By Jeanette Garretty and Avi Deutsch
May 17, 2024 – In 2007, on the eve of the global financial crises, the economies of the European Union and the US were almost identical in size. Fifteen years later, in 2022, the US economy was 1.5 larger than the EU’s.[1] The difference in GDP per capita is even more striking, with the average American now accounting for more than twice the economic output of the average European.[2]
Much water has passed under the bridge since 2007, beginning with the response to the global financial crises, through the sluggish growth of the twenty-teens, the Covid-19 pandemic, global inflation runup, and ending with the Russian invasion of Ukraine and the resulting European energy crises. Through it all, Europe has consistently struggled to find its economic footing. Today, on the eve of what many expect to be a new period of economic growth fueled by artificial intelligence and the transition to renewable energy, it’s worth asking why Europe has fallen so far behind, what the geopolitical implications of the growing economic gap, and how US-based investors could be affected by Europe’s ongoing travails.
What’s Behind Europe’s Slow Growth
One often heard explanation for Europe’s slow growth, especially among the economic right, is the abundance of regulation in Europe. This assertion requires more nuance. The US has plenty of regulations, but Europe has a different attitude toward regulation, and these are used for a different purpose. In the US, one could characterize regulations as being adopted grudgingly and under frequent protest, often only to repair egregious damage (e.g., environmental regulations) or after considerable attempts at private sector solutions. In Europe, regulations are fundamentally viewed as a necessary protection, a means towards achieving the vision for the future. To a certain extent, the European approach to regulation is the equivalent of the US approach to fiscal spending. Consider, for example, the US’ Inflation Reduction Act and its incentives for semiconductor fabrication, as opposed to European regulatory dictates requiring local content, local sourcing or specific product use.
Regulation joins other elements of economic policy that have potentially contributed to a different trajectory for European growth. Many of these elements are not new and have historically compromised the path forward following economic crises and competitive challenges. Chief among these is labor force mobility, which is judged to be less than that in the United States due to still-extant border regulations and cultural preferences. Another factor that is difficult to measure but generally cited is the age and quality of the capital stock. In recent years, some have hoped that investments required to address the impact of the Ukranian War (primarily in energy or energy-intensive industries) and investments in the energy transition would serve the additional purpose of modernizing the capital stock. But, in an economic policy environment where the preservation of jobs has long had priority, productivity enhancing equipment investment has been given short shrift. Finally, the composition of government spending must be noted for its differences with the United States. High levels of defense spending in the United States are often bemoaned, but there is no greater example of the ancillary economic benefits of such spending than Silicon Valley. Many of the original innovators and investors in high technology got their start in the defense electronics arena.
Together, these economic policies that adversely impact economic growth adversely –or fail to promote economic growth— have become more problematic as birth rates have dropped, population growth has decelerated into an actual decline, and the population has rapidly aged. Arguably, the slower the population growth, the more important it is to have a dynamic economy that supports high levels of productivity growth. Some observers have countered that, as a result of these demographic changes in Europe, per capita GDP has actually increased in some European countries while the size of the European economy relative to the US has fallen, implying an improved standard of living.[3] However, per capita calculations ignore the diversity of the demographic impact; slowly growing economies often skew living standards to the benefit of those who have already achieved their wealth (their housing, their education, their retirement, etc.) and away from new entrants seeking opportunities to move-up economically.
History is not destiny, but history shapes attitudes and behaviors in often-underappreciated ways. In the approximate 250 years of US history, vast swaths of the country were settled by pioneers moving away from established centers. These individuals were forced to innovate, with little central government assistance, accepting the associated risks of such a life.
Europe (and, for that matter, another slowly growing economy, Japan) was not formed in the same fashion, and the nearest pioneering equivalent came out of the extreme trauma of two World Wars. The understandable desire for stability and security as a result of the devastation was further emphasized by the German experience with hyper-inflation between the two wars; the muscular monetary policy that exists to this day, committed to price stability at almost all cost, is a direct legacy of the German experience in the 1920s. The European Central Bank has no dual mandate to ensure growth and price stability, as does the US Federal Reserve.
Risk tolerances differ between individuals; why wouldn’t risk tolerance differ between policymakers and economies as well? Europe’s fiscal policy, which focuses more on stability than innovation, and monetary policy, which centers around price stability at any cost, are both more risk-averse than their American counterparts. And the price for lower risk (less volatility) is well-understood to be lower growth.
Has Europe Reached a Post-Growth Age?
One interlinked reason for the economic differences between the US and Europe could be different cultural attitudes towards work. “Americans just work harder” Nicolai Tangen, chief executive of Norway’s $1.6 trillion sovereign-wealth fund manager, told the Financial Times in April.[4] Whether his assertion is true or not, it’s worth asking if working less hard would be a bad thing. After all, many would argue that economic growth isn’t a goal in and of itself, but rather a tool for achieving a certain quality of life. Perhaps Europe has reached the stage, famously described by the economist Maynard Keynes, as a time “when these needs are satisfied in the sense that we prefer to devote our further energies to non-economic purposes.”[5]
Though Europe is far behind the US in GDP per capita, it’s possible that Europeans have a lower wealth-saturation point than their American counterparts. Many historical and cultural forces come together to shape people’s relationship to money, work, consumerism, and leisure. Europe’s greater social security net is likely both a cause and an outcome of cultural ideas about what constitutes a good quality of life. If the American Dream is defined by a white picket fence, the European dream includes more leisure, time with family and friends, job security, and greater stability.
