Social Europe

  • EU Forward Project
  • YouTube
  • Podcast
  • Books
  • Newsletter
  • Membership

The productivity slowdown, inflation and austerity

Alfred Kleinknecht 22nd July 2022

Calls for the ECB to hike interest rates to stem inflation have missed the negative impact of ‘structural reforms’ of labour markets on innovation.

structural reforms,innovation,inflation,supply side,labour market,productivity,European Central Bank,ECB
Returning to the high road of innovation-led productivity growth is preferable to another ‘Volcker shock’ to curb inflation associated with the low road of labour-intensive growth (Gorodenkoff/shutterstock.com)

In key member states of the Organisation for Economic Co-operation and Development, productivity ­growth has slowed significantly since ­around 2004-05 (Figure 1). This is essentially due to two factors.

First, the contribution of information and communication technology to aggregate productivity growth in major OECD countries strongly declined from 2004 onwards, after a ten-year ICT boom in the United States. Secondly, ‘supply-side’ labour market reforms prove harmful to innovation, especially where innovation relies on a highly cumulative knowledge base. There are many arguments on this but, most importantly, structural reforms aimed at easier firing and higher turnover of staff are detrimental to the accumulation of (tacit) knowledge from experience.

Figure 1: growth (%) of gross domestic product per hour worked, 1975-2019 (five-year moving averages)

structural reforms,innovation,inflation,supply side,labour market,productivity,European Central Bank,ECB
Source: The Conference Board, Total Economy Database

Slower productivity growth means slower growth of the cake that can be distributed between capital, labour and government, and this makes it harder to solve distributional conflicts or, for example, to finance the European Green Deal. Intensified distributional struggles can in turn increase inflation.

Such struggles ­can be exacerbated by a side-effect of low productivity ­growth—labour-intensive economic growth. An economy can only grow with more working hours or more productive working ­hours. With failing productivity growth, recourse to higher labour input is the only alternative to feed economic growth. But, sooner or later, labour-intensive growth will make labour markets tighter.

From the viewpoint of supply-side economics, there is then a risk that unem­ployment will become far too low—and this where there is little (extra) to be distributed due to the productivity crisis. ­The coincidence of tiny growth of the cake to be distributed with more assertive trade unions in tighter labour markets can increase inflatio­nary pressure. This will make supply-siders call for some new ‘Volcker shock’—in 1979, amid high inflation, the then chair of the US Federal Reserve, Paul Volcker, hiked its interest rate to 20 per cent and precipitated recession—raising unemployment and thus disciplining workers.

Germany versus the US

The relationship between low productivity growth and highly labour-intensive economic growth can be illustrated by comparing Germany and the US, respectively ‘co-ordinated’ and ‘liberalised’ market economies in the varieties-of-capitalism schema of Hall and Soskice. Figure 1 shows that, between 1975 and 1995, US produc­ti­­vi­ty growth was lower and hence more labour-intensive (Figure 2) than in the European Union and Japan.

This can be explained by the US taking a lead in implementing supply-side labour-market reforms. These were followed by weaker innovation performance in its old economy, thus creating the ‘rust belt’. In contrast, there was up to 2005 still a highly productivity-driven and therefore relative­ly labour-extensive growth in Germany (Figure 3).

All values in Figures 2 and 3 are normalised to 1960 = 100. On that benchmark, produc­tivity in Germany increases to 450 in 2020, while in the US it reaches just 300 during the same period. Working ­hours provide the mirror image: between 1960 and 2020 US growth required a doubling of working hours ­(100 to 200), while in Germany they ­fell (100 to 77).

Yet the ‘booming US jobs machine’ was to serve as a major selling-point for supply-side economics. Its advocates repeatedly referred to a ‘sclero­tic’ Europe creating too few jobs, purportedly because of ‘rigid’ labour mar­kets and ‘over-mighty’ trade unions. In fact, economic growth in Germany was more intelli­gent: Germans produced more with less work­, ­while Americans had to sacrifice lots of leisure time to bring about growth.

Figure 2: labour-intensive and poorly productive growth in the US, 1960-2020 (1960 = 100)

structural reforms,innovation,inflation,supply side,labour market,productivity,European Central Bank,ECB
Source: Conference Board, Total Economy Database

Figure 3: productivity-driven and labour-extensive growth in Germany, 1960-2020 (1960 = 100)

structural reforms,innovation,inflation,supply side,labour market,productivity,European Central Bank,ECB
Source: Conference Board, Total Economy Database

This was how Germany avoided high unemployment, despite total working hours falling from 1960 while labour supply from women and migrant workers increased substantially. Average working hours per employee per year happened to be equal in the US and Germany in 1975—1,813. Twenty years later, however, while the US figure remained almost unchanged (1,817 hours), the German tally had fallen to 1,531. By 2020, the gap had widened further—1,751 hours in the US versus 1,324 in Germany.

