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Europe has long looked across the Atlantic at the US economy with a mixture of horror and awe. The EU population would not accept the health and social inequalities in America, but it wishes it could be as rich as the US. That tension was amplified in 2023 when the US economy grew 3.1 per cent in the year to the fourth quarter, dwarfing the 0.2 per cent the EU managed. As Americans revel in unexpected economic strength, France feels forced to cut back public spending and Germany frets about recession.
Over a longer period, European performance is both better and worse than people tend to think. It is not correct to say, as the European Council on Foreign Relations did last year, that the US economy is now more than 50 per cent larger than the EU’s economy, having been smaller in 2008. Those figures rely almost entirely on exchange rate movements. But it is true and fair to highlight 2008 as something of a turning point. Before then, the EU (excluding the UK) had a larger economy, and now it is about 10 per cent smaller.
But the reasons for this change are nuanced. Much of the difference before and since has come from a more rapidly rising US population. Real gross domestic product per head grew 53 per cent between 1995 and 2022 in the US, compared with 47 per cent in the EU.
Break this down further and demographics clearly plays an even more decisive role. Partly because Europe has an older population and partly because its people don’t die as early, GDP growth per person of working age has been broadly the same on both sides of the Atlantic since 1995. The European growth rate just eclipses that of the US, growing 56 per cent compared with 54 per cent. For sure, European levels of GDP per person of working age are lower, but this reflects choices to have longer holidays, retire earlier and work fewer hours.
Before Europeans gloat about their joie de vivre, that is not the end of the story. The main reason for a stable gap between US and EU GDP per person of working age has been two offsetting forces netting out. European employment rates have risen from about 60 per cent of the working-age population in 1995 to a rate close to or even slightly higher than the traditional US rate of more than 70 per cent. Offsetting a rising European employment rate have been slower improvements in output per person employed and per hour worked. Europe has more people in work now than it did, but they are not terribly productive. And it will struggle to keep raising employment rates for ever.
Part of the fix for slow European growth must therefore include improving the productivity of workers and capital. This element was well addressed in a speech last week by Isabel Schnabel, a member of the European Central Bank’s executive board.
Schnabel argued that improving Europe’s productivity growth rate would rely on better management of companies in a more dynamic business environment. Specifically, she called for governments to sharpen the competitive environment, allowing more creation and destruction of European companies, greater EU integration to expand the effective market size and more effective deployment of public investment. She was right on all three counts.
There is a fourth component of the business environment that she overlooked, however, which Europe has recently gained more scope to exploit than at any time over the past two years. That is, creating a supportive macroeconomic environment for growth and productivity improvement. In short, the EU’s stagnant economy could benefit from running hotter than the ECB currently allows.
Raising its main interest rate from -0.5 per cent in the summer of 2022 to 4 per cent today, it imposed a serious squeeze on the European economy, designed for a world in which the EU had to accept that its move away from Russian oil and gas made it poorer, that workers needed to take large real pay cuts and that firms had to accept limits to their profitability. Those dark days are thankfully behind Europe. Import prices have fallen back sharply and the terms of trade have almost recovered. Whatever the appropriate setting of monetary policy was to tame inflation, it is lower today.
On Tuesday, the spot wholesale gas price was about €24 a megawatt hour. The future price for next winter was under €29 per MWh, less than on the eve of Vladimir Putin’s full-scale invasion of Ukraine two years ago. Holger Schmieding, chief economist of Berenberg Bank, estimates that the eurozone’s import bill for fossil fuels this year will be barely above 2019 levels. It means a recovery in real wages and spending is fully compatible with stable inflation across the eurozone and the wider EU.
I have never fully advocated running an economy hot to see if it raises productivity growth, but there cannot be a better time for such an experiment. There is little case for a further economic squeeze across the EU now the energy facts have changed.
The European economy deserves a break and a kick-start this year to foster growth alongside the normalisation of inflation. Policymakers need to accept the continent is richer than they thought and exploiting that boost is a necessary but not sufficient condition for a longer-term improvement in Europe’s productivity performance.