The “Great Recession” and subsequent debt crisis have left Europe with a deep and painful legacy.

Output remains seven percent below the pre-crisis trend; public debt levels continue to reach historic highs; banks remain fragile; and the euro area is severely out of balance. To ensure that today’s downturn does not evolve into long-term slow growth and deflationary trends, European policymakers need to respond with far-reaching structural reforms.

Before taking a look forward, it is helpful to take a brief look back. After seeing GDP per capita, adjusted for purchasing power, decline from just above the US level in 1820 to less than half in 1950 (a period capped by two world wars), Europe’s economy staged an impressive recovery in the decades that followed. Trade accelerated, resources shifted from agriculture to manufacturing, and the income gap with the United States began to close as Europe absorbed US business organisation and technologies, the spread of which had been delayed by conflicts and depression.

Europe’s renaissance ground to a halt in the 1970s, however. Oil shocks and a large deterioration in macroeconomic fundamentals marked the turn. Mistaken policy choices, strictly regulated labour markets, and a more volatile economic environment made it difficult to adapt to slower growth, and relative incomes stalled at a level 25 percent below that in the United States.

For the following 20 years, GDP per capita in both Europe and the United States grew at an even pace of about 2 percent per year and European incomes remained 75 percent as high as those in the United States. In the 1990s – as the use of new information and communications technology (ICT) surged in the United States and stagnated in Europe – the income gap began to widen again. The reasons behind Europe’s failure to exploit its ICT potential are up for debate, but rigidities in Europe’s product and labour markets and restraints on competition in sectors that particularly benefit from ICT (for example, retail) are likely to have played an important role.

This general picture of a widening Europe-US gap comes with two caveats. First, the slowdown in per capita incomes largely reflects declines in hours worked. Europe’s output per hour has continued to converge to that of the United States. In 1980, the gap between European and US output per person and output per hour worked were both approximately 25 percent. By 2008, however, the gap in output per person widened to over 30 percent, while the gap in output per hour worked narrowed to less than 15 percent.

A variety of factors could account for the sluggish growth of both the demand for and the supply of labour in Europe, including tax structures that raise the cost of labour; higher hiring and firing costs; more effective collective bargaining; and stronger worker preferences for leisure. For these reasons, Europe’s workforce participation is low; those who do work tend to take longer holidays, spend more time unemployed, and retire earlier than their US counterparts.

Second, this picture of lagging growth hides the relative – if often temporary – successes of a number of European economies, some of which pushed beyond 75 percent of US income levels. Switzerland and the Scandinavian countries did relatively well over most of this period; the UK was revived by the liberalising reforms pushed through by Margaret Thatcher; and Ireland and Spain enjoyed a growth spurt with the adoption of the euro, which the current debt and competitiveness crisis has only partially reversed.

While some countries enjoyed success, EU leaders in 2000 tried to address overall weaknesses by putting forward the Lisbon agenda, a long list of structural reforms designed to revive European growth. Targets included increasing worker participation to 70 percent of the working-age population and raising spending on research and development to 3 percent of GDP by 2010.

Today, the Lisbon agenda is widely regarded as a failure, in both design and implementation. The original agreement focused on too many issues (EU leaders attempted to correct this by dropping many of the targets after the midterm review in 2004) and policymakers failed to push for the necessary reforms. In June 2010, EU leaders agreed to a follow-on programme encompassing a smaller and more targeted set of reforms, known as Europe 2020. But it remains to be seen whether it will fare any better.

As the Lisbon agenda demonstrated, Europe 2020 is an ambitious undertaking in good times. The legacy of the Great Recession will make its targets far harder to achieve. Although the crisis originated in the United States, the recession hit Europe harder, reflecting some of the structural rigidities that Lisbon attempted unsuccessfully to correct. The European private sector response to the crisis was slower than that in the United States. Compared to the US, Europe depended more on manufacturing, construction – two sectors hit hardest by the crisis – and bank lending; European banks were in turn more reliant on less stable wholesale financing than on deposits.

