Dalia Marin, Professor of International Economics at the School of Management of the Technical University of Munich, is a research fellow at the Centre for Economic Policy Research.Dalia Marin The Nobel laureate economist Paul Krugman has kicked off an important debate by questioning whether Europe is really in decline, as former European Central Bank President and former Italian Prime Minister Mario Draghi argued in his 2024 report on European competitiveness. In several commentaries, Krugman shows that when relative European GDP is measured at current PPP prices (that is, GDP adjusted for differences in countries’ overall price levels), rather than GDP per capita at constant prices, Europe is holding up well relative to the United States. Europe should therefore not be overly concerned about technological inferiority and instead appreciate the standard of living it has achieved. If we want to know who enjoys a higher standard of living, the relevant measure is the purchasing power of income—namely, GDP per capita at current PPP prices. According to this measure, Europe is performing as well as the US. But, as Krugman himself points out, this raises an empirical puzzle: how can Europeans enjoy the same standard of living as Americans despite significantly lower productivity growth, as reflected in lower per capita GDP growth at constant prices? GDP at constant prices captures productivity growth over time because it measures the volume of output produced per hour worked. As Draghi emphasized, US productivity growth has been driven primarily by Silicon Valley. The US produces and consumes the leading high-tech products, whereas Europe largely consumes them without producing them. If Silicon Valley is excluded, the productivity gap between the two regions largely disappears. But the London School of Economics economist Luis Garicano responded that Krugman’s argument is flawed because it neglects the positive spillover effects of innovation in Silicon Valley, reflected in substantially higher wages throughout the economy than comparable workers in Europe receive. Nobel laureate economist Philippe Aghion, Antonin Bergeaud of HEC Paris, and Garicano further argued that Krugman relies on the wrong measure of productivity. Image by: Reuters But does it really matter for Europeans’ standard of living where innovation occurs? Innovation certainly matters for economic growth, but not necessarily for a country’s standard of living. The goods produced in Silicon Valley have become steadily cheaper over time due to domestic and international competition, which forces IT firms to pass productivity gains on to consumers in the form of lower prices. As a result, the purchasing power of European consumers has risen alongside that of US consumers. Europe has benefited from adopting technologies developed elsewhere. Krugman’s “paradox” is resolved: Europeans produce less per hour worked compared to Americans, but their income can nevertheless buy just as much because Europeans have benefited from trade with the US. This argument is supported by the seminal work of Gene Grossman of Princeton and Elhanan Helpman of Harvard examining the determinants of economic growth and welfare in countries engaged in worldwide innovative activity. A country that falls behind in innovation, such as Europe, may lose an ever-growing share of world markets, and its growth rate may decline as international competition eliminates the duplication of innovation efforts. Yet despite slower growth, the lagging country may still gain in terms of economic welfare, because international competition among firms with monopoly power ensures that consumers benefit from innovations taking place in the more innovative country. In short, European consumers can enjoy all the benefits of the products invented in Silicon Valley. Large monopoly profits for US firms do not alter this conclusion, so long as IT prices decline as much in Europe as they do in the US, which they largely do. But Europe does need to worry about economic growth. Its largest economy, Germany, has been stagnating since 2019, as measured by GDP at constant prices. Germany’s weak economic performance has far more to do with China than with the US, despite US President Donald Trump’s tariffs. The turning point in Germany’s economic fortunes roughly coincided with China’s rapid growth in technological capacity and meteoric rise in high-value exports, reflected in its position as a global innovation leader in green and digital technologies. Image by: REUTERS This has hit Germany hard because China is now challenging several of its most R&D-intensive sectors, including automobiles, machine tools, and chemicals. With Germany losing global market share to China in precisely these core industries, economic growth has come to a standstill. If this continues, Germany—and Europe more broadly—may lose out not only in terms of innovation, but also in terms of living standards, despite benefiting from cheaper imports of Chinese electric cars and machine tools. Economic growth depends on the amount of inputs, such as labor and physical capital, that an economy employs to produce output. American GDP per capita is higher in part because Americans work more. Germany’s labor input, by contrast, is low compared with other countries: employees work about 1,350 hours per year on average, compared with 1,500 in France and 1,800 in the US. Concerned about falling living standards after seven years of economic stagnation, German authorities plan to increase the number of hours worked. In particular, policymakers want to strengthen incentives for women’s participation in the labor market by removing tax advantages that encourage mothers to stay at home. This has some logic. Average annual hours worked are relatively low in Germany because many women entered the labor market through part-time employment. While this increased labor-force participation, it reduced the average number of hours worked per employee. Germany has one of the highest labor-force participation rates in the OECD, but its average annual working hours are among the lowest. Unfortunately, increasing labor input is unlikely to be enough to revive Germany’s economy. By far the most important determinant of long-term economic growth is a country’s ability to innovate and generate new ideas. Yet Germany risks losing precisely those industries that have historically driven its economic success to China, where much of the recent innovation in these sectors has taken place. Not only is economic growth (GDP per capita at constant prices) at stake for Germany and Europe; so is their standard of living (GDP per capita at PPP prices). The debate launched by Krugman ultimately highlights the distinction between economic growth and economic welfare. Europe has so far been able to maintain living standards despite lagging behind the US in innovation, largely because globalization has allowed European consumers to benefit from technological advances developed elsewhere. But this advantage cannot be taken for granted indefinitely. As Germany’s experience illustrates, a prolonged loss of innovative capacity and industrial competitiveness can eventually translate into slower growth, weaker incomes, and declining living standards. Increasing labor supply may provide a temporary boost to output, but it cannot substitute for the creation of new technologies and industries. Europe’s long-term prosperity depends not on working more hours, but on restoring its ability to innovate and compete at the technological frontier. Copyright: Project Syndicate, 2026.www.project-syndicate.org Tweet Views 350