The world Europe confronts is changing rapidly. On the hand, the United States is becoming widely viewed as an indispensible, but unreliable ally. Equally importantly, the global economy appears to be entering an era of rapid technological change for which Europe is not fully prepared. To be sure, the region enjoys an enviable economic model; combining high living standards, relatively low inequality, and a strong commitment to sustainability. However, structural impediments have limited the area’s ability to exploit new opportunities, and to cope with external shocks. Indeed, since the dawn of the internet age, the European economy has lagged dramatically behind the USA. And, the situation has worsened since Covid and the Global Financial Crisis (Chart below). (In an earlier blog, I discussed how France is dealing with these issues, see “France: Plus Ca Change”).

What lies behind this underperformance? This report will outline the underlying obstacles limiting Europe’s long-term GDP growth potential, and the geo-political challenges posed by the new US Administration, China’s rise as a technological power, and the potential end of fighting in Ukraine. Can Europe remedy this protracted period of underachievement? Not surprisingly, media attention focuses on the need for additional defense spending. However, deep-seated reform, perhaps necessitating fundamental changes to the region’s cherished economic model, likely will be required. Without change, Europe risks being left behind.

Should investors remain sceptical? Indeed, European financial markets have chronically lagged the USA for 15 years, reflecting the region’s subpar economic prospects. However, I advocated an over-weight position in European equities in 2025, largely reflecting the ECB’s clearer cyclical path to lower inflation and interest rates compared to the USA. Converting this tactical optimism into a long-term strategy, however, will require evidence European policymakers have gotten the message.

So far, signals remain mixed. Positively, Europe will deliver additional defense spending. And, the incoming German government appears set to boost infrastructure expenditure. In France, however, the Barnier governent collapsed over the 2025 budget. And, key countries are not joining the “coalition of the willing” to secure a future peace in Ukraine. The continued increase of right-wing, nationalistic parties illustrates Europe’s mainstream leaders must deliver improving living standards….without further delay!

For now, stay overweight Europe relative to the USA. I favour Scandinavia, Ireland, Switzerland, UK, Germany, Italy, and Spain. Avoid France. Radical changes will be required in Europe’s tech, energy, and service sectors, and opportunities could become attractive. If reform gathers momentum, beneficiaries of stronger domestic spending (consumer, capex, and defense) will outperform. Tech and Pharma will outpace older industrial sectors.

Productivity: The Heart of the Matter

Mario Draghi’s must-read report “The Future of European Competitiveness” identified tepid productivity growth as the region’s chief problem. Indeed, nearly 80% of European GDP underperformance stems from subpar output per hour gains. To be sure, all advanced economies, including the USA, have experienced a deceleration in efficiency improvements following the GFC (Chart above). But, European advances have lagged far behind the USA for decades. Trends in the large European economies, e.g. France, Germany, UK, and Italy have been especially worrisome. Without productivity improvements, real incomes and spending stagnated. Indeed, European consumer spending has trailed the USA by 26% since 1995.

The causes and remedies of the productivity problem are numerous. Most importantly, however, is the deficiency in European private and public sector capital spending, particularly since the austerity following the GFC (Chart above).

Likewise, Europe’s inflexible economic model has prevented the region from exploiting the attractive opportunities in the digital age (clean tech is an exception), as McKinsey has repeatedly indentified (Chart above). Indeed, the dissemination of digital technology into the broader European economy has lagged both Asia nad the USA; contributing to Europe’s innovation and productivity deficiencies.

Instead, Europe has remain entrenched in older, industrial sectors. In terms of revenues, for example, eight of Europe’s largest 10 companies are in the challenged auto and fossil fuel sectors. In the USA, by contrast, seven are technology and health care firms. Indeed, the ability of the US corporate sector to exploit new opportunites is highlighted by the fact that in 2024 only 2 of the largest 15 US companies were amongst the biggest firms in 2000 (Exxon and Walmart).

Similarly, European low research and development expenditure relative to the USA has contributed to the region’s innovation deficit (Chart above). It’s not that European entrepeneurs don’t have good ideas. Indeed, the educational system has many positive attributes, although the USA has more elite universities. Rather, Messr Draghi suggests the USA is far better at commercialising its innovations. For example, US start-ups have far greater access to venture capital financing (next Chart). And, the still-fragmented EU Single Market prevents new businesses from achieving economies of scale. Indeed, European entrepeneurs often head to the USA to seek funding, and to take advantage of the large US market.

Demographics and Labour Markets: Getting Old

The urgency to boost productivity is underscored by Europe’s poor demographic outlook. Indeed, low birth rates and an aging population are already leading to labour shortages, and will exacerbate pressures on public finances (Chart below). On a relative basis, the USA is better positioned. But, Europe is not uniform. Demographic pressures are more pressing in Italy, Spain, Germany, and Eastern Europe compared to France, Switzerland, Scandinavia, and the UK.

Moreover, Europe’s more inflexible labour markets both disincentivises hiring, and impedes the reallocation of workers towards more dynamic sectors. As an example, labour taxes and non-wage costs are far higher than in the USA (next Chart). Large budget deficits limit the scope for needed tax cuts for workers.

