Executive summary

In the aftermath of the recession, countries across Europe face a range of challenges. The immediate one is to consolidate the nascent recovery and create jobs. But if European economies are to thrive in the next decade they also need to meet the longstanding productivity challenge: European businesses are less productive on average than those in the United States, and this gap had been widening for over a decade before the recession took hold.

This report provides new evidence on an important contributor to this productivity gap: the dynamism of Europe's business landscape. It focuses on a new, purpose-built database of business growth in the period from 2002 to 2005, drawing on individual records for six million businesses, the result of an international collaboration involving eight European countries, the United States, Canada, and New Zealand.

The dearth of European equivalents to Google or Microsoft, innovative start-ups that grow quickly to dominate their markets, has long vexed European policymakers. But the analysis in this report highlights that this is only part of a wider picture:

• European countries have on average a lower share of high-growth firms than the US. But they also have fewer medium-growth firms and fewer shrinking firms. At the same time, Europe has a much larger share of 'static' firms, that is, firms that neither expand nor contract in a three-year period.
• The top half of firms grow faster in the US than in the average European country, while the bottom half shrink faster. Thus, the US has both faster-growing and faster-shrinking firms, and consequently at the end of the period the gap between successful and unsuccessful firms is larger in the US.
• There is a strong negative correlation between the growth rate of firms at the top and the bottom of the growth distribution. In other words, the faster successful companies grow, the faster unsuccessful companies in the same industry shrink.

The lower dynamism of European businesses – both in terms of growth and contraction – should be a concern. It points to less experimentation and a slower reallocation of resources from less to more productive businesses in Europe, both important drivers of productivity growth. The analysis of the database supports this link: a less dynamic business growth distribution is associated with lower productivity growth. Importantly, both a higher share of growing and shrinking firms are correlated with faster productivity growth.

This has a number of implications for policymakers in Europe. Policies targeted solely at high-growth businesses, such as improving the climate for venture capital, are not on their own sufficient to address the lack of dynamism that hampers Europe's productivity performance. They need to be combined with deeper structural reforms that remove not just barriers to entry, but also barriers to growth and contraction, such as improving product and labour market regulation, tackling access to finance, and reducing the European market fragmentation that stops businesses, especially in service industries, operating across borders.

Over the coming months, NESTA and its partners will use this newly developed database to examine the specific drivers of business growth, with a view to providing more detailed evidence to support policymakers in tackling Europe's growth challenge.

Acknowledgements

This report was written by Albert Bravo Biosca. The author would like to thank Shantha Shanmugalingam for his contribution in shaping the report. Kirsten Bound, Chiara Criscuolo, Henrik Lynge Hansen, Juan Mateos-Garcia, Glenda Napier, Yannis Pierrakis, Conor Ryan and Stian Westlake also provided very valuable comments.

The database analysed in this report builds on a joint effort between FORA and NESTA, with support from the International Consortium for Entrepreneurship (ICE), and has greatly benefited from the work led by Eurostat and the OECD to harmonise business registers across countries (in particular the Entrepreneurship Indicators Programme). Several people in addition to the author have participated in the long process leading to this new database, including Joseph Alberti, Henrik Lynge Hansen, Rodrigo Lluberas and Glenda Napier. Ditte Petersen and Mark Hart deserve a special mention, for their respective contributions in putting together the manual and the code file that initiated this project.

This initiative would not have been possible without the generous collaboration of many researchers and statistical agencies in the participating countries that provided the data underlying this report, and whom the author would like to thank:

Austria

Werner Hölzl Austrian Institute of Economic Research – WIFO

Canada

Sonja Djukic, Chris Johnston and Chris Parsley Industry Canada, Statistics Canada and Industry Canada

Denmark

Henrik Lynge Hansen FORA

Finland

Henri Kahonen, Petri Rouvinen and Mika Pajarinen Ministry of Employment and the Economy, The Research Institute of the Finnish Economy (ETLA) and The Research Institute of the Finnish Economy (ETLA)

Italy

Patrizia Cella and Caterina Viviano Istituto Nazionale di Statistica (ISTAT)

Netherlands

Rico Konen Centraal Bureau voor de Statistiek (CBS)

New Zealand

Geoff Mead Statistics New Zealand

Norway

Svein Myro and Christian L. Wold Eide Statistics Norway and Ministry of Trade and Industry

Spain

Valentín Llorente Garcia Instituto Nacional de Estadística (INE)

United Kingdom¹

Michael Anyadike-Danes, Rodrigo Lluberas and Mark Hart ERINI, NESTA and Aston Business School

United States

David Brown and Javier Miranda US Census Bureau

NESTA is the UK's foremost independent expert on how innovation can solve some of the country's major economic and social challenges. Its work is enabled by an endowment, funded by the National Lottery, and it operates at no cost to the government or taxpayer.

