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The report on The Future of European Competitiveness, submitted in September by Mario Draghi, former European Central Bank president and former prime minister of Italy, is a call to action to meet the challenges the European Union faces this decade, with the virtue of daring to quantify the potential investment needed: 5 percent of GDP per year during 2025–30. The message is clear: Every year the European Union delays action, the gap with the United States will open further. There is no time to waste.
The report argues that the European Union’s main weakness is its lower growth relative to the United States, driven primarily by the European Union’s fragmentation. This weakness is compounded by three new challenges: enhancing the resilience of the economy against geopolitical threats and trade wars, addressing climate change and the green energy transition, and boosting national security and defense. By their nature, these new challenges must be dealt with mostly at the EU rather than the national level.
We agree with much of the report. It raises all the right issues. If EU fragmentation is indeed a major obstacle to growth, then reducing it can indeed have large benefits and few costs. The report, especially in its part B, is a trove of granular information and of potential concrete measures to take in the major sectors in the economy. We feel however that some of the issues require further discussion. This is what we do in this column, often playing devil’s advocate to get the discussion going.
Competitiveness or productivity?
Let us start with a strong statement: The title of the report, The Future of European Competitiveness, is misleading. What the report is about, and indeed should be about, is productivity, not competitiveness. Productivity determines the standard of living. Competitiveness is a different issue: A country can have low productivity and still be competitive. This is what a flexible exchange rate is supposed to achieve and typically does. The European Union does not have a competitiveness problem—in fact, it runs a current account surplus. If anything, it has a potential productivity problem.
Is the productivity gap really exploding?
In comparing the European Union to the United States, and in characterizing the diagnostic of the report, Draghi has talked about an “existential challenge” and, if nothing is done, a “slow agony.” This overstates the case. Since 2000, EU GDP growth has indeed been on average 0.5 percent lower annually than that of the United States, but most of the difference has come from demographics, not productivity. EU growth of real income per capita has been about 0.1 percent lower annually than in the United States, a small difference but enough to increase the gap by about 2.5 percent over 25 years. Not negligible for sure, but not quite enough to qualify as agony.
This being said, even if the productivity gap vis-à-vis the United States has not substantially increased, it still remains. The days when Europe was rapidly catching up with the United States are long gone, and convergence has not been achieved: Europe has not been able to run the last mile. It is very much worth examining why.
Is being an innovation leader essential for growth?
The report emphasizes, rightly, the sharp differences between EU and US performance in the technology sector. The fact is indeed stark: There are no leading technology companies in the European Union. Does this mean that the slow agony, if it has not happened yet, will start soon? The answer is: Not necessarily. There are plenty of countries that are not innovation leaders but that grow at similar rates as the United States. Just like a cyclist in a race who remains behind the course leader to be protected from the wind and is happy to remain a close second, countries do not necessarily need to innovate in order to thrive; they can copy and implement the innovations of others. Indeed, this seems to be the case for the European Union: Productivity growth outside of the information and communication technology sector is the same as or higher than it is in the United States.
Security rather than growth?
The main issue therefore may not be growth so much as national security. Technology leadership matters when it becomes a key driver of national security—as the growing US sanctions and restrictions on semiconductors show. It is therefore critical to develop indigenous European technology leaders to boost resilience and national security, and that will require a European approach: The scale needed to thrive in the new technologies implies that it will be almost impossible to reach technological leadership at the EU member state level. In other words, as the report argues, more EU innovation would be good in all sectors, but it is crucial in those where security is essential.
Green transformation and growth?
The report argues that the green energy transformation may drive higher growth. This is optimistic. Fighting climate change requires putting a positive price on something, CO2 or another greenhouse gas, that was previously free. In the language of macroeconomics, this is an adverse supply shock, just like an increase in the price of oil. In the standard growth model, it leads to a lower level of output and a decrease in growth until the transition to green energy has been achieved. Could things turn out better? Yes, to the extent that, despite a worse starting point, technological progress happens to be much more rapid in the new technologies, growth could indeed eventually turn out higher. But the difficult transition must be acknowledged to avoid creating unrealistic expectations.
Defragmentation and better regulation: Keys to higher growth?
