What Europe can learn from the US about growth, reveals IMF report

A thriving business sector, with young high-growth firms on the rise, especially in the tech sector – are key if Europe is to speed up its productivity which is lagging behind the US, according to the International Monetary Fund (IMF). 

The organisation’s newly published report “Europe’s Declining Productivity Growth: Diagnoses and Remedies” is calling for urgent steps to close the productivity gap between the EU and the US, especially in high-growth sectors, such as information technology.

“The productivity of US listed tech firms increased by around 40% over the past two decades, while that of European tech firms has remained stagnant.”

European GDP per capita is lagging behind the US

The slowdown in productivity growth in Europe has become one of the key reasons behind a widening per capita income gap with the United States. 

In September, the Draghi report has already pointed out that “a wide gap in GDP has opened up between the EU and the US, driven mainly by a more pronounced slowdown in productivity growth in Europe”, also stating that “on a per capita basis, real disposable income has grown almost twice as much in the US as in the EU since 2000.”

Now the IMF says that it is down to European firms to alter this course, although at present their “productivity growth engines are being muted”.

Compared to those in the United States, “Europe’s large leading firms are falling behind in terms of productivity and innovation, with the difference particularly pronounced in tech sectors”, said the report. “Second, at the other end of the spectrum, Europe suffers from a deficit of startups, with too few among them growing fast and eventually making it to the top.”

The challenge ahead for Europe’s firms

According to the IMF, Europe’s limited effective market size and low level of equity financing (the process of raising capital through the sale of shares) are the key drivers holding back the continent’s large leading firms from scaling up and innovating.

Even though the EU and US economy both represents about 15% of the global economy when measured at purchasing-power parity, the EU’s market is more segmented internally. “The intensity of trade across EU countries is less than half of the level of trade across US states”, underlines the report. 

European firms turn to equity financing far less than their US competitors. However, this is seen as a critical means of financing more risky and intangible investments – which are particularly important in the tech sector – that cannot be pledged as collateral. 

Meanwhile, Europe’s venture capital industry (financing provided by firms or funds to startups, at an early stage), the ultimate funding source for emerging companies in technology, is only one-quarter of its size in the US.

In the EU, debt financing is more widespread, even though it exposes firms to bank-related financial stress. 

This trend contributes to lower and more volatile research and development (R&D) investments in the continent, according to the IMF. Low R&D investments are particularly detrimental to how much Europe’s firms could adopt digital technologies, which need massive upfront spending on development. 

Compared to the US, European firms have spent 3-4% of their sales on R&D in recent decades, one-third of what their US counterparts have allocated. US tech firms also enjoyed higher sales growth, pushing further the absolute R&D spending gap between the two regions.

What are ‘gazelles’ and how do they contribute to Europe’s productivity?

According to the IMF, the EU has an overabundance of small mature low-growth firms but faces a scarcity of high-growth young firms. They are the so-called gazelles.

European firms tend to remain smaller, partially due to a lack of capital to finance risk-taking and realize their potential. 

As a result, fewer innovative young firms end up reaching top-firm status in Europe.

The IMF cites their data, clearly pointing fingers at the problem: the median founding year of the top 10 listed firms is 1985 in the US, while it is 1911 for Europe. 

Young high-growth firms are on the rise in Europe, though they remain below the levels seen before the global financial crisis. European gazelles account for about 0.5% of total firms, while their sales growth exceeds that of large leading firms by about 10 to 15 percentage points. 

What are the remedies to boost productivity in the EU?

Continued efforts towards a deeper single market, is among the most recommended steps by the IMF, including removing administrative barriers on a domestic level in the member states. 

Cutting remaining intra-EU trade barriers could raise effective market size and stimulate European firms’ productivity, says the IMF. The organisation reckons that the direct impact of reducing such barriers to the level observed among US states could potentially increase productivity by 6.7%. 

It is also highly necessary for the EU to advance “towards the EU capital markets union”, which could also pave the way to increased risk funding, by easing the constraints that limit equity capital in the continent.

This is also crucial to support creating gazelles.

Another key driver to nurture more high-growth firms is to bring about a wider pool of venture capital and other means of risk financing.

According to the IMF’s analysis, European firms vastly improve their performance upon receiving VC backing. 

However, “in the past decade, VC investments were less than 0.2% of GDP in the EU compared with nearly 0.7% in the US and they were concentrated in a few countries such as the United Kingdom or France”.

Europe also needs to address its demographic challenges, by investing in human capital by upgrading skills, and bringing in more female workers on the labour market, according to the IMF. 

A further recommendation is to implement more R&D tax incentives to support young, innovative firms, which is currently applied in fewer than a quarter of EU countries. “They should also ideally be harmonized across countries so that R&D investments take place where their expected returns are highest,” adds the report. 

European firms should also invest in education, digitalisation and the adoption of frontier technologies to secure higher productivity in the future.