Previous Fora / 2003

Speech of Alexandre Lamfalussy (First President, European Monetary Institute)

World Science Forum, Budapest, 8 November 2003

By Alexandre Lamfalussy
Former President of the European Monetary Institute
University of Louvain (UCL), Louvain-la-Neuve, Belgium

Knowledge, Science and Economic Growth: A European Perspective

Introductory remarks: correcting Europe's dismal growth performance should be the EU's prime policy objective

Both Europe and the rest of the world badly need a substantially faster growing European Union. The improvement of Europe's anaemic growth performance should rank very high on our policy makers' agenda.

This is obviously desirable from a purely inward-looking, "selfish", European angle. Not so much, or at least not exclusively, because our citizens would like to see their standards of living improving - but, more important, because slow growth (and, a fortiori, stagnation) puts at risk our ability to preserve even the most elementary solidarity features of the European "model". The rising social security and health care deficits and the acrimonious discussions on which country should finance and in what amounts the intra-EU transfers (which are an integral part of the Union's cohesion objective) show that we are already beginning to experience the deleterious effects of slow growth. Moreover in an ageing society the need to revamp our pension systems put an additional stress on the inter-generational transfer process.

At the same time, the EU does not live in isolation from the rest of the world. It is part - a significant part - of our rapidly globalising world economy. Let me make two points in this respect. The first refers to the problems currently encountered by the accession countries, including by our host country to-day. These countries are already very much, in terms of trade and investment flows, part of the EU. As a result their own growth performance is strongly dependent on that of the EU, even though this relation, thankfully, is not a linear one. My second point refers to a more general, and arguably more systemic danger. The world economy cannot continue to rely, as it did during the 1990s, on the driving force of the US economy. We should accept that in a worldwide depression the US economy is called upon to act as the "consumer of last resort", but it cannot perform this function continuously. The current account deficit cannot go on rising indefinitely. Sooner or later, US households will have to start saving. We do not know when the limits of these imbalances are reached, but when they are, adjustment will have to take place. But unless domestically propelled growth picks up in Europe (assisted by that of Japan) we run the risk that the adjustment process will imply sharp exchange rate changes or a US recession, or a combination of both, which is about the last thing we would like to see happening.

The main argument I would like to submit to you in this short presentation is that to achieve a lasting and sustainable acceleration in its rate of growth, the EU should undertake major initiatives for developing a knowledge-based economy. We should, however, have no illusions. This requires policy measures which will not yield results in the short run - but this is precisely the best reason for not delaying their implementation. Nor should we expect that an expanding stream of innovations, which is one of the most striking manifestations of a knowledge-based economy, will automatically lead to faster growth. A wide range of measures will have to be taken, which should induce and enable entrepreneurs to make effective use of innovations. Such innovations are a necessary, but far from sufficient condition for pushing out the "growth frontier".


Europe versus the United States


A useful way to start setting out my argument is to briefly compare the recent growth experiences of the US and the EU. But just a short warning. Do not expect me to idealise the US experience by falling into the trap of believing that a "new economy" replaced the "old one" - which would mean, among other things, that the business cycle has been abolished and that we should expect fast and steady growth for the foreseeable future, if only we were able to copy the US example. Such delusions have turned out during the past couple of years to be what they were: nonsense. But we should equally avoid committing the opposite mistake, namely ignoring that something important was beginning to happen in the US in the mid-1990s, which is worth being taken into account. Let me spell out the meaning of this last statement.

A comparison of the level of GDP per head between the US and the EU for the year 2000 should not give rise to too much concern. Admittedly, after a period of speedy catching up with the US during the 25 years following World War II, the European GDP per head stabilised for the rest of the century around, roughly speaking, 70% of the US level. But by 2000 the greater part of this difference was due to the fact that fewer Europeans worked fewer hours per year than their American counterparts. Labour productivity per hour was only about 10% below the US level - with some European countries (Belgium, France, the Netherlands, Italy) actually exceeding that level. And we have to keep in mind that this is the component of GDP per head that could potentially be influenced by research-based innovations.

