ructural reforms and employment-friendly wage developments.
Graph 2, as a starting point for the analysis, decomposes labour productivity growth into its two components, with the US and the Rest of World included for comparison purposes. The productivity growth slowdown is evident, with the EU's long established superiority in terms of labour productivity growth having disappeared over recent years.
Graph 2: Decomposition of Labour Productivity Trends
The benign interpretation of the observed productivity growth trends sees the recent deterioration in performance mainly as the mirror image of structural labour market improvements. Under this view the EU may now simply be in a transition phase whereby wage moderation and positive labour supply shocks may have initially created a negative trade-off between employment and productivity growth, basically via a temporary decline in capital-labour substitution. However, the dynamic adjustment path towards a new equilibrium with higher employment and lower structural unemployment will also involve capital accumulation that should eliminate the trade-off over the medium-term. The more pessimistic view, on the other hand, is that the labour productivity growth slowdown reflects a genuine negative shock, either in the form of a decline in total factor productivity growth or additional pressures on capital productivity; clearly, in such a scenario, prospects for a recovery of labour productivity growth are much bleaker.
Obviously, both interpretations are likely to contain an element of truth, posing the analytical challenge to derive inference on the relative magnitude of the employment and productivity shocks and their respective consequences for overall productivity and employment developments. The picture is complicated by a third possible factor, namely aggregate demand. Both fiscal consolidation and precautionary household savings could have contributed to a decline in growth and, in particular, of productivity growth.
We have employed both a structural VAR analysis and a simulation using the Commission's QUEST model to study these three shocks, shocks to employment, shocks to productivity and shocks to aggregate demand and to measure their relative importance for productivity and employment. What is of specific interest in the context of this paper is the dynamic response of productivity to structural employment shocks. In technical terms, we use a structural VAR (SVAR) methodology, based on Stock and Watson (1988) and Blanchard and Quah (1990), for the identification of structural shocks. The intuition for shock identification in Blanchard and Quah is based on the idea that demand shocks only have temporary effects while supply shocks have permanent effects. Stock and Watson extend this approach and allow for separate supply contributions from labour and productivity (TFP). In orde...
