Bringing back EU competitiveness

Strategic Foundations for Competitiveness: Understanding, Innovating, and Enabling Growth in the EU

The capacity to generate wealth, competitiveness, is defined as the capability of businesses to efficiently utilize productive resources in successfully providing goods and services within the global economic landscape. Competitiveness is crucial for achieving a high standard of living and sustainable GDP growth, reliant on increased productivity. It hinges on effective resource allocation and the proficiency of numerous firms in excelling where their comparative advantage is strongest. This success is contingent on optimizing global trade opportunities and maximizing value within integrated global production chains. Public policies and institutions play a vital role in fostering an environment supportive of this dynamism.

Driving and adapting to change through innovation is another pivotal aspect. Sustaining competitiveness necessitates continual enhancements in productivity and ongoing adaptation to economic shifts. Innovation encompasses product and process innovation, catching up with improved technologies, and the growth of innovative firms. Investment, particularly in research and development, adoption of new technologies, and workforce retraining, is integral to innovation. Strategic positioning in key technologies and future opportunities is essential for driving and adapting to change effectively. This involves a robust advanced manufacturing sector and a presence in crucial areas such as life sciences, digital technologies, and green technologies.

Furthermore, creating an enabling environment for firms to thrive and adapt depends on four key enablers: human capital, strategic infrastructure, climate change and environment considerations, and financial sector capacity. These factors collectively contribute to the ability of businesses to create high-value jobs. The EU Single Market plays a significant role in enhancing competitiveness by eliminating internal barriers, promoting trade, facilitating market entry, and fostering competition, resulting in economies of scale, efficiency, and resource allocation. Maximizing the European Single Market is crucial for cultivating a healthier, more prosperous, and competitive European economy. Competitiveness within the EU should be conceptualized at three levels: the enabling environment, the ability of firms to drive and adapt to change, and the ultimate results in terms of productivity growth, trade performance, and economic well-being. Achieving this requires structural reforms, the removal of investment barriers, and the integration of the EU Single Market. The subsequent section will consolidate the information to identify existing gaps.

Wealth creation: Is Europe realizing its potential?

The ultimate assessment of a country or region's competitiveness lies in the economic well-being it can attain and its prospects for sustained growth. Competitiveness should not be viewed as a zero-sum game, and traditional metrics like the share of world exports or world GDP may be misleading due to lower-income countries catching up. Instead, analyzing GDP per capita, productivity, and growth allows us to gauge the untapped potential for Europe as a whole and assess convergence within the region. While not a direct indicator of competitiveness, trade performance metrics further refine the competitive positioning of different countries and regions globally.

One key measure of Europe's unfulfilled potential is comparing its GDP per capita with that of the United States. Despite convergence in the early post-war decades, the EU's GDP per capita has consistently remained below that of the US. Particularly concerning is the halt in the catch-up process since the mid-1980s, resulting in a doubling of the GDP per capita gap in absolute terms. Notable gaps exist within Europe:

The "North-South" gap: GDP per capita growth is significantly lower in EU South countries compared to their Northern counterparts, with a considerable gap emerging since the economic crisis.

The "North-East" gap: While EU East countries show encouraging growth rates, the absolute gap relative to Northern Member States has widened rather than shrunk, indicating a loss of convergence momentum.

Convergence in the EU has faced challenges, with several low-income countries, especially in the EU South, falling behind. The economic crisis has further widened the gap between poor and rich regions within the same countries. From 2000 to 2008, less-developed regions were growing at a stronger pace than more developed ones, but this trend reversed in 2008-2013, with many less-developed and medium-developed regions struggling in terms of output.

Understanding Europe's Productivity Challenges: Examining the Labor Productivity Gap and Factors Influencing Efficiency

The Productivity Gap

Examining productivity growth in Europe compared to the United States helps elucidate the widening GDP gap. Europe's labor productivity growth, measured in GDP per hour worked, lagged behind the US, Japan, and South Korea in the years leading up to the crisis.
Since the mid-1990s, the most significant contributor to the labor productivity growth gap between the US and the EU has been in market services, such as wholesale and retail trade or financial and business services, leveraging extensive Information and Communication Technologies (ICT). The EU struggled to capitalize on new technology to the same extent as the US due to insufficient investments in skills and organizational changes. The financial crisis exerted a notably adverse impact on productivity growth, particularly in the EU compared to the US. The EU's largest decline originated from various manufacturing sectors, likely reflecting higher susceptibility to global demand fluctuations than the services sector. Financial and insurance activities exhibited resilience in the EU, with productivity growth outperforming the US.