NESTA is a world leader in its field and carries out its work through a blend of experimental programmes, analytical research and investment in early-stage companies. www.nesta.org.uk

Part 1: Introduction

As European economies recover from the recession, they face significant challenges. Not least of them is the perennial productivity problem: European businesses are not as productive as those in the United States, and this gap has been widening since the mid-1990s. This divergence deserves more analysis. In a unique project, 11 countries in Europe, North America and New Zealand worked together to produce a new database that measures how quickly businesses grow or shrink in each country, allowing a much better statistical overview of business dynamism to be developed.

Europe faces serious economic and social challenges. The recession has left the continent burdened with low employment and high fiscal deficits. More worryingly, with its high indebtedness, an ageing population and overly rigid institutional structures, Europe's long-term prospects are not encouraging either.

The fear is that, without decisive changes, Europe will fail to compete with fast-growing emerging markets and a traditionally more dynamic US economy. This could have dire consequences for Europe's ability to maintain its quality of life, economic prosperity and social cohesion.²

This challenge is not new. Even before the recession, many European countries lagged behind when it came to generating exciting new ventures, capitalising on new technologies or making the most of globalisation.³ The result was weak economic growth and a widening productivity gap with the US.⁴

Lack of dynamism and insufficient innovation are often blamed for this poor performance. Both Europe and the US have highly successful companies, but the European ones tend to be much older. The demographics of the world's 500 largest companies by market capitalisation illustrate the point. The US and Europe both have a large number of companies in the top 500, but only 2 per cent of the European companies in the top 500 were founded after 1975, whereas 14 per cent of the US firms were.⁵

Barriers to growth appear to be one of the reasons behind this. Recent research suggests that post-entry growth rather than entry rates represent the main difference between the US and Europe business dynamics.⁶ Firms that entered the market in the late 1980s and 1990s grew three times faster in their first seven years in the US than comparable firms in the average western European country. These results are backed by surveys of entrepreneurial attitudes showing that European entrepreneurs are less likely to expect to have at least 20 employees after five years than their US counterparts.⁷

A better understanding of the dynamics of business growth would provide further insight on Europe's economic performance and its recent history of slow productivity growth. Productivity grows faster in competitive environments where firms continuously expand or shrink, as this speeds up the reallocation of resources (both labour and capital) to their most productive use.⁸ A dynamic distribution of firm growth is also intimately linked to innovation, it reflects an environment where firms experiment with new projects, scaling them up when successful while being able to backtrack and shrink when they are unsuccessful.⁹

But despite considerable progress in the last decade, data on business growth remain scarce.¹⁰ This makes it difficult to examine differences in growth dynamics across countries, as well as to ask what factors drive it, how it impacts on economic performance and what policymakers can do about it.

In response to this challenge, a collaboration was established between researchers and statistical agencies in 11 countries across three continents to collect new and comparable data on business growth. The resulting database describes the distribution of business growth for all established firms in the participating countries. It measures how firms expanded and shrank in different countries and industries between 2002 and 2005, after the dotcom bubble but before the height of the boom that preceded the recent financial crisis.¹¹ See Box 1 for a brief description of the process used to assemble this new database.

This report briefly summarises initial findings from this new database. The accompanying working paper provides a more thorough examination of the database and its characteristics, presenting the data underlying this report.¹² And in on-going work NESTA and partners are exploiting this new database to examine the drivers behind the dynamics of business growth in different countries.

A note on the scope of our analysis

The database contains information on business growth in Austria, Canada, Denmark, Finland, Italy, the Netherlands, New Zealand, Norway, Spain, the UK and the US. This provides a good mix of small and large economies as well as Southern and Northern European countries. Data have, so far, not been available for France, Germany or the new EU member states.¹³ While there are differences that should not be ignored, the regularity of the patterns identified across the European countries that have participated in this project suggests that the results may apply more widely in Western Europe.

When discussing the results, the terms 'Europe' and 'European countries' are used interchangeably to refer to the simple average across the participating European countries.¹⁴ This is then compared to the US, a country also facing challenges of its own but historically a benchmark in terms of productivity growth and business dynamism. Work is underway to expand the database to capture business growth in more countries.

Box 1: Developing a new database on business growth across countries

Measuring the distribution of business growth consistently across several countries presents a challenge. Official business registers provide the most comprehensive coverage of business activity in a country, since they are assembled from tax, social security or other administrative records for the universe of companies. But due to their nature they are strictly confidential and access is highly restricted. Accordingly, the project required the active participation of each national statistical office or, alternatively, local researchers with authorised access to the microdata.

Collaborations were established across eleven countries: Austria,¹⁵ Canada,¹⁶ Denmark, Finland, Italy, the Netherlands, New Zealand, Norway, Spain, the UK and the US. Each has provided harmonised micro aggregated data on business growth following standard definitions provided at the outset of this project (which built on the Eurostat-OECD Manual on Business Demography Statistics developed by the Entrepreneurship Indicators Programme). The resulting database draws on individual records for six million firms, which employed over 125 million people in 2002.

