Accounting for slow growth in Europe and Japan

Christopher Phillip Reicher a Kiel Institute for the World Economy This version: August 29, 2011

Abstract:
In this short paper I discuss some of the likely sources of Europes and Japans slow growth relative to the United States in the decade and a half leading up to the Great Recession. I argue that slow and decelerating growth in much of Europe and Japan could be explained by two major factors: Differing population dynamics and an apparent end to postwar convergence. I also explore the issue of movements in the output gap as a factor underlying slow growth. I find using two measures of the output gap that Japans lost decade of the 1990s did not see a persistent negative output gap. While the worst of the lost years between 1998 and 2004 saw a series of adverse cyclical shocks, the slow growth performance of Japan and also Germany since 1990 is the result of their finishing its process of postwar convergence combined with a shrinking population.

Contact information: Hindenburgufer 66, 24105 Kiel, Germany. Email: christopher.reicher@ifw-kiel.de; Phone: +49 (0)431 8814 300. JEL: E00, N10, O47 Keywords: Slow growth, Japan, Germany, output gap, convergence. None of the opinions expressed here are the opinions of the Institute or my colleagues.

Accounting for slow growth in Europe and Japan

Introduction and motivation

In a recent blog post entitled, Where does the Japanese slowdown come from?, Tyler Cowen has quoted a paper (2011) where I argue that it makes little sense to look at the unemployment rate as a guide to the Japanese business cycle. The Japanese unemployment rate does not vary by much over the business cycle; almost all of the cycle in Japan comes from fluctuations in measured productivity with some contribution from hours per worker. An implicit conclusion of that paper is that it makes sense to look at output growth directly since unemployment is not a reliable cyclical indicator in Japan. Just because Japan has had low unemployment does not mean that it had not suffered through a severe slump. Between 1991 and 2007 (excluding the Great Recession), Japans economy had grown at a continuously compounded annual rate close to two percent slower than that of the United States. Based on a simple comparison of growth rates between the countries, Japan appears to have become and remain mired in a deeper and more persistent depression than the Great Depression in the United States.

There is a problem to simply looking at output growth, however. It is necessary to look at such things as population growth when comparing the growth of output across countries. For instance, much has also been made of the lower growth rates experienced before the crisis in Europe than in the United States.1 Similarly, much of the discussion of the lost decade or lost years in Japan is predicated on the assumption that the low GDP growth of the 1990s and 2000s reflects some sort of failure for the Japanese economy to produce near its potential. The rest of this note explores the sources of different growth rates between France, the United Kingdom, Germany, Japan, and the United States in the past two decades. These are major economies for which reasonably good annual time series data exist since 1970.

First I discuss the behavior of the components of GDP growth relative to the United States, and then I discuss what the effect of these different components has been in each country relative to the United States. I argue that the patterns seen in Japan, Germany, and to some extent France, are the result of the end of convergence in output per worker and a sharp decline in the hours worked per worker. In the case of Japan, labor market outcomes have
For instance, Dovern, Jannsen, and Scheide (2009) blame the entry into the Euro for an overvalued real exchange rate and hence slow cyclical growth in Germany from 1999 through 2005.
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converged toward U.S. patterns, while much of Germanys and Frances great stagnation come from a secular decline in hours worked per worker to levels well below U.S. levels. In addition, population dynamics in these countries have been such that these countries will naturally grow more slowly than the United States.

Then I reexplore the issue of the cyclicality of unemployment, particularly in Japan. By looking at the Okuns Law relationship between unemployment and output, I find that there is a moderately strong relationship between unemployment and the cycle which can be used to try and approximate the output gap in Japan. When doing this, I do not find evidence of a persistently negative output gap during the 1990s, though I do find evidence that the 1998 recession was a strong one. Other estimates of the output gap during that period support this assessment. Japans Great Stagnation is primarily the result of a decreasing population and an end to convergence in productivity and not primarily the result of a string of adverse cyclical shocks during the early 1990s.

This paper seeks to discuss growth in Europe and Japan in a nontechnical way. The role of this note is to plot some data and try to put together a rough narrative as to what has happened to economic growth rates across countries since 1990. I find that the data broadly support the idea put forward by Cowen (2011) that a large amount of early postwar growth consisted of picking low-hanging fruit, with Europe and Japan continuing to pick low-hanging fruit until about 1990 or so. I hope to offer a few pieces of data which suggest that the growth situation in Europe and Japan has not been quite as bad over the past two decades as critics have made it out to be.

