Europe’s Economic Decline

How the EU fell behind US – What’s Behind the EU’s Struggles?

Europe once represented a bastion of economic strength and stability, with high standards of living, strong productivity growth, and a robust social safety net. However, in recent decades, the European economy has fallen behind countries like the United States and China. Europe has struggled with low growth, high unemployment, debt crises, political fragmentation, and now faces deep uncertainties from Russia’s invasion of Ukraine. What explains Europe’s economic travails? In this blog, I summarise the key factors discussed in a video on Europe’s economic decline.

The Post-War Boom Ends

In the post-war decades, Europe, and especially countries like Germany, enjoyed an economic “miracle” with rapid catch-up growth. European integration via the EU single market in the 1990s brought down barriers and boosted trade and investment. Standards of living converged towards American levels.

However, this momentum has faded over the past 20 years. Whilst sporadic shocks like the Great Recession, euro debt crisis, Brexit and the COVID-19 pandemic all delivered blows, more deep-rooted problems around demographics, lack of technological leadership, excessive regulation and flawed policy choices have hobbled Europe.

The Perils of Austerity

Much of Europe embraced fiscal austerity after the 2010 euro zone debt crisis, prioritising deficit and debt reduction over growth. However, spending cuts and tax hikes often proved counter-productive, dampening demand and recovery. For example, Italy’s debt-to-GDP ratio still soared from 115% to over 150% despite austerity efforts. Slower growth shrinks the tax base, offsetting any savings.

Austerity has been especially painful for crisis-hit countries like Italy and Greece that saw wage declines and brain drain. But even powerhouses like Germany have adopted excessively tight budgets. Nobel Prize-winning economist Paul Krugman has been a vocal critic of European austerity.

Demographic Headwinds

An aging population is another brake on European growth. Low birth rates and limited immigration mean that Europe’s workforce is shrinking. An older population saves less, invests less and is less entrepreneurial. Rising health and pension costs are also a fiscal burden.

Whilst female labour participation and migration helped offset aging in the past, today anti-immigrant sentiment has taken hold. Europe’s median age is now the highest in the world. An aging society was a key factor behind Japan’s growth struggles. This demographic challenge will be extremely difficult for Europe to navigate.

Lagging on Technology and Innovation

Europe has so far missed out on the big tech revolution that propelled the growth of companies like Google, Amazon, Microsoft, Facebook and Apple. The EU only accounts for 4% of the world’s tech “unicorns” (start-ups valued over $1 billion) whilst the US claims over 50%. Stringent regulations like GDPR have not dented big tech’s dominance.

Areas like artificial intelligence, biotechnology, computer chips and batteries are also led by the US and China. Europe spends less on R&D and its markets often lack the scale and dynamism to nurture world-beating tech champions. Even Germany’s mighty auto sector is losing ground to American and Chinese rivals.

Over-Regulation in Germany

Germany long served as Europe’s growth locomotive. However, its economy has stagnated, with declining competitiveness in traditional strongholds like cars, machinery and chemicals. Economists argue Germany suffers from excessive red tape and planning lags. Obtaining permits takes 50% longer than the OECD average. Outdated regulations also hinder adoption of digital technologies.

Germany’s abandonment of nuclear power has left it heavily exposed to Russian gas imports. The surge in energy prices after Russia’s invasion of Ukraine has hit both German industry and Europe’s economy. Reorienting to renewable energy will be costly and difficult.

Problems with the Euro

The euro currency union brought benefits like lower transaction costs but also imposed strains. Interest rates and policies set by the European Central Bank have at times been too loose or tight for individual countries.

Lacking currency flexibility, countries within Europe have struggled to adjust to asymmetric shocks. When the 2008 crisis hit, southern European countries were plunged into debt crises as bond yields spiked, resulting in harsh austerity programs. The crisis exposed cracks in the euro zone’s architecture that linger today.

Silver Linings?

Recent shocks like the pandemic, Ukraine war and energy crisis have admittedly hit Europe hard. But looking ahead, if managed properly, these upheavals could potentially help accelerate overdue reforms and investments.

For example, the Ukraine crisis and supply chain bottlenecks have spotlighted Europe’s over-reliance on imports from Asia. Reshoring manufacturing and building domestic technology supply chains could boost jobs and growth. The green energy transition also offers huge opportunities if climate investments are ramped up intelligently.

Europe Less Dire in Some Respects

While Europe clearly faces stiff economic headwinds, some statistics should be viewed carefully. For example, US GDP per capita exceeds the EU, but Americans also work substantially longer hours. Europeans enjoy more leisure time.

Measured in dollar terms, EU productivity has fallen behind the US. However, adjusted for local costs and living standards (purchasing power parity), EU productivity has kept pace or even exceeded the US per hour worked.

The 50% drop in the euro’s value over the past decade also complicates direct comparisons. So whilst Europe undoubtedly faces lacklustre growth and painful adjustments, talk of terminal decline or irrelevance seems premature.

Demographic Destiny?

Europe’s rapidly aging population is perhaps the thorniest challenge. With low fertility rates, shrinking workforces are bound to act as a perennial drag on growth. Combined with rising public spending pressures, Europe’s demographic destiny could blunt the impact of any reforms.

Counteracting demographic headwinds through rising migration would require confronting deep-set political opposition. Even with enlightened policies, Europe’s relative weight in the global economy seems poised to gradually ebb.