Europe’s stark warning

The EU faces a ‘slow agony’ without significant investment and reform, a top European economist has forewarned. If the continent hopes to catch up with the US and China, it will need to make some radical changes in order to adapt to an increasingly competitive and unstable world

 
 

Europe is at an economic crossroads. Mario Draghi, the former head of the European Central Bank, has warned that the continent faces an “existential challenge” unless it can reverse decades of economic stagnation and flatlining productivity. In a 400-page report penned for the European Commission, the former Italian premier delivered a sombre message: without significant investment and concerted co-operation, the EU risks losing its very reason for being.

The challenges facing the EU are by no means new. The continent has been plagued by low growth since the start of this century, and has grappled with sluggish wages and weak productivity since the global financial crash. As Draghi’s report notes, up until now, “slowing growth has been seen as an inconvenience but not a calamity.” But the world in which the EU operates is changing dramatically. World trade is slowing, and the EU’s share of this trade is in decline. Geopolitical tensions are high both in Europe and the Middle East, with the Russo-Ukrainian war also exposing the EU’s reliance on foreign gas. On European soil, meanwhile, ongoing cost-of-living crises and the rise of right-wing populist parties are causing ever-increasing fragmentation across the continent. Against this backdrop, low growth can no longer be dismissed as an inconvenience. In this new world, Europe’s lack of growth has become a threat to its future. And as China and the US race ahead with investments in frontier technologies and the green economy, Europe risks being left behind.

It is not all doom and gloom, however. Draghi’s report also sets out an ambitious blueprint for reversing the EU’s ailing fortunes, advocating for closer collaboration and hefty investment in shared European objectives. Cutting regulation, boosting innovation and unlocking the benefits of decarbonisation all form part of Draghi’s plan to revitalise Europe’s economy. And while these recommendations have proved popular with economists and business leaders alike, the sobering reality is that the proposal comes with quite a price tag. Somehow, Draghi warns, the money must be found, or else the EU must “genuinely fear for its self-preservation.”

Brave new world
In 1946, Winston Churchill gave a landmark speech at the University of Zurich, in which he advocated for a ‘United States of Europe.’ After the atrocities of two world wars, the idea of a more united, collaborative Europe began to gain traction, and the first steps towards a European Union were tentatively taken. Buoyed by a post-war growth miracle, the ‘Original Six’ nations of Belgium, France, Germany, Italy, Luxembourg and the Netherlands began to pursue economic integration, establishing the European Economic Community with the signing of the Treaty of Rome in 1957. Collaboration grew over the following decades, and the ‘European Union’ was officially founded in 1993 when the Maastricht Treaty came into force. With the birth of the single market, the EU emerged as the largest and most economically integrated trading bloc in the world.

The promise of free movement of people, goods, services and capital was a real boon for European businesses of all sizes. Conceived as a way to eliminate trade barriers, stimulate competition and strengthen European integration, upon its launch the single market proved to be a boost to the EU economy. Trade with Europe flourished, employment opportunities improved, and member states saw their GDP tick up in response. In short, the single market worked for the world of the day. Now, some 30 years later, that world has all but disappeared.

In the late 1980s, when the single market was taking shape, Europe was the beating heart of the global economy. The post-war baby boom had created a young and growing workforce, and across central and eastern Europe, communist regimes were collapsing. China and India together represented less than five percent of the world’s economy, and Europe was keeping pace with the US on innovation, research and development. But the global picture now looks very different. Over the last three decades, the EU’s share of the global economy has shrunk. China, India and other rising Asian economies now play a leading role on the global stage, while the US is roaring ahead as the world’s economic heavyweight.

In 2008, the EU economy was still fractionally larger than that of the US. By 2023, however, the US economy was around 50 percent larger than the EU, reflecting a dramatic divergence of economic fortunes on either side of the Atlantic. While growth in the EU is slowing, it is surging in the US, much to the surprise of economists and forecasters. The long-lasting impact of the Covid-19 pandemic, rampant inflation and a widespread energy crisis pushed the EU to the brink of recession last year, and its current economic outlook remains subdued. By contrast, the US has defied expectations to emerge from the pandemic stronger than ever. Wages are up, unemployment is down, and new business creation is at a record high. Looking to the East, meanwhile, even a cooling Chinese economy continues to outpace European growth. In this brave new world with new economic titans, Europe is simply struggling to keep up.

Looking inward
The shifting geopolitical landscape has certainly taken a toll on Europe’s economic fortunes. But if the continent is to truly get to grips with the challenges it faces, it will need to own up to issues of its own making. For decades, Europe has remained highly dependent on imports, particularly when it comes to fossil fuels and raw materials. Draghi himself has named Europe as the most dependent of all major economies, highlighting that “we rely on a handful of suppliers for critical raw materials, and import over 80 percent of our digital technology.”