Even if Europeans are indeed content with their economic fortunes, they may still find it hard to continue swimming in place. Remaining competitive in the global economy is no easy task even for those seeking economic growth. The state of real wage growth in Europe presents a tail of diminishing income. This recent ‘cost of living’ crisis is showing up in European political discourse, on roads clogged with protesting tractors and, in poor approval ratings, and in growing support for far-right candidates.[6] Some Europeans might be ready to work less, but others are having a hard time maintaining their existing quality of life, leading to political unrest.
Geopolitical Consequences of Europe’s Economic Weakness
Geo-political issues have emerged as a hallmark of this decade, following the emergence of the global Covid-19 pandemic, the Russian invasion of Ukraine, and the increased concerns over China’s intentions in the South China Sea. In this era, economic power is commonly recognized as a source of global political power and a crucial element of national security. The size of a country’s defense budget, funded in no small part by economic growth, is a concrete metric of this power, as is the capacity of a country to undertake various fiscal measures with global impact.
An example of this non-military critical power is China’s Belt-and-Road policy. Another example is Europe’s aggressive approach to environmental protection policies. If Europe’s economic growth continues to lag its competitors in the global political arena, its capacity to wield geo-political power — to enhance both its security and its economic prospects — will be necessarily compromised. Already, a number of European climate initiatives have been trimmed back or put on hold because of reduced fiscal budgets, most notably in Germany.
Additionally, as has been demonstrated by the long malaise from which Japan is only now, maybe emerging, central bankers consumed by weak economic growth are unable to play a bigger role in the global economic theater in ways that might advantage their constituent companies and populations. Both Japan and Europe, at various times, hoped that their currencies would become a reserve currency for world markets, only to find that hope dashed by the monetary and fiscal policy challenges exacerbated by poor economic growth. At the same time, when central bankers in major markets are contending with substantially different economic conditions, it is difficult to coordinate monetary policy— coordination that can reduce volatility in financial markets and enhance the free flow of liquidity around the world.
Finally, growth that lags political, social, and economic expectations historically fuels popular unrest. At a minimum, the disappointment of living under reduced means often leads to protectionism via trade sanctions or high taxes or both. The risk for Europe of a two-tier economic stratification of the population, with current older workers obtaining long-promised lifestyle and retirement benefits and younger workers faced with considerably less than the generation before, is very real, with unknown ramifications for social cohesion.
Europe’s slow growth also presents a challenge to other economies around the world. Europe represents roughly one-sixth of global GDP and is the largest trade partner to the US and vice versa. Beyond trade, economic growth attracts financial capital and generates financial capital. In the first instance, the capital directed to Europe could be used to fund innovation, grow businesses, and, via the generation of tax revenue, for aspirational long-term government programs such as those that address climate change. In the latter, the financial capital generated by European growth has funded important foreign direct investment worldwide, establishing Europe as one of the largest investors in foreign countries in the world. A shrinking presence of Europe on the world economic stage benefits no one and harms many others beyond Europe itself.
What Does this Mean for Investors
The weakness of the European economies does not necessarily mean that investors should avoid European markets altogether. It does, however, require investors to be more intentional about how they are exposed to Europe. Many European companies, and especially the larger ones—think LVMH, Airbus, Nestle, and Volkswagon—are global giants that stand to benefit from economic growth around the globe. Furthermore, valuations in the European stock market are significantly lower than in the US markets. For example, the Euro Stoxx 50 twelve-month forward price-to-earnings ratio sits at 14.5, vs 21.4 for the S&P500.[7]
Private markets might present even more opportunities for investors, especially those willing to assume the risk of distressed assets. Certain countries and industries are likely to thrive in a variety of macro-economic conditions, and slower growth and depressed markets present opportunities for the right investors.
In all, Europe still represents a large share of the global economy and an even larger share of the world’s developed economies, and likely has a place in any diversified portfolio. However, in absence of a change in policy that would set the continent on a different economic path, investors should make sure they understand their exposure to Europe, and what role this exposure plays in their portfolio.
The impact of Europe’s slow growth on the global economy and geopolitical structures is even harder to predict. But they should still not be ignored. These are best addressed through a lens of overall global growth expectations and the resulting investment return expectations. Importantly, slower economic growth means less prosperity for all, increased chances of economic downturns, and, in a globalized world with little control over the flow of capital, an increased chance for financial contagions. Together, these present an investment landscape that is potentially more volatile but without the higher returns. Investors should take note and make sure their portfolios are aligned with their risk tolerance and the return profile necessary to make their financial plan work.
Sources
[1] https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?end=2022&locations=CN&start=1995
[2] https://data.worldbank.org/indicator/NY.GDP.PCAP.CD?end=2022&locations=US-EU&start=2007
[3] https://www.bruegel.org/analysis/european-unions-remarkable-growth-performance-relative-united-states
[4] https://www.ft.com/content/58fe78bb-1077-4d32-b048-7d69f9d18809?accessToken=zwAGF82rHPhokc9Y_ni7EHdNMtOwSH1p-dGICQ.MEUCIB92ZD8RpEwttSdx97vCKqoHRztL-4oU2MAsBDoUzWp8AiEAw4jTSc9-9XTFDOduLFvoGLO3Gl9B_yFhjUNn44EwYDc&sharetype=gift&token=72e36875-f5a6-4123-b259-e4d175432d4e
[5] https://www.econ.yale.edu/smith/econ116a/keynes1.pdf
[6] https://www.theatlantic.com/ideas/archive/2024/03/america-europe-post-pandemic-growth-comparison/677617/
[7] Source: Bloomberg Finance, retrieved 5/13/24
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