The European Union has a productivity problem: since 2000, it produces nearly 30 percent less output per hour worked than it would have if real output per hour worked had been growing at U.S. rates.
The failure to nurture innovative start-ups into “superstar” companies is one of the reasons for the EU's sluggish productivity growth.
At the root of the problem are Europe's fragmented economic and financial systems: without a more frictionless single market for goods, services, labour and capital, it becomes more expensive and difficult for successful start-ups to scale.
On top of that, Europe's bank-based financial system is not well-suited to lending to risky startups. High-tech startups often develop new technologies or business models that are risky and difficult for banks to value. And the value of a startup often lies in its people, ideas, and other intangible capital, which is difficult to offer as collateral for a bank loan. Banks are also constrained by rules that (rightly) limit unsecured lending to risky companies, even fast-growing ones that have the potential to make big profits in the future.
Europe's private capital pool is also smaller and more dispersed than in the United States. Europeans park their savings in bank accounts rather than capital markets. For every dollar Europeans invested in stocks, investment funds, pension funds or insurance funds in 2022, Americans invested $4.60. This is partly because Europeans rely more on pay-as-you-go pensions than Americans. But whatever the reason, the end result is less availability of equity financing for companies.
Market fragmentation is due in part to national laws, regulations and taxes that impede cross-border integration, financing and risk sharing. Many institutional investors prefer to allocate capital to companies based in their home country. This also applies to venture capital investments, especially for smaller funds.
Increased venture capital investment could stimulate productivity and strengthen the EU's innovation ecosystem, but Europe's shallow venture capital pool means a lack of investment for innovative start-ups, undermining economic growth and improving living standards.
As our new paper argues, measures to strengthen the EU venture capital market and eliminate cross-border financial frictions for pension funds and insurance companies that invest in venture capital could increase the flow of capital to promising start-ups and boost productivity growth.
Following the UK's departure from the EU in 2016, the EU lost its largest venture capital base, London, and what remains is nowhere near the size of its US base.
Over the past decade, venture capital investment in the EU averaged just 0.3% of gross domestic product, less than one-third the average in the U.S. During this period, U.S. venture capital funds raised $800 billion more than European venture capital funds.
Venture capitalists invest heavily in risky research and development activities that are crucial to propagating innovative ideas and increasing overall growth. They are adept at cherry-picking promising startups and committing resources to the best performing ones.
Compared to their transatlantic competitors, Europe's more established startups also have a less attractive option to grow through an IPO in the EU, which reduces the incentive to invest in them in the first place. And as fast-growing startups begin to scale rapidly, they often have to raise funds abroad due to limited funding in Europe – the so-called scale-up financing gap. Many startups relocate their operations overseas once they secure scale-up financing from abroad. As a result, Europe loses out on many of the benefits of having successful startups at home – both the direct growth effects and positive spillover effects such as technology diffusion.
National authorities can take several steps to support their domestic venture capital markets.
The venture capital sector is characterized by high risks and information asymmetries, but also positive externalities that private investors do not internalize. Well-designed tax incentives for equity investments in start-ups and venture capital funds can help stimulate a sector that is underdeveloped or non-existent due to market failures. It reduces regulatory and tax frictions for venture capital investments. Developing private pension funds has a range of benefits, including expanding capital markets and the domestic pool of capital to invest in venture capital. It allows national public financial institutions, which have played a key role in supporting the development of the venture capital sector in some countries, to expand the availability of capital and other support to venture capital funds and innovative start-ups. They should invest on commercial terms and help attract more private capital, especially from institutional investors such as pension funds and insurance companies. This can be done quickly, before other efforts bear fruit.
Actions at the European level would also help: the most important step the EU can take is to complete the single market for goods, services, labour and capital, which will take time.
On a more immediate basis, authorities can:
Tweak the rules for insurers and other investors in large venture capital funds to reduce obstacles to venture capital investment, particularly supporting growth capital. Expand the capacity and tools of the European Investment Fund (EIF) and the European Investment Bank to channel more resources to venture capital funds and innovative start-ups. Encourage the EIF to develop a fund of funds aimed at attracting capital from institutional investors across the EU, to fund large venture capital funds with a pan-EU focus. This will reduce fragmentation of the capital pool and help institutional investors better understand venture capital as an asset class, helping to close the funding gap for scale-ups.
In the medium term:
Reducing stock market fragmentation and increasing stock market depth, liquidity and valuations to make listings in the EU more attractive – a key challenge for capital markets integration, but one that will be politically more difficult.
Government intervention is often not a perfect solution, but it may be necessary in the short term to accelerate the development of the venture capital sector and funding for innovative start-ups. This would not only stimulate productivity in the EU but also strengthen its competitiveness. Increased venture capital funding for the “clean tech” sector would support the EU's green ambitions and reduce the need to rely on expensive subsidies that could distort the single market.