The report attributes much of the productivity gap to fragmentation and regulation, thus the focus on the measures on defragmentation and partial deregulation. If this is right, then indeed these look like desirable and easy reforms, yielding benefits without threatening the larger welfare state architecture. However, one may worry that the report oversells the achievable gains. Surely much of the productivity gap comes from factors outside the scope of the report—higher social protection, inadequate education and professional training, higher costs of separation, etc.; these will not disappear. Fragmentation is surely relevant, with countries insisting on having their national champions and reluctant to give up political control; the issue is how much such fragmentation stands in the way of returns to scale. From an efficiency viewpoint, is larger always better? Part B of the report makes a strong case that it is in many sectors, but the reality may be more nuanced—after all, there are many instances of investors buying large companies to take them apart and unlock productivity and value—and likely sector specific—more relevant for technology companies that rely on network effects than, for example, telecom companies.
Similar issues come up with regulation and competition policy, both at the national and the EU level. EU competition policy may need to evolve to help meet the challenges. In the United States, the litmus test for competition policy is consumer prices: If companies can successfully argue that a merger or acquisition will lead to increases in efficiency that eventually result in lower prices, the operation will likely succeed, and remedial measures will only be applied, if needed, ex post. In the European Union, however, the litmus test is market structure: If a merger or acquisition is seen at risk of creating a position of market dominance, even if that market dominance would be necessary to increase efficiency, the operation will likely be opposed. In a world where the development of new technologies requires network effects and scale, these differences in competition policy may explain why the dominant network companies are all in the United States. To simplify the point: Would Amazon have been able to grow and develop in the European Union?
How much can be expected from the capital market union?
What the problem facing the European Union is not: insufficient saving or insufficient investment. Investment as a share of EU GDP is roughly the same as it is in the United States, 22 percent. The saving rate is a bit higher, resulting in a current account surplus. Thus, “mobilizing saving” is a misleading headline. The EU saving rate is high and is reflected in high investment. The issue is, as the report correctly argues, that savings may not be channeled into the right investments and may reflect insufficient risk taking. This reflects a largely bank-based intermediation structure, segmented along national lines. The capital markets union is unlikely to make a major and timely difference at this margin. The report estimates that it would take a decrease of 250 basis points in the cost of capital to induce the required new investment. It is not clear that such a decrease would generate the right kind of investment, and, in any case, this is far beyond what one can hope from better financial integration.
Can EU public investment and subsidies be financed by debt?
The report concludes that the EU investment rate must increase by about 5 percent of GDP per year, with public investment accounting for about 1.5 percent, and that substantial public subsidies to induce the desired increase in private investment will be needed as well. It argues, correctly, for these decisions to be taken at the EU level: By their nature, reducing fragmentation and rethinking regulation and competition policy must take place at the EU level. Given the public-good nature of defense, green transformation, etc., much of the public investment and design of subsidies must also be designed and implemented at the EU level.
This does not however necessarily imply that it should be financed by EU debt rather than by taxes. There are two relevant aspects here, debt sustainability and macroeconomic effects. EU debt is debt, even if, because it is mutualized, it is typically cheaper debt than the debt issued by national governments. Given the high levels of debt and, especially, the large primary deficits in several countries, the issue of overall debt sustainability cannot be ignored. Some of the measures proposed in the report may indeed increase future growth and thus government revenues. Some, such as defense, may not, at least directly. Some, such as those that shift the energy mix, may instead decrease growth for some time and decrease future revenues. Thus, future revenues should not be assumed to pay for themselves, and a credible fiscal framework will be critical to sustain this effort. To be concrete, under the reasonable assumption that interest rates will remain close to growth rates, some of the additional spending can be financed by debt, but a credible plan requires that, in the medium term, the primary balance, i.e. the difference between revenues and spending, returns to zero.
The other aspect, the macroeconomic effects of such a large increase in overall investment in an economy currently close to potential, must also be considered. The European Central Bank will have to manage what will likely be a more volatile growth and inflation process buffeted by various supply shocks, and International Monetary Fund computations cited by the report may understate the risk of overheating. The recent experience of US fiscal deficits, their effect on shortage-induced price spikes and commodity prices, and their contribution to the inflation burst, is relevant here as far as the timing, design, and delivery of the needed investment. For both reasons, prioritizing investment and subsidies to fewer sectors, and limiting the effect on debt, is of the essence.
We have raised many issues that we hope will contribute to a broader and deeper discussion. We want to reiterate our agreement with much of the report, and our hope that it will lead to measures that increase EU productivity and standard of living, address the climate transition, and boost national security.
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