Briefly, average annual employment growth over a three-year period (2002-2005) was measured for each surviving private sector firm¹⁷ with at least one employee.¹⁸ Based on their growth rate, firms were placed in one of the 11 growth intervals.¹⁹ These data were used to compute the percentiles of the growth distribution and produce growth distribution curves for up to 51 sectors, ten firm size classes and five age groups.²⁰ The accompanying working paper²¹ provides further details of the database construction process, the underlying definitions and the limitations of this approach.²²

Part 2: Exploring the distribution of business growth across countries

This section uses this newly developed database to examine the dynamics of business growth across countries. This analysis reveals that differences in business growth dynamics between the US and Europe go beyond just high-growth firms, with fewer firms in Europe growing moderately or shrinking and more of them remaining stable. In many European countries smaller firms struggle to grow relative to their US peers, while this is not necessarily true for larger firms.

The distribution of business growth for private sector firms is summarised in Figure 1. Each column indicates the share of firms with ten or more employees with average annual employment growth rates over a three-year period falling within that growth interval (with the range covering 11 intervals from less than -20 per cent to more than +20 per cent employment growth per annum).

At first glance, the distribution of business growth for the average European country and the US looks broadly similar.²³ It is symmetric with extreme bursts of growth or decline occurring quite regularly. Significantly, existing firms are more likely to shrink than grow, and the median firm experiences slightly negative growth.

However, closer examination highlights significant differences between Europe and the US. Figure 1c reports the relative difference between the US and the European average in the share of firms that fall within each growth interval. This reveals that US firms are more likely to expand or contract, while European firms are more likely to remain stable. These differences are examined in more detail below.

European firms are less likely to grow fast

Firms at the 95th percentile²⁴ of the growth distribution grew 21 per cent faster in the US than in the average European country (86 per cent and 71 per cent respectively over a three-year period, a 15 percentage point gap – Figure 2a). This pattern holds across most European countries when considered individually. While the UK and Spain had higher growth rates at the 95th percentile than the US, the gap with other European countries was significant, with the Netherlands, Norway and Austria faring particularly poorly in terms of fast-growing companies.

Europe also has fewer moderately growing firms

The US-Europe gap in high-growth firms is relatively well documented, but focusing exclusively on the top of the growth distribution can give an incomplete picture of business growth dynamics. The analysis reveals that Europe also has fewer medium-growth firms. The share of firms growing between 10 per cent and 20 per cent per annum was 15 per cent higher in the US than in the average European country (9.9 per cent and 8.6 per cent respectively).

Consistently with that, the growth rate at the 75th percentile of the distribution was higher in the US than in any other European country (bar Spain). US firms in this percentile grew by 18 per cent over the period, 19 per cent faster or 3 percentage points more than the average for European countries (Figure 2b).

The cross-country rankings for the 95th and 75th percentile have some similarities, but there are noteworthy differences. The UK tops the country rankings when looking at the fastest-growing firms, but appears at the bottom when moderate-growing firms are considered instead (US firms' growth rate at the 75th percentile was 6 percentage points higher than for UK firms or 50 per cent greater).

European firms are more likely to stay the same size than their US counterparts

Europe has fewer medium and high-growth firms. Instead, a greater proportion of European firms experience very modest or zero growth. The share of firms that did not expand or contract²⁵ over the period in the US was almost a third lower than in the average European country (9.2 per cent vs. 13.6 per cent). This is the largest gap between Europe and the US in all the 11 growth intervals considered, both in absolute and relative terms.

Broadening the definition of stability to include firms that grow or shrink by less than 5 per cent per annum leads to a similar conclusion:²⁶ 45.6 per cent of European firms were stable on this metric compared to 37.4 per cent in the US (Figure 2c). This eight percentage point gap is explained by both a larger share of expanding and contracting firms in the US.

Europe is a diverse continent, but this pattern holds for seven of the eight European countries in the study, with their share of stable firms ranging from 43 per cent to 50 per cent, significantly higher than in the US (Spain is the exception, discussed in more detail below).

US firms also shrink faster than in Europe

There are also differences in the bottom half of the growth distribution. Fifty per cent of US firms with ten or more employees shrank, compared with just 46 per cent for the average European country. US firms at the 25th percentile of the distribution shrank by 24 per cent, 27 per cent or 5 percentage points faster than in Europe, where the average decline was 19 per cent (Figure 2d). While US firms shrank faster than in any European country, the differences within the continent were still substantial. At the 25th percentile the contraction rate ranged from 22 per cent in Norway to only 16 per cent in Austria.

Hence, the US has both faster-growing and faster-shrinking firms than the average European country. This is no coincidence, since the two are correlated. Each data point in Figure 3 represents a specific industry in a particular country, and shows the growth rate at the 90th and 10th percentile, normalised by the growth rate of the median firm.²⁷ A strong negative correlation emerges between the growth rate at the top and the bottom of the distribution. In other words, the faster successful companies grow, the faster unsuccessful companies in the same industry shrink.²⁸ This would be expected since, after all, firms frequently grow at the expense of other firms, by attracting their workers or taking over their markets.

