Will Europe Take Any Necessary Measures?

Analysts from BCA Research recently examined a crucial question regarding Europe: Will the region take the necessary steps to rejuvenate its economy and address its challenges? Their assessment, however, is cautiously pessimistic.

Despite calls for significant reforms from notable figures such as Mario Draghi, Europe appears to be on a path of relative decline compared to global competitors, especially the United States, unless drastic changes are implemented.

At the core of Europe’s difficulties is a substantial productivity gap. Since the introduction of the euro, the continent has increasingly lagged behind the U.S., exhibiting a 47% GDP per capita deficit (adjusted for purchasing power parity) as of 2023.

Low productivity is primarily responsible for this gap, accounting for 72% of the deficit, while diminished labor contributions account for the remaining 28%. This aligns with the criticisms outlined in Draghi’s report, which describes Europe as overly rigid, heavily regulated, and fragmented across national borders.

This fragmentation, compounded by inadequate investment in research and development, has resulted in Europe falling behind in economic advancement. As a currency union without a fiscal union, Europe faces fundamental issues. The euro unites economies that are politically and economically divergent, leading to inconsistent policies, inefficient markets, and low investment.

BCA Research is skeptical about Europe’s likelihood of implementing Draghi’s proposed reforms—such as simplifying regulations, enhancing market integration, and fostering a cohesive industrial policy. National capitals are reluctant to pursue these changes, fearing a loss of sovereignty. As a result, Europe may only respond decisively when economic discomfort reaches critical levels.

A significant indicator of this fragmentation is the investment disparity between Europe and the U.S. Europe consistently invests less in both private and public sectors—across infrastructure, innovation, and capital expenditures. In contrast, higher returns on investment in the U.S. encourage enhanced spending, while Europe’s lower capital intensity, a fundamental driver of productivity, reflects its underwhelming investment rates.

This trend is particularly concerning in sectors like telecommunications, where national market fragmentation hampers economies of scale, reduces profitability, and discourages investment. While Europe remains a leader in green technologies, it has fallen short in digital areas such as artificial intelligence, cybersecurity, and quantum computing—critical areas for maintaining global competitiveness. The continent’s fragmented markets and insufficient R&D investment mean it is perpetually playing catch-up.

BCA Research highlights that Europe trails the U.S. in venture capital deals by 80%, underscoring a severe lack of high-risk funding for innovation and new business initiatives. Draghi’s proposed reforms require an increase in investment of €750-800 billion annually by 2030, focusing on energy transition, digital technologies, defense, and R&D. Yet, BCA Research doubts that this ambitious target will be realized due to significant political resistance to deeper integration.

National interests dominate the political landscape, with countries like Sweden openly opposing crucial elements of Draghi’s plans, including the issuance of common bonds. Even France and Germany, the European Union’s largest economies, struggle with political inertia, making meaningful progress unlikely until after the next round of elections.

The absence of a unified fiscal policy exacerbates Europe’s challenges. The budget of the European Commission is considerably smaller than that of the U.S. federal government, limiting its ability to effectively respond to economic shocks or direct substantial investments. This problem is further intensified by the lack of a capital market union, hindering Europe’s ability to raise funds efficiently.

Consequently, countries such as France, Spain, and Italy face higher borrowing premiums than Germany, contributing to further fragmentation and financial instability during crises. Without a more cohesive fiscal policy, Europe remains exposed to economic shocks.

BCA Research warns that, structurally, European equities are likely to continue underperforming compared to their U.S. counterparts. The eurozone’s productivity challenges and fragmented markets create obstacles for European firms competing with American businesses. This trend is unlikely to change without significant and politically challenging reforms in the near future. Additionally, Europe’s long-term economic health is threatened by stagflation—a detrimental blend of sluggish productivity growth, a declining labor force, and extensive entitlement programs that will increase demand beyond what the economy can supply. This imbalance is expected to fuel inflation, which the European Central Bank may find difficult to manage, potentially leading to more frequent financial crises and a structurally weakened euro.

Nonetheless, BCA Research does see some short- to medium-term potential for Europe. Over the next five years, the region might experience a period of cyclical outperformance, spurred by strengthening global capital expenditures that could benefit European equities, especially if U.S. tech stocks face price adjustments. However, such gains are likely to be fleeting amid an overarching structural decline.