Where did the money go? Why did Southern and peripheral European countries fair so poorly during a period of large capital inflows from the rest of Europe?

March 19, 2019

TFP and value-added gains from an efficient allocation of resources between 1996 and 2011.

Weak or even negative productivity growth is a major reason for the poor economic performance of most Southern and peripheral European countries, including Portugal, in the 2000s.  This weak, or even negative, productivity growth happened at the same time that the Eurozone became more financially integrated, which is something that was expected to improve resource allocation efficiency, facilitate risk sharing, and boost economic growth.  In this paper, the authors investigate if, over time, there were changes in the degree of allocative efficiency of resources, which could have led to a significant decline in total factor productivity (TFP) and GDP growth and, if these changes did occur, what may explain them.

The paper shows that within-industry misallocation almost doubled between 1996 and 2011 in Portugal—reallocating resources away from the least towards the most efficient firms, would have increased gross output by 17% in 1996 and 28% in 2011 (see Figure 1).  In terms of aggregate value added, output would have been 48% and 79% above actual GDP levels in 1996 and 2011, respectively. To put these figures in perspective, the deterioration of allocative efficiency between 1996 and 2011 may have shaved around 0.6 percentage points (pp) off annual gross-output growth and 1.3 pp off annual GDP growth during the 1996–2011 period.  These are large figures because Portuguese GDP grew, on average, 1.5% per year over this period.  The results are driven by the service sector, whose levels of misallocation are significantly higher and increased much faster than those of the manufacturing sector. Indeed, five industries—construction, ground transportation, transportation services, general support services, and wholesale of food and drinks— in the service sector account for 72% of the total increase in resource misallocation between 1996 and 2011.  These are important findings because they strongly suggest that misallocation of resources was a significant contributor to the stagnation of TFP in some European countries.

The paper also shows that capital distortions are more important than labor and output distortions in explaining potential value-added efficiency gains, especially in the service sector and that, relative to larger firms, smaller firms benefitted from capital and labor subsidies.  The latter result suggests that a large proportion of firms may have survived because they had access to cheaper credit and labor.  Access to cheaper capital and labor by smaller firms can be due to firm size-contingent laws passed by the Portuguese Government or stem from the fact that such firms managed to evade taxes or to circumvent some general labor and/or capital regulations.  The increasing importance of capital and labor distortions suggest that the large amounts of European structural funds made available to Portuguese firms through size-dependent regulations may have contributed to the survival of many small and relatively inefficient firms, and in this way also contributed to the increasing levels of misallocation.

Click here to go to the paper by Daniel A. Dias, Carlos Robalo Marques, and Christine Richmond.