Europe’s future on a knife-edge

Europe’s fading fortunes

At home in the European Union, a “pronounced productivity slowdown” has resulted in the EU economy slipping much further behind the US. "On a per capita basis, real disposable income has grown almost twice as much in the US as in the EU since 2000", according to a recent report by Mario Draghi, which addresses European competitiveness and the future of the European Union.

Draghi, a former prime minister of Italy (2021-2022) and former President of the European Central Bank (2011-2019), and distinguished Italian economist also describes how Europe’s world has changed. Changing US politics means that Europe will have to assume greater responsibility for its security. Europe has abruptly lost its most important supplier of energy, Russia, due to the war in Ukraine. And geopolitics are also undermining trade relations with China.

Europe misses the digital revolution

Draghi argues that “the productivity gap between the EU and the US is largely explained by the tech sector”. While technological change is accelerating rapidly, Europe has largely missed out on the digital revolution. The global tech sector is dominated by enterprises from the US and Asia, while “Only four of the world’s top 50 tech companies are European”.

At the same time, Europe needs more productivity growth just to tread water and compensate for its shrinking workforce due to its ageing population. Negative attitudes towards immigration, which are widespread across Europe, certainly do not help the old continent cope with population ageing. Another daunting challenge for Europe is achieving its ambitions for decarbonisation.

All up, Draghi estimates that “to digitalise and decarbonise the economy and increase its defence capacity, the investment share in Europe will have to rise by around 5 percentage points of GDP to levels last seen in the 1960s and 70s”. As many commentators have noted, it is hardly likely that Europe can rise to this challenge.

As Draghi says, Europe faces an existentialist challenge. “Europe’s fundamental values are prosperity, equity, freedom, peace and democracy in a sustainable environment”. But maintaining those values requires becoming more productive, and thus radical change – something which will be very difficult to achieve. A waning in the viability of the European model could well lead to further social and political fracturing in Europe.

Europe’s renaissance imperative

Europe must first close the innovation gap with the US and China, especially in advanced technologies. While the relatively new “GAFA” companies – Google, Apple, Facebook and Amazon – lead US innovation, European innovation is dominated by old companies, notably in the automotive sector – few new companies are rising up to disrupt existing industries. Overall, EU companies spent around EUR 270 billion less on R&D than their US counterparts in 2021.

Europe has the potential to rise to the challenge! Talented researchers and entrepreneurs file patents, but such innovation often fails to be commercialised. Many European entrepreneurs prefer to seek financing from US venture capitalists and relocate their headquarters abroad. While growing numbers of young, talented Europeans study in the US and found their companies there.

The second area that Draghi identifies for action is decarbonisation and competitiveness. He laments that Europe suffers from high energy prices, which are primarily driven by Europe’s lack of natural resources. But he also believes that improvements need to be made to the common energy market in support of competitiveness and growth.

Decarbonisation could be a growth opportunity for Europe, as it is a world leader in clean technologies like wind turbines, electrolysers and low-carbon fuels, and more than one-fifth of clean and sustainable technologies worldwide are developed on the continent. But Draghi is fearful of Chinese competition which is becoming acute, driven by a powerful combination of subsidies, innovation and scale.

Dealing with new security challenges

The last area for action that Draghi deals with increasing security and reducing dependencies. “As the era of geopolitical stability fades, the risk of rising insecurity becoming a threat to growth and freedom is rising”. Europe is particularly exposed. Europe relies on a handful of suppliers for critical raw materials, especially China. Europe is also hugely reliant on imports of digital technology. For chips production, 75-90% of global wafer fabrication capacity is in Asia.

If the EU does not act, it risks being vulnerable to economic coercion. Draghi argues that the EU needs a genuine “foreign economic policy” to retain its freedom. But would EU member countries really be willing to coordinate preferential trade agreements and direct investment with resource-rich nations, as Draghi proposes?

Improving Europe’s defences

Europe’s physical security threats are rising, while the US commitment to defending Europe is flagging and Europe is not ready to defend itself. Only ten Member States spend more than or equal to 2 percent of GDP on defence, in line with NATO commitments. The Ukraine war has acted as a stimulus to European defence spending, but Europe needs to spend much more than 2 percent of GDP.

At the same, reflecting its size, the EU countries are collectively the world’s second largest military spender. But this is not reflected in the strength of its defence industrial capacity. Europe’s defence industry is too fragmented, hindering its ability to produce at scale. It also suffers from a lack of standardisation and interoperability of equipment, weakening Europe’s ability to act as a cohesive power. For example, twelve different types of battle tanks are operated in Europe, whereas the US produces only one. What is standing in the way? But here, as in many domains, Europe is falling short of what we could achieve if it acted as a community.

Europe’s challenging reform agenda

Many of Draghi’s recommendations for improving Europe’s competitiveness and strengthening the future of the EU involve deepening Europe’s single market (including for capital markets), greater policy coordination among EU members, larger investments in R&D and national security, and improving the ease of doing business. He concludes that the risk is that over time Europe could become less prosperous, less equal, less secure and, as a result, less free to choose its destiny.

Europe’s deep fundamental political problems

Draghi’s analysis and recommendations may seem hard hitting. But Draghi himself is very much part of the European establishment, and he steers clear of addressing some of Europe’s thorny political problems.

At a time when increased immigration can be part of the solution to addressing the challenges of an ageing population, public opinion is swinging sharply against immigration in most EU countries. Europe needs to adopt a more selective approach to immigration, and invest much more in facilitating the economic and social integration of migrant populations – rather than putting up barriers to immigration.

While deeper and closer European integration and coordination are necessary to strengthen productivity, European nationalism is turning against the EU and Brussels in many countries. This is a tragedy. The role of the EU in ensuring postwar peace and prosperity has been an unqualified success, which should be better communicated to European populations. It is also testified by the desire of so many countries to join the EU. Europe’s elites must do a much better job at communicating the importance the EU, and more effectively address perceived democratic deficit issues.

While Putin’s Russia has revealed itself to be a corrupt, authoritarian regime, with little respect for other countries’ national sovereignty and with decidedly 19th century-style imperial ambitions, Putin’s regime strangely enjoys admiration and respect among important segments of the European population. In a world of fake news, it is difficult to do battle with the curious attraction for many of Putin. But EU political leaders must do more to expose the rotten nature of the Putin regime, tighten up sanctions and close up all the policies and loopholes that enable Putin and his gang to hide their ill-gotten wealth in Western countries.

In sum, the economic and political challenges facing Europe are enormous, and even more daunting than those laid out by Draghi’s report. And it is not only Europe which is affected. In this world, where the authoritarian regimes of China, Russia, Iran and North Korea are working together in partnerships, the democratic West also needs to be stronger and better coordinated. But Europe has become the weak link in the coalition of Western capitalist democracies.