By Michael Roberts
About a year ago, the European Union’s Commission asked Mario Draghi to write a landmark report on the future of Europe’s economy. Draghi is a former Goldman Sachs banker, former head of the Italian central bank and then President of the European Central Bank, before becoming briefly the prime minister of Italy. So, in the eyes of the Commission, he was clearly suited to look for ways of saving European capital from falling behind the rest of the world.
This week Draghi’s report was published. This is at a time when the major European economies are either in recession (Germany, Sweden, Austria) or stagnating (France, Italy). Hardly any EU economy is growing more than 1% a year and the EU/EZ area average is just +0.2%.
The report, called The future of European Competitiveness, is 600 pages long. It paints a miserable but accurate picture of the EU economies’ relative decline in output and productivity growth, living standards and technical progress compared to the US and Asia.
Rapid recovery after World War II
Europe came out of a terrible war in 1945 that decimated its people and the economy. But over the next 50 years of the 20th century it made a rapid recovery economically (at least in the core countries of Europe), eventually rivalling output and living standards in North America and Japan. It established new institutions aimed at integrating the national economies of the region and avoiding any more wars within.
The report says, “the European model combines an open economy, a high degree of market competition and a strong legal framework”. It has built a ‘Single Market’ of 440 million consumers and 23 million companies, accounting for around 17% of global GDP, while achieving rates of income inequality that are around 10 percentage points below those seen in the US and China.
At the same time, the EU has delivered leading outcomes in terms of governance, health, education and environmental protection. Of the world’s ten top-scoring countries for the application of the ‘rule of law’, eight are EU member states. Europe leads the US and China in terms of life expectancy at birth and low infant mortality. Europe’s education and training systems deliver high educational attainment, with a third of adults having completed higher education.
EU has pushed sustainability and environment standards
The EU is also the world leader in sustainability and environmental standards, backed by the most ambitious global targets for decarbonisation and can benefit from the largest exclusive economic zone in the world, covering 17 million square kilometres, four times the EU’s land surface.
But now it is in serious crisis – indeed Draghi calls the situation “an existential challenge.” And in the report, Draghi goes steadily through the sorry story of Europe’s relative economic performance in the 21st century – indeed since the euro single currency was launched.
Relative economic decline in the last two decades
EU economic growth has been persistently slower than in the US over the past two decades, while China has been rapidly catching up. The EU-US gap in GDP at 2015 has gradually widened from slightly more than 15% in 2002 to 30% in 2023. The gap has widened less on a per capita basis as the US has seen faster population growth, but it is still significant at 34% today. The main driver of these diverging developments has been productivity. Around 70% of the gap in per capita GDP with US is explained by lower productivity in the EU.
Many EU economies have prospered and depend on expanding world trade. But the era of rapid world trade growth has passed: the IMF projects world trade to grow at just 3.2% a year over the medium term, a pace well below its annual average from 2000-19 of 4.9%. Indeed, the EU’s share in world trade is declining, with a notable fall since the onset of the pandemic.
High cost of energy in the EU
In the past, Europe was able to satisfy its demand for imported energy by procuring ample pipeline gas from Russia, which accounted for around 45% of the EU’s natural gas imports in 2021. But following the Ukraine conflict, this cheap energy has now disappeared at huge cost to Europe. The EU has lost more than a year of GDP growth, while having to re-direct massive fiscal resources to energy subsidies and building new infrastructure for importing liquefied natural gas. While energy prices have fallen considerably from their peaks, EU companies still face electricity prices that are 2-3 times those in the US and natural gas prices are 4-5 times higher.
Most important to Draghi is that Europe’s position in the advanced technologies that can drive future growth is declining. Only four of the world’s top 50 tech companies are European and the EU’s global position in tech is deteriorating: from 2013 to 2023, its share of global tech revenues dropped from 22% to 18%, while the US share rose from 30% to 38%.
The impact of an ageing population
The falling behind in productivity growth is most damaging to European capital’s future. The EU is entering the first period in its history in which growth will not be supported by rising population. By 2040, the workforce is projected to shrink by close to 2 million workers each year. It’s not covered in the report but a recent new study found that Europe’s ageing population “will cause massive headwinds for economic growth.” While demographic change has previously contributed positively to per capita economic growth, in the coming decades, it will reduce the growth rate of the Europe’s G4 economies by 0.3 to 1 percentage point per year.