But the cross-Atlantic comparison becomes much less reassuring when we consider the rate of increase of labour productivity (per hour) since 1995. Until that date the European rate of increase consistently outstripped that of the US, although the difference began to shrink in the 1980s. But in the second half of the 1990s the rate of growth of European labour productivity dropped to 1.4%, while the American rose to 2%. Moreover, while we do not have reliable more recent comparable figures, all statistical guesstimates point to staggering productivity increases of 4 to 5% in the US during the period 2001-2003 (a remarkably a-typical development during these years of, on average, sluggish growth), with the European performance remaining, at best, close to the low rate of increase registered during the 1995-2000 period.

There is an emerging consensus among economists, and economic historians, on how to explain and reconcile these facts and developments. The speed and success of the post-war catching up process by Europe owes a lot both to the Marshall plan and to the wise decision to develop a multilateral trading and payments system in Europe, which paved the way for establishing the Common Market and, later, the European Community. At the same time the large European corporations made good use of the opportunity offered to them to take over and digest advanced technology and business management techniques which had been developed in the US. This was supported by genuine R & D programs, often under the guidance of governments, in some key strategic sectors, such as energy, transport and communications. However, by the time Europe was beginning to exhaust the large productivity-raising potential of "imitation" and of rebuilding an efficient infrastructure - sometime during the late 1970s and the 1980s - the target itself (i.e. the efficiency of the US economy) was beginning to become a moving target itself. As a result of rising living standards in the Western world, there appeared a growing demand for a greater variety of goods, for less standardised and higher quality products. Progress in information and communications technology made it possible to adjust the production facilities to these new requirements. The single most important indicator of these developments was the decline of the share of manufacturing in GDP and the corresponding increase in services. And these very global figures do not do full justice to the real importance of services: what is still labelled as manufacturing output contains an ever-increasing input of services. As a matter of fact, the distinction between manufacturing and services is in the process of being eroded. Correspondingly, as regards employment, the shift to services has become more pronounced than would be suggested by the changes in the composition of GDP.

The main point I would like to make is that the US economy has managed to adjust to the challenges thrown up by these developments more successfully than the EU taken as a whole: this is the most likely explanation of the acceleration of US productivity growth during the past ten years.


Why has Europe not been able to take up these new challenges, and what to do about it?


A number of pathbreaking academic studies have demonstrated that as countries approach the technology frontier - that is, once the "imitation" opportunities are exhausted - genuine innovation will have to play the key role in raising productivity. At the same time other academics, using inter-country comparisons, have shown that there is a strong link between university education and the rate of growth of productivity - a proposition that looks intuitively plausible, because both in the process of achieving scientific breakthroughs and in actually turning them into usable innovations we have to rely on people with a solid tertiary educational background.

The OECD provides us with valuable information on its member countries' position, but glancing through these figures does not make pleasant reading for a European. In 2000, for the EU as a whole the share of the population (in the age group of 25 to 64 years) which has gone through tertiary education was a shade less than 24%, as opposed to the staggeringly high 37% in the US. What I find even more revealing is that the two EU member countries with the highest proportion were Ireland (35.6%) and Finland (32.3%), that is, two countries ranking very high in terms of innovational achievements and in their success of taking up the challenges I have just mentioned.

Another useful information supplied by the OECD is the share of total expenditure on tertiary education as per cent of GDP. The figure is 3 for the US, but only 1.4 for the EU, with the three Nordic countries being the only ones comfortably exceeding 2%.

All this pleads in favour of enhancing the rate of participation of the EU's population in higher education. But to this simple, perhaps too simple, quantitative objective, I would like to add two more requirements.

The first relates to all levels of our educational systems - primary, secondary, tertiary. As I shall argue in my concluding remarks, a knowledge-based economy will bring socially acceptable benefits only if the accelerated structural changes it implies will be accompanied by substantial, but smooth, shifts in employment patterns. People will have to adjust to continuously changing technology and accept to move from one job to another. Our educational systems must enhance the intellectual and moral capacity to adjust. This is as much, and probably more important than the mere accumulation of knowledge. Quite an assignment.

