European Competitiveness, and How Not to Fix It

The Draghi Report Gets a Lot Right and the Main Thing Wrong

I feel I should make clear at the start here that I’m not hoping for the EU to take digital leadership away from the US. I’m not a fifth columnist for Brussels. I’m just a proud member of team Liberal Democratic West.

The LDW is far from perfect, but it created stable and secure societies where people generally go to bed at night not worrying about bombs dropping or the secret police kicking in the door. Our team built the countries that people risked their lives trying to enter, not escape. That’s an important difference, so I want America’s European LDW teammates to remain stable and secure. Robust economic growth and technological progress help in achieving that goal; I therefore want more of both in the EU.

So I’m grateful to Mario Draghi, because he just made it impossible for Europe to ignore its own economic and technological problems. No, scratch that: its own economic and technological crisis.

Unexpectedly Plain Talk from a Technocrat

Draghi, the former Prime Minister of Italy and head of the ