Why Is Europe’s Economy Falling Short?

For much of the postwar era, European policymakers have prioritized stability and predictability over fostering breakthrough innovation. Today, as the United States and China compete for AI dominance, a stagnant Europe is struggling to regain its place at the technological frontier.

The geopolitical shocks of the past few years, particularly Russia’s invasion of Ukraine and US President Donald Trump’s assaults on the postwar order, have brought Europe’s economic and strategic vulnerabilities into sharp relief. But it is the race for AI supremacy between the United States and China that has made Europe’s lagging innovation and declining competitiveness impossible to ignore.Against this backdrop, MIT’s Simon Johnson sat down with fellow Nobel laureate economist Philippe Aghion to examine what ails Europe and how to revive its dynamism. Their conversation addresses the costs of excessive regulation, the role of creative destruction in fostering competition, and the case for keeping AI out of the classroom. It has been edited for length and clarity.

Simon Johnson: Let’s start with your most famous contribution to economics, which is your theory of creative destruction. Can you explain it in non-technical terms?Philippe Aghion: The term “creative destruction” was coined by Joseph Schumpeter to describe the process by which new technologies displace old ones. But when I was a student, there was no growth model that incorporated creative destruction, so Peter Howitt and I developed one. The basic idea was that growth is driven by successive generations of talented entrepreneurs who create firms and expand them. Innovation is a cumulative process. You stand on the shoulders of those who came before you. At the heart of this process lies a fundamental tension: you need innovation rents to motivate investment in R&D, but yesterday’s innovators often attempt to use their market power to block new entrants who might subject them to creative destruction. Societies must therefore strike a balance between allowing talent to flourish and ensuring that today’s successful firms do not become barriers to the next generation of innovators. From Pioneer to LaggardSJ: This leads directly to the focus of this conversation: unlocking European dynamism. In your view, the European economy is troubled, or at least faces some major challenges.PA: I wouldn’t say “troubled.” Europe is not on the verge of a major crisis. Instead, the danger is a long period of stagnation or sluggish growth. Between 1945 and the late 1980s, per capita GDP in today’s eurozone was catching up with that of the US. Much of that growth came from rebuilding Europe’s capital stock, which had been devastated during World War II, and from catching up with the Second Industrial Revolution that transformed the US in the early 20th century. But Europe has failed to make the transition from catch-up growth to frontier innovation. In particular, it has failed to harness the IT revolution because it lacks institutions that support frontier innovators. Instead, it remains stuck in mid-tech, incremental innovation, while the US and now China have moved into breakthrough, high-tech innovation. That, fundamentally, is Europe’s problem. SJ: Whenever I visit France, I’m very impressed by your technology and infrastructure. The high-speed trains, for example, are fantastic. We don’t have those in the US.And then there’s nuclear power. Nuclear energy held great promise after WWII, but most countries ultimately failed to make it viable. France stands out as an exception.You mentioned the IT revolution. I remember very clearly how a friend in Paris in 1990 or 1991 showed me his Minitel terminal. At the time, Minitel was essentially a directory of businesses in the Paris region, but in retrospect, it was the first time I saw anything like the internet.While I understand your point about Europe struggling to become a frontier innovator after the mid-1980s, my question is: Where exactly were the frictions? Why didn’t Minitel evolve into the internet? And why did France fail to become a leader in breakthrough innovation?PA: You’re absolutely right—and very generous —to point out France’s strengths. When it comes to transport technology, whether it is high-speed rail or even Airbus, France and Europe have achieved remarkable success. And the same goes for nuclear energy. France, in particular, used to be a leader in nuclear power before political pressure from the Greens led us to step back from it. Now, however, France is rebuilding the sector. France was also a pioneer in biotech. The foundations of mRNA technology, for example, were developed at the Institut Pasteur. Europe is still very strong in basic research. Despite severe underfunding, it still accounts for 25% of the scientific citations underlying breakthrough patents worldwide. Yet this research doesn’t translate into breakthrough innovations in Europe. Mario Draghi’s 2024 report on European competitiveness, along with other reports I’ve been involved in, all ask the same question: Why is it that we consistently fail to turn those research breakthroughs into breakthrough innovations? Creative Destruction Stops in BrusselsSJ: I recently spent some time in the Carnavalet Museum in Paris, and what really struck me was how innovative France was under the Third Republic. Many of the old structures, power centers, and oligarchies associated with Napoleon III were swept away, and new people, new ideas, and institutions emerged.That seems like a perfect example of creative destruction. The Paris Metro was at the technological frontier, and France was a scientific powerhouse in the early 20th century. The US won relatively few Nobel Prizes before 1940. The scientific leaders were, without question, Germany, France, and the United Kingdom—probably in that order.So, France has a long tradition of innovation. But somehow it hasn’t fully connected to the modern era.PA: You’re right. We lack what it takes to become true breakthrough innovators. Sometimes it happens when you’ve been great in the past: you rest on your laurels and live on your past accomplishments. That’s what happened to us. Of course, there are exceptions, like aerospace, defense, and nuclear energy to some extent. But we allowed too many industries to leave France over the past 40 years. One important difference between today and the early 20th century is that the European Commission didn’t exist then. I don’t want to bash the Commission, but it has often stifled innovation. Postwar Europe was designed to ensure that France and Germany would never again go to war. The idea was that rules would force us to depend on each other rather than fight. European institutions were thus created to help us live peacefully, not to make us innovators. We need rules, of course. But now we have too many. Since the 1980s, economic governance in Europe has been shaped by an approach that imposes strict limits on member states. For example, budget deficits cannot rise above 3% of GDP, regardless of whether spending goes toward pro-growth investments. Similarly, Europe constrained industrial policy in the name of competition policy, whereas the US and China have found ways to reconcile the two. As a result, European rules have limited the ability of member states, including France, to move into breakthrough, high-tech innovation. The EU institutions in Brussels do many good things, but they are often a pain in the neck. SJ: This brings us to the Draghi report. Draghi is a very distinguished economist, with a PhD from MIT, and enormous policy experience. His report offers a reform agenda that largely works within existing European structures. Given your view that Brussels stifles innovation, how much progress could really be made if its recommendations were fully implemented?PA: I did not mean to suggest that everything coming out of Brussels is negative. For example, the creation of the European Research Council has been a tremendous success. I was able to build an innovation lab at the Collège de France thanks to ERC funding.