EU bids to get in shape to compete

By Brian Groom

Financial Times

Published: March 7 2005

At the start of a series on the European Union's search for ways to lift economic growth rates and create more jobs, the FT assesses the prospects for progress as the targets are honed down.

Five years ago, the European Union's leaders suffered their own collective version of irrational exuberance. In Lisbon, at what was dubbed "the dotcom summit", they issued a ringing pledge to turn stodgy old Europe into "the most competitive and dynamic knowledge-based economy in the world" by 2010.

Pouring out a shower of commitments and targets to embrace the internet age, modernise welfare systems and catch up with the US, the leaders promised to raise real economic growth to an annual average of 3 per cent - up from 2 per cent - and create 20m jobs in a decade. Romano Prodi, then European Commission president, said the EU had broken its taboos. Tony Blair, Britain's prime minister, hailed a "sea change in EU economic thinking" towards innovation, competitiveness and employment.

Ever since then, EU leaders have tried to live this down. Optimism was punctured as brutally as the dotcom bubble was on world stock markets. Exuberance turned to disappointment and then to self-flagellation. Although there were extenuating circumstances to the outcome - including terrorism, geopolitical uncertainty and crashing markets - the so-called Lisbon agenda has become synonymous with missed targets and failure of political will.

The mood will be very different when leaders meet in Brussels this month to review the results at the halfway stage. It is a fact that most of the 28 main objectives and 120 sub-objectives are beyond reach. Europe has continued to fall behind: average growth in the eurozone was about 1.8 per cent last year - compared with 4.3 per cent in the US, 6 per cent in India and 9 per cent in China. Gross domestic product per head is stuck at 71 per cent of US levels.

Yet the EU is not giving up. In the face of widespread scepticism about the chances of successfully breathing life into the initiative, José Manuel Barroso, Mr Prodi's successor, will urge government heads to redouble efforts by focusing on narrower priorities to boost jobs and growth. He wants them to play down the additional social and environmental objectives with which the Lisbon agenda was larded.

This has provoked charges that he is pursuing a "neo-liberal" agenda - a dirty word to many Europeans, for whom it implies a move away from welfare-based societies. Mr Barroso says it is only by reforming its economy that the EU will be able to maintain its high standards of social and environmental protection. He insists: "The overall Lisbon goals were right but the implementation was poor. It must work because there is not a credible alternative."

Are things really that desperate? There is an argument that Europe, having overdosed on optimism, is now overdoing the gloom. It already has some of the world's most successful economies - mostly those of Nordic countries - and even its reform laggards are making efforts to catch up.

Germany, long seen as the continent's sick man, has been though painful changes to curb unemployment benefits and cut health and pension costs. Growth remains slow and more remains to be done but a number of economists believe it will turn the corner. "The incentives have already worked. Unit labour costs compared with other euroland countries have improved over four years by about 10 per cent," says Norbert Walter, Deutsche Bank's chief economist.

The French government is braving union protests to relax the 35-hour working week, allowing employees to work up to 40 hours for extra pay. It has already rolled back generous public sector pensions. Measures are even planned in Italy, where the freedom of Silvio Berlusconi, the country's prime minister, to undertake reform has been restricted by union opposition and coalition divisions. These include changes in bankruptcy rules, faster judicial procedures, higher research and development spending and steps to encourage small companies to merge.

Where governments are not moving fast enough, corporate Europe is taking up the challenge. Companies, particularly in Germany, are going through drastic restructuring to cut wage bills, helping drive profits to levels well above the historical average. Siemens, DaimlerChrysler and Volkswagen are among those that have extracted longer hours or pay freezes from their workforces.

Helping to drive the changes is increased competition for investment - especially from the 10 countries in central, eastern and southern Europe that joined the EU last May. The eight ex-Communist EU members saw GDP rise 5 per cent last year - up from 3.7 per cent in 2004 - and the World Bank forecasts a 4.5 per cent increase for them in 2005 - more than twice the "old" EU's growth rate.

The new members are too small to have much impact on the Lisbon targets, since they increase the size of the EU economy by only 5 per cent. While they help to speed up GDP growth and have a positive impact through the competition fostered by their lower wages and tax rates, they hinder efforts to reach targets for employment and research and development.

In spite of the EU's failure to meet the Lisbon mid-term goals, its economic performance is routinely portrayed too negatively, according to economists at Goldman Sachs, the US investment bank. David Walton, the bank's chief economist, says: "The US over the past 10 years or so has grown at fractionally above 3 per cent. The EU has grown just above 2 per cent. The main reason that the US grows at 3 per cent is because it has tremendous growth in its population. Over the past decade, its population grew by 1.2 per cent a year on average. In the EU, it grew by 0.4 per cent."

In GDP per head, argues Goldman, the growth gap was much narrower: 1.8 per cent in the EU against 1.9 per cent in the US. In productivity growth it was 1.8 per cent against 2 per cent. A Deutsche Bank study maintains that the US's faster labour productivity growth since the mid-1990s, compared with Europe, is "largely a statistical artefact caused by different classifications as well as varying calculation and measurement methods".

Goldman believes average growth in the EU will continue at about 2.2 per cent over the next 10 years. Faster growth in Germany will be balanced by slower increases in France and Spain. "If you really want euroland to grow at US rates, you need to be prepared to see the kind of migration and population growth they get," Mr Walton says.

The bank's forecasts are at the optimistic end of the scale, however. Many economists believe the eurozone's potential growth rate - the level at which the economy can expand without igniting inflation - has fallen to 1.5-2 per cent.

