Europe is out of shape, but a surge of productive investment could set it right

Europe must boost investment. Its productivity and competitiveness depend on it – as do its future wealth and debt sustainability.

Europe, like much of the rest of the world, still faces a bloated balance sheet. Its assets have ballooned faster than its productive output for more than two decades now. And as the world’s wealth grew to an unprecedented $600tn this year, the eurozone’s wealth also climbed to $135tn – 6.6 times its GDP. Hands down, accelerating productivity is the best way to restore some equilibrium and secure future prosperity, according to new research by the McKinsey Global Institute (MGI). Productivity growth is also urgently needed to help pay for rising pension and healthcare costs, a step-up in defence and the net zero transition while also wrestling with increasingly expensive and unsustainable levels of public debt.

Conversely, without a decisive shift to accelerate productivity, the research also finds that Europe runs the risk of returning to ‘secular stagnation’ again, where excessive savings from households working through real estate debt combines with insufficient corporate investment to produce sluggish growth and near-zero interest rates. Staying on this course, Europeans would be worse off. For example, Germany’s GDP gap with the United States – currently at $29,000 per person – could widen by $19,000 to $48,000 per person by 2033 in the stagnation scenario we model. And debt ratios would remain too high, kicking the can further down the road.

The decisive shift to unlock productivity growth must include more investment – in the right places. Investment drives about 80% of productivity growth globally. Yet large European corporations trail their US counterparts by about $700bn a year in combined capital expenditure and research and development (R&D). The industries most likely to shape the future of global competitiveness are where Europe’s investment gaps loom largest.

Foreign direct investment as a bellwether – or canary in the coalmine

But there is good news in the investment pipeline, according to more new MGI research. Announced greenfield foreign direct investment (FDI) into Europe from outside the bloc is currently about 40% higher than it was before the pandemic, compared with a 25% rise globally. FDI announcements offer foresight, indicating where tomorrow’s productive capacity may be built. Alongside domestic investment, FDI can bring Europe new technical knowledge, seed supplier ecosystems, and anchor skills in places that can use them.

Following the trail of recent FDI announcements, we see Europe’s oversize gain is driven by three bright spots since 2022: an average of $28bn a year pledged by US tech giants into AI-enabling data centers, $20bn a year into new energy infrastructure mostly from Asian and Middle Eastern partners, and about $18bn a year into electric vehicles and battery projects, with about half coming from China. These three bright spots align with some important strategic priorities for Europe.

However, clouds also loom. Europe’s outflows are about twice its FDI inflows. And where US and European inflows were once similar, Europe is now attracting only about 70% of the US’s pledged FDI levels each year. Europe’s shortfall is most visible in advanced manufacturing – knowledge-intensive industries like semiconductors and batteries – where it captures just a third of the US’s levels. Since 2022, technology powerhouses based in Japan, South Korea and Taiwan are among the top global investors announcing US projects in areas where scale, speed and know-how are critical. Here, FDI announcement trends may serve as the proverbial canary in the coalmine, warning of danger ahead if Europe can’t increase its FDI magnetism.

Four priorities for Europe now

To escape this predicament, Europe needs investment to boost its competitiveness. MGI’s new research points to four productive priorities.

First, public procurement should be strategically used to attract and mobilise private capital and innovation. Europe’s substantial public spending in defence, energy infrastructure and healthcare could create big opportunities for private-sector innovators looking for contracts to build tomorrow’s hydrogen infrastructure, defence technologies and outcomes-based healthcare initiatives, for example.

Second, Europe must eliminate, or at least reduce, its market fragmentation and drive scale. Adopting a common regulatory framework or simplified business code – for instance, a ‘28th regime’ – could help European firms compete with other advanced economies by cutting through some of Europe’s diverse and complex labour market rules, VAT and corporate tax systems, insolvency frameworks, stock option rules and corporate laws.

Third, Europe’s focus should be on a ‘private equity and venture capital union’ more than a ‘capital markets’ or ‘savings and investment union.’ Growth and innovation are funded first and foremost from cash flows, venture capital and private equity. Yet Europe’s venture capital assets under management are equivalent to only about a quarter of US totals. European pension funds may hold the key. Redirecting even a little more of their assets into venture and growth equity could unlock patient capital for Europe’s 32 million small and medium-sized enterprises and feed their ambitions.

Fourth, Europe should take steps to attract more FDI to build out the industries of the future as special strategic projects, bringing in expertise and resources from multinational corporations across borders. Regulatory sandboxes for innovative investments in priority areas can help fast-track promising projects. And some selected bureaucratic rules can be simplified or eased, even as Europe takes its time on broader regulatory reform.

Policymakers and corporate leaders should commit to reforms and investments that drive productivity and competitiveness. Getting this right isn’t merely about income, wealth, and balance sheets – it’s about Europe securing its economic future in an increasingly competitive global landscape.

This article is a contribution from a member or partner organisation of Friends of Europe. The views expressed in this #CriticalThinking article reflect those of the author(s) and not of Friends of Europe.