Slowing growth has been seen as an inconvenience but not a calamity

In a time of peace and prosperity, such arrangements may not necessarily be cause for alarm. However, the Russo-Ukrainian war has exposed just how vulnerable Europe can be to geopolitical shocks. Before Russia’s invasion of Ukraine, Russia was Europe’s largest supplier of natural gas, by some margin. Around 45 percent of Europe’s gas imports came from Russia in 2021, with the country also supplying the EU with over 100 million tonnes of crude oil and over 50 million tonnes of coal each year. That all changed in May 2022, when the Russian taps started to turn off. With cheap Russian energy no longer an option, Europe was forced to look towards other, more costly alternatives.

In this era of heightened geopolitical risk, Europe must reconsider its reliance on imports. Once reliable dependencies have morphed into vulnerabilities, and the EU can no longer assume that its suppliers will always provide the goods that it so urgently requires. And Russian gas isn’t Europe’s only weak point as far as imports are concerned. While the US has been looking to reduce its dependence on Chinese imports since 2018, Europe has grown increasingly reliant on the Asian superpower for critical resources – in particular, those rare earth materials that are crucial to enabling the clean energy transition.

“This is an area where we rely on one single supplier – China – for 98 percent of our rare earth supply, for 93 percent of our magnesium, and 97 percent of our lithium – just to name a few,” the President of the European Commission, Ursula von der Leyen noted in a speech given in Brussels last year.

“Our demand for these materials will skyrocket as the digital and green transitions speed up,” she warned. “Batteries that are powering our electric vehicles are forecast to drive up demand for lithium by 17 times by 2050.”

It is clear that Europe will be unable to realise its clean energy ambitions without access to these critical raw materials, but the Russo-Ukraine war has taught the continent a difficult yet timely lesson on over-dependencies. In recognition of this challenge, the European Commission has introduced a Critical Raw Materials Act, which sets out benchmarks to be met by domestically sourced, processed and recycled raw materials. It looks like Europe is learning from its recent misfortunes, but it will need to increase its diversification efforts if it hopes to create a secure future in an increasingly unstable world.

A united Europe?
One of the guiding principles of the ‘European project’ is the belief that the countries of Europe are stronger together than they are apart. The single market was, in many ways, founded on this theory, and sought to break down barriers and encourage collaboration across the continent. An admirable ambition, certainly. But the reality of the single market has been very different.

As many critics have noted, the single market is not so ‘single’ in practice. There are significant barriers to true cross-border exchange, from differences in national tax systems to conflicting requirements for e-commerce. To make matters more complicated, there are separate national markets for financial services, energy and transport, meaning that we see a divergence of policies and regulations along national borders. This complex landscape can be off-putting to foreign firms that may otherwise want to invest and scale up in the EU.

“We have left our single market fragmented for decades, which has a cascading effect on our competitiveness,” Draghi says. “It drives high-growth companies overseas, in turn reducing the pool of projects to be financed and hindering the development of Europe’s capital markets.
And without high-growth projects to invest in and capital markets to finance them, Europeans lost opportunities to become wealthier.”

According to Draghi, it is not just the single market that ought to become more consolidated. He argues that the EU needs to unite around a shared purpose and a shared vision if it is to achieve its full potential.

“It is evident that Europe is falling short of what we could achieve if we acted as a community,” he laments. In other words, Europe needs to think big, and to start exploiting its scale. The EU has a massive collective spending power, Draghi argues, but does not adequately pool its resources to achieve shared objectives. When it comes to policy, too, we see fragmentation and divergence across Europe, rather than joined-up strategic thinking. Rallying EU member states around common goals may prove a difficult task when there are so many national interests at play, but collaboration at scale may be the only way that the EU can keep pace with the giant economies of the US and China.

The productivity problem
While economists have spent years fretting over Europe’s sluggish growth, EU citizens have generally been less concerned by the continent’s flagging GDP. That is, until now. Inflation began creeping up after the onset of the Covid-19 pandemic, and rose even more dramatically following Russia’s invasion of Ukraine in 2022, fuelling cost-of-living crises in many nations across Europe. Households began to feel the sting of increased food and gas bills, while a decline in real wages made it more difficult for families to make ends meet. Across the pond, it is a very different story. Thanks to its rich supplies of oil and gas, energy prices have remained relatively stable in the US, with Americans paying between three and four times less for their energy consumption compared with their European counterparts. With wages rising and unemployment low, US citizens are reaping the benefits of a flourishing economy.

By contrast, a 2023 survey carried out by the European Parliament found that the rising cost-of-living was the most pressing worry for 93 percent of Europeans, ahead of public health, climate change and even the spread of war in Europe. The survey revealed that almost half of the EU population felt that their standard of living had fallen since the onset of the Covid-19 pandemic, indicating that individual citizens and families are beginning to feel the impact of Europe’s economic poor performance.