Surviving firms make a different contribution to employment growth in Europe and the US

US and European surviving firms also differ in their aggregate contribution to employment growth. On aggregate, surviving firms (including micro firms)²⁹ created employment in the average European country but destroyed it in the US.³⁰ The higher share of large firms combined with their faster contraction resulted in US surviving firms reducing their employment by 2.8 per cent over the period (Figure 4a). By contrast, those established European firms that survived over the period increased their employment by 3.3 per cent on average (although there are quite significant differences across countries).³¹

But surviving firms are only one of the contributors to employment growth. Figure 4b displays private sector employment growth over the period, which also captures job creation and destruction through entry and exit of firms.³² It shows that overall employment growth in the US was both positive and higher than in the average European country. Given that the contribution of established business to net job creation was negative in the US, the question that arises is who filled the gap? The answer is entrepreneurs. These appear to play a much more significant role in job creation in the US than in Europe, although definitive conclusions would require further data.³³

Differences in growth dynamics cannot be explained by the smaller size of European firms, sectoral mix or business cycles

European firms are significantly smaller than their US counterparts, with the average surviving European firm employing 14 people compared to an average of 30 people in the US.³⁴ While the vast majority of firms in both continents have fewer than 50 employees (95 per cent or higher), the distribution of employment across different sizes of firms varies widely.³⁵ Firms with more than 250 employees accounted for over 60 per cent of employment in the US, but less than 40 per cent in Europe.³⁶ At the other extreme, firms with fewer than ten employees represented only 8 per cent of employment by surviving firms in the US, less than half their share in the average European country (18 per cent).³⁷

However, differences in growth dynamics are not the result of differences in the firm size or sectoral mix in different countries. When firms of similar size or in the same sector are compared, European firms still grow and shrink more slowly than those in the US. If anything, the US-Europe gap becomes somewhat larger when firms of the same size are compared. There are, however, differences in the magnitude of the gap between smaller and larger firms and also across different sectors,³⁸ with manufacturing having a significantly larger gap (see Box 2 for a discussion of the differences by size class).

Business cycles could potentially explain the lower dynamism that European firms display. Without time series information it is difficult to accurately examine this hypothesis. However, it does not appear that the cycle fully accounts for Europe's lower dynamism. Although most countries experienced an expansionary phase in the study period, the US economy was growing by 3.1 per cent per annum whereas the European countries considered here grew by only 2.2 per cent on average (although with significant variation within Europe). Thus even when the performance of the US economy was superior, US firms contracted more rapidly than European ones. Therefore, the US-Europe differences in growth dynamics are unlikely to be just the result of the business cycle. There is also a structural component to them.³⁹

The business cycle may however have had a notable impact in some of the countries included in the study, particularly New Zealand and Spain.⁴⁰ Figure 5 displays the share of firms that fall within each growth interval in each country relative to the US.⁴¹ It suggests that the full growth distribution for Spain and New Zealand shifted upwards, coinciding with the large economic boom that both countries experienced. Business cycles thus appear to be at least partially responsible for the high business growth that these two countries exhibited, and therefore they played a role in some of the country rankings.

Figure 5 also shows that the main patterns identified hold across most European countries. In summary, the top half of firms grow faster in the US than in Europe while the bottom half shrink faster. As a result, at the end of the period, the gap between successful and unsuccessful firms is larger in the US.

Box 2: Small vs. large: The distribution of business growth by firm size

The US-Europe differences in business growth dynamics vary across firms of different sizes. Figure 6 shows the average growth rate over the period for all surviving firms by their size at the beginning of the period. Surviving smaller firms grew faster than larger firms on average, both in Europe and the US.⁴² But the comparison between both continents highlights some crucial differences.

Micro, small and medium firms grew more slowly in the average European country than in the US (even if there is significant variation within Europe).⁴³ On the contrary, large European firms did relatively better, shrinking by significantly less than their US peers. For instance, medium firms grew by 3.4 per cent in the US on average, compared to 2.4 per cent in Europe. On the contrary, large firms shrank by 8.3 per cent in the US, but by only 1 per cent in Europe.⁴⁴ As a result, the gap between the average growth rate of medium firms and large firms was almost 12 percentage points in the US, compared to less than four percentage points in the average European country. Thus it appears it is more difficult for European SMEs to grow to challenge larger incumbents.

A look at the full distribution sheds more light on this. Figure 7 displays all the percentiles of the growth distribution by firm size for the US and the average European country.⁴⁵, ⁴⁶ Figure 7c reports the difference in percentage points between both continents. A positive value indicates that European firms had a higher growth rate (or shrank by less) than US firms over the period. Regardless of size, firms in the top third of the distribution grew faster in the US than in the average European country, while US firms in the bottom third shrank faster as well.

