The US economy’s lead over that of Europe, a trend first evident in the aftermath of the global financial crisis and cemented during the coronavirus pandemic, is set to last into 2024 and beyond.
The IMF last week became the latest economics organisation to declare that the US economy would power ahead, forecasting an expansion of 1.5 per cent next year. This compares with IMF forecasts of 1.2 per cent for the eurozone and 0.6 per cent for the UK.
But what explains the persistent divergence between two of the world’s richest regions, in which the US has grown at roughly double the pace of the eurozone and the UK over the past two decades?
The reasons range from cyclical to structural. Relatively short-term factors such as post-pandemic stimulus and Russia’s full-scale invasion of Ukraine have played into the difference, but so have underlying divergences such as access to credit and investment trends, along with industrial composition and demographics.
Here is a breakdown of some of the factors:
Stronger pandemic stimulus boosts spending
During the pandemic, officials on both sides of the Atlantic resorted to aggressive fiscal stimulus to stop a health crisis from turning into an economic one.
However, the US did so at a greater scale. After registering a double-digit shortfall in 2020, the primary government deficit for 2021 was still a massive 9.4 per cent of GDP in the US, more than double the level of the eurozone and almost double that of the UK.
“The US experienced a particularly strong fiscal response after the pandemic, which supported the economy,” said Jennifer McKeown, chief global economist at Capital Economics.
The generous government support has helped drive a recovery in US consumer spending, one of the prime reasons why growth in the country has been so strong.
Repercussions from Russia’s invasion of Ukraine
Pierre-Olivier Gourinchas, the IMF’s chief economist, said European households may have been more “prudent” than their US counterparts for other reasons, including their proximity to the war in Ukraine.
Gourinchas argued that Europe’s “brutal” energy price shock — another consequence of Russia’s invasion — has been the “most important” driver of the two regions’ recent economic divergence.
The wholesale European gas price surged to a record high, much higher than the US equivalent, in the aftermath of Russia’s February 2022 invasion. That pushed the consumer inflation rate for energy up to 59 per cent in the UK and 44 per cent in the eurozone.
“The region is poor when energy prices are high,” Gourinchas said of Europe during the fund’s annual meetings in Marrakech.
Tomasz Wieladek, chief European economist at the investment company T Rowe Price, agreed. “Europe’s main source of energy has turned out to be unreliable,” he said.
The US’s booming tech sector
A critical structural factor behind the US-European divergence is the difference in the industrial composition of the two economies.
The US has a booming tech sector, with successful and innovative companies such as Amazon, Alphabet and Microsoft that have no European equivalents in Europe. With the US dominating artificial intelligence, that gap is likely to widen, economists warn.
By contrast, Europe specialises in industries that are increasingly facing the threat of Chinese competition, such as electric vehicles.
Europe, and Germany in particular, were “a massive winner [from] globalisation the way it existed until 2018, but that type of globalisation now seems to be over,” said Christian Keller, head of economics research at Barclays Investment Bank.
The US is also proving more nimble in shifting its economy towards green technology.
The $369bn Inflation Reduction Act has helped to incentivise investment in green technologies, with hundreds of billions of dollars in subsidies and tax credits. The EU response has been slower and more complex to implement, according to many economists.
Attracted by the IRA, some European companies have shifted investment to the US, including Total Energies, BMW and Northvolt.
“There’s definitely an investment renaissance in the US right now,” said Paul Gruenwald, chief economist at S&P Global Ratings.
Invest in the US
Easier access to finance has long helped the US economy, including its tech sector, to boom.
More venture capital, and better developed debt and equity markets, have made it easier for US companies to fund their expansion than their European counterparts, which rely much more on banks. Europe has also endured a sovereign debt crisis and fiscal austerity — both of which have hit investment.
In AI alone, venture capital investment over the past decade has topped $450bn, nearly 10 times that of the eurozone or the UK, according to data from the OECD.
“The ability to raise large sums, to finance quite risky investment, just isn’t there [in Europe],” said Keller. “The European bank finance model doesn’t allow it.”
Nathan Sheets, chief economist at US bank Citi, flagged that venture capital had provided a “flexible financing mechanism” for tech. “I’m sure it is easier to pitch tech ideas to a venture capital firm in Silicon Valley than it would be to pitch it to a large European bank,” he added.
Businesses can be scaled up more quickly in the US, as the country offers a large market with a consistent language and regulatory system, aiding innovation. Despite its single market, Europe is still in many ways fragmented, particularly in the services sector.
Innovation from top US universities, such as the Massachusetts Institute of Technology on the east coast and Stanford on the west, has also helped.
“Once you have that agglomeration of expertise it tends to kind of proliferate,” said Sheets.
Those factors have helped boost US investment and productivity, a crucial determinant of living standards, much more than in Europe.
An ageing society and weak labour market
Europe’s rapidly ageing population and weaker population growth is weighing on the continent’s public finances. It is also having an impact on the gap with the US, which — unlike Europe — has seen its working-age population expand since 2010, albeit at an increasingly slow pace.
“Europe has grappled with low productivity growth for some time, and the effects of population ageing and labour supply constraints are starting to bite,” said Alfred Kammer, the IMF’s Europe director, earlier this month.
Without the differences in demographics, the gap between transatlantic growth would be less stark.
However, demographic trends in the coming decades are also set to work in the US’s favour.
Wieladek also noted that European growth had been aided by labour market tailwinds in recent decades, such as more women and older people working.
“The wages of skilled eastern European workers are rising rapidly,” he said. “Social reform in western Europe — which contributed to raising labour market participation — has likely reached its limits.”
An ever-widening gap?
With stronger investment and better demographics, the gap between the US and Europe is likely to widen further in the coming years.
“The US could increase its potential growth while Europe struggles to maintain the lower growth it already had,” said Keller.
A European catch-up “seems quite unlikely”, said Samy Chaar, chief economist at the bank Lombard Odier.
Sven Jari Stehn, economist at investment bank Goldman Sachs, agreed that the US would “continue to outgrow the euro area in coming years”, even if the temporary post-pandemic factors fade.
However, the high US deficit — it is set to boost public debt from the current 97 per cent of GDP to 119 per cent by 2033, a record high — poses a threat to its growth.
“The US will have to take tough decisions on the fiscal side,” said Keller.
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