Unacceptably low unemployment

One of the most important victories of the right in recent decades has been that centre-left parties have spent more time discussing reforming labour markets and moderating wage claims than achieving a productivity-driven (and labour-extensive) growth path, complemented by adequate reductions of standard working hours.

With Germany experiencing only modest productivity growth since the 2002-05 labour-market re­forms under a social-democrat-led government, two things can be expected to happen. First, there is less (extra) to be distributed each year, so someone—capital, labour and/or government—has to sacrifice claims for extra revenues. The most likely outcome is wage stagnation and greater clamour for austerity.

Secondly, however, the bargaining position of labour improves as a result of more labour-inten­sive growth and falling unemploy­ment. More asser­tive trade unions will then most likely face a supply-side campaign that the European Central Bank ­must hike interest rates, to ‘do something’ about unacceptably low unemploy­ment supposedly causing inflationary wage claims. Yesterday the bank announced a 0.5 per cent increase, with more action promised as early as September.

Obviously, this time, a new Volcker shock for disciplining workers will not need a 20 per cent interest rate. A few additional percentage points are probably sufficient in today’s overheated markets to achieve a crash in the value of properties, stocks and bonds, not to speak of crypto-currencies and other junk. Historical experience shows that crashes in financial markets—and certainly in several markets simultaneously—can cause longer-lasting recessions.

Default assumption

For more than 150 years, economists have made the default assumption that innova­tion is ‘exogenous’. It’s a comfortable assumption: if, whether neoclassical or Keynesian, they know so little about innovation­, then it probably isn’t that important.

Yet because of their ignorance about innovation, supply-siders have no idea that (the diffusion of) innovation is suffering from their structural reforms—and that this ulti­mately leads to lower productivity growth and a tight labour market, in which wage demands can easily exceed (low) productivity ­growth. In this situation, they know no better than to strangle the business cycle through inte­rest-rate hikes, hoping that high unemploy­ment will eventually make wages fall and thus render inflation manageable­.

Yet falling wages again reduce productivity ­growth, which narrows the scope for distribu­tion even further, thus creating additional inflatio­nary pressures and even tighter public budgets, with calls for renewed austerity measures. In the end, the Volcker shock becomes an enduring, painful exercise.

Fortunately, there are alternatives. First, supply-side structural reforms of labour markets detrimental to innovation—especially innovation reliant on cumulative knowledge—should be rolled back. Secondly, tighter labour markets should be allowed to do their job: if demand is greater than supply, prices (in this case wages) need to go up. This is how markets are supposed to work.

Greater wage-cost pressure will favour a turn to a more productivity-driven (and less labour-intensive) growth model, as in Germany before 2005, via quicker diffusion of advanced process technology raising productivity growth. Bigger productivity gains, in turn, will increase the cake that can be distributed, which can relax inflationary pressures as well as austerity demands.

Alfred Kleinknecht
Alfred Kleinknecht

Alfred Kleinknecht is emeritus professor of economics at TU Delft and visiting professor in the School of Economics, Kwansei Gakuin University, Nishinomiya, Japan.

Harvard University Press Advertisement

Social Europe Ad - Promoting European social policies

We need your help.

Support Social Europe for less than €5 per month and help keep our content freely accessible to everyone. Your support empowers independent publishing and drives the conversations that matter. Thank you very much!

Social Europe Membership

Click here to become a member

Most Recent Articles

09d21a9 The Future of Social Democracy: How the German SPD can Win AgainHenning Meyer
u42198346 How Trump’s Tariff Regime Fuels Global OligarchyGabriel Zucman
u421983462 041df6feef0a 3 Universities Under Siege: A Global Reckoning for Higher EducationManuel Muñiz
u4219836ab582 af42 4743 a271 a4f423d1926d 0 How Trade Unions Can Champion Solidarity in Europe’s Migration DebateNeva Löw
u421983467298feb62884 0 The Weak Strongman: How Trump’s Presidency Emboldens America’s EnemiesTimothy Snyder