The second requirement concerns mainly university education but it can only be met if it is well prepared on the secondary, and even on the primary levels. Progress in science needs first-class brains, an ever-inquiring mind, stimulating academic environment, recognition of merit - and, also, even at the early stage of university education, taking the habit of team-work and accepting competition. All this cannot be achieved everywhere at the same time. To put it bluntly: enlarged access to tertiary education should not take place at the expense of developing "centres of excellence". We must try to reconcile "elitism" with the broadening of the university population. Again, this is not going to be an easy task.

At any rate, it will not be enough to produce in great numbers people capable and willing to undertake research. Money needs to be spent on R&D and, moreover, spent in a way that helps achieving results. For Europe badly needs results. On a per head of population basis, international patents produced by the EU represent barely one fifth of those produced by the US. This should not come as a surprise when we note the fact that R & D expenditure in the US is around 2.6% of GDP, while it is only 1.8% in the EU, with only Sweden and Finland exceeding the US level, and Germany being close to it. I realise that these figures may not be telling the whole story, but anyone even remotely connected with research can tell you that US research facilities attract in increasing numbers the best of our young brains. Money does count, of course, but it is not the only factor at work. The existence of competing "elite" centres of excellence, providing a stimulating environment both for fundamental and applied research matters just as much.

There can be no doubt that total European expenditure on R&D should be increased. But the way in which it is spent matters as much, and probably even more than the total amount. What should be the guidelines in this respect? Given the short time available for this presentation, you will allow me to appear somewhat dogmatic. First, and negatively, I would not give priority to spending a lot of public money on R&D facilities managed by governments and, more important, serving development objectives defined by government. I do not deny that in some instances this type of financing did yield results in the past. But there is a danger of picking the wrong sectoral developments, and when there is a concentration on a few very large projects, the mistakes can be awfully costly. Second, and more positively, I would favour targeting universities with a proven track record and small or medium sized businesses, again, with some successes behind them. In this second case, tax credits would seem to be the best vehicle. Third, whatever the choices of recipients or of the research areas, peer review procedures should be used.

None of these undertakings will yield tangible results in the form of accelerating productivity increases unless the broad economic and institutional environment stimulates research and, ultimately, induces entrepreneurs to turn R&D results into profit making innovations. Since this is not the subject of this Forum, I do not propose to deal with this decisive requirement. Let me just list what I would regard as some of the major components of this environment. First, well organised and clear intellectual property protection including, among others, protection of software innovations - a topic on which we are far from having reached agreement. Second, ensuring open entry, including cross border open entry. Third, promoting the supply of risk capital both to start-ups and to firms that are beyond that stage but have no access to traditional equity financing. Just one remark on this topic: the end of the 1990s witnessed good progress in Europe in this field, but the internet debacle and three years of growth recession have significantly reduced the appetite for this kind of risk taking. Fourth, labour market flexibility without which firms will find it very difficult to redeploy skills in a period of rapid change. Last but not least, a stability oriented macroeconomic policy.


Challenges thrown up by a knowledge-based economy


Whilst there is no doubt in my mind that Europe will improve its growth performance if it is capable of moving towards a genuinely knowledge-based economy, it is arguable that an economy more extensively based on the use of knowledge and science does not necessarily mean plain sailing, - or as one would say in French - is not "un grand fleuve tranquille". It speeds up structural changes - this, I take it for certain. But it may also increase uncertainty in our economic life due to the fact that it implies navigating in uncharted waters. Let me take up these two points one after the other.

Structural changes have dominated the life of our capitalist market economies since time immemorial. These changes are both the driving force and the corollary of progress; but they are not painless. They involve what Schumpeter so aptly called "creative destruction". Waves of innovation introduce new products, new firms, new industries. They force existing firms to adjust, and when they are unable to do so, to disappear. In some instances whole industries are destroyed. For entrepreneurs to survive and to prosper requires on their part an ability to detect at an early stage the significance of innovations and to react correspondingly. Labour is "released" from declining or disappearing firms and is supposed to take up job opportunities offered by the newcomers. In the milder version of this process the redeployment of skills may take place within existing firms. This, of course, is more easily said than done. It is not easy to acquire new skills, nor is it easy to become geographically mobile. But past waves of innovation - steam engine, railways, electricity, automobile - extended their impact on industrial structures over relatively long periods, which allowed shifts in employment structure to take place gradually. The post-war rural exodus in European countries was not a painless exercise, but it stretched over fifteen to twenty-five years: it was not the fifty year old farmer who had to move to an urban centre to take up a manufacturing job, but his children.

