Mind the Gap

Robert C. Pozen

From Foreign Affairs, March/April 2005

Article preview: first 500 of 2,172 words total.

Summary:  With the EU's addition of ten new members and a likely slowdown in U.S. productivity growth, Europe has a chance to overtake the U.S. economy. To actually do so, however, it must boost its competitiveness with some much-needed reforms.

Robert C. Pozen is Chairman of MFS Investment Management, a trustee of the American Academy in Berlin, and former John Olin Visiting Professor at Harvard Law School.

Most Americans consider the United States far ahead of Europe economically. Over the last 30 years, real per capita income (based on purchasing power parity) has consistently been 30 percent higher in the United States than in the 15 "western" countries of the European Union (the EU15). In the last decade, the U.S. economy has expanded much faster than that of the EU15, and demographic trends suggest that this disparity will continue.

The recent addition of ten eastern European countries (the EU10), however, offers the EU an opportunity to overcome several critical constraints on its economy. Meanwhile, the usually high productivity growth that has driven the U.S. economy over the last decade is not likely to continue at such a torrid rate, while the sluggish rate of productivity gains in the EU15 could rise sharply. If the EU can successfully integrate the EU10, and the United States fails to find new ways to increase productivity, then the economic gap between Europe and the United States will start to narrow for the first time since 1970.

AMERICAN ADVANTAGES

Gross domestic product has grown at an average rate of 3.3 percent a year in the United States over the last decade, compared to 2.1 percent a year in the EU15. Per capita GDP growth, however, has been very similar: 1.8 percent a year in the United States, 1.7 percent in the EU15. The main factor driving higher U.S. economic growth is not greater productivity gains; it is a more rapidly expanding population.

These demographic differences will likely keep GDP growth higher in the United States than in the EU15 over the next few decades. The average fertility rate in the United States is 2.1 children per couple, almost 50 percent higher than in the EU15. This means that the U.S. population will grow from 290 million today to approximately 370 million by 2030, whereas the population of the EU15 will stay roughly flat--at 380 million--in the same period.

A second, and related, factor behind differences in American and western European economic growth is the financing of retirement benefits in the context of the aging of the baby boomers. The "support ratio"--the ratio of workers paying into retirement plans to retirees drawing out benefits--will erode more quickly in the EU15 than it will in the United States, directly undermining the pay-as-you-go approach to financing retirement benefits. Despite this impending demographic crisis, the EU15 has been much slower than the United States to adopt the alternative approach: financing retirement benefits through advanced funding of pensions. Most pensions in the EU are structured as defined benefit plans (rather than defined contribution plans), and outside of the United Kingdom most of these are funded by current company earnings. In the United States, by contrast, defined benefit plans must be funded by separate trusts maintained by individual companies, and they are far less common than defined contribution plans, which are fully funded each year by employee and employer contributions.

A third key factor explaining differences ...

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