EUROPE'S PRODUCTIVITY DILEMMA
It’s always been quite interesting to look at statistics for economic research on different topics of interest. While doing research for my latest book La Revolución del Mercado I suddenly found a comparative statistic I completely ignored before, which were GDP per capita levels in each of the American states in correlation to European countries. I obviously knew some states in the USA were richer than others and their respective comparative advantages, but before doing research for the book I had never stopped to ask myself why some states, at a particular level, were so much richer than whole European nations (measured in GDP per capita).
You would be astonished to know that DC has an average GDP per capita of nearly $180,000 dollars, while the richest European country, being Luxembourg, has a GDP per capita of $113,954. But that’s not the most surprising data. Mississippi, being the poorest American state, registers an annual GDP per capita of $31,881, while the comparative European nation to it is Spain with an average GDP per capita of $31,060, being the seventieth richest country in Europe, out of 44 countries, according to the World Bank. So, why is the poorest American state richer than 27 European countries?
I’ve given it a long thought, and after diving into several academic papers studying the issue, I found that nearly all of them reach the same conclusion: Europe has a productivity dilemma, meaning that it is actually much less productive than its comparative regions, which prevents it from reaching its maximum potential growth.
There are several factors which might explain this productivity gap between Europe and other fully-developed nations, and some of the best known arguments might be: the gap in R&D investment between Europe and the USA, mobility of economic factors and agents, greater valuation of intangible assets in the American economy, or greater capital allocation costs in Europe due to a much larger bureaucratic net, which makes innovation and research much more difficult and tedious, apart from expensive.
There are three factors which are outstandingly relevant for me in relation to the European productivity lag, which are: Europe’s lack of investment in R&D, some structural weaknesses as infrastructure and adoption of new technologies, and finally and most importantly, European long-term barriers to investment, most of them having bureaucratic roots.
One classical example of dirigisme, lack of innovation and failed interventionist policies has been the French economy, transferring these effects to many European nations on the way. I’ll base the practical study of all these factors around an extended study based on comparative statistics between the EU and the US, extracting data from a research paper presented last July by Olivier Blanchard et al. (Productivity and competitiveness in the euro area: A view from France), and another one by the European Comission in 2018 ("Annual growth survey 2019: For a stronger Europe in the face of global uncertainty").
Let see how deep is Europe’s productivity dilemma!
Firstly, throughout the last years investment in the European economy has been slowing down, primarily due to the long-lasting effects of the ultra-expansionary monetary policy developed by the ECB mainly since 2012; registering 4.7 trillion euros in its sheet at the end of 2018. The ECB balance sheet represents nowadays almost 40% of the total eurozone GDP, which goes hand to hand with an excessive liquidity of approximately 1.8 trillion euros. To this situation we should add political tensions as Brexit or nascent populisms in Europe, and economic instability in some European countries as Italy or even Germany, which incentivize the proliferation of this productivity-destructive monetary policy.
As has been noted before on several occasions, one of Europe’s greatest issues are its structural weaknesses, summed up to the lack of political will to commit pretty necessary structural reforms, and betting everything to the previously commented and ever-lasting flooding monetary policy. The lack of structural reforms, as labour or capital markets reforms (the Spanish labour reform was very mild) have widened the investment gap (as a % of GDP) between Europe and the US, which implies that European firms and governments are not being able to be up to date in technological adoption, haven’t even yet started to transform their main business models. A clear proof of how Europe is losing the technological race, and most importantly, how they are not even willing to compete, are Macron’s words asking for greater public control over “strategic industries”, which are really enormous dinosaur conglomerates, where innovation and productivity are the nearest thing to a fairy tale.
To put some data on the table, according to Ameco, the investment gap in machinery, equipment and intangibles (mostly R&D and patents) between the EU and the US has widened from nearly 0% to 1.4%, in relation to GDP.
Often, we speak about how the social elevator is broken and how that impedes citizens in lower income quintiles to progress throughout their life. But not many people have directed the same approach to the elevator between firms. Why I’m I talking about this? Well, one of the most relevant signs of innovation in a market economy is when younger innovative firms eat market share from older participants in the market, replacing old and unproductive firms for buoyant new companies, with much larger productivity rates and which at the entrance moment adapt much better to existing market expectations. This is not new at all, as theories about “creative destruction” have existed since Schumpeter’s time.
When we look at who is really investing (public and private funds) on R&D around the world, the picture is even more worrisome for Europe. There’s been a dramatic rise of Chinese investment in innovation (2.2% of GDP) , mainly based on tertiary sector activities, followed by the US (2.7% of GDP) , mainly centred in technological output... and well, and then the static and undynamic Europe (1.2% Spain, 1.3% Italy, 1.7% UK…, not taking into account Nordic countries) .
Another of Europe’s greatest problems is its financial sector, which due to its lack of innovation and technological change is slowing down investment in intangible assets. The financial sector as a whole is of course NOT to blame for it, but its structure, which is mostly conformed by traditional banking, which tends to receive very small returns over equity. The core cause for this have been mainly further government restrictions on financial innovation and alternative investment after 2008, along with ultra-low interest rates, which have completely teared down the banking business. The equity risk remains very high in almost every European country, due to inflated indices, which are another secondary effect of central bank’s promotion of financial leverage and irrational investment. Risk premiums can be confusing in this scenario, as they are right now artificially low due also to monetary policy effects, which have provided a safety mattress for many European nations as Greece or Italy, with outstanding public debts of 182% and 134% of GDP, respectively.
The fourth most important cause of Europe’s lack of productivity is mainly the lack of investment in infrastructure, not only physical but technological. And here I’m not making just a quantitative analysis, but a qualitative one. Europe is only investing 1.75% of its GDP in quality infrastructure, which remains a 25% below the pre-crisis levels, in average. And its not just public investment, but PPPs (Public-Private partnerships) that have also contracted in volume. A lack of infrastructure, or of its quality, causes financial and business planning to be much more uncertain and volatile. We need a much greater cooperation between public institutions and the private sector to solve this problem.
But, what’s the solution, or at least one of the solutions to Europe’s productivity dilemma?
In my opinion, the European institutions should promote a dynamic and attractive business environment by reducing regulations for firms and facilitating entry and exit for firms on the different European markets. We should also advance towards a larger and more effective single market, vanishing every single commercial or trade barrier between member countries, which should facilitate technological investment and transfer of intangible assets between firms and institutions in different locations. Improving Public-Private partnerships for investment in R&D and quality infrastructure, which provide an easier path for socioeconomic development, is crucial at the moment. All Europeans should work together to close the innovation gap we actually have with other regions around the world. Globalization and international cooperation have been the keys to development along the last 40 or 50 years. Let’s continue following that path!