Europe falling behind: Structural transformation and labor productivity growth differences between Europe and the U.S

This paper investigates the convergence and subsequent divergence of labor productivity between the U.S. and Europe through a quantitative general equilibrium framework that integrates endogenous changes in employment shares as a function of exogenous and unbalanced labor productivity growth rates across sectors. We calibrate our model to the U.S. and test it against Europe from 1970 to 2019. Our model accurately captures structural transformation and aggregate labor productivity paths, as well as the timing of Europe’s transition from convergence to divergence relative to the U.S. Leveraging a set of numerical experiments, we find that the reallocation of labor toward less productive sectors in response to sectoral productivity changes hinders the potential effects that the productivity growth in market services may have on the aggregate labor productivity: The heterogeneous productivity observed within services brings forth a Baumol cost disease whereby productive sectors gain less employment share than their productivity growth would imply under constant shares, despite their strong income effects. An extended version of our model that accounts for international trade suggests that it is implausible for Europe to export its way out of the aggregate stagnation unleashed by labor reallocation toward unproductive sectors.