By contrast, in a knowledge-based economy, which at the same time coincides with globalisation, the speed of change picks up dramatically. We cannot prepare ourselves gradually, both mentally and in terms of skills, to a well identified occupational challenge; we have to take up the challenge when it comes. As I mentioned earlier, this requires the acquisition of an adjustment capability right from our first steps in our social life - in the family and in the kindergarten, and throughout our school years - which puts a heavy burden on our educational systems. It also requires a broad economic environment that helps, rather than hinders, professional and geographical mobility. However, even if all these requirements are satisfied, the fact still remains, I suspect, that people differ from each other and differ precisely in their capacity to adjust. Some of these differences may be attenuated by education, but they will not be eradicated. This is liable to increase income differentials (a process which is already under way) to a degree that becomes socially and ethically unacceptable - hence an additional burden on our European solidarity commitment.

Let me now turn to my second concern, namely to the possibility that scientific progress may inject an additional dose of uncertainty in our economic life. I use the word "may" deliberately, because I do not know the answer to my queries. But instead of talking about my concern in general terms, I would like to say a few words about the impact of scientific developments in the area of financial markets in which I have acquired some professional experience. The development of the theory of finance, during the past thirty years, has been spectacular. Its key contributors have been rewarded by a number of Nobel prizes - two of them just last month. These contributions have led to a steady stream of highly sophisticated financial innovations, which are now being widely used in risk management by all financial market participants. I refer here to the large and growing family of financial derivatives, which allow risk-averse market participants to transfer their risk to willing risk takers - in areas such as interest rates, asset prices or (on a very large scale to-day) credit risks. Many of us believe that the use of such hedging devices by banks played a non negligible part in ensuring that banks have not been hit as much as one could have feared by the very severe market turbulences which occurred during the past three years. This may have allowed us to avoid a potentially damageable systemic crisis, since the failure of banks, which are at the heart of our payments systems and are the providers of liquidity to the rest of the financial industry, could indeed have led to a systemic crisis. So far so good.

There are, however, "buts". The system as such cannot insure itself against an external shock. The meltdown of equity prices or the bankruptcy of large non-financial firms represent a genuine, global, loss. All that insurance does is to redistribute this loss, by transferring risks from risk-averse market participants to willing risk takers. To the extent that these risk-takers know what they are doing, and properly assess their risk-resistance capabilities, the system as a whole gains in stability. But these two conditions are not necessarily satisfied. The variety and complexity of credit derivatives is mind-boggling - they are not standardised - and legal uncertainties abound. Moreover, the assessment of risks in financial markets is a tricky business. The instrument may be of the highest sophistication, but the statistical series which are used are in most cases less than reliable. Even more important, regularities observed in asset price behaviour may easily break down in a world subject to radical changes. Those of you familiar with recent financial history will guess that this is an oblique reference to the 1998 LTCM crisis. There is a world of difference between these kind of insurance contracts and those based on mortality tables or on statistics relating to, say, automobile accidents. Finally, we have to bear in mind that central banks and governments which are in charge of maintaining systemic stability possess only incomplete information on which segments of the financial industry acted as risk-taking insurers and even less on the intricate set of interconnections established through the use of derivatives. To put it mildly, our highly innovative financial system taken as a whole has not gained in transparency. On the contrary, it has become remarkably opaque.

Let me conclude by asking you not to read into these final remarks what I do not intend to say. Europe badly needs a knowledge-based economy, for reasons that I hope I had spelled out clearly. But on our route towards this objective we should not give up our sense of prudence and we should not believe that progress in that direction will solve all our problems. Yes, it will bring sizeable benefits to most of us, but not without throwing up new challenges. You may say that this remark is just the usual manifestation of a central banker's innate caution. Well, it may be. But that does not mean that I am necessarily wrong.