Paul - Be Careful What You Want to Prove
Europe on Hysteresis
Like 100,000 other readers, I am a big fan of Paul Krugman’s Substack pieces as well as his many contributions to the New York Times over many years, not to mention his mostly innovative academic work. However, I started years ago to turn skeptical regarding his analyses of European economies. Lately, he has been making the point that things are not as bad as most analyses of the state of European economies suggest. I don‘t think that his many vacation trips to European countries are guiding his perception. What seems to drive him beyond his very clear economic analytical skills is the hope that capitalism does not automatically imply bad outcomes for the majority of citizens. He has a valid point. Europeans, at least in the core countries, enjoy free or affordable health systems, live much longer than U.S. citizens, have much longer paid holidays, and are, on average, better educated than North Americans. Wages are lower, and so is the productivity level, but if one includes price levels of goods and services, things are not bad at all. Europeans operate under the rule of law and an independent judicial system, compared to the US. Corruption on the highest political level can occur, but not in the way the US is currently experiencing. Even though inequality in income and wealth has increased in Europe, the level is much lower than in the Gilded Age societies of North America. The distribution of income and wealth is k-shaped but not as pronounced as in North America.
Does this mean all or most is good in Europe? No! Not at all. Europe, or for the sake of the argument, is turning towards a path of stagnation, for economic and political reasons. The danger is that it may lose the economic foundation for the good life its median citizens enjoy. Let me start with the productivity problem. According to Krugman, it is not a real problem. His attempt to explain the widening gap of productivity, measured as output per hour, by the US advantage of one sector does not hold up: ‚America’s faster growth (in output per hour) reflects its dominance of a narrow sector, IT, and has not translated into lagging European productivity measured in terms of the value of the goods an hour’s labour can produce.‘ His little graph, which distinguishes between productivity measured in constant and current prices, favours the calculation by PPP (Purchasing Power Parities), which, according to him, is the best way for a comparison. Even if one accepts this argument, one can still see that the gap increased between 2019 and 2023. I would add that extending the comparison to 2025 will show a continuation of the rising gap. Let us take the case of Germany. The graph uses PPP as asked for, and shows that Germany’s productivity gap has increased until 2025. This is not really surprising given the stagnation of the German economy. And yet, it seems to me to indicate a problem that is the basis of the lagging IT sector.
The picture is not different if one takes a comparative look at the whole EU. The productivity gap, again measured and calculated as output per hour in PPP, is widening.
The Draghi Report on the loss of international competitiveness (I know, a term Krugman sees as highly flawed…) offers some valuable insights. Like Krugman, Draghi explains the productivity gap between the EU and the US mainly by the tech sector, or Europe’s relative lack of one. He sees fragmentation as the key problem. The EU has around 100 tech-focused laws and over 270 regulators active in digital networks across all Member States. Financing instruments are split along national lines, which blocks large investment pools and creates unnecessary complexity for the private sector. The Single Market, despite decades of effort, remains incomplete. Europe’s Horizon Europe R&D funding programme, though having a €100 billion budget, is spread across too many fields, access is excessively complex and bureaucratic, and it is insufficiently focused on disruptive innovation. Rather than going for risky innovative activities, European companies operate mainly on a path of incremental innovation, which was pretty successful for a long time but is inferior in times of disruptive innovations. If an innovation gap is in place, then hysteresis processes tend to increase it over time. What looks for the moment like a minor problem can quickly grow into a big problem.
European welfare states are not cheap. They need steady and growing tax receipts from the state to provide adequate fiscal resources to maintain the system. Stagnant economic growth is a problem as diminished government resources create conflicts between various state functions. A long-term problem is the overageing of most European societies. US life expectancy reached roughly 79 years in 2024, lagging significantly behind the average for comparable European nations, which typically range from 81 to 84 years. It speaks of the quality of life, mainly supported by the quality of its social systems, that European people have longer life expectancies than the citizens of the US. What is a great achievement can come under pressure when the share of the active population is getting smaller. A problem of insufficient labour supply can limit the growth and production potential. Even more so, when what is actually happening is that European countries restrict immigration and simultaneously are experiencing problems in improving productivity.
The immediate effect shows up in the health and pension system. Lifetime working time and pension time are getting decoupled. Most pension systems were designed in a way that lifetime working time and thus contributions into the system allowed the payment of pensions for a particular time period. If this time period is getting longer, the system needs adjustments. Those adjustments, it turns out, are creating resistance on the side of greying voters who make up a significant chunk of voters. Things are not getting better with the rise of nationalist right-wing parties, which make, besides other illusory and dangerous policy proposals, far-reaching promises to increase pensions and to stick to early retirement regulations.
Krugman is correct: Europe is no technology museum. It has enormously skilled workers and well-developed education systems, which can be the base for an innovation offensive. Germany and the EU have a global lead in AI standard-setting, foundational research quality, and the application of AI in traditional industrial processes. Whether industrial AI will improve still-existing comparative advantages in manufacturing is open, as the political support for such an innovation strategy is relatively weak. The €5.5 billion German AI initiative focuses on next-generation models and data infrastructure with a specific industrial applications focus, with flagship knowledge-transfer projects for automotive, chemicals, biotechnology, cleantech, medicine, and agrifood showing a good direction, but the available funding is much too small to make a lasting impact. In contrast, the five largest EU countries spend €42 billion per year subsidizing fossil-fuel-powered company cars alone, with Italy at €16 billion, Germany at €13.7 billion, France at €6.4 billion, and Poland at €6.1 billion. What Europe currently lacks is a political class that looks forward rather than defending old industries and technologies. Time is running!
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