In Brussels, the Commission sees the position as serious. The EU's executive arm thinks slower productivity growth is dragging down levels of wealth and that Europe is not investing enough. The US spends €100bn ($132bn, £69bn) a year more on research and development, it says, while the EU has only a quarter of the number of patents per head of population found in the US. In the US, 32 per cent of the population has a university or similar degree compared with 19 per cent in Europe - and the US is investing twice as much per student as most European countries.

Europe also faces the alarming prospect of decline in the working-age population - something caused by falling birth rates and rising life expectancy, which the Commission believes will cut average potential GDP growth in the EU to 1.25 per cent by 2040. Mr Barroso thinks other trends could drag economic performance down if not addressed.

As for corporate Europe, it can boast many companies with leading positions in their sectors - such as Vodafone in telecommunications services, Nokia in mobile phone handsets, Nestlé in food, SAP in enterprise planning software, Airbus in aircraft manufacture, Novartis in pharmaceuticals, BP in oil and HSBC in banking. Some of these have grown to prominence only in the past 20 years, proof of the dynamism the Old World can still produce.

There are not enough of them, however. In the most recent annual FT Global 500 survey, 247 of the top 500 companies by market value came from North America and only 156 from (EU and non-EU) Europe. US companies held 15 of the top 20 places: the only eurozone representative was the hybrid Royal Dutch/Shell, while three others were British. In time, Asia, which had 92 of the top 500 but only one of the 20 biggest (Japan's Toyota), is likely to have an increased share of leading companies.

Many of Europe's best-known companies face tough competition. For instance, the pharmaceuticals industry, a traditional European strength, has seen a big part of its research base move across the Atlantic. And much of European industry is in mature sectors rather than those with the biggest growth potential.

Europe has competitive strengths in semiconductors, mobile telephony, aeronautics, medical technologies and environmental technologies but it is weaker in instrumentation, information technology, biopharma and biotechnology. In the emerging field of nanotechnology, Europe leads in scientific output but lags behind in exploiting it.

Business people themselves have a litany of complaints about their regulatory environment, from the cost of patenting inventions in Europe - four times greater than in the US - to the constraints of red tape and an array of labour market rules that restrict hiring and firing and impose heavy payroll taxes to fund welfare payments.

Few in Europe would disagree that further reform is needed but can it be done in a top-down fashion, as the EU leaders attempted in Lisbon? Mr Barroso sees this as a grand project to compare with the single market in the 1992 and the euro in 1999. But whereas these were achieved by legislation, the Lisbon agenda is an intergovernmental initiative that lacks an enforcement mechanism. Mr Barroso wants member states each to agree a national action programme to improve delivery, yet many are sceptical as to whether this would move the reforms forward.

Results have been achieved. As an example, it is now possible to set up a small business in Spain in 48 hours, compared with 30 to 60 days in the past. The general pattern is of progress but not fast enough to meet the targets. The EU's employment rate, for instance, has risen from 61 per cent in 2000 to 64.4 per cent: the aim was to reach 67 per cent in 2005 and 70 per cent by 2010. R&D spending as a proportion of GDP is 2 per cent, barely up on the original level and adrift of the 3 per cent target.

Some Lisbon aims are contradictory. Expanding workforces to include lower-skilled people may, in the short term, depress productivity. The 3 per cent GDP growth target is hard to reconcile with many countries' desire to limit immigration. There is high-level scepticism about whether that target can be achieved in the timeframe. "The answer is 'frankly, it can't in the medium term - in two to four years'," says one EU policymaker. "The potential growth rate does not change quickly."

Even if Mr Barroso sticks to areas where the Commission has powers, he faces problems. A proposed directive to extend the cross-border single market to services - which on some estimates represent 70 per cent of the European economy - has met fierce resistance, particularly in France, where it is feared jobs will be lost to immigrant workers from eastern Europe. The Commission has signalled it is prepared to see the directive, inherited from Mr Prodi's team, heavily watered down.

Many countries are in practice reluctant to expose companies and markets to foreign competition. Energy liberalisation is slow. Cross-border consolidation remains difficult in many industries. While legislation has been passed in financial services, the jury is out as to the prospects for a single market in spheres such as banking and retail financial products. Thirty years of effort to create a single patent for inventions have foundered on national sensitivities about languages.

Not everyone believes the Lisbon agenda is doomed to failure. "The chance of this type of reform [gaining] momentum is better if you set goals," says Michael Heise, chief economist at Allianz, the German financial house.

Yet if countries do not reform simply because they are urged to, surely they will do so in the face of competition from China, India and eastern Europe? The EU's 10 new members are having an impact out of proportion to their size. It is not only the eastward flow of investment in sectors such as cars that has enabled west European employers to extract concessions from workers. Competition from flat taxes, which began in Estonia and took off with Slovakia's 19 per cent rate on income, capital and consumption, is reverberating. Austria has cut corporate rates and Germany is feeling the heat.

It is not a foregone conclusion that Europe, and western Europe in particular, will lose the global battle for investment. "The return on capital in Europe compares reasonably favourably with other parts of the world," says Mr Walton at Goldman Sachs.

Or, as Mr Heise puts it: "In the second half of this decade, the chances are much better for catching up, for approaching these [Lisbon] goals. I don't know whether we will reach them by 2010. That's not the main point - it is to change the trend."

If Europe does succeed in turning itself around, few will care whether it comes through exhortation or raw competition. The important thing is that it should try.