The European Union has a productivity problem. Its people produce nearly 30 percent less per hour worked than they would have, had real output per hour worked increased in line with that in the United States since 2000.

A failure to sufficiently develop innovative startups into “superstar” firms is one of the reasons for the bloc’s poor productivity growth.

Europe’s fragmented economy and financial system partly underly this problem. Without a more frictionless single market for goods, services, labor, and capital, it’s more expensive and difficult for successful startups to scale up.

On top of that, Europe’s bank-based financial system is not well-suited to finance risky startups. High-tech startups often develop new technologies and business models, which are risky and may be hard for banks to assess. And the value of startups often lies in their people, ideas, and other intangible capital, which is difficult to pledge as collateral for a bank loan. Banks are also constrained by rules that (rightly) limit lending to risky firms without collateral—even fast-growing ones that are likely to make large profits later.

European pools of private capital are also smaller and more fragmented than in the US. Europeans park more of their savings in bank accounts rather than capital markets. Americans invested $4.60 in equity, investment funds, and pension or insurance funds for every dollar invested in such assets by Europeans in 2022. In part, this is because Europeans rely more on pay-as-you-go pensions than Americans. But regardless of the reason, the end result is less availability of equity financing for companies.

The fragmentation of markets stems in part from national laws, regulations, and taxes that hamper cross-border consolidation, capital raising, and risk-sharing. Many institutional investors prefer to allocate capital to companies based in their own countries. This often applies to investments in venture capital as well, especially in smaller funds.

Greater venture capital investments could spur productivity and strengthen the EU’s innovation ecosystem. But Europe’s shallow pools of venture capital are starving innovative startups of investment and making it harder to boost economic growth and living standards.

As our new paper argues, measures to strengthen the EU’s venture capital markets and remove cross-border financial frictions to pension funds and insurers investing in venture capital could increase the flow of funding to promising startups and fuel productivity gains.

The EU lost its largest venture capital center, London, following the United Kingdom’s vote to leave the Union in 2016 and its remaining centers lack the scale of those in the United States.

Over the past decade, the EU’s venture capital investments averaged just 0.3 percent of gross domestic product, less than one-third the average in the US. American venture capital funds raised $800 billion more than their European counterparts over this period.

Venture capitalists invest heavily in high-risk research and development activities that are pivotal to spreading innovative ideas and raising overall growth. They are skilled at picking promising startups and channeling resources to the best-performing companies.

Compared with competitors across the Atlantic, Europe’s more established startups also have less attractive options to grow through initial public offerings in the EU. This reduces the incentives to invest in them in the first place. And, when fast-growing startups start to scale up quickly, they often need to seek financing abroad because the availability in Europe is limited—the so-called scale up financing gap. Many startups then move operations overseas when they get that scale up financing from abroad. Europe then loses out on many of the benefits of having startups succeed at home—both the direct growth impact and positive spillovers such as technology diffusion.

National authorities could take several steps to support their domestic venture capital markets:

• The venture capital sector is characterized by high risk and information asymmetries, but also positive externalities not internalized by individual investors. Well-designed preferential tax treatments for equity investments in startups and venture capital funds could help jumpstart the sector where it is underdeveloped or non-existent due to these market failures.
• Reduce regulatory and tax frictions to investing in venture capital. Developing private pension funds would have multiple benefits, including expanding domestic capital pools to invest in capital markets and venture capital.
• Enable national public financial institutions—which have played an important role in supporting the development of the venture capital sector in some countries—to expand capital availability and other support to venture capital funds and innovative startups. They should invest on commercial terms and help attract more private capital, especially from institutional investors such as pension funds and insurers. This can be done quickly before other efforts bear fruit.

Measures at the European level would help too. The single most important step the EU could take is to complete the single market for goods, services, labor, and capital. This will take time.

More immediately, the authorities could:

• Fine-tune rules for insurers and other investors in larger venture capital funds to reduce impediments to investing in venture capital, especially to support growth financing.
• Expand the capacity and instruments of the European Investment Fund (EIF) and the European Investment Bank to channel more resources to venture capital funds and innovative startups.
• Encourage the EIF to develop a fund-of-funds aimed at attracting capital from institutional investors across the EU that would finance large venture capital funds with a pan-EU focus. This would help reduce fragmentation of capital pools, increase the familiarity of institutional investors with venture capital as an asset class, and help close the scale up financing gap.

Over the medium term:

• Reduce stock market fragmentation to boost their depth, liquidity, and valuations, which will make listing in the EU more attractive. This is a key part of the capital market union agenda, but will be more politically challenging.

While government interventions are often a less-than-perfect solution, they may be needed in the near term to accelerate the development of the venture capital sector and financing for innovative startups. This would not only spur EU productivity, but also bolster competitiveness. More venture capital financing for “clean tech” sectors would also support the EU’s green ambitions and reduce the need to rely on costly subsidies that could distort the single market.