Recently, when European Union officials visited Washington, they were met with an eye-opening presentation from Jerome Powell, the Chair of the US Federal Reserve. He showcased a striking chart that compared American productivity over four decades against that of the European Union.
This graph illustrated that the United States has enjoyed a solid increase in productivity at 2%, while the European Union lagged behind with just 1% growth.
As Mr. Powell shared with a Senate committee, “The striking disparity in income and living standards after 40 years is astonishing.” A European official noted candidly that “it’s uncomfortable for Europeans to confront this chart. It unmistakably illustrates the EU’s relative economic decline, which translates into a decline in political influence.”
Across the board, the EU has been grappling with a slew of unprecedented crises: the fallout from the Covid pandemic, the geopolitical ramifications of the Russian invasion of Ukraine, an urgent push towards a sustainable, net-zero economy, and preparations for potential expansion—all of which come at a time when Europe faces increasing competition from the United States and China.
So, while Europe was already straining to boost its growth and competitiveness, these recent tumultuous events added more complexity to a challenging scenario.
In the wake of this situation, last year, the European Commission assigned former ECB president Mario Draghi the task of outlining a path forward for Europe. His findings, released in September, indicated a staggering need for investment: Europe requires between €750 billion to €800 billion annually just to cover existing obligations.
These figures are nothing short of astronomical.
For context, during the negotiations for the EU’s seven-year budget cycle, member states engaged in contentious debates over a mere €50 billion to finalize the agreement.
In the view of Tony Murphy, the Irish president of the European Court of Auditors (ECA), “We’re at a crucial crossroads,” with pressing financial demands for enlargement, security, and defense, calling into question where the necessary funding will originate.
The first step likely will involve member states boosting their contributions to the EU budget. Additionally, there are the EU’s “own resources”—like customs duties, VAT income, and fines from the European Court of Justice—which also help fill the coffers. However, even these streams will fall short, as many member nations are already burdened with their debts, and achieving consensus on new revenue sources is notoriously difficult.
This brings us to a concept that has been previously considered complicated and obscure: a Capital Markets Union (CMU).
Put simply, Europeans are estimated to hoard around €33 trillion in various bank accounts. Advocates argue that this capital could be more effectively channeled into European companies, fostering innovation and enhancing the EU’s competitiveness against both the US and China.
“The financial landscape we envision demands vast, costly changes, especially at a time when governments have scant resources,” said one official regarding the economic hurdles. Meanwhile, Europe is sitting on a treasure trove of private savings, which are mostly just stagnating in accounts that yield little in interest.
Two intertwined issues have inhibited retail investors in the EU from stepping beyond traditional savings. Firstly, there’s a noticeable lack of a stock market investment culture across Europe, particularly when compared to the United States, where citizens actively invest for their pensions in a robust, accessible national market. Secondly, the EU’s investment landscape is a graphic novel of 27 disparate stock markets, each with its own rules on taxation, pensions, and insolvency, confounding potential investors.
That fragmentation leads to a critical question: how does this impediment factor into Europe’s overall competitiveness? In today’s economy, particularly in the US, startups drive innovation and growth, typically turning to capital markets for funding rather than traditional banks.
“The stark truth is that entrepreneurs in Europe prefer bank financing over capital markets, unlike their American counterparts,” remarked Paschal Donohoe, the president of the Eurogroup of finance ministers, at a recent City of London meeting.
“Banks play a pivotal role in crafting deeper, liquid markets. However, they tend to be more conservative and focus on domestic interests,” he elaborated.
One EU official aptly noted, “Our financial system is well-suited for the bygone 20th century. In today’s landscape, the emphasis should be on nimble, high-growth, and often risky startups, which don’t thrive on bank loans but instead flourish in the realm of capital markets.”
In his groundbreaking report, Draghi also highlighted a glaring oversight: no company valued over €100 billion has emerged from Europe organically in the last 50 years. In stark contrast, six US firms boast valuations exceeding €1 trillion.