The data and some narrative

The data come from the OECDs National Accounts and Annual Labor Force Statistics databases. All variables are compared with their counterparts in the United States since the PPP-adjusted GDP series come in nominal U.S. dollars. The comparisons can be broken down based on an accounting identity which links the following items:

GDP = GDP per hour worked (productivity), times actual hours worked per employed worker (the intensive margin), times the employment rate (employment as a share of the labor force), 2

times the labor force as a share of the population aged 15-64 (the participation rate), times the working age population.

Figures 1 through 4 show the first four of these objects for the five countries relative to their U.S. counterparts. Figure 1 shows the evolution of productivity relative to U.S. productivity since 1970.

Figure 1: Productivity (output per hour) relative to the United States

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0.4 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

France

United Kingdom

Germany (West)

Germany (Unified)

Japan

Source: OECD data and authors calculations. All numbers are relative to the United States.

During the first half of the sample, most of these countries played catch up with the United States. Since 1990, most of these countries have seen their productivity relative to the United States stabilize at levels which vary between countries. Simply extrapolating past trends would result in a very large measured output gap during the 2000s even though much previous growth reflects convergence. Germany and France have stabilized at a level of productivity roughly comparable to that of the United States. The United Kingdom has stabilized at a productivity level of about 80% relative the United States, and Japan has stabilized at about 70%. Much of the slowdown in Japan has come because it has stopped converging with the United States. In Japan, convergence before 1990 was particularly rapid, while it ground to a halt in about that year. Figure 2 shows hours per worker, the intensive margin, relative to the United States. 3

Figure 2: Hours per worker relative to the United States

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0.75 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

France

United Kingdom

Germany (West)

Germany (Unified)

Japan

Source: OECD data and authors calculations. All numbers are relative to the United States.

All four countries have seen a strong secular decline in hours worked relative to the United States. Japan is not out of the ordinary, although it saw a particularly rapid decline in hours per worker during the recession of the early 1990s. Falling hours worked relative to the United States will cause GDP growth to be lower than it otherwise would have been. Combining falling hours worked with falling productivity growth will cause output growth to have decelerated particularly strongly in Japan and Germany relative to the United States.

Figure 3 shows the employment rate relative to the United States for these countries. In Japan, the unemployment rate is consistently low, and the employment rate is almost always higher than that in the United States. France and Germany endured a three-decade slump relative to the United States; up until 2007 they had consistently lower employment rates (i.e. higher unemployment rates) than the United States. The trend in Japan has been toward falling employment rates and rising unemployment rates, though that trend has merely sent Japanese employment and unemployment rates toward U.S. levels. In 2007, the unemployment rate was 3.8 percent in Japan while it was 4.6 percent in the United States.

Figure 3: Employment rate relative to the United States

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0.9 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

France

United Kingdom

Germany (West)

Germany (Unified)

Japan

Source: OECD data and authors calculations. All numbers are relative to the United States.

Figure 4 shows the behavior of the labor force participation rate. Europe has had lower labor force participation rates over recent decades to go along with its lower employment rate. Japanese labor force participation has in fact risen slightly since 1990 and is higher than that in the United States. Arguments about Japans weak labor force participation rates do not seem to show up in data on the labor force participation rate.

In short, just based on a look at Figures 1 through 4, it seems like Europe and Japan have seen a Great Stagnation much stronger than that seen by the United States based on looking at output growth. Much of their growth before 1990 was driven by simple productivity convergence. Naturally, after convergence happens, an economy will grow more slowly relative to its previous path. In Japan, the end of convergence is particularly sharp; it occurs around 1990. In Germany, the statistics are clouded by the change in the definition of Germany in 1990-91. It is striking that all-German productivity has hovered around U.S. levels since the reunification in spite of clear improvements in eastern German productivity and living standards since 1991.

Figure 4: Labor force participation rate relative to the United States

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0.8 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

France

United Kingdom

Germany (West)

Germany (Unified)

Japan

Source: OECD data and authors calculations. All numbers are relative to the United States.

A counterfactual analysis

This section decomposes the differential growth experiences of these four countries relative to the United States into components attributable to the components of GDP laid out in the accounting identity. This answers the question, All else equal, if the United States had seen growth in (for example, productivity) like that seen by (for example, Germany), what would have happened to its overall GDP growth rate? Since the growth rates used here are continuously compounded, these numbers are additive, and summing up the differential growth rates in the components of GDP will give the differential growth rate in GDP.