But the magnitude of the gap varies by firm size. Throughout the distribution, the curve for large firms is around 3-5 percentage points above that for medium firms (the curve for small firms is less steady). Therefore, it appears that, compared to the other firms in their own country, large firms do relatively better in Europe, while medium firms do relatively better in the US. In summary, medium firms grow significantly faster in the US than Europe above the median, but they also shrink significantly faster below the median. On the contrary, US large firms grow only slightly more than their counterparts in Europe, but they contract much more rapidly.

Part 3: Business growth dynamics matter for productivity growth

This section seeks to explore whether the higher inertia of Europe's business population matters. Research highlights that business growth dynamics have an important impact on productivity growth, and the analysis of the database supports this. A very static firm growth distribution betrays the fact that firms are not experimenting and pursuing new opportunities. And it reveals also that the reallocation of resources towards more productive firms is slow. This implies that the persistence of Europe's larger share of static firms could have potentially damaging consequences for its long-term economic performance.

Productivity growth requires both experimentation and the reallocation of resources towards successful innovators

Countries can increase productivity by accumulating capital and imitating what others have invented elsewhere. But once these sources of growth have been exhausted, innovation is the main engine left to drive productivity growth.⁴⁷ It is also the most appropriate response to increasing competition from emerging markets, which forces firms and countries to move up the value chain.

But innovation requires experimentation in the real world, going beyond the R&D lab. It is about putting new ideas into practice. Trying a new business model, exploiting a new technology or launching a new product often requires expanding a firm's current capabilities, which may mean for instance setting up a new plant or hiring a new marketing team. But since experimentation is uncertain and market selection harsh, a 'wait and see' approach often replaces risk-taking if failure is too costly.⁴⁸ The larger proportion of static firms in Europe suggests that more European firms are following this risk-averse approach. Too many appear either unwilling or unable to experiment and exploit new growth opportunities. As a result, they fail to innovate effectively.

The benefits of innovation are only maximised when firms build on it. This means expanding and replacing less successful firms, driving productivity growth in the process. The reallocation of resources towards more productive plants directly accounts for about half of total factor productivity growth in US manufacturing.⁴⁹ But European firms grow and shrink more slowly than US firms. And, as a result, the process of job reallocation across firms is slower, hampering productivity growth in Europe.

A more dynamic business growth distribution also reflects a more competitive market, which in turn impacts on incentives to innovate.⁵⁰ An environment with higher levels of entry and growth results in increased competitive pressures, forcing firms either to improve their performance or to shrink and exit.⁵¹ The higher proportion of static European firms suggests lower competitive pressures, potentially damaging long-term productivity growth.⁵² This is consistent with research showing that the limited turnover of big businesses, which is quite typical in Europe, damages economic growth.⁵³

A more dynamic growth distribution is associated with higher productivity growth

The academic literature thus suggests that the reallocation of resources across firms is one of the main drivers of productivity growth, and further analysis using this new database supports this finding.⁵⁴ A basic regression is used to examine the relationship between a dynamic growth distribution and productivity growth. Specifically, total factor productivity (TFP) growth at the industry-country level in 2002-2005 is regressed on the share of firms that remain completely static,⁵⁵ which is used as a proxy for the dynamism of the growth distribution. Controls for initial productivity and average employment growth as well as for industry and country characteristics are also included.⁵⁶

The estimation finds that the greater the share of firms that do not expand or contract, the lower the productivity growth observed. Specifically, a 1 percentage point (pp) increase in the share of firms remaining completely static is associated with 0.2pp lower annual TFP growth.⁵⁷ When splitting non-static firms between those that expand and those that contract, the estimation suggests that both growing and shrinking firms are associated with faster productivity growth.

The magnitude of the coefficients is non negligible. In the decade prior to the financial crisis, Europe's annual TFP growth lagged the US by 1.1pp on average.⁵⁸ If taken at face value and under very generous assumptions, the coefficients would suggest that Europe's more static growth distribution could potentially account for over two-thirds of its recent productivity growth underperformance.

But correlation does not imply causation. In other words, these estimates do not imply that a reduction in the share of firms that remain static causes TFP growth. Rather they highlight a wider correlation between business dynamism and productivity growth, which is consistent with findings presented elsewhere.

There can be both productive and unproductive churn

While a dynamic business growth distribution is generally a positive sign, it is not a sufficient condition for productivity growth if the reallocation of resources is not directed towards the most productive firms. This may occur when less productive firms have better access to finance, better government or supplier contacts, managers who care more about empire-building than improving performance, or when a speculative bubble distorts the allocation process.