The sovereign debt crisis that followed on the heels of the Great Recession will force Europe’s most troubled economies (Greece, Ireland, Italy, Portugal and Spain) to implement painful and drawn-out austerity measures in the coming years. However, public sector retrenchment and tax hikes will be insufficient: these countries must also reverse the considerable loss of international competitiveness they have experienced since adopting the euro. Though a depreciating euro will help them adjust, the European periphery will also need to reduce wages and costs generally with respect to the European core, and in particular Germany, Europe’s largest and most competitive economy.

During this long adjustment period, Europe will be highly vulnerable to adverse shocks. Governments are already over-extended – the International Monetary Fund projects debt in the five troubled economies, Germany, France, and the UK to average nearly 100 percent of GDP in 2015 – and will be unable to provide fiscal support in the event of another downturn.

Banks remain weak and could threaten public finances – the Anglo Irish Bank fiasco continues to make this clear – but are also set to constrain credit growth. European Central Bank interest rates have little room to go lower, and the divergence of growth rates within Europe will further complicate monetary policy: holding interest rates at record lows could prompt carry trades and higher-than desired inflation in the European core, while raising them could push the periphery even deeper into recession.

Finally, policymakers from around the world must recognise that European weaknesses are global weaknesses. Given that the EU is responsible for 35 percent of world trade (including intra-EU trade) and 40 percent of outward foreign direct investment, greater turbulence in Europe is unlikely to be contained in the region.

Nevertheless, with the continent mired in such a crisis, it is easy to forget Europe’s successes. Western Europe’s GDP per capita is higher than that in Japan, three times higher than that in Brazil, nearly five times higher than that in China, and ten times higher than that in India.

In the short term, avoiding sluggish and uncertain growth will be difficult – if not impossible – as Europe corrects the excesses that caused the crisis, reduces government deficits, and narrows internal competitiveness imbalances.

In addition to the current malaise, a sharply contracting labour force will also weigh on long-term European growth. The UN projects that, over the next twenty years, the workforce in Europe will shrink by more than 10 percent while growing by more than 6 percent in the United States. However, if appropriate reforms are passed, Europe could capitalise on a number of opportunities unique to the continent and possibly return to its relatively high pre-crisis growth path over a sustained period.

Five keys to future prosperity

The weight of the current crisis continues to pull the baseline trajectory of European growth downward. The changes outlined below offer hope, but they will not come automatically and cannot be made on the margins. Major coordinated action by European countries will be required to overcome the crisis; without such efforts, Europe’s declining growth prospects will harden into reality.

Information and communication technology: Despite its head start, the United States continues to invest more than Europe in ICT, having spent 61 percent more per capita than the euro area in 2009. Not surprisingly, there is considerable room for Europe to improve: the United States averaged 76 internet users per 100 people, compared to the euro area’s 63 users. By making it easier for companies to reorganise profitably around new technology, policymakers could enhance ICT penetration in Europe.

Emerging markets: As a percentage of GDP, Europe exports more than twice as many goods to emerging markets as does the United States and 1.5 times more goods to emerging Asia, the world’s fastest-growing region. As such, Europe is better positioned than the US to benefit from the rise of developing economies. But as these emerging countries trade increasingly with each other, maintaining market share will become more difficult.

Market integration: In the 19th century, the United States was able to move ahead of Europe mainly because technology and investment spread quickly in its large, unified market. Though the EU is moving toward integration, the average income in the three richest EU economies (excluding Luxembourg) is more than three times that in the three poorest, compared to a difference of 78 percent between the three richest and poorest US states, suggesting that market integration is far from complete. Better integration and labour mobility could yield significant efficiency gains and help facilitate the spread of ICT.

Labour policy: On average, EU members rank 40th out of 183 countries for ease of doing business, and 104th for hiring employees (compared to fourth and first in the United States, respectively). Enhancing labour flexibility would make the private sector more dynamic. Pension reform, which fiscal sustainability is also likely to require, would encourage greater labour force participation.

Immigration: In 2005, foreign-born citizens represented only 9.1 percent of the EU’s population, compared to 13.3 percent in the United States. A more liberal and better-targeted immigration policy should help not only replace a shrinking labour force, but also aim to better integrate immigrants into EU society.