Most Popular Articles

u4219834647f 0894ae7ca865 3 Europe’s Businesses Face a Quiet Takeover as US Investors CapitaliseTej Gonza and Timothée Duverger
u4219834674930082ba55 0 Portugal’s Political Earthquake: Centrist Grip Crumbles, Right AscendsEmanuel Ferreira
u421983467e58be8 81f2 4326 80f2 d452cfe9031e 1 “The Universities Are the Enemy”: Why Europe Must Act NowBartosz Rydliński
u42198346761805ea24 2 Trump’s ‘Golden Era’ Fades as European Allies Face Harsh New RealityFerenc Németh and Peter Kreko
startupsgovernment e1744799195663 Governments Are Not StartupsMariana Mazzucato
u421986cbef 2549 4e0c b6c4 b5bb01362b52 0 American SuicideJoschka Fischer
u42198346769d6584 1580 41fe 8c7d 3b9398aa5ec5 1 Why Trump Keeps Winning: The Truth No One AdmitsBo Rothstein
u421983467 a350a084 b098 4970 9834 739dc11b73a5 1 America Is About to Become the Next BrexitJ Bradford DeLong
u4219834676ba1b3a2 b4e1 4c79 960b 6770c60533fa 1 The End of the ‘West’ and Europe’s FutureGuillaume Duval
u421983462e c2ec 4dd2 90a4 b9cfb6856465 1 The Transatlantic Alliance Is Dying—What Comes Next for Europe?Frank Hoffer

Hans Böckler Stiftung Advertisement

WSI Report

WSI Minimum Wage Report 2025

The trend towards significant nominal minimum wage increases is continuing this year. In view of falling inflation rates, this translates into a sizeable increase in purchasing power for minimum wage earners in most European countries. The background to this is the implementation of the European Minimum Wage Directive, which has led to a reorientation of minimum wage policy in many countries and is thus boosting the dynamics of minimum wages. Most EU countries are now following the reference values for adequate minimum wages enshrined in the directive, which are 60% of the median wage or 50 % of the average wage. However, for Germany, a structural increase is still necessary to make progress towards an adequate minimum wage.

DOWNLOAD HERE

S&D Group in the European Parliament advertisement

Cohesion Policy

S&D Position Paper on Cohesion Policy post-2027: a resilient future for European territorial equity”,

Cohesion Policy aims to promote harmonious development and reduce economic, social and territorial disparities between the regions of the Union, and the backwardness of the least favoured regions with a particular focus on rural areas, areas affected by industrial transition and regions suffering from severe and permanent natural or demographic handicaps, such as outermost regions, regions with very low population density, islands, cross-border and mountain regions.

READ THE FULL POSITION PAPER HERE

ETUI advertisement

HESA Magazine Cover

What kind of impact is artificial intelligence (AI) having, or likely to have, on the way we work and the conditions we work under? Discover the latest issue of HesaMag, the ETUI’s health and safety magazine, which considers this question from many angles.

DOWNLOAD HERE

Eurofound advertisement

Ageing workforce
How are minimum wage levels changing in Europe?

In a new Eurofound Talks podcast episode, host Mary McCaughey speaks with Eurofound expert Carlos Vacas Soriano about recent changes to minimum wages in Europe and their implications.

Listeners can delve into the intricacies of Europe's minimum wage dynamics and the driving factors behind these shifts. The conversation also highlights the broader effects of minimum wage changes on income inequality and gender equality.

Listen to the episode for free. Also make sure to subscribe to Eurofound Talks so you don’t miss an episode!

LISTEN NOW

Foundation for European Progressive Studies Advertisement

Spring Issues

The Spring issue of The Progressive Post is out!


Since President Trump’s inauguration, the US – hitherto the cornerstone of Western security – is destabilising the world order it helped to build. The US security umbrella is apparently closing on Europe, Ukraine finds itself less and less protected, and the traditional defender of free trade is now shutting the door to foreign goods, sending stock markets on a rollercoaster. How will the European Union respond to this dramatic landscape change? .


Among this issue’s highlights, we discuss European defence strategies, assess how the US president's recent announcements will impact international trade and explore the risks  and opportunities that algorithms pose for workers.


READ THE MAGAZINE

Social Europe

Our Mission

Team

Article Submission

Advertisements

Membership

Social Europe Archives

Themes Archive

Politics Archive

Economy Archive

Society Archive

Ecology Archive

Miscellaneous

RSS Feed

Legal Disclosure

Privacy Policy

Copyright

Social Europe ISSN 2628-7641