Europeans are right to be concerned about their financial future. The gap in living standards between the EU and the US is widening, with real disposable income growing twice as much in America since the year 2000. This economic divergence has become ever more pronounced since the Covid-19 pandemic, and economists have been searching for the cause. According to Draghi, there is one main factor behind Europe’s poor performance – its persistently low productivity. Europe’s productivity problem is well known by now. Productivity has been slowing across the continent since the 1970s, and it can’t simply be blamed on leisurely lunches and afternoon siestas. A failure to invest in emerging industries from the 1990s onwards has continuously hampered the EU’s opportunities for growth.

“Europe largely missed out on the digital revolution led by the internet and the productivity gains it brought: in fact, the productivity gap between the EU and the US is largely explained by the tech sector,” Draghi notes in his report. “The EU is weak in the emerging technologies that will drive future growth.”

If the EU has already missed out on significant productivity gains that the digital revolution could have brought, it threatens to make the same mistake again with the forthcoming artificial intelligence revolution. Already, the US and China are surging ahead with investments in AI and other frontier technologies, leaving the EU lagging behind in this new race. Similarly, while Europe is well-placed to lead the global green energy transition, it now risks losing its edge to China unless it ramps up its spending on R&D and upskilling. Quite simply, Europe cannot afford to forgo the productivity gains that these new industries promise to bring.

This is a particularly pressing issue in the context of the demographic shift that the continent is experiencing. Europe’s population is ageing rapidly, while a slowdown in birth rates means that growth cannot be supported by future generations alone. By 2050, the number of over-85-year-olds in the EU-27 is expected to more than double, while the European workforce is projected to lose up to two million workers per year from 2040. Against the backdrop of these looming challenges, productivity growth will be all the more vital to achieve.

A costly cure
In his report, Draghi does not shy away from the difficult economic reality that Europe finds itself in. The situation, he acknowledges, is bleak, but is by no means hopeless. Alongside his analysis of the issues at hand, the former Central Bank chief sets out an ambitious plan to revitalise the European economy. His proposals are far-reaching and radical, and primarily centre around three main areas for action: closing the innovation gap with China and the US, maximising the benefits of decarbonisation and increasing security while reducing dependencies.

In this era of heightened geopolitical risk, Europe must reconsider its reliance on imports

These proposals cannot be achieved, he warns, without significant investment. In fact, Draghi says that the EU must increase spending by €800bn per year if it is to stand a chance of improving its economic fortunes in the long term. This represents approximately five percent of the bloc’s entire GDP, highlighting the scale of the challenges ahead. By contrast, the Marshall Plan recovery programme spent between one and two percent of GDP on rebuilding a decimated Europe, and propelled much of the continent beyond pre-war levels of growth. Unlike 1948, however, present-day Europe has no external backer. This time around, it will need to find the means to fund its own recovery. The question of cost is precisely where Draghi’s plan comes unstuck. In principle, his proposals are pragmatic, timely and potentially transformative. But the cost of implementing them may simply prove too high – particularly for those more skittish and risk-averse EU member states.

“The private sector is unlikely to be able to finance the lion’s share of this investment without public sector support,” Draghi acknowledges. “Some joint funding for investment in key European public goods, such as breakthrough innovation, will be necessary.”

But with the EU coffers conspicuously empty, common debt may be the only way to reach the scale of investment that Draghi is proposing.

This will be a hard sell in more frugal-minded nations such as Germany and the Netherlands, who have very little desire for more joint spending, and even less appetite for joint borrowing. Indeed, just three hours after Draghi’s report was released, the German Finance Minister Christian Lindner responded to these calls for more common debt by confirming that “Germany will not agree to this.”

The wake-up call
And it is not just the cost of the proposals that is causing jitters across the EU. Many of Draghi’s plans focus on deeper integration and closer collaboration across core areas such as defence, decarbonisation and the digital economy. While more co-ordinated activity in these areas would help Europe to exploit its size and its collective strengths, it may also require member states to give up some of their powers in the interest of shared objectives.

The gap in living standards between the EU and the US is widening

Until now, many EU countries have been very reluctant to cede powers of any kind, and have even dragged their feet over policy co-ordination. But this has resulted in the fragmented EU that exists today – hampered by excessive regulation and unnecessary duplication. Draghi’s report may just prove to be the wake-up call that the EU needs to finally tackle its current disjointed ways of working.

The scale of the challenge facing Europe is seemingly too immense for countries to tackle on their own. Geopolitically and economically, the EU is in near-crisis mode, and has perhaps never felt so divided on the key questions regarding its future. It is true, however, that a crisis can also be a catalyst for change – if leaders are able to seize the momentum and take a risk on far-reaching reforms. The cure for Europe’s ills may well prove pricey, but inaction could cost the continent a whole lot more.