“The root of the problem isn’t a lack of ambition or ingenuity in Europe,” Draghi maintains. “We are rife with talented innovators and entrepreneurs filing patents. Yet, once we reach the commercialization phase, we stumble. Regulatory inconsistencies stifle our innovative enterprises from expanding.”
This stifling environment compels European entrepreneurs to seek funding from American venture capitalists, often leading them to relocate their operations stateside to find growth opportunities.
Some EU nations have advanced financial markets—countries like the Netherlands, Sweden, and Denmark set exemplary standards for fostering investments that benefit domestic corporates. Yet, they struggle to achieve the scale necessary to challenge the US market dominance.
“Let’s be candid,” stated an EU insider. “No European capital market can compete with the sheer scale of New York. We relinquished London due to Brexit, and what remains lacks size and scope on the global stage.”
For over a decade, the necessity for Europe to create its own investment capital pool has been abundantly clear. Initially regarded as a “nice to have,” it has morphed into a “need to have” due to the pandemic, the Ukraine conflict, and burgeoning climate initiatives. A senior official remarked, “Failing to address this will only exacerbate our decline. The trajectory is alarming; over the next two decades, we risk becoming marginal on the global stage.”
As one Irish Government minister aptly pointed out, “Without a robust Capital Markets Union, we will keep losing investors to the US. Irish enterprises will be unable to secure the necessary growth funds, and critically, we won’t be able to implement an investment strategy that allows average salary earners a chance to grow their savings safely.”
Governments within the EU are stepping up their commitment to this concept. In March, EU leaders expressed their intent for a Capital Markets Union to “provide European businesses access to a broader range of financing at reduced costs” while empowering citizens to invest their savings and tackle the collective challenges ahead.
According to the European Commission, its focus will shift from top-down directives on capital markets to eliminating regulatory hurdles and allowing member states to shape their own growth. There’s been a flurry of activity to facilitate knowledge-sharing among nations and begin dismantling barriers obstructing cross-border investments.
However, national sensitivities pose significant challenges. Enabling citizens to invest across borders and ensuring startups have access to funds interact with sensitive areas of national sovereignty, including taxation and insolvency laws, among others.
As one EU official explained, “Altering insolvency law means engaging justice ministers. Adjusting tax regulations extends beyond finance.”
Consider a scenario where an Irish investor wishes to stake money in an exciting Estonian tech startup. They would need to familiarize themselves with that company’s performance metrics, financial reporting, and corporate governance on the Tallinn stock exchange to make an informed decision.
Lack of a cohesive legal framework serves as a significant deterrent to cross-border investment within the EU.
Discussions linger about how a harmonized capital marketplace would be functional. Eastern European nations fear such a union would primarily benefit countries that already have advanced financial industries.
One country, France, has already expressed a preference for a unified EU overseer, ideally located in Paris, to ensure compliance across member states.
In March, Eurozone finance ministers failed to arrive at consensus on this, and efforts in April yielded similar results.
Donohoe is believed to favor a singular regulatory framework, with emerging indications that the incoming Financial Services Commissioner Maria Albuquerque shares this perspective.
Among the recurring issues is how to manage disputes. If an investor from Ireland backs a Polish enterprise and a disagreement arises regarding their investment, without a unifying legal structure at the EU level and avenues for recourse, hesitation will undoubtedly follow.
The ongoing intricacies surrounding insolvency law are another hurdle. How will investors recover their funds if a firm faces bankruptcy? Member states have attempted to agree on baseline harmonization concerning insolvency laws, and a proposal is in the pipeline for potential phased consensus on this complex matter.
There’s also talk surrounding a proposed “28th regime,” where EU nations could collaboratively harmonize their regulatory frameworks to simplify and create an appealing environment for innovation and investment.
Addressing insolvency law poses a prevalent challenge for common law jurisdictions like Ireland, where remediation pathways differ from civil law practices observed in the rest of the EU.