While Northern Europe was narrowing the gap with US labor productivity until the mid-1990s, it has since lost ground, experiencing slowed annual growth since 2008. In contrast, Southern Europe avoided a fall in productivity growth during the crisis, largely due to a significant reduction in employment, particularly in low-skill sectors. Eastern Europe witnessed a dramatic decline in labor productivity growth after the crisis began, and although the growth rate is relatively high, absolute labor productivity levels remain significantly lower than in the US or the rest of Europe.

Total Factor Productivity (TFP) measures the efficiency and effectiveness of utilizing different labor and capital inputs. Before the crisis, European efficiency, as indicated by TFP estimates for 2000-2007, grew more slowly than in the US and Japan. During the crisis, EU TFP experienced a more substantial decline compared to other major economies, affecting all regions within the EU (North, South, and East).

Unpacking Europe's Economic Landscape: Services, Trade, and Employment Dynamics

Services constitute approximately 75% of the EU GDP, yet their share in trade accounts for only around 25%. Given the increasing significance of services in the tradable sector, further analyses are needed to gain a better understanding of productivity and trade developments in this sector.

Figure 8 illustrates the shares of global value-added manufacturing exports per capita for the EU, the US, and Japan, indicating that Europe holds a competitive position comparable to that of the US. Noteworthy sectors where the EU maintains a substantial market share in global value-added exports include machinery and transport equipment.

International trade dynamics have evolved, becoming more intricate due to the increasing granularity of specialization patterns. Traditional trade flow measures like gross exports and imports can be misleading, especially with the rise of trade in intermediate goods. Analyzing the value added of exports helps overcome these challenges by capturing the domestically generated value in goods produced for export, excluding foreign value added from imported intermediary goods.

Despite the EU's goal of achieving a 75% employment rate for the working-age population (20-64 years) by 2020, the employment rate stood at 69.2% in 2014, below the US (71.8%) and significantly lower than Japan (77.5%). To revitalize growth and competitiveness, Europe must prioritize job creation. While the EU's unemployment rate surpassed that of the US and Japan for an extended period, convergence occurred in 2009. However, since 2010, the US has been notably more successful in reducing its unemployment figures.

Although the female employment rate in the EU has increased over time, it still lags significantly behind the male rate (63.5% compared to 75.0%). Unlocking the potential of bringing more women into the labor force could prove beneficial.

Europe's Capacity for Change – Innovation and Adaptation

Productivity undergoes significant enhancement through two primary mechanisms: innovation, which propels the frontier in terms of product sophistication and production efficiency, and the absorption of innovations, a process involving adaptation and catching up with the advancing technological frontier.

Europe faces a substantial Research and Development (R&D) gap, posing a critical challenge for improving the innovation environment. Indicators evaluated by the World Economic Forum (WEF) indicate that the EU lags behind the US, Japan, and South Korea in various dimensions of the innovation environment. Notably, company spending on R&D and university-industry collaboration display the largest gaps with the US. The innovation environment is notably weaker in many Southern and New Member States. Even for countries heavily invested in innovation, external shocks can have a substantial impact, particularly on smaller nations operating within a compartmentalized EU innovation environment.

R&D intensity in Europe is significantly lower than in the US, Japan, or South Korea, attributed to Europe's smaller high-technology sectors and lower R&D intensity in many sectors. While fiscally constrained countries have witnessed declining R&D expenditure, countries like Germany, France, and the UK have partially offset this trend. Nevertheless, achieving the EU's objective of 3% GDP expenditure on R&D necessitates an additional EUR 130 billion in annual spending, with a substantial portion accounted for by a gap in private sector R&D spending, particularly in manufacturing industries where the EU holds a significant role.

Public sector R&D in the EU is about 1% of GDP, lagging behind the US by approximately EUR 50 billion in absolute terms and falling short of the required amount by EUR 60 billion to meet the 3% target. Public sector R&D expenditure primarily focuses on the cost-intensive natural sciences and engineering disciplines, aligning with its role in providing research infrastructure for basic and applied research.

Using patent applications as an approximate indicator, Europe is notably behind Japan, the US, and South Korea in terms of per capita patent applications. The EU-US gap has widened over the past two decades, underscoring the need for concerted efforts to address the R&D deficit and enhance innovation performance in Europe.

