27.09.24 Review

Europe's Rut: Why Europe has fallen behind and why it will not heed Mario Draghi's warnings and proposals


The war in Ukraine, the rise of right-wing populism, and the threat of Donald Trump returning to the White House are forcing European states to reassess their position on the global stage. European countries have suddenly realised just how inadequate their current capacity is in facing the challenges and threats before them. Extraordinary measures are needed to respond to these challenges.

One step in this direction is the strategy for boosting the EU's competitiveness, developed by former European Central Bank President Mario Draghi at the request of European Commission President Ursula von der Leyen. In his report, Draghi portrays Europe as a community that chronically underfunds innovation and infrastructure sectors, inevitably losing in competition with the US and China.

Political decision-making, overregulation, and the lack of coordination in industrial policy have become critical obstacles to economic success under new competitive conditions. These factors have led to Europe’s systemic lag behind the US and China, and closing this gap will require annual investments of €750-800 billion (around 4-5% of the EU’s GDP). Draghi proposes raising these funds by expanding the EU’s joint debt program.

Draghi also suggests a large-scale program of industrial policy reforms and structural transformations within the EU, aimed at reducing bureaucracy in the bloc and increasing the level of integration between countries.

Draghi’s initiatives appear revolutionary and will likely face resistance within the European community. However, according to the report, in the fight for a place in the new geopolitical order, Europe is destined to be an outsider if it fails to take decisive steps to improve its competitiveness.

Why Europe has fallen behind

In his report titled ‘EU Competitiveness: Looking Ahead’, Mario Draghi writes that in terms of competitiveness, Europe has long lagged behind its main economic rivals – the US and China. One of the reasons for this is the slow economic growth of EU countries in the early 2000s, along with a slowdown in labour productivity growth in Europe, which has widened the gap between European GDP and that of the US and lowered the standard of living in the EU. Since 2000, real disposable income per capita in the US has grown almost twice as fast as in Europe.

In recent years, this gap has become critical due to rising geopolitical tensions, the loss of cheap energy supplies, and the digital revolution, which has largely bypassed Europe. According to Draghi, to stimulate sustainable growth, the EU must close the innovation gap with the US and China, develop a unified plan for decarbonisation and competitiveness, improve European security, and reduce the EU’s dependence on external suppliers of critical raw materials and technologies.

However, Draghi writes that achieving these goals is currently hindered by three main factors. First, Europe lacks cohesion, as well as the ability to set clear priorities and take coordinated action. A major weakness of Europe is its slow and fragmented political decision-making process, which prevents the EU from developing and implementing effective industrial development strategies. Second, regulatory burdens stifle innovation in Europe, particularly for small and medium-sized enterprises, and the internal market remains too fragmented, causing fast-growing companies to relocate abroad and limiting the development of the capital market. Additionally, the EU does not effectively use its financial resources. For instance, the volume of joint defence procurement among EU countries remains low, with most defence spending going to suppliers from non-EU countries.

In the area of innovation, Draghi suggests that Europe refocus its collective efforts on closing the gap with the US and China, particularly in high-tech sectors. Over the past 50 years, no company worth more than €100 billion has been created from scratch in the EU, he notes. Since 2008, 30% of European ‘unicorns’ have moved jurisdictions because they could not scale their business on the continent. ‘The problem is not that Europe lacks ideas or ambition, but that innovation is blocked at the next stage: we cannot translate innovation into commercialisation’, Draghi writes.

Europe also needs to take steps to reduce its growing dependence on a few major suppliers of critical raw materials and digital technologies. He notes that 75% to 90% of global chip production capacity is located in Asian countries.

A new industrial policy

‘Today's industrial strategies – as evidenced by the examples of the US and China – integrate several policy areas, including tax, trade, and foreign policy’, writes Draghi. However, the sluggishness and disjointedness of the decision-making process in the EU make it nearly impossible to develop such strategies in Europe. For instance, the European automotive industry is not only suffering from the EU's ambitious plans to phase out gasoline and diesel cars within the next decade, but it is also struggling to compete with China’s electric vehicles, which are heavily subsidised by Beijing. To address this issue, the EU ‘needs a comprehensive approach that covers all stages’ of car production – from research and mineral extraction to recycling and manufacturing.

The defence sector is one area where the EU could compete with the US, Draghi believes. The annual turnover of the defence industry in the EU in 2022 was €135 billion, and some EU products and technologies are at least on par in quality with those produced in the US. However, combined defence spending in the EU is about one-third lower than in the US. While the US allocated $140 billion (16% of total defence spending) to defence research and development (R&D) in 2023, in Europe, the total funding for defence R&D in 2022 amounted to just €10.7 billion, or 4.5% of overall defence spending.

Additionally, the European defence industry is fragmented and is primarily represented by national players operating in relatively small domestic markets. This fragmentation leads to problems with standardisation and operational interoperability of equipment. For instance, in supplying 155mm artillery to Ukraine, EU states sent ten different types of howitzers, which created significant logistical challenges for the Ukrainian armed forces. While EU countries operate 12 types of battle tanks, the US uses just one.