Draghi concludes: “We will have to lean more on productivity to drive growth. But if the EU were to maintain its average productivity growth rate since 2015, it would only be enough to keep GDP constant until 2050 – at a time when the EU is facing a series of new investment needs that will have to be financed through higher growth.”
The problem is that low productivity growth is caused by low investment in productive sectors, particularly in the new technologies. The gap between productive investment to GDP in the US and Europe is some 1.5% points of GDP every year.
The report only refers in a note to a study by the European Investment Bank (EIB) on where this gap in productive investment originates. That study shows that the overall investment rate to GDP in the EU is actually higher on average than in the US. Part of the reason is that in the Long Depression years of 2010-19, US GDP rose faster than in the EU. So even though US investment rose faster than in the EU, the investment ratio to US GDP remained lower than in Europe.
Gap in ‘productive investment’
Moreover, once price deflators for real investment are properly compared for the two regions and real estate and construction investment is excluded (50% of investment in the EU compared to 40% in the US), the gap in ‘productive investment’ rates is reversed. On average over the period 2012-2020, the average gap in real terms was 2.6 percentage points (pp) of GDP. Fifteen countries had an investment shortfall vis-à-vis the US that was larger than the EU average, including some of the bigger economies, such as the Netherlands (2.7 pp), Germany (2.8 pp), Italy (4.0 pp), France (2.5pp) and Spain (4.3 pp) – in other words, the core of Europe.
The EIB found that the EU’s investment shortfall was largely in ‘intangible assets’ ie patents, intellectual property and software etc. In these areas, the US was well ahead. EU companies specialise in “mature technologies where the potential for breakthroughs is limited, they spend less on research and innovation (R&I) – EUR 270 billion less than their US counterparts in 2021. The top 3 investors in R&I in Europe have been dominated by automotive companies for the past twenty years. It was the same in the US in the early 2000s, with autos and pharma leading, but now the top 3 are all in tech.”
Draghi highlights US dominance in formation of large scale multinationals
What are Draghi’s explanations for the low levels of productive investment in Europe, particularly in technology? Being a good banker, Draghi lays the blame on the ‘lack of finance’ and on a failure to merge corporations into large scale multinationals that can compete with the US. “Europe is stuck in a static industrial structure with few new companies rising up to disrupt existing industries or develop new growth engines. In fact, there is no EU company with a market capitalisation over EUR 100 billion that has been set up from scratch in the last fifty years, while all six US companies with a valuation above EUR 1 trillion have been created in this period.”
Draghi says that a key reason for less efficient ‘financial intermediation’ in Europe is that capital markets remain fragmented and flows of savings into capital markets are lower. There needs to be an EU-wide capital market and EU-based venture capital that does not rely on the US. You see: “many European entrepreneurs prefer to seek financing from US venture capitalists and scale up in the US market. Between 2008 and 2021, close to 30% of the “unicorns” founded in Europe – startups that went on the be valued over USD 1 billion – relocated their headquarters abroad, with the vast majority moving to the US.”
There is just too much bureaucratic regulation and inefficient credit markets to “unlock private capital.” According to Draghi, “EU households provide ample savings to finance higher investment, but at present these savings are not being channelled efficiently into productive investments. In 2022, EU household savings were EUR 1,390 billion compared with EUR 840 billion in the US.”
Lower rate of profitability in Europe
But is it inefficient EU capital markets that is the cause of lower productive investment in Europe? The report hints at the real cause when it says private financing costs are too high compared to the returns that the EU’s capitalist sector require to increase productive investment, as opposed to investing in real estate or financial assets. The real cause lies in the lower rate of profitability for European capital compared to the US. This is particularly the case since 2017 (in this example below of US and German profitability).
Higher concentration of capital in the US
Not in the report, but perhaps relevant, is that in the EU there are many more smaller companies where profitability is low, while in the US a higher concentration of capital has boosted profits for the few mega techs at the top. Since 2000, gross profit rates in the United States have risen and industry concentration has soared, but these trends are not found in the European Union.
Draghi concludes that “the resulting cycle of low industrial dynamism, low innovation, low investment and low productivity growth in Europe could be characterised as “the middle technology trap”. But, in my view, this is a product of the ‘profitability gap’.