R&D Needs in Key Strategic Sectors

To regain competitiveness, the EU must catch up with the US and, to a lesser extent, Japan, in crucial technology areas shaping future products and services. These include:

1. Life sciences: Additional annual public sector investment of EUR 15 billion in basic research is needed, along with an extra EUR 10 billion of private sector R&D investment, mainly in pharmaceuticals and diagnostics/personalized medicine.

2. Semiconductors: Closing the gap requires EUR 5 billion of additional annual public sector support, mainly for co-financing industrial-scale pilot plants, and EUR 15 billion of private sector R&D, mostly for bespoke chips for industrial applications.

3. Software: An additional EUR 20 billion is required annually, mainly for developing business process and cloud computing software, primarily from the private sector as these areas are closer to commercialization.

While the EU exhibits competitive strengths in advanced manufacturing, transport equipment, green energy, water, and waste technologies, its position is increasingly being challenged. Additional investments are necessary to maintain Europe's leadership in these key technologies. Examples include:

1. Transport equipment: To sustain its leading position, Europe needs to address challenges such as developing clean alternative fuels, digitalization, and improving transport system interoperability. The majority of these investments must come from the private sector, but public sector support of around EUR 8 billion until 2020 is required for co-development, financing of pilot infrastructure, and lead markets for innovations.

2. Energy technology: Sustained R&D investment is needed in renewable energy technologies, including storage, to meet long-term European climate targets and maintain Europe's lead in this field. Public support is particularly required for emerging low-carbon technologies. Annual expenditures of up to EUR 70 billion until 2020 are required in various fields.

3. Water technology: Adequate investment in Research, Development, and Innovation (RDI) is key to maintaining EU leadership in the global water sector. The optimal annual private sector R&D is estimated at over EUR 7 billion per annum by 2020, with a current gap of EUR 3 billion per year.

4. Solid waste technologies: Increased RDI in materials recovery/recycling is necessary to overcome Europe's dependence on imported materials. Europe is well-positioned to capture a significant share of the growing worldwide demand for environmental technology. Current annual R&D investment of around EUR 15 billion needs to be maintained.

Catching-up: The Absorption of Innovation

In addition to pushing the frontier through research and development, firms must continually reinvest to absorb new technology and know-how to maintain competitiveness. In regions traditionally dependent on less advanced manufacturing and services, the emphasis is on moving toward the frontier and shifting from lower to higher value-added activities.

Foreign Direct Investment (FDI) often plays a crucial role in bringing technology and know-how into a country, with positive "spill-over" effects. However, Europe performs worse than the US on indicators related to the availability of latest technologies, firm-level technology absorption, and the role of FDI in technology transfer. This is particularly concerning in Italy, Poland, Romania, and Bulgaria.

A Dynamic Business Environment

In a dynamic and innovative economy, the continuous ability of firms to reinvent themselves or be replaced is crucial for overall productivity. Recent research led by the European Central Bank (ECB) indicates that the ability to reallocate resources between firms significantly contributes to productivity. The entry of new firms brings fresh ideas, products, services, and processes into the economy. For an economy to remain dynamic, older, inefficient firms must make way for younger, more innovative ones, freeing up valuable labor and capital resources.

The business environment in the EU is characterized by a lack of dynamism, hindering the commercialization and widespread adoption of innovation throughout the economy. This lack of dynamism is partly due to a large share of stable firms (those with employment growth or shrinkage of less than 5% annually) and a low share of fast-growing firms, especially compared to the US. This indicates a less experimental environment and a slower pace of resource reallocation, both essential drivers of productivity growth. Moreover, competition policy in Europe historically favored incumbent firms and overlooked the importance of entry, exit, and turnover. Higher entry costs and lower firm turnover in Europe relative to the US have contributed to the widening EU-US gap since the 1990s.

The concept of 'creative destruction' for firms, a process lacking in Europe's business environment, is directly linked to this issue. A higher turnover of firms, associated with more creative destruction, is typically linked to faster productivity growth. Improving business dynamism can help the EU generate innovative, transformative, and globally impactful companies.

Despite these challenges, the foundation for a sound and efficient EU business environment is largely in place. European institutions generally match the quality of those in the US. In the World Bank's Ease of Doing Business ranking, eight EU Member States are among the top 20, with the majority ranking between 20 and 40, and some falling below 60. However, there are concerns, especially regarding the complexity of starting a business, where the EU faces more challenges on average compared to the US. Another area of concern is related to accessing credit, with EU15 generally outperforming EU13 in this aspect.