Table 1: Counterfactual analysis from 1991 to 2007: Annual growth rates

Country France United Kingdom Germany (Unified) Japan Prod. Hrs / wkr 0.07% -0.46% 0.73% -0.27% 0.12% -0.43% -0.07% -0.64% E rate LFP rate Pop growth Total diff -0.13% 0.29% -0.76% -0.99% 0.07% 0.08% -0.79% -0.19% -0.35% 0.46% -1.32% -1.52% -0.26% 0.48% -1.50% -1.98%

Source: OECD data and authors calculations. All numbers are given as continuously compounded growth rates relative to the United States.

Table 1 shows the decomposition for the period 1991-2007, which covers the sixteen years before the Great Recession. In the cases of France, Germany, and Japan, almost all of the growth differential is explained by differences in population growth. Differences in productivity growth have contributed almost nothing to the growth differential except in the United Kingdom. The United Kingdom, as also seen in Figure 1, has seen continued slow convergence with the United States, while France, Germany, and Japan have stopped converging. The data support the assertion made by Daniel Gros (2011) that, ...the idea of a Japanese-style lost decade is misleading even when applied to Japan. Slow growth in Japan over the last decade was due not to insufficiently aggressive macroeconomic policies, but to an unfavorable demographic trend.

In Japan, hours per worker have fallen more rapidly than in the United States. The same is true, however, in the three other economies. Much more work would need to be done to understand how much of this is due to convergence and how much of this is due to other factors. In 2007, Japanese and U.S. workers worked comparable amounts (just under 1,800 hours per worker) while in 1990, Japanese workers worked 10% more than Americans. By contrast, in 2007, the average German worker worked 1,430 hours while in 1970, the average German worker worked slightly more than the average American worker. Either way, the slow growth in Germany, France, and Japan, seems to be entirely driven by slower population growth and by a fall in relative hours worked, in that order. None of it appears to be driven by differential productivity growth or by large changes in the labor force participation rate, and changes in the employment rate only contributed a small part to the differential growth performance among countries over the longer term. The one country where the employment rate did seem to matter was Germany, and Germany has performed much better with respect to that metric since 2007.

A comparison with the period before 1990

This section repeats the same analysis for the period from 1970 to 1990 and discusses the reasons for the growth slowdown between 1991-2007 and 1970-1990. Table 2 shows the difference in relative growth rates for the different components of GDP, comparing the 19912007 period with the 1970-1990 period.

Of all of these countries, Japan has had the strongest growth slowdown relative to the United States, though France and Germany have each also seen a strong relative growth slowdown. Japan, France, and Germany have seen sharp slowdowns in productivity growth as productivity has reached a plateau relative to that of the United States. Japan has also seen more deceleration in its population growth rate, although Germany is not far behind. Table 2 basically demonstrates what a look at Figure 1 would showit is misleading to compare growth rates across time in Japan since both population and productivity growth have slowed dramatically. A naive extrapolation of either trend would show Japans slump to be far worse than it really was.

Table 2: Difference between relative growth rates: 1991 to 2007 vs. 1970-1990: Annual growth rates
Country France United Kingdom Germany (Composite) Japan Prod. -1.89% -0.25% -1.71% -2.62% Hrs / wkr 0.26% 0.01% 0.48% -0.33% E rate 0.14% 0.27% -0.18% -0.24% LFP rate 0.98% 0.49% 1.20% 1.08% Pop growth -0.31% 0.16% -0.72% -1.14% Total diff -0.82% 0.68% -0.92% -3.25%

Source: OECD data and authors calculations. All numbers are given as continuously compounded growth rates relative to the United States.

In short, the great stagnation of Europe and Japan relative to the United States seems to be driven by a strong combination of more normal productivity growth and, in the case of Germany and Japan, an outright shrinking population. The long-run deceleration in growth in Europe and Japan relative to the United States is mainly a product of a deceleration in productivity convergence.

Okuns Law, the cyclicality of unemployment, and measuring the output gap

There are other ways to look at the issue of the cyclicality of employment. The study of Reicher (2011) decomposes the variance of output growth based on the contributions of its components and finds that measured productivity in Japan contributes most of the variance of output flucutations. This analysis takes a different look, by using the (un)employment rate as a cyclical indicator. The analysis takes the data from Reicher (2011) for France, Western Germany, Japan, the United Kingdom, and the United States. All data are HP filtered with a smoothing parameter of 100 and then taken in first differences; I get similar results if I take 8

first differences and then filter. The data are constructed to provide consistent estimates for Western Germany throughout the sample, and again the sample ends in 2007.

Table 3 shows the results of regressing growth in log GDP per capita on growth in the log employment rate. The idea is that the employment rate is primarily driven by the cycle, while the other components of output are driven mostly by their trends. Regressing GDP growth on growth in the employment rate will give an approximate relationship between the output gap and the employment rate gap.

