European competitiveness, revisited

19 January 2016

Competitiveness is a nebulous concept, too vague to guide policy. The focus should be on productivity, and how to raise it in an imperfect world which suffers from a lack of demand. 

Since the start of the eurozone crisis, the word competitiveness has been on everyone’s lips. Loss of competitiveness is now widely (and wrongly) accepted as a primary cause of the crisis; and making Europe more ‘competitive’ has become a priority for policy-makers. What is most remarkable, however, is that there is no agreed definition of what competitiveness is – and most implicit meanings are incorrect. If Europe wants to become more competitive, it needs to focus on productivity growth, not wage reduction or current account surpluses. It also needs to put more thought into sequencing and prioritising reforms, taking into account the imperfections of Europe’s economies and the current macroeconomic backdrop. Finally, raising competitiveness, so defined, requires more, not less democracy.

The popular notion of competitiveness applies business concepts such as profits and competition to countries and international trade. For firms, the concept is relatively simple: companies compete with each other, in part on price, in part on quality and innovation. The winners of this competition make a profit, and the losers may go out of business. 

For countries, almost none of this applies. Countries do not make a profit. The trade surplus, often understood as some kind of profit for a country, is not profit at all. First, a trade surplus simply means that a country has consumed and invested less than it has produced – some of the production was shipped abroad without a one-for-one compensation in the form of imports. The revenue from the export surplus was thus reinvested abroad. Instead of a profit, a trade surplus simply represents a capital export. Second, by definition all trade surpluses in the world need to sum to zero, because the world as a whole cannot run a trade surplus – unless it started trading with Martians. World corporate profits on the other hand are large, and clearly not zero. Treating trade surpluses as ‘profits’ would imply that world profits are zero, which is absurd. 

As for price competition, the analogy between a country and a firm is misleading. Prices matter for competition, and countries can help their export industries – for example by engineering an under-valued exchange rate, or by suppressing wages. Both come at a cost, however. First, lowered exchange rates or suppressed wages reduce real incomes – in the exchange rate’s case, by making imports more expensive – and hence the economic well-being of citizens. Second, such a strategy is founded upon depressed demand at home, for which the rest of the world needs to compensate, often through unsustainable booms in consumption or investment. The last few years’ financial and European economic crises clearly show how costly this strategy is over the medium term, for a supposedly ‘competitive’ country. Since the early 2000s, Germany’s economy has relied increasingly on foreign demand – financed by German capital exports through its trade surplus. German investors have lost almost half a trillion euros on their foreign investments since the onset of the crisis. Gaining price competitiveness is therefore not a winning strategy, and can hardly be at the core of any reasonable definition of competitiveness.

The final analogy between a country and a company concerns quality: producing better or more goods and services with fewer inputs. Economists call this ‘productivity’ and it is a well-defined and important concept. A competitive country in this sense is a productive country that manages to combine the factors of production in the most efficient way, and thereby also creates incentives for more investment. As a result, its citizens are economically better off. To define competitiveness as productivity thus comes closer to a proper definition of competitiveness, as it could be applied to countries. 

The World Economic Forum (WEF) defines competitiveness as “the set of institutions, policies and factors that determine the level of productivity of a country”. State institutions, labour and financial markets, infrastructure and education, and many other things interact to make a country productive, and hence competitive; and it is in all of these areas that countries need to invest both money and political effort. 

An index such as the one used in the WEF’s global competitiveness report is a useful starting point for measuring competitiveness, particularly in international comparisons that include developing and emerging economies. But taking the WEF’s approach to competitiveness as a policy guideline for Europe has three important drawbacks. 

First, the best mix of policies to make a country more productive may differ from country to country, even when these countries are at a similar stage of development. No country will ever have a perfectly competitive ‘first-best’ set of institutions and policies – if such a first-best even exists in a constantly changing world. Becoming more competitive therefore means working with a highly imperfect and country-specific set of institutions, rules and constraints. In such a ‘second-best’ world, it does not automatically follow that a policy to move towards, say, a more liberal product market automatically leads to a more productive economy. Other constraints could stand in the way, for example a lack of funding for firms that could make use of more liberal product markets. In such a second-best setting, it is very difficult to determine the correct sequence of reforms, and whether they are compatible with other institutions in an economy.

