higher standards of living, and behind the rates of productivity growth stands especially innovation, or, if the growth rates are poor, lack thereof. Productivity growth means that an economy uses resources more efficiently, i.e. resources that are made available when productivity grows spur economic activities and structural economic change. At its core, productivity growth reflects a firm’s ability to produce more (or at least the same amount of) output with less input. It is generally driven by companies’ ability and willingness to deploy new technologies, embrace new ideas and business processes, and adjust to new and innovative business models. In other words, these are the factors that allow firms to employ inputs for the production of goods and services in a more efficient way, and to explore new types of commercial activity or even invent new markets.
The OECD (2015), along with many others, argues that productivity will be the main determinant of economic growth over the next 50 years, with investment in innovation and knowledge-based capital (KBC) being the top determinant of productivity growth. Judging by recent rates of productivity growth, however, Europe’s economies are not on track for fast economic growth. Productivity growth has underperformed for quite some time, and there has been a general trend of declining productivity growth for the past three or four decades. Low productivity growth rates are not a problem exclusive to Europe; other Western economies like the U.S. suffer from low rates of productivity, too (van Ark 2014).
In contrast to the U.S., however, Europe’s productivity problem is more alarming since it does not come on the heels of a productivity surge during the IT boom from the mid 1990s till 2004. Europe’s productivity decline has been much more steady. Moreover, Europe’s productivity performance remains substantially behind U.S. productivity growth. Recent statistics suggest that the Euro area is, at aggregate level, much less productive than the U.S. When measured in output per hour in purchasing power U.S. dollar, Europe’s level of productivity was just 70 per cent of the U.S. level in 2014, a gap of 30 percentage points (TCB 2015). By comparison, the Euro area stands at 84 per cent of U.S. productivity. As distinctly shown by Figure 1, all European countries for which data is publicly available show productivity growth rates that are well below those of the U.S.
Figure 1: Multifactor productivity growth rates
What explains the gap in productivity growth rates between the U.S. and EU countries? The extensive use of ICT is a significant determinant of the American lead in productivity growth (IMF 2015), and it was the chief reason behind the surge in productivity growth in the 1990s. Similar gains from ICT adoption cannot be observed for all developed economies, and Europe in particular is falling behind. The growth in multifactor productivity, which is a good proxy for an economy’s capability of adapting to new technologies and innovation, is comparatively low.
Figure 2: Multifactor productivity growth and ICT capital formation
Source: OECD, EU KLEMS.
In European countries for which data is available, there is a clear positive relationship between productivity growth and the use of ICT in production, as expressed by the share of ICT capital investment in total investment (see Figure 2). However, it is not only that productivity growth lags behind the U.S.; it is also concentrated in a few sectors where ICT as an input for production has always been central. For the period 2001 to 2009, Figure 3 shows that annual productivity growth was particularly strong for finance and insurance and telecommunications. This explains, for instance, why the UK (where the financial services sector is an important source of economic output) was amongst the fastest growing economies before the financial and economic crisis, with above-average productivity growth rates. The UK’s financial services sector showed high absorption rates for ICT capital investment. After the crisis, however, ICT capital investment weakened considerably in the UK, as did the country’s productivity growth.
Figure 3 also shows that productivity growth in other sectors than finance, insurance and telecommunication was much lower and often negative for many EU countries. As outlined by the IMF (2015), personal services (hotels, restaurants, social, and other personal services), traditional non-market (or less marketable) services (public administration, education and health services), but also real estate services show much lower than aggregate productivity growth rates due the lack of innovation and technological change in these services.
Those sectors that are characterised by a relatively high degree of protection – such as public services, professional services, construction and network industries – show negative or comparatively low productivity growth rates (see also OECD 2014). The explanation is partly about the openness of these sectors to investment in ICT, but, as we will discuss later, it is related to institutional factors rather than endogenous resistance to technology and innovation. The investment in, and the cross-sectoral adoption of, KBC substantially contributes to productivity growth (Kretschmer et al. 2013; IMF 2015). In other words, the chief economic merit of innovation – in ICT and generally – does not come from its invention or creation but adoption in the wider economy. ICT and KBC such as computerised information, innovative ideas, and economic competencies contribute to productivity growth in terms of a better functioning of product, services, labour and capital markets (Andrews and Criscuolo 2013).
Figure 3: Average annual industry TFP growth rates, 2000 – 2009
Source: EU KLEMS.
Benchmarking the general composition of productivity growth in the EU with the U.S., which has a similar balance between manufacturing and services in its economy, is instructive, and gives further indication about how the European economy fails to grow faster through an expanding digital economy. It is not just a matter of investment in ICT, but also what happens in the broader services sector when the economy gets transformed. Obviously, the European services sector growth has trailed the expansion in U.S. services. The same is true for productivity growth, and what contribution the services sector gives to general productivity growth.
The McKinsey Global Institute has estimated the productivity gap in business services between the EU and the U.S. to be as high as 43 percent (MGI 2010; BIS 2011). Figure 4 gives further evidence to that observation. It shows the contribution of major industrial sectors to aggregate productivity growth in the U.S. and the EU for the period 1995 to 2007. The difference between market service contributions is striking: 0.6 percentage points for the EU against 1.8 percentage points for the U.S. Similarly, Timmer et al. (2011) show that between 1995 and 2005 business services contributed 0.7 percent annually to productivity growth annually in U.S. commercial services and -0.1 percent annually in the EU. It should be noted that business and commercial services include a wide range of highly diversified ICT services, such as programming, data facilitation and storage, and digital marketing services.
The difference between the EU and the U.S. in the contribution from ICT production is equally notable. In goods production, however, it is clear that European economies are ahead of the U.S. when measured in terms of contribution to productivity growth. Generally, productivity growth in the manufacturing sector is pretty strong in Europe, and that sector also shows high rates of investment in ICT. Europe’s problem seems rather to be pretty isolated to the ICT sector itself and, importantly, the obstacles for ICT to power services sectors to a greater extent.
Figure 4: Major sector contributions to labour productivity growth in selected EU economies and the United States, 1995-2007
Source: Timmer et al. (2011). In this study, “market services” include a wide variety of economic activities, ranging from trade and transportation services, to financial and business services, but also hotels, restaurants, and personal services.
 Business services include not only professional services (accountancy, legal, engineering, marketing, tax and management consultancy, architects), but also IT, software services, technical testing, and labour search services etc. Business services are mainly used as inputs by other firms (see Kox 2012).