Table 3: Results of regressing cyclical output growth on growth in the employment rate
Country France Germany (West) Japan United Kingdom United States Estimate Std. Err. 1.646 0.309 1.413 0.301 4.590 1.057 1.060 0.250 1.699 0.172 R2 0.4475 0.3871 0.3502 0.3513 0.7371

Source: Reicher (2011), from OECD and German national sources.

The results from Table 3 show that the United States, France, and Germany all obey an Okuns Law with a coefficient of a similar magnitude. In those countries, the (un)employment rate is a reliable guide to the cycle. In the United Kingdom, output moves about one for one with unemployment. In Japan, output moves much more than employment, at a rate of 4.5 to 1. This means that for a cyclical unemployment gap of one percentage point, output falls short of trend by about 4.5 percent. Put another way, unemployment moves in a very dampened manner relative to the rest of the cycle.

Figure 5 shows the output gaps in the five countries derived using Okuns Law. Surprisingly, according to Okuns Law, Japans output gap was positive throughout most of the 1990s until the Asian financial crisis caused output to collapse. Output during the early 2000s remained low as unemployment peaked in 2002. Figure 6 shows the output gap as calculated by the OECD using a production function approach. Figure 5 shows a much worse business cycle in the early 2000s for Japan than Figure 6 does. Both figures give a broad impression that the mid-1990s were not actually that bad for Japan and that the cycle only became a problem after the 1998 financial crisis. If both measures of the output gap are any indication, Japans lost years lasted roughly six years, from 1998 through 2004.

Figure 5: Output gaps derived from Okuns Law

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Source: Regression coefficients from Table 3 multiplied by the employment rate gap, derived using an HP filter of 100.

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19 70 19 71 19 72 19 73 19 74 19 75 19 76 19 77 19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07

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Figure 6: Output gaps for five countries (OECD Economic Outlook)

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Source: OECD Economic Outlook 89 (2011).

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From what evidence can be pieced together using data on labor markets in Japan, the 1990s did not appear to feature a persistently negative output gap. To the extent that labor markets deteriorated in Japan and remained in a persistent slump, the worst of that deterioration happened after the 1998 crisis and not after the collapse of the housing market and banking system in the early 1990s. The derivation of the output gap is obviously sensitive to the choice of filtering techniques, so the degree to which the output gap turned negative during the 1990s in Japan is far from settled.

Conclusion

Relative to the United States, the economies of other industrialized countries have grown rather slowly since about 1990 or so. This note has shown that most of the divergence in growth from 1991 through 2007 has come because different countries have seen their working age populations grow at different rates. In addition, falling hours worked per worker relative to the United States have contributed somewhat to slower growth in Europe and Japan.

Looking at the deceleration of growth rates between 1970-1990 and 1991-2007, I argue that most of the decelerating growth seen in Europe and Japan has come through the end of convergence in productivity. Germany and France have converged toward U.S. productivity levels; the United Kingdom has converged toward a level just over 80% of that of the United States, and Japan has converged toward a level just over 70% of that of the United States. Any analysis which depends on extrapolating past growth rates forward will detect a spurious output gap in the latter period even where none exists. The apparent nonstationarity in growth rates also makes it much more difficult to disentangle trend and cycle.

With those caveats in mind, I revisited the issue of the cyclicality of unemployment in Japan. I find that Okuns Law in Japan displays a much larger coefficient than in the United States or in Europe. This implies that one could view the output gap as a very large multiple of the employment gap. Using unemployment data detrended using a smoothing parameter of 100, I find that the worst of Japans lost years really occurred from the crisis of 1998 until the onset of a cyclical revival which began in 2003-04.

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References

Cowen, Tyler, 2011. Where does the Japanese slowdown come from? Online at: http://marginalrevolution.com/marginalrevolution/2011/08/where-does-the-japaneseslowdown-come-from.html (Retrieved 26 August, 2011).

Cowen, Tyler, 2011. The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will(Eventually) Feel Better. Dutton Adult.

Dovern, Jonas, Nils Jannsen, and Joachim Scheide, 2009. Die Bedeutung monetrer Gren fr die deutsche Wachstumsschwche 19952005. Kiel Working Paper 1492.

Gros, Daniel, 2011. The Japan Myth. Euronomics, Project Syndicate. Online at: http://www.project-syndicate.org/commentary/gros18/English (Retrieved 29 August 2011).

Organization for Economic Cooperation and Development (OECD), 2011. Economic Outlook 89. Electronic version, June 2011.

Reicher, Christopher P., 2011 A simple decomposition of the variance of output growth across countries. Kiel Working Paper 1703. Forthcoming, Applied Economics Letters.

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