Exhortations to increase efficiency will solve neither the overvaluation of sterling nor the euro-zone's structural problems

Since I wrote a fortnight ago that the overvalued pound was likely to produce a political explosion if it did not fall of its own accord, sterling has risen further. The main response of Bank of England officials has been to express sophisticated agnosticism about the forces that influence the exchange rate. They have also reiterated the familiar slogan that the Bank's job is to target inflation, and not sterling. By contrast, Gordon Brown, the UK finance minister, continues with his message that higher productivity is the best hope for hard-pressed exporters.

Accounting for the US-Europe income gap
	Output per hour worked*	Output per employee*	GDP per capita*
US	100	100	100
Euro-zone	94	82	66
UK	82	71	68
Source: OECD		*Figures for 1998, US=100

Meanwhile, the new Review of the National Institute for Economic and Social Research has pointed out that market interest rate differentials imply that "a very slender depreciation of sterling against the euro" is expected even by 2004. It also suggests that British producers put up with the exchange rate 18 months ago because they believed it would be temporary. But now more of them see it as permanent, and "regard production in the UK as uneconomic". This belief is particularly affecting overseas investors who came to Britain in the mid-1990s when sterling was weak.

My suggestion was that the least risky strategy was for Mr Brown to make an opening bid for the range of conversion rates at which he would like sterling to enter the euro - on present evidence and if the other official conditions are met.

But I now want to leave the exchange rate as such and to turn some critical attention to Mr Brown's stress on productivity. I am sure he realises that this cannot be a quick solution to the problems of Britain's trading sector, but it nevertheless seems to be his most important economic policy aim. Indeed, the importance of productivity is a Treasury message to which British citizens have been subjected since the late 1940s, when Sir Stafford Cripps was finance minister. That message is beginning to be transmitted in some of the euro-zone countries whose leaders cannot face the prospect of fundamental labour market reform.

Of course productivity is important, but it is a much more problematic concept than is generally realised, and is not a cure for all economic ills. Fortunately, some light is shed on the limitations of the productivity message in Emu One Year On, an excellent report from the Organisation for Economic Co-operation and Development.

The OECD is concerned with the problem of why the euro-zone has performed so badly by comparison with the US. As a by-product, it sheds light on the supposed UK productivity problem.

The gist of the argument is shown in the accompanying table. One of the many meanings of productivity is output per hour worked. Here a surprising fact emerges. Output per hour in the euro-zone, which was just over 70 per cent of the US level in 1973, had risen by 1998 - the year before the euro was launched - to 94 per cent of that level. In other words, the productivity gap had almost been closed.

The snag is that gross domestic product per head - the main determinant of living standards - was still one-third below that of the US. Shorter working hours reduced the comparative output per employee, and an even bigger reduction was due to a much smaller proportion of the euro-zone population being in employment.

The UK picture was different. Output per hour in 1998 was only 82 per cent of the US level. As working hours were shorter in the UK, relative output per employee was lower still. Yet GDP per capita was roughly the same in the UK as in the euro-zone, and in both cases about a third below the US level.

How could this be so? It was because higher output per person in the euro-zone than in the UK was more than offset by a smaller employment ratio. A lower proportion of the euro area population was in the labour force, and of those a smaller proportion had jobs.

As the OECD states: "The problem of labour under-utilisation in the euro area is concentrated in much lower participation and employment rates of young and old workers of both genders and, to a lesser extent, of prime-age female workers." There would be no problem if the contrast were simply due to continental European workers wanting to enter the labour force later and retire earlier, and being willing to pay the cost for doing so. But if the lower employment ratio in the euro-zone reflects labour market institutions and other rigidities that price people out of work, it is the GDP per capita numbers that give a fairer picture of performance.

On that basis the performance of euro-zone countries is not superior to British performance, whatever euro enthusiasts say. The main effect of their more centralised system of wage bargaining and greater labour market regulation has been a higher rate of unemployment and non-participation in the labour force.

The misleading nature of labour productivity comparisons is not solved, as some economists suppose, by looking at a measure known as "total factor productivity". This is simply a weighted average of output per hour and output per unit of capital. It has the advantage of taking account of the efficiency with which capital equipment is used. But it does not reveal the extent to which capital has been substituted for labour due to workers becoming too expensive to employ.

The OECD suggests that the contrasting performance of productivity and labour utilisation in the euro-zone may be because gains in productivity have been "partly achieved at the expense of employment... Skill-based technical changes may have led to higher unemployment in Europe because, in contrast to what has happened in countries with high employment rates, the adjustment could not be absorbed by the widening of the wage dispersion between the skilled and unskilled labour force.

"Part of the overall productivity gains would then stem from the difficulty for the lower-skilled unemployed to price themselves into a job, a problem often accentuated by generous benefit schemes that lower the incentives to re-enter the labour market."

Improvements in output per hour will only help to price euro-zone workers into jobs if the productivity gain is not all passed on in higher pay. Some incentive must be retained for employers to add to their local labour force. An improvement in recorded output per person can simply be the result of shutting down less profitable plants and switching new investment to emerging countries.

The key to reducing structural unemployment is not just lower labour costs, but labour costs nearer to market-clearing levels. Meanwhile, the OECD warns that "a greater European-Union wide harmonisation of social policies" - on which Social Charter enthusiasts are so keen - may worsen the employment chances of less skilled workers.