Low-growth firms

Europe’s wide productivity gap warrants a closer look. My colleagues recently examined the performance of European companies with the potential to become macroeconomic growth engines—established productivity leaders as well as young high-growth firms (Adilbish and others 2025). The findings reveal significant innovation and productivity gaps relative to the global frontier for both groups.

Not only do Europe’s leading companies lag their US competitors, but they are falling further behind over time. This is true across all sectors, but especially for tech. While the productivity of US-listed tech firms has increased by about 40 percent over the past two decades, European tech firms have seen almost no improvement. 

One reason could be that US firms are simply trying harder: They have tripled their research and development spending to 12 percent of sales revenue, three times European companies’ ratio, which has languished at an average of 4 percent in recent decades.

The future would look brighter if Europe could hope for young high-growth firms to reduce the innovation and productivity deficit. Alas, the EU has few such companies. And they have a substantially smaller economic footprint than those in the US, where younger firms account for a far larger share of employment.

In other words, the EU has too many small, old, and low-growth companies. About a fifth of European employees work in microfirms with 10 people or fewer, about double the US figure. And while the average European firm that has been in business 25 years or more employs about 10 workers, comparable US companies employ 70 (Chart 2).

What explains these stark differences? Our research points to Europe’s still-fragmented consumer markets for goods and services. But capital and labor markets are also at fault, further limiting companies’ incentives to scale up and their abilities to do so.

Europe’s bank-dominated financial markets favor physical collateral for their loans. But young companies, especially in the tech sector, typically have fewer physical and more intangible assets, such as patents. The continent needs capital markets to channel savings into large-scale long-term investments in risky but potentially revolutionary ideas.

Scarcity of high-skilled workers is another problem. This reflects both high barriers to cross-border labor mobility and the overall lack of human capital needed for innovative sectors. This is compounded by many countries’ aging populations, which could make the new ideas that produce young and high-growth firms harder to come by. 

Stronger single market 

For now, at least, Europe’s productivity gap does not stem from a shortage of innovative ideas. It remains an important incubator for innovation in foundational science and technology, and its companies continue to push the intellectual frontier, especially in fields like pharmaceuticals and bioengineering (see “Europe’s Innovators Are Waking Up” in this issue of F&D). Even so, there is a troubling trend of innovative European firms taking their talents to more dynamic markets elsewhere, with future “unicorn” companies valued at more than $1 billion leaving the EU for the US at a rate that is 120 times faster than the other way around, according to research by Ricardo Reis, of the London School of Economics.

Europe certainly has enough savings available to finance higher investment. At about 15 percent of GDP, the EU’s household saving rate is about three times that of the US. Yet Americans invested $4.60 in equity, investment funds, and pension or insurance funds for every dollar invested in such assets by Europeans in 2022. The fundamental issue is the EU’s more limited ability to channel ideas and capital into productive uses within its borders. Put simply, the continent’s fragmented internal market has failed to realize a lot of income growth.

All this underscores the urgency of completing the single market agenda. Sound macroeconomic policies, including securing price stability to provide certainty to investors and meeting spending challenges without upending fiscal sustainability, are necessary preconditions. Next, countries must step up reforms in the core areas of the single market.

Lowering internal trade barriers, in goods and especially in services, must be a priority. It would incentivize firms to undertake R&D and other high-risk, high-reward investments. The EU could raise its GDP by 7 percent if it reduced internal barriers for goods trade and multinational production by 10 percent, our research shows. There is plenty of room for improvement by opening protected sectors, liberalizing services, and harmonizing regulations.

These efforts must be accompanied by progress toward an integrated capital market, or savings and investments union (see “Europe’s Elusive Savings and Investment Union” in this issue of F&D). Critical reforms—including reviewing the prudential regime for insurers and harmonizing oversight of capital markets—could channel the EU’s substantial savings into much-needed equity financing for all companies.

Young high-growth firms would benefit significantly from the greater availability of capital and lower financing costs—capital that market integration could deliver, especially if paired with national reforms to unleash venture capital investment.  

At the same time, countries must be careful not to undermine the single market and all its opportunities with poorly conceived industrial policy. Industrial policy can play a role if it corrects market failures—by pushing companies to become greener or to take up transformative technologies, for example. But protecting mature industries from sweeping structural transformation is not sensible. Europe must look forward, not backward. 

Even carefully targeted industrial policy can backfire by diverting trade and production patterns away from established areas of comparative advantage. Countries must coordinate industrial policies or, better still, agree to set them at the EU level (Hodge and others 2024).

Greater resilience

A fully integrated single market would also strengthen Europe’s economic resilience in today’s perilous, shock-prone world. Companies that serve more customers in more countries are less affected by economic ups and downs at home. The same principle applies to personal investment portfolios when financial market barriers are lowered and people spread their holdings across the whole EU. The benefits of risk sharing can be sizable, but diversification is still limited compared with the US.

Similarly, the EU could reduce its dependence on imported oil and gas, protect itself from volatile global energy markets, and lower prices for consumers with a more integrated energy market. 

To take full advantage of EU reforms, national efforts must match regional ambition. Labor markets, human capital, and taxes are in the greatest need of reform to promote growth, our forthcoming research shows. Advanced economies would benefit most from deregulating product markets, deepening credit and capital markets, and promoting innovation. For many central, eastern, and southern European countries, the top priorities are investing in skilled labor, removing red tape, and improving governance. The growth gains could be sizable. 

Power of integration

The 2004 enlargement welcomed Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia to the EU. Two decades later, GDP per person in those countries is more than 30 percent higher than it would have been without accession. For the countries already in the EU, GDP per person is 10 percent higher than it would have been without expansion (Beyer, Li, and Weber 2025).

This leap in living standards underscores the powerful impact of integration. Current reform proposals are a start, but more ambition is needed. A stronger single market would improve the EU’s economic outlook, support its policy priorities, and strengthen its resilience, ensuring that the region remains a global leader in innovation, sustainability, and quality of life. It’s an opportunity Europe cannot afford to squander.