The second drawback of the WEF’s approach is that the macroeconomic context matters for the success of reforms, and hence their impact on productivity. The most well-intentioned structural reforms, implemented at the wrong time, can fail to generate economic growth or can even make matters worse. For example, labour market liberalisations in the midst of a downturn can exacerbate already weak demand – unless exports can pick up the slack. Conversely, minor structural reforms, such as Germany’s labour market overhaul in the early 2000s, can work very well if implemented just before a worldwide economic boom. This notion is particularly relevant for the eurozone: the current lack of demand requires a laser-like focus on structural reforms that can immediately unleash investment, without hurting demand further.

Finally, improving competitiveness is not a goal but a process. A country needs to constantly reassess its policies and institutions, and target reforms at the most binding constraints on productivity growth, whatever those may be at the time. Countries therefore need to have the political institutions in place that induce policy-makers to constantly implement reforms aimed at improving productivity. The best forum for this constant deliberation is a well-functioning, pluralist democracy – which requires, besides regular and fair elections, an independent press that scrutinises the claims of vested interests and objectively informs the electorate; researchers and intellectuals that question conventional wisdom and explore new ways to organise society and the economy; and a fine balance between interest groups and less well-represented groups in the democratic process.

A comprehensive concept of competitiveness therefore requires the following. At the European level, the acute lack of demand, especially in the eurozone, makes it hard for structural reforms to pay off. Therefore, the European Central Bank (ECB) needs to be bolder in its monetary policy; and Europe should rethink its fiscal policies so that the combined fiscal and monetary stance of Europe ensures sufficient demand. 

Moreover, companies need access to a deep pool of financing, both equity and debt, that only a Europe-wide capital market and banking system can provide. Without adequate funding, firms cannot easily invest to take advantage of newly opened markets or new innovations. Firms that grow strongly (and thereby create the most jobs), and innovative young firms, often have particular trouble financing their expansion in Europe, as they lack the collateral to convince banks to fund them. Equity financing or venture capital markets are underdeveloped in Europe. 

To increase productivity, European policy-makers should focus on areas where a larger market size and increased competition between firms can boost investment, innovation and hence productivity, for example in tradable services. Here, Europe has lagged behind the US in terms of productivity growth for more than a decade. 

Finally, the EU should agree on stronger democracy-enhancing reforms and initiatives, such as common enforceable standards for a fair and transparent justice system, or support for a free and pluralistic press. As two recent analyses by the European Commission show, countries in the EU score very differently on justice systems and media pluralism. The EU should also use its competition and consumer protection tools more aggressively to tackle national vested interests. 

At the national level, European countries need to ensure that their tax systems support a meritocratic and risk-taking society. Higher taxes on inherited wealth or land to finance favourable tax treatments for start-ups and entrepreneurial risk-taking would boost Europe’s innovative capacity. Member-states should end the favourable tax treatment of debt, relative to equity, to encourage the more innovation-friendly equity financing of firms. Tax incentives for private investment should also be stronger during a downturn, to encourage investment when the economy most needs it.

In addition, the state should invest more in research and development, with the explicit aim of maximising innovation. Governments should also provide more risky equity financing themselves: under such a system, the public purse would suffer the inevitable losses of innovations that fail, but also reap the benefits of those that pay off. Given current low interest rates and weak demand, it is also in most countries’ interests to spend more on public investment like infrastructure. In combination with other reforms, such investment would generate high returns for many European countries, particularly those that have invested very little in recent years, such as Germany. 

In order to become more competitive, Europe should stop using the word competitiveness. It is a nebulous concept, too vague to guide policy, and easily misused by interest groups to push for policies that serve some but not society as a whole. Instead, Europe should focus on productivity growth and ask how best to achieve it. The answer will be much more complex than the word competitiveness suggests.

A slightly shorter version of this insight was published by the Berlin Policy Journal.

Christian Odendahl is chief economist at the Centre for European Reform.