How to improve productivity and investment
What is to be done about the productivity and investment gaps? Draghi says that “a minimum annual additional investment of EUR 750 to 800 billion is needed corresponding to 4.4-4.7% of EU GDP in 2023. For comparison, investment under the Marshall Plan between 1948-51 was equivalent to just 1-2% of EU GDP. Delivering this increase would require the EU’s investment share to jump from around 22% of GDP today to around 27%, reversing a multi-decade decline across most large EU economies.” That’s a rise in investment to GDP levels not seen since the Golden Age of the 1950s and 1960s when Europe rapidly expanded after the war.
Is it feasible to expect European capital to be able or willing to restore those golden investment decades 50 years later? As the report recognises. “Historically in Europe, around four-fifths of productive investment has been undertaken by the private sector, and the remaining one-fifth by the public sector.” So in a capitalist Europe, it is up to the capitalists to invest more to deliver the needed higher productivity in the key areas. The public sector cannot do that and the EU Commission and Draghi certainly don’t want public investment to replace the capitalist sector through public ownership and planning of the ‘commanding heights’ of Europe’s economies.
So Draghi’s answer is the usual pro-business solution. There must be monetary and fiscal incentives by governments to ‘encourage’ capitalists to invest. First, there must be lower costs of financing, but “delivering private investment of around 4% of GDP through market financing alone would require a reduction in the private cost of capital by approximately 250 basis points in the European Commission model.” Hardly possible in the current inflationary environment. And anyway, “although improved capital market efficiency (e.g. through the completion of the Capital Markets Union) is expected to reduce private financing costs, the reduction will likely be substantially smaller. Fiscal incentives to unlock private investment therefore appear necessary to finance the investment plan, in addition to direct government investment”.
The EU ‘fiscal rules’ and balancing budgets
So the EU-wide governments must provide more public funds. But this leads to another problem. EU governments, particularly in core Europe, are driven by the need to ‘balance the budget’ and not to increase public debt or tax too much. There are the EU fiscal rules that cannot be broken!
Draghi wants more ‘joint borrowing’ ie the EU issues more EU-backed debt to fund projects. But this is a great taboo in the EU. Germany and the Netherlands have low levels of public debt and are loath to backstop their more indebted neighbours. Less than three hours after Draghi finished his presentation, Germany’s Finance Minister Christian Lindner said that “Germany will not agree” to ‘joint borrowing’, as joint borrowing “can be summarized briefly: Germany should pay for others. But that can’t be a master plan.“
Droghi wants more EU-wide taxes and more investment in technology
Draghi suggests more EU-wide taxes to boost the size of the EU Commission which is too small and concentrates spending on ‘social cohesion’, regional subsidies and agriculture rather than on ‘productive investment’.
Draghi wants to cut EU public spending in the existing areas and switch it to technology. “If the investment-related government spending is not compensated by budgetary savings elsewhere, primary fiscal balances may temporarily deteriorate before the investment plan fully exerts its positive impact on output.” Such a switch would not go down well among farmers and in eastern Europe.
Summarising this ‘existential challenge’
To summarise, the Draghi report outlines the serious decline in European capital’s competitive performance in the 21st century compared to the US and Asia. It is an ‘existential challenge’ that can only be overcome by a massive rise in investment, mainly in new technologies. This can only be achieved by the capitalist sector investing more. Public investment is too small and, anyway, the EU’s pro-business governments don’t want to take over the major private companies and have planned public investment instead. That would be the end of a capitalist Europe. So Draghi says what they need to do is to encourage Europe’s big business to invest more with cheaper credit, deregulated markets and increased government fiscal incentives to “unlock private investment”. However, the chances of the governments of the EU member states agreeing to spend more to help EU businesses sufficiently is slim.
The only way that the required humungous upswing in productive investment could happen is if the profitability of European capital leaps forward. But that won’t be achieved by making credit costs cheaper, but only by a sharp rise in the exploitation of labour in Europe and by the ‘creative destruction’ of ‘middle technology’ to reduce costs. If that does not happen, then the EU’s relative decline globally will continue and even accelerate.
From the blog of Michael Roberts. The original, with all charts and hyperlinks, can be found here.
