Economy

Will Europe do whatever it takes?

Investing.com — Analysts from BCA Research in a note examined a pivotal question: Will Europe do whatever it takes to revive its economy and tackle its problems? The analysts however deliver a cautiously pessimistic verdict. 

In spite of calls for bold reform from figures like Mario Draghi, the European region seems destined to continue declining relative to its global competitors, particularly the United States, unless radical change is achieved.

At the heart of Europe’s troubles is a major productivity gap. Since the adoption of the euro, the continent has steadily fallen behind the U.S., with a 47% GDP per capita deficit (adjusted for purchasing power parity) as of 2023. 

The core issue is low productivity, which accounts for 72% of this gap, while reduced labor contributions make up the remaining 28%. This echoes the concerns laid out in Draghi’s report, which frames Europe as too rigid, overly regulated, and fragmented across national borders. 

It is this fragmentation, along with insufficient investment in research and development, that leaves Europe trailing at the economic frontier.

Europe is a currency union without a fiscal union, which is at the root of these problems. 

The euro binds together economies that are politically and economically divergent, which results in inconsistent policies, inefficient markets, and low levels of investment. 

BCA Research remains skeptical about Europe’s ability to adopt Draghi’s reforms, such as simpler regulation, greater market integration, and a coherent industrial policy. Afraid of losing their sovereignty, national capitals are hesitant to make the necessary changes. 

While Europe’s sickness is evident, it may not feel compelled to act until the pain is unbearable.

A critical manifestation of this fragmentation is the disparity in investment between Europe and the U.S. On both the private and public fronts, Europe consistently invests less, whether it’s in infrastructure, innovation, or capital expenditures. 

Compared to the U.S., where higher returns on investment encourage more robust spending, Europe lags behind. The continent’s capital intensity, a key driver of productivity, trails that of the U.S., reflecting the lower rate of investment that characterizes European economies. 

As BCA Research notes, this trend is particularly worrying when examining sectors like telecommunications, where fragmentation across national markets prevents the emergence of economies of scale, diminishing profitability and stifling investment.

While the region remains a leader in green technologies, it has fallen behind in digital technologies like artificial intelligence, cybersecurity, and quantum computing. 

These are crucial for maintaining competitiveness on the global stage, but Europe’s fragmented markets and insufficient investment in R&D leave it playing catch-up. 

According to BCA Research, venture capital deals in Europe lag by 80% compared to those in the U.S., underlining the continent’s lack of high-risk funding for technological advancements and new business ventures.

Draghi’s proposed reforms would require Europe to boost its investment by €750-800 billion annually by 2030, focusing on energy transition, digital technologies, defense, and R&D. 

Yet, as BCA Research points out, this goal is unlikely to be met. The continent’s political landscape is fraught with resistance to deeper integration. 

National interests prevail, and countries like Sweden have already expressed opposition to key aspects of Draghi’s plan, such as the issuance of common bonds. Even France and Germany, the two largest economies in the EU, are paralyzed by political indecision, with little hope for meaningful progress until at least the next round of elections.

The lack of a unified fiscal policy further exacerbates Europe’s challenges. The European Commission’s budget is significantly smaller than that of the U.S. federal government, leaving it unable to effectively smooth out economic shocks or direct large-scale investments. 

This is compounded by the absence of a capital market union, which prevents Europe from raising funds efficiently. 

As a result, countries like France, Spain, and Italy pay higher premiums on their borrowing than Germany, leading to further fragmentation and financial instability during periods of crisis. Without a more integrated fiscal policy, the continent remains vulnerable to these shocks.

BCA Research warns that, structurally, European equities will continue to underperform relative to U.S. equities. The eurozone’s productivity issues and fragmented markets make it difficult for European companies to compete on the same level as their American counterparts. 

This trend is unlikely to reverse without significant reforms, which seem politically unfeasible in the near term. Moreover, Europe’s long-term economic prospects are hindered by stagflation—a toxic combination of weak productivity growth and declining labor force, alongside large entitlement programs that will drive demand far beyond what the supply side of the economy can meet. 

This mismatch will fuel inflation, which the European Central Bank may struggle to control, leading to more frequent financial crises and a structurally weaker euro.

However, BCA Research does see some potential for Europe in the short to medium term. Over the next five years, Europe may see a period of cyclical outperformance. 

Global capital expenditure is expected to strengthen, benefiting European equities, particularly as tech stocks in the U.S. face a potential de-rating in the coming years. However, these gains would likely be temporary within a broader structural decline.

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