The only wheels that the economist sets in motion are greed and war among the greedy, competition.
Karl Marx
The EU is generally perceived as a 'geopolitical and military dwarf and an economic giant'. An understandable characterization, but that image is rapidly changing. The Russian invasion of Ukraine and Trump's likely re-election increase the awareness that European security is vulnerable. The belief that the EU must become a geopolitical player and strengthen its own defense industry and armed forces is growing. An enormous challenge, even more so because Europe is also falling behind economically. The US and China are outperforming the EU’s growth year after year and Europe's share of global GDP continues to decline. If Europe wants to maintain a meaningful position within the changing world order, its economy must undergo drastic reforms. So, what’s wrong with Europe’s economy and what can the EU do to change that?
First and foremost, the EU lacks scale. The EU does have in internal market, but that is not the same as a large domestic market that nations like the US and China have. Innovation requires enormous investments, which can only be achieved through large funds. The EU lacks an integrated capital market; the banking sector in Europe is still largely nationally organized and the rules for investing still differ considerably between European countries. Europe is working on a so-called capital market union, with the aim of giving companies easier access to financing in or with other EU countries. This initiative should lead to economies of scale that are desperately needed to invest in technology. However, this is a slow process and Europe’s innovation is already lagging far behind both superpowers due to insufficient spending on research and development. As a result, the EU is becoming increasingly dependent on technology from those countries, with all the vulnerabilities that this entails. Just imagine what would happen if Europe ignored the American demand not to supply the most modern chips to China, and the US subsequently decided to suspend its cloud services - this would seriously disrupt society in Europe.
Energy prices in Europe pose an even more acute problem. The EU gave up Russian gas and oil for the right reasons, which led to a serious energy crisis and huge price increases, while China and India are now buying that same Russian oil and gas for a lot less than Europe paid for it. The US is more or less self-sufficient, producing shale gas that is many times cheaper than the LNG that European countries have to import to meet their energy needs. Moreover, the energy transition in Europe is progressing too slow, much slower than in China. All this poses a serious threat to Europe's competitiveness. Large, energy-intensive companies are already leaving the EU or consider to do so in order to maintain their competitiveness. Large-scale US investment measures in critical sectors, such as the Inflation Reduction Act, are accelerating this trend.
On top of that the regulatory burden in Europe is high. European rules and national rules make it often difficult and in some cases impossible for entrepreneurs to comply with the strict regulations and stay competitive at the same time. The US market is more dynamic, and it’s labor market is more flexible. It is a mystery to me why in my country, the Netherlands, where there are major staff shortages, short working weeks are fiscally attractive and longer working weeks are fiscally unattractive. Not entirely without reason, many American employees regard their European colleagues, with their short working weeks, long vacations and early retirement, as 'fat cats'. And many a Chinese employee will burst out laughing when he hears that his European colleague refuses to accept more than a commuting distance of more than 50 kilometers, even though he receives unemployment benefits.
All in all, it is not surprising that the EU is underperforming. In 1960, the percentage of global GDP achieved by the current EU countries was about 36%. By 2020, this had shrunk to approximately 22%. The expectation is that this will only be 10% by the end of this century. Of course, the declining percentage of Europe’s global GDP can be explained by the growth of emerging economies such as China and India. But not completely, as the economy of the current EU countries was the same size as that of the US around the mid-1990s and is now 20% smaller. The gap is widening and will be further enhanced as the US turns its back on Europe to focus more on competing with China.
So how can the EU’s economy adapt to global challenges? Well, at least not through less European integration or leaving the EU, as many populists claim. It seems to me that Brexit has proven this is the least smart option. Further integration and economies of scale through drastic reforms are the way to turn the tide. The member states and the European Commission have asked two Italian former prime ministers, Enrico Letta and Mario Draghi, to submit reports on the future of the European internal market and what is needed to improve the growth dynamics of the EU economy. Not an obvious choice, by the way, Italy is simply not a standout when it comes to economic strength and both prime ministers have been unable to improve that much. Nevertheless, let's look at the content and summarize their recommendations.
Enrico Letta’s main recommendation in his report is to “unleash the potential of small and medium-sized enterprises (SMEs)”. SME’s are of great economical value, but lots of SME’s are struggling to survive. Access to financing is paramount, especially because they have to make major investments due to numerous transitions, such as energy, digitalization and sustainability. SME’s could benefit from a European capital market union, provided that ample funds are also made available for research and development. To this end, Brussels will have to argue for more European public/private financing, including the use of more risk capital such as private equity.
The release of Mario Draghi’s report has been postponed a few times and will most likely be released in September, but we can take a look ahead – much is already known. The report is expected to thoroughly analyze the lagging of the European economy and recommend far-reaching measures resulting from that analysis. Draghi will recommend to set up a major industrial fund. He argues that there’s no longer fair competition, the US and China also favor their companies. This will undoubtedly lead to countermeasures and protectionism, with all its consequences, but the EU cannot continue to watch as both superpowers benefit their own companies at the expense of Europe. The big question is how Europe will pay for this. Draghi has Eurobonds in mind for this, no doubt. However, that may help the richer member states to finance the poorer member states, but that does not make the EU as a whole more competitive.
The EU economy falling further behind the US and China has major consequences for the future prosperity and stability of Europe. It’s fortunate that the European Commission is showing some sense of urgency lately, but resistance to reforms is persistent in many European countries. This applies to a wide range of economic reforms, from labor legislation to the stimulation of a favorable business climate. Illustrative in this context is the dissatisfaction among the French population against the increase in the retirement age to (notably!) 62. An earlier EU-plan presented in 2000, the so-called Lisbon agenda, aimed at becoming the most competitive economy in the world; the EU should by 2010 be a dynamic knowledge economy with high-quality jobs and better social cohesion. It failed miserably. The cause? Draghi points out that Europe is strong in research, but fails to bring innovation to the market and scale it up. If that really is Europe's biggest problem, extensive financing could help, partly for reasons of scale. But a thorough analysis of European economies reveals the need for many more reforms. Member states continue to adhere to the idea of sovereignty and devise constructions to benefit their own companies. This blocks economies of scale and competitiveness against large companies from outside the EU. Europe’s labor market is not flexible enough, many companies have great difficulties finding employees with the right skills. This requires a knowledge policy, which is not in place yet. The existing social security systems in Europe are unsustainable with an aging population and a shrinking workforce. Now that Europe has to spend more on things like education, research, innovation, healthcare, energy and defense, there is simply less left over for short working weeks, long-term unemployment benefits and early retirements. To put it bluntly: Europeans will have to work harder for fewer benefits.
Some member states see the need for broad reforms, but leaving the initiative to national governments only widens the differences between them. Former Dutch Prime Minister Mark Rutte recently said in the European Council that 'the Netherlands is prepared to give up sovereignty for a stronger internal market', and that is exactly what all member states should do to revive Europe's lagging economy.
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