The newly strengthened resolve among member states to establish a Capital Markets Union comes with the recognition that past regulations, established in the wake of the global financial crisis and the EU banking failures, need recalibration.
In March, Eurozone finance ministers prompted the Commission to “accelerate efforts to lessen the regulatory load in the EU’s financial market setup, especially for smaller market participants.”
One particularly sensitive topic revolves around securitization. Looking back at the global financial meltdown, securitization—and specifically credit default swaps—played a significant role, being bundled into enticing packages that masked the underlying risks.
In the aftermath of the crash, regulation tightened, leading to a severe contraction of the securitization space across the EU. This has resulted in a dearth of qualified talent able to reinvigorate the market.
“Securitization remains a vital instrument for creating liquidity in secondary markets,” remarked one informed official. “One of the Commission’s immediate priorities will be finding a way to reinstate this mechanism.”
Another pressing issue is the disparity in tax rates across member states. How can a cohesive European capital market function with each country applying its own investment tax schemes? Ireland exemplifies this challenge, where Italian investors find it more advantageous to access Irish-domiciled funds compared to domestic options due to tax implications.
The tax deductions imposed on Exchange Traded Funds (ETFs) are particularly burdensome. ETFs enable smaller investors to diversify their holdings, but Ireland taxes them at a punitive rate of 41%, plus an additional “deemed distribution” tax every eight years—applied even if the assets are untouched. These tax barriers discourage Irish participation.
In contrast, Germany showcases a thriving ETF market due to its favorable tax treatment.
To address these concerns, former Finance Minister Michael McGrath initiated a review of the funds landscape, aimed at recognizing how Ireland could eliminate some of these deterrents and absorb best practices from the EU.
A survey conducted by the Central Bank of Ireland found that as recently as 2015, merely 5% of Irish ETF holdings belonged to households, a figure that dwindled to 3% by 2019, primarily due to tax implications.
The review recommended prioritizing reforms to the current investment fund and life assurance taxation policies. Unfortunately, the recommendations arrived too late for the Finance Bill, leaving the next government with the responsibility of implementing changes.
In the realm of financial literacy, Ireland lags behind its counterparts. Such barriers further complicate investment dynamics, leading to an urgent need for improved financial education initiatives. Recent reports indicated that while 57% of Irish adults meet the OECD’s basic literacy measures, they still scored lower compared to UK (67%), Germany (66%), and Australia (64%).
“While Europeans excel in saving, they fall short on investing. Irish households rank among the lowest in capital market participation,” argued Umar Ahmad, Director of EU Affairs with Irish Funds. “Investment is crucial for long-term financial health, and boosting financial literacy will empower citizens to manage their finances better.”
If efforts to cultivate a capital markets entity pan out, opening avenues for the average citizen to invest and enabling startups better access to funds, a significant dilemma remains. Can returns on investments within Europe compete with the higher yields found in US companies or those that have blossomed after transitioning to the American market?
Investors will be faced with a deep existential question: are they investing for spectacular returns, or are they motivated by a desire to uplift the European economy and tackle critical challenges collectively? “Is boosting retail participation solely about seeking better returns?” wondered one EU insider. “If so, we could end up channeling investments into indices, which are predominantly US-owned.”
Discussions are also anticipated regarding tax incentives that could prioritize investments in European green technology. In Ireland, debates may arise over whether a surge in retail investment through the concept of a Savings and Investment Union—the rebranded Capital Markets Union—could nudge investors toward sectors like defense. While some argue that, despite Ireland’s traditional neutrality, domestic defense forces are in dire need of modern capabilities, supporting European manufacturers could bolster local economies.
Regardless of the support for this initiative among member states, it’s clear achieving these aims will require a sustained, multi-year commitment.
Edited by: Ali Musa
alimusa@axadletimes.com
Axadle international–Monitoring
