Europe has a significant lag in productivity growth compared to the United States and China, said the Institute of International Finance (IIF) in a comment on October 3.

Despite comparable levels of capital spending, Europe has been falling behind the US and needs massive investment to close the gap and stay in the game in both labour productivity and total factor productivity (TFP), since the mid-1990s.

“The current state of the European economy is characterised by a loss of international competitiveness and a significant lag in productivity growth compared to China and the United States,” said Marcello Estevão, managing director and chief economist at IFF, in a note. “This sluggish productivity growth is not solely attributable to the pandemic, the Russia-Ukraine war, energy supply issues and geopolitical tensions. It also stems from the Euro area’s debt crisis and the lack of bold measures taken in its aftermath to bolster Europe’s productivity.”

The recent report from former Italian Prime Minister and ex-European Central Bank boss Mario Draghi underscores the importance of boosting innovation, investment and structural reforms as key to addressing Europe’s productivity gap. As bne IntelliNews reported in a long-read article, Europe has lost its competitive edge.

“The focus of Mario Draghi’s report on European competitiveness, investment, innovation, technology and structural reforms are core to Europe’s growth challenge,” Estevão said. This comes as the European Union’s growth potential remains hindered by lingering effects of the Euro area’s debt crisis and a lack of bold post-crisis reforms.

While the EU’s investment-to-GDP ratio has been comparable to that of the US since the mid-1990s, Europe’s annual real GDP growth averaged only 1.6% from 1996 to 2024, compared with the US’s faster 2.5%. Since 2022, the EU’s investment ratio has declined from 24% to 21%, contributing to a sharp slowdown in GDP growth to 0.7% in the first half of 2024.

The TFP growth differences within the EU’s four largest economies highlights particularly stagnant TFP dynamics in Italy and, to a lesser extent in Spain, from 1995 to 2019, IFF says. The Covid pandemic resulted in productivity losses across the EU in 2020, with the most severe declines in Spain and France, while the US economy surprisingly continued to maintain productivity growth throughout the pandemic. Except for France, TFP levels have recovered to their pre-pandemic levels.

In terms of capital growth, the 2009-2010 European debt and global financial crisis resulted in significant declines in capital spending, particularly in Spain. Weaker spending led to diminished capital accumulation during 2012- 2019, contributing much less to potential growth in both the EU and US economies, according to IFF.

The Draghi report proposes increasing annual capital spending by €800bn, or 5% of GDP, which could raise EU real GDP growth by 0.4 percentage points per year. However, as the report suggests, the effectiveness of this additional investment hinges on how well it is directed towards high-value sectors.

“Where and how this capital is allocated could make a substantial difference,” Estevão notes, particularly in fostering technological and managerial innovation.

Labour force and immigration policy

The report also stresses the critical role of labour force dynamics in Europe’s economic future. With an ageing population in the EU and a significant decline in the pool of inactive workers post-Covid, labour force growth is likely to moderate in the coming years, says IFF. As a result, labour-intensive sectors, such as services, may be forced to raise wages to encourage workers to increase their hours, and so push up inflation again especially if stagnant labour productivity does not pick up.

“In the post-pandemic period, working-age population growth accelerated in the EU, including in Germany, with particularly robust momentum in Spain. This unusual labour force growth appears to have been driven largely by inactive senior workers returning to the labour market and strong immigration,” says Estevão. “However, according to the European Commission’s estimates, trend de- clines in average hours worked per employee have continued to make negative contributions to potential growth rates in Germany, Spain and France since 2019. After employment and hours worked per employee are taken into account, total hours worked have boosted potential growth everywhere since 2019.”

Labour force growth in Europe is expected to moderate in the coming years thanks to a demographic crisis and low fertility rates; there is nowhere in Europe where fertility is above the 2.1 births per woman replacement rate. That has raised concerns about the sustainability of any potential long-term output growth.

“This highlights the importance of a well-thought immigration policy to buoy Europe’s potential growth,” Estevão says, noting that immigration could offset the expected decline in the working-age population and support productivity in labour-intensive sectors.

Looking ahead, addressing Europe’s productivity challenge will require more than capital investment. Structural reforms to boost TFP growth, coupled with policies to attract and integrate skilled workers, are seen as vital to sustaining the EU’s competitiveness on the global stage.

"Stronger incentives for technological and managerial innovation will be crucial to reversing this trend," Estevão concludes.