Why Europe Is Losing the Tech Race

The United States is the world’s dominant financial and technological power. China is the global manufacturing hegemon. What is Europe’s economic leverage? That question lies at the core of a recent report by former European Central Bank President Mario Draghi. In a nutshell, Draghi argues that the European Union is facing huge economic challenges that could soon make the bloc irrelevant on the global economic scene. This may sound like an alarmist take. Yet a deep dive into U.S., Chinese, and European economic data shows that Draghi’s analysis is spot on. The EU needs to overhaul its economic model—starting with the way it approaches the financing of innovation—if it wants to avoid being squeezed between the United States and China.

The causes of Europe’s economic woes are structural. Demographics and productivity growth determine long-term economic prospects, and the EU is not doing well on either metric. Take demographics: Primarily because of low fertility rates, the EU’s workforce could shrink by around 2 million workers each year by 2040. Europe’s poor demographic prospects will have important ripple effects, not least because financing growing public health care and pension costs will prove increasingly tricky as Europeans age. Things do not look better for productivity, which has grown at a modest 0.7 percent per year on average since 2015—less than half the U.S. rate and a mere one-ninth of China’s reported figure over the same period. One data point says it all: In 1995, U.S. and EU productivity was broadly similar. Today, Europe’s productivity is about 20 percent below America’s.

The United States is the world’s dominant financial and technological power. China is the global manufacturing hegemon. What is Europe’s economic leverage? That question lies at the core of a recent report by former European Central Bank President Mario Draghi. In a nutshell, Draghi argues that the European Union is facing huge economic challenges that could soon make the bloc irrelevant on the global economic scene. This may sound like an alarmist take. Yet a deep dive into U.S., Chinese, and European economic data shows that Draghi’s analysis is spot on. The EU needs to overhaul its economic model—starting with the way it approaches the financing of innovation—if it wants to avoid being squeezed between the United States and China.

The causes of Europe’s economic woes are structural. Demographics and productivity growth determine long-term economic prospects, and the EU is not doing well on either metric. Take demographics: Primarily because of low fertility rates, the EU’s workforce could shrink by around 2 million workers each year by 2040. Europe’s poor demographic prospects will have important ripple effects, not least because financing growing public health care and pension costs will prove increasingly tricky as Europeans age. Things do not look better for productivity, which has grown at a modest 0.7 percent per year on average since 2015—less than half the U.S. rate and a mere one-ninth of China’s reported figure over the same period. One data point says it all: In 1995, U.S. and EU productivity was broadly similar. Today, Europe’s productivity is about 20 percent below America’s.

Economists have long debated the causes of Europe’s meager productivity. The long list of culprits includes low labor mobility, overwhelming red tape, and flaws in the education system. Low EU expenses on research and development, however, stand out as one of the main drivers of the growing productivity gap between the U.S. and EU economies. The data is striking: At $886 billion, or 3.4 percent of GDP, in 2022, U.S. R&D expenses were more than twice as high as the EU’s, at $382 billion, or 2.3 percent of GDP. China is not far behind; the country is already the world’s biggest spender on public R&D and is catching up fast in private spending as well. On this measure, the United States and China are giving themselves the means to succeed in the global transition toward high-tech, digitalized economies. Meanwhile, the EU is lagging far behind.

There is not much that EU policymakers can do to improve the bloc’s demographic outlook. The main potential fix would entail continued large-scale immigration far into the future, but the growing appeal of populist, far-right parties makes this course unlikely. On productivity growth, however, European policymakers have scope to act.

On this front, the Draghi report calls for a financial electroshock to boost R&D spending. His team of economists reckons that the EU needs to spend an extra 750 billion to 800 billion euros per year to close the gap with the United States and ensure that the bloc does not fall far further behind its competitors. Such an investment push would be huge. It would represent around 5 percent of EU GDP each year—a massive amount by any standard. This is precisely why it is unlikely to happen.

The private sector alone would not be able to shoulder such eye-popping costs. In turn, the fate of Draghi’s calls for an investment push will hinge on Europe’s ability to massively boost public spending on R&D. In theory, this scale of funding could be done through joint EU borrowing, which was first used in 2020, when EU member states gave the European Commission the green light to issue up to 750 billion euros in bonds to finance the post-COVID economic recovery. Yet this time, joint borrowing does not appear to be in the cards. Shortly after the release of the Draghi report, German Finance Minister Christian Lindner declared that “joint borrowing will not solve the EU’s structural problems.” With Germany saying nein, Draghi’s proposal for EU bonds looks dead for the foreseeable future.

Even if Draghi’s calls for a huge investment push are likely to remain unheeded, the bloc still has options to boost innovation spending—for free. On this front, Europe could seek to fix two well-known issues for European start-ups: fragmented public funding across EU member states and sectors as well as a relative dearth of private venture capital.

On fragmentation of public support, the Draghi report makes a simple observation. The 27 EU member states all offer one form or another of financial support to some technological sectors they deem to be critical. Taken together, the amounts are far from trivial. However, there is catch. The lack of EU-wide collaboration to identify a few priority sectors means that a multitude of industries are receiving little money, hindering the emergence of European technology champions.

This situation calls for a bold remedy: EU member states should identify a handful of critical sectors and jointly go big in these fields. Crucially, this does not mean favoring specific firms in an attempt to pick winners and distort competition. Nor does it mean that each EU member state should pick its own pet projects and ask the EU to subsidize their development. And of course, the bloc should also refrain from sustaining zombie firms that would be unprofitable without infusions of taxpayers’ cash.

Instead, what this means is that the EU should create an EU-level structure to identify and fund priority sectors, essentially transferring to EU institutions the responsibility to spell out which sectors should receive public R&D money in a bid to foster the emergence of a more coherent EU financing landscape. Frontier technologies such as artificial intelligence and quantum computing would be obvious sectors for the EU to go all in. The data is stark: More than 80 percent of global AI funding goes to U.S. or Chinese firms compared with just 7 percent to EU businesses. The gap is similarly striking for quantum computing. Seven of the top 10 global firms in the field are U.S.-based. Two are Chinese, and one is Japanese; none is European. In these two fields, the pooling of resources across EU member states could go a long way to bridge the divide between Europe and its competitors.

The emergence of EU tech champions would come with an added benefit: It would lift Europe’s place on the radar of global venture capital funds. Since 2013, about five times more venture capital has gone into U.S. start-ups than European ones. The lack of such funding in Europe comes with dramatic consequences for EU startups: Of the 147 unicorns (start-ups whose value stands above $1 billion) that have emerged in the EU since 2008, about one-third eventually relocated abroad, mostly to the United States, often because they could not find sufficient financing in Europe to grow their operations. Of course, streamlining the hodgepodge of EU and national regulations would also come a long way to boost Europe’s attractiveness to venture capital funds.

There is little chance that EU policymakers will answer Draghi’s calls for a massive investment boost. Yet even absent a huge financing push, the bloc still has ways to boost productivity growth in a bid to remain relevant on the global economic scene. Granted, these measures would not be enough to bridge the gap between Europe and its competitors. What they could do is slow down the bloc’s economic demise.

The stakes are high: Without an overhaul of EU innovation financing, the likeliest scenario is that the bloc will continue to fall further behind the United States and China in the global race for economic might, technological prowess, and geopolitical relevance. What’s more, Europe will struggle to finance its generous social model without sustained economic growth. Tackling Europe’s productivity gap should be at the top of the to-do list of the new European Commission.