The current evidence base suggests that not only is churn low throughout Europe, but also that it is not always productivity enhancing. Recent research finds that there are large differences across countries in the correlation between firm growth and initial productivity levels. For instance, in the UK the most productive 25 per cent of firms grow three times faster than the median firm, while the 25 per cent least productive firms shrink very fast too.⁵⁹ In contrast, in other European countries such as Italy, France or Spain, firms in the bottom quartile of the productivity distribution (i.e. the least productive firms) continue to exhibit positive growth, or shrink only marginally.⁶⁰

The consequence is a more inefficient allocation of resources in Europe.⁶¹ While large firms are generally more productive than small firms, the slower expansion of the most productive firms and the limited contraction of unproductive incumbents in many European countries results in a much weaker correlation between size and productivity than in the US.⁶² In other words, too often in Europe the more productive companies are not the ones with the largest market share. Consequently, the potential to increase productivity by simply reallocating resources between existing firms is significantly larger in European countries.

Part 4: Driving business growth – causes and policy responses

The debate on high-growth firms often considers them in isolation. The argument frequently highlights Europe's inability to generate an equivalent to Google or Microsoft, those few companies that start small and quickly grow to dominate their respective markets. And so it focuses on targeted policy responses. But the analysis presented in this report highlights that the malaise is much more widespread, with a significant impact on productivity growth. This section briefly discusses what policymakers can do about it, focusing on three key areas: reforming product and labour market regulation, reducing market fragmentation across Europe, and improving access to finance.

In recent times, European policymakers have focused on encouraging entrepreneurship, and progress has been made on lowering barriers to entry.⁶³ Less attention has been paid however to addressing barriers to growth and contraction. The analysis in this report highlights that tackling these barriers will be important if Europe is to close the productivity gap.

To do so, action must go beyond a narrow focus on high-growth firms. Policies targeted more specifically at them, such as stimulation of private venture capital, are necessary, but they are not on their own sufficient to address the wider failure to thrive and failure to shrink that hampers Europe's productivity performance.

Policymakers should encourage an environment that rewards experimentation, penalises inertia and reduces the costs of failure: that is, an economy in which innovative firms experiment with new ideas, exploit new growth opportunities and, if successful, supplant less productive firms, which shrink and exit. This is creative destruction at work.⁶⁴ Of course, it is not without downsides. A larger share of shrinking firms, even if offset by a group of faster-growing companies, can generate significant adjustment costs,⁶⁵ so the appropriate mechanisms also need to be in place to facilitate the transition and protect those that lose in the process.

The list of potential responses to improve business dynamism in Europe is not short, but in light of current debates it is worth highlighting some of them:

Labour market regulation

If badly designed, can become a major barrier to growth. Inflexible employment protection legislation hampers both firms' incentives to experiment with uncertain growth opportunities and the reallocation of labour to more productive uses.⁶⁶ A better alternative is the much cited but yet not very widely adopted 'flexi-security' model, which protects individuals instead of jobs, and so allows for the higher flexibility intrinsic to a more dynamic business structure while providing the stronger safety net for individuals that this higher flexibility also requires.⁶⁷

Product market regulation

Continues to be higher in Europe than in the US, hampering competition and keeping the cost of inaction low.⁶⁸ The result is stagnant firms. Those that should shrink manage to stay afloat, and many with the potential to grow prefer not to take the risk if their shareholders, often undiversified and risk-averse in family firms, already enjoy a satisfactory lifestyle. Increasing competition through further product market liberalisation would encourage greater ambition and result in a more dynamic growth distribution.

The fragmented market

That European firms face constrains their ability to grow, reducing as well competitive pressures across Europe. While the single market has made it easier to sell goods across borders in the EU, the liberalisation of the market for services, where much of the US-EU productivity gap originates,⁶⁹ is too slow. And even after ongoing reforms have been implemented, differences in regulation across member states will still make it difficult for firms, particularly SMEs, to operate across different jurisdictions.⁷⁰ The approval of the proposed European Private Company (SPE)⁷¹ and the expansion of this approach to other areas of regulation would thus be useful steps to help reduce the fragmentation of the European market.

Access to finance

Continues to be a major barrier to business growth, and the tightening of financial regulation risks restricting it further in the short term.⁷² Thus it is important to have a better understanding of the value added of different types of financial activities to avoid damaging the sources of finance that support the development and growth of European firms. Similarly, regulatory attempts to rein in some of the excesses linked to financial innovation should be mindful so as not to impede the emergence of new innovative models, as venture capital once was, which could potentially help to alleviate the perennial financial constraints that growing businesses face, and provide the financial services that facilitate their expansion.

Several other factors, internal or external to the firm, could also help explain Europe's underperformance, and should be taken into account when developing the right policy mix. For instance, European firms appear to be much less effective than their US peers at taking advantage of new technologies, such as IT.⁷³ They are also more likely to be poorly managed, particularly those with second-generation family management or in low competition markets.⁷⁴ Europe's less entrepreneurial culture, unforgiving bankruptcy regimes, underperforming research base and weak university-industry links, among others, have also been mentioned as potential barriers to growth to be addressed.⁷⁵

There are however differences within Europe. While several barriers are common across the continent, policymakers in various countries have been successful at overcoming some of them.⁷⁶ European countries have thus much to gain from learning from their neighbours that are further ahead, as well as from experiences elsewhere.