Competitive industrial strategies in the EU must be developed and implemented at a supranational level – this is one of the central ideas of Draghi's report.

Technology and energy

The report highlights the significant fragmentation of the EU's telecommunications sector compared to the US and China. In the fixed broadband market, the three largest EU operators collectively hold a 35% market share, compared to 66% for the top three US operators and 95% for the top three Chinese operators. This fragmentation has reduced the profitability of the industry; EU revenue per subscriber and capital expenditure per capita are less than half of those in the US and Japan. Additionally, the EU's regulatory approach has led to a ‘costly proliferation’ of regulatory obligations for telecom operators. Europe needs to adopt a new telecommunications law that will reduce the level of preemptive regulation at the national level, establish the principle of ‘equal rules for equal services’ across the EU, and impose investment obligations on companies.

Another area requiring a new industrial strategy is IT and artificial intelligence (AI). The EU continues to lose ground in the cloud services market, trailing behind American companies. To maintain competitiveness, the EU must strive for leadership in AI development in key sectors. However, innovation in this field is currently hindered by EU regulations, including the General Data Protection Regulation (GDPR) and the AI Act. One unique competitive advantage for the EU lies in quantum computing, but the lack of private investment is preventing it from achieving leadership in this area.

Finally, Draghi considers improving the EU’s competitiveness in the energy sector to be crucial for the success of his plan. Currently, gas prices in the EU are three to five times higher than in the US, and electricity prices are two to three times higher than in the US and China. This gap is due to the dependence on gas imports, volatility in spot markets, high carbon costs, EU-imposed caps on gas and coal prices, outdated infrastructure, and excessive regulation.

To reduce dependence on fossil fuels, Draghi calls for the decarbonisation of the EU's energy system, streamlining the permitting process for renewable energy projects, upgrading energy grids, and advancing carbon capture, utilisation, and storage technologies to accelerate the EU's transition to green energy. European countries also need to harmonise energy taxation and align pricing incentive systems, and eventually create a fully integrated energy union.

Two key tools

The strategy for restoring EU competitiveness proposed by Mario Draghi will require annual investments of €750-800 billion (around 4-5% of the EU’s GDP). He suggests raising these funds by issuing joint obligations among member states, similar to the approach taken during the pandemic. ‘The EU must continue to issue common debt instruments that will be used to finance joint investment projects aimed at enhancing the EU's competitiveness and security’, writes Draghi. Otherwise, he believes, Europe will be unable to secure the necessary level of investment in areas such as telecommunications, arms procurement, and defence research.

‘Europe does not coordinate actions where it matters, and its decision-making rules have not undergone significant changes as the EU has expanded, while the global environment we face has become more hostile and complex’, Draghi writes. A key element for the success of the strategy is political reform. On average, it takes 19 months to pass new laws, and the process encounters multiple vetoes along the way. As of 2019, the EU had enacted around 13,000 legislative acts, compared to just 3000 in the US Another issue is the current unanimity system for decision-making in the EU, which Draghi proposes replacing with qualified majority voting, to prevent individual countries from blocking reforms.

Why Europe will resist

Draghi's ideas will form the basis of the European Commission's policy for the next five years, announced re-elected EC President Ursula von der Leyen at a press conference dedicated to the presentation of the report. She expects all commissioners to contribute to reducing corporate reporting obligations by at least a quarter. Von der Leyen has sent a personal letter to each of the new commissioners outlining her vision for their mission in office.

For example, the Commissioner for Democracy, Justice, and the Rule of Law, Michael McGrath, will be tasked with simplifying the EU's data protection rules (GDPR) to better align with the commercial needs of the community and facilitate digital transformation and data sharing with international partners. The Commissioner for Technology, Security, and Democracy, Henna Virkkunen, responsible for improving digital competitiveness and productivity, will need to adjust the enforcement of the Digital Markets Act and the Digital Services Act. Executive Vice President of the European Commission, Teresa Ribera, will have to find a way to implement the ‘Green Deal’ while maintaining the competitiveness of EU countries.

However, Draghi's plan is likely to face widespread resistance, particularly concerning the proposed funding model. The wealthiest northern European countries will oppose the issuance of new debt. In fact, on the day of the report's release, German Finance Minister Christian Lindner stated that ‘Germany will not agree’ to the issuance of new bonds. The second issue is leadership. The engines of any pan-European initiatives, France and Germany, are currently almost paralysed by the electoral setbacks of centrist parties. Third, the necessary support for Draghi's plan in the European Parliament must come from the Green and Socialist parties, but they are far more concerned with addressing climate change and social inequality rather than restoring competitiveness, meaning they are likely to push in the opposite direction of Draghi's plan.

The analysis presented by Draghi on the loss of European leadership is unlikely to be enough to shift the EU’s cumbersome institutional trajectory. The shortcomings Draghi highlights are, in a way, part of Europe's identity – elements of European uniqueness. Neither European politicians nor their voters are eager to see Europe become more like China or the US. Most likely, it will take more dramatic and unmistakable signs of an impending crisis to change their minds.