Building a political consensus regarding the role immigration could play an important role in offsetting these demographic pressures. Of course, migration is a hotly-contested issue everywhere. Ironically, perhaps, the discontent is greatest in some Mediterranean countries in which the share of foreign workers is relatively low (next Chart).

However, high youth unemployment and pressure on low-paid workers contributes to political discontent, and opposition to immigration, especially in France, Italy, Spain and Greece. Deep-seated labour market reforms are needed to boost productivity and real incomes. Is this feasible if AI threatens low-paying jobs?

Service Sector Reform: Boosting Domestic Demand

Accelerating productivity growth (if achieved) would lift real incomes and private domestic spending, which has lagged the USA by nearly 30% since 1995. Stronger spending would contribute to an expansion in Europe’s service sector, which is considerably smaller than in the USA.

However, weak demand is only part of the reason for the underdevelopment of this enormous sector. European service businesses are much more highly regulated than their American counterparts (Chart above). It’s worth noting, however, Europe is not uniform: barriers are far more onerous in less dynamic Northern and Eastern European nations, e.g. Germany, France, Spain, Italy, Poland, etc. than in Scandinavia, the UK, and Switzerland.

Therefore, widespread deregulation of the service sector will be crucial to unlocking the potential of this huge segment of Europe’s economy. Indeed, regulation has contributed to the tertiary sector’s poor productivity performance relative to the USA. Importantly, the gap is especially pronounced in the most dynamic ICT area (Chart above).

Energy Transition: Don’t Squander the Lead

Admirably, Europe is at the vanguard in the fight against climate change. Europe emissions are lower than elsewhere, and the region is a leader in many key green technologies. Of course, many challenges remain. From a competitive perspective, Europe suffers from considerably higher electricity prices than than other regions, reflecting its poor endowment of natural gas and other fossil fuels (next Chart). Therefore, continued development of renewal sources of energy is critical; already 70% of EU electricity is generated by alternatives compared to just 40% in the USA.

However, fossil fuels still play a dominant role in Europe’s total energy consumption: accounting for 60% of energy usage (still lower than USA’s 80%). In large part, this reflects the transportation sector’s failure to reduce fossil fuel usage and CO2 emissions, especially striking in comparison to other economic areas (next Chart). The expanding use of electric vehicles, therefore, will be critical in reaching climate goals, and improving competitiveness. Fortunately, Europe is at the forefront of this sector’s development.

China’s rise as a “clean tech” rival is already threatening Europe’s first-mover advantage in the EV and wind power sectors (next Chart). Meanwhile, if a peace agreement emerges in Ukraine, Europe may be tempted to (or asked to) increase its purchases of Russian fossil fuels. Since the invasion of Ukraine, Europe has virtually eliminated purchases of Russian coal and oil. However, Russian NG still acounts for 15% of Europe’s overall NG imports (although down from nearly 50% in 2021). Hopefully, cheap imports won’t derail the transition to renewables.

External Challenges: Trump, China, Fragmentation

The shifting international environment poses key risks to European policymakers’ ability to meet their electorates’ demands for long-term GDP growth and rising living standards. I will deal with each of these issues in future blogs, but here are some initial considerations.

Defense Spending

I am very confident European NATO members will boost defense spending towards 2.5% of GDP in the next decade. Indeed, Europe regularly spent this amount prior to the collapse of the Soviet Union (Chart above). In fact, many countries (with important noteable exceptions of Spain, Italy, and France) already have reached the 2% target. Chalk it up for a win for Donald Trump, but Russia’s invasion of Ukraine has been the decisive incentive (next Chart).

Trump 2.0: Trade War and Reciprocity

If common sense would prevail, the USA and European Union would build on their extensive trade and investment ties. Indeed, the USA enjoys a goods and services trade surplus with Europe. And, Germany, Italy, and Ireland account for the bulk of America’s bilateral trade deficit in goods. Regarding tariff reciprocity (equating tariff levels between the two areas), levies on non-manufactured goods are low and quite uniform between the USA and EU (next Chart). Unfortunately, I don’t expect common sense to prevail. Trade disputes will escalate in April; starting with autos and spreading to other sectors. Hopefully, EU pledges to increase further the importation of American LNG will help ease tensions.

China and Global Trade Fragmentation

As a trade-oriented zone, Europe is vulnerable to geopolitical shift towards reshoring and global trade fragmentation. In resonse to the Trump Administration’s aggressive trade strategy, Europe already has deepen ties with Canada and China. But, as mentioned, China’s rise as a technology power could potentially threaten Europe’s leadership in key climate-related sectors. In addition, Europe is even more vulnerable than the USA in the race for semiconductors (Chart above) and critical raw materials (Chart below). And, so far Europe has been less successful in securing future supply chains in these key inputs.

Who’s Going to Pay For This?

Boosting investment in defense, infrastructure, education & training, R&D, and capex (not to mention the health and pension outlays for an aging population) will not be cheap. Unfortunately, many nations have experienced sharply rising government debt during the GFC and Covid (Chart below). Germany, Switzerland, and Scandinavia have lower debt; therefore, they enjoy a greater ability to boost spending. France, Italy, the UK, and others do not. In all cases, spending priorities will come under increasing scrutiny. Outlays aimed at the energy transition, digitalisation, and boosting productivity should be at the top of the list. Overall, however, Europe enjoys more fiscal space than the heavily-indebteded USA.