Summary

Measures to avert a full blown sovereign debt crisis, reduce deficits and consolidate the nascent recovery are rightly priorities for policymakers now. But the weaknesses of the European economy preceded the financial crisis. So a return to 'business as usual' will not be enough if Europe is to maintain living standards in an ever more competitive global economic environment.

This report shows that Europe's inability to generate an equivalent to a Google or Microsoft is part of a wider European picture which includes also more static firms and fewer shrinking firms. Measures specifically targeted at high-growth firms, such as improving the climate for venture capital, are necessary. But they will be insufficient without wider reforms, including deepening the single market, improving product and labour market regulation and reducing a wide array of barriers to growth and exit.

Policymakers need to quickly fix the underlying structural issues that constrain businesses across Europe and hinder productivity growth, helping in the process to rebuild confidence in the European economy. After all, the sooner we start addressing Europe's long-term growth challenge, the easier it will be to navigate today's uncertainties. In the months ahead, NESTA and partners will seek to use the newly developed database to provide the evidence base for policymakers seeking to give Europe a competitive edge again.

Appendix figures

References

Acemoglu, D., Aghion, P. and Zilibotti, F. (2006) Distance to Frontier, Selection and Economic Growth. 'Journal of the European Economic Association.' 4(1), pp.37-74.

Aghion, P. (2006) 'A primer on innovation and growth. Bruegel Policy Brief 2006/06. Brussels: Bruegel.

Aghion, P., Bloom, N., Blundell, R., Griffith, R. and Howitt, P. (2005) Competition and Innovation: An Inverted-U Relationship. 'Quarterly Journal of Economics.' 2005 120:2, pp.701-728.

Aghion, P., Dewatripont, M., Hoxby, C., Mas-Colell, A. and Sapir, A. (2007) 'Why reform Europe's universities?' Bruegel Policy Brief 2007/04. Brussels: Bruegel.

Ahn, S. (2001) 'Firm Dynamics and Productivity Growth: A Review of Micro Evidence from OECD Countries.' OECD Economics Working Paper No. 297. Paris: OECD.

Armour, J. and Cumming, D.J., (2008) 'Bankruptcy Law and Entrepreneurship.' American Law and Economics Review, 10, (2), pp.303-350.

Arnold, J., Nicoletti, G. and Scarpetta, S. (2008) 'Regulation, Allocative Efficiency and Productivity in OECD Countries: Industry and Firm-level Evidence.' OECD Economics Department Working Paper No. 616. Paris: OECD.

Baily, M., Hulten, C., Campbell, D., Bresnahan T. and Caves, R. (1992) Productivity Dynamics in Manufacturing Plants. 'Brookings Papers on Economic Activity: Microeconomics.' Vol. 4, pp.187-267. Washington, DC: Brookings Institution.

Baldwin, J.R. and Gu, W. (2006) 'Competition, Firm Turnover and Productivity Growth.' Economic Analysis Research Paper Series 042. Ottawa: Statistics Canada.

Bartelsman, E., de Wind, J. and Gautier, P. (2010) 'Employment Protection, Technology Choice, and Worker Allocation.' CEPR Discussion Papers 7806. London: CEPR.

Bartelsman, E., Haltiwanger, J. and Scarpetta, S. (2004) 'Microeconomic Evidence on Creative Destruction in Industrial and Developing Countries.' The World Bank Policy Research Working Paper No. 3464. Washington, DC: The World Bank.

Bartelsman, E., Haltiwanger, J. and Scarpetta, S. (2009) 'Cross-Country Differences in Productivity: The Role of Allocation and Selection.' NBER Working Paper No. 15490. Washington, DC: World Bank.

Bartelsman, E., Perotti, E. and Scarpetta, S. (2008) 'Barriers to exit, experimentation and comparative advantage.' June 2008. Bonn: IZA and Amsterdam: Tinbergen Institute.

Bernecker, A. (2010) 'A European Private Company.' Deutsche Bank Research Briefing. Frankfurt am Main: Deutsche Bank Research.

Bloom, N., Sadun, R. and Van Reenen, J. (2009) 'Americans Do I.T. Better: US Multinationals and the Productivity Miracle.' NBER Working Paper 13085. Cambridge, MA: NBER.

Bloom, N., Sadun, R. and Van Reenen, J. (2009) 'Do Private Equity Owned Firms Have Better Management Practices?' CEP Occasional Paper 24. London: CEP.

Bloom, N. and Van Reenen, J. (2007) Measuring and Explaining Management Practices across Firms and Countries. 'Quarterly Journal of Economics.' 122(4), pp.1341-1408.

Bosma, N. and Levie, J. (2009) 'Global Entrepreneurship Monitor. 2009 Global Report.' London: Global Entrepreneurship Research Association.

Bozkaya, A. and Kerr, W. (2009) 'Labor regulations and European private equity.' NBER Working Paper No. 15627. Cambridge, MA: NBER.

Bravo Biosca, A. (2010) 'Firm growth dynamics across countries: Evidence from a new database.' Mimeo, November 2010. London: NESTA.

Caballero, R. and Hammour, M. (2000) 'Creative Destruction and Development: Institutions, Crises, and Restructuring.' NBER Working Paper no. 7849. Cambridge, MA: NBER.

Disney, R., Haskel, J. and Heden, Y. (2003) Restructuring and productivity growth in UK manufacturing. 'Economic Journal.' Vol. 113(489), pp.666-694.

European Commission (2008) 'Proposal for a council regulation on the Statute for a European private company.' COM(2008) 396/3. Brussels: European Commission.

European Commission (2007) 'Improving knowledge transfer between research institutions and industry across Europe: embracing open innovation'. COM(2007) 182. Brussels: European Commission.

Eurostat-OECD (2007) 'Eurostat-OECD Manual on Business Demography Statistics.' Luxembourg: Office for Official Publications of the European Communities.

Fogel, K., Morck, R. and Yeung, B. (2006) 'Big Business Stability and Economic Growth: Is What's Good for General Motors Good for America?' NBER Working Paper No. 12394. Cambridge, MA: NBER.

Foster, L., Haltiwanger, J.C. and Krizan, C.J. (2006) Market Selection, Reallocation and Restructuring in the U.S. Retail Trade Sector in the 1990s. 'The Review of Economics and Statistics.' Vol. 88, Issue 4, pp.748-758.

FSB-BCBS (2010) 'Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements. Basel: Bank for International Settlements, Financial Stability Board and the Basel Committee on Banking Supervision.

Gilbert, R. (2006) Looking for Mr. Schumpeter: Where Are We in the Competition-Innovation Debate? 'Innovation Policy and the Economy.' Vol. 6, (2006), pp.159-215.

Hall, R. (1995) 'Lost Jobs.' Brookings Paper on Economic Activity 1 (1995), p.221-256. Washington, DC: Brookings Institution.

Haltiwanger, J., Jarmin, R. and Miranda, J. (2010) 'Who Creates Jobs? Small vs. Large vs. Young.' NBER Working Paper No. 16300. Cambridge, MA: NBER.

Haltiwanger, J. (1997) Measuring and analyzing aggregate fluctuations: the importance of building from microeconomic evidence. 'Review. May issue, pages 55-78. St Louis: Federal Reserve Bank of St Louis.

Inklaar, R. and Timmer, M.P. (2008) 'GGDC Productivity Level Database: International Comparisons of Output, Inputs and Productivity at the Industry Level.' Groningen Growth and Development Centre Research Memorandum GD-104. Groningen: University of Groningen.

McKinsey & Company (2010) 'Beyond austerity: A path to economic growth and renewal in Europe.' McKinsey Global Institute: McKinsey & Company.

Mortensen, D. and Pissarides, C. (1994) Job Creation and Job Destruction in the Theory of Unemployment. 'The Review of Economic Studies.' 61, No. 3 (July 1994), pp.397-415.

Nicoletti, G. and Scarpetta, S. (2003) Regulation, productivity and growth: OECD evidence. 'Economic Policy. Volume 18, Issue 36, pp.9-72.

O'Mahony, M. and Timmer, M.P. (2009) Output, Input and Productivity Measures at the Industry Level: the EU KLEMS Database. 'Economic Journal. 119(538), pp.F374-F403.

OECD (2009) 'Measuring entrepreneurship: a digest of indicators, 2009 edition.' Paris: OECD.

Saint-Paul, G. (2002) Employment protection, international specialization, and innovation. 'European Economic Review.' 46(2), pp.375-395.

Schumpeter, J. (1942) 'Capitalism, Socialism and Democracy.' New York: Harper & Brothers.

The World Bank (2010) 'Investing Across Borders. Washington, DC: The World Bank.

Van Ark, B., O'Mahony, M. and Timmer, M.P. (2008) The productivity gap between Europe and the United States: Trends and Causes. 'Journal of Economic Perspectives.' Volume 22, Number 1, Winter 2008, pp.25-44.

Véron, N. (2008) 'The Demographics of Global Corporate Champions.' Bruegel Working Paper No. 2008/03, July 2008. Brussels: Bruegel.

Veugelers, R. and Cincera, M. (2010) Europe's missing yollies. 'Policy Brief.' 2010/06. Brussels: Bruegel.

Wölfl, A., Wanner, I., Kozluk, T. and Nicoletti, G. (2009) 'Ten Years of Product Market Reform in OECD Countries - Insights from a Revised PMR Indicator.' OECD Economics Department Working Paper No. 695. Paris: OECD.

NESTA 1 Plough Place London EC4A 1DE [email protected] www.nesta.org.uk Published: November 2010 GD/62 ISBN 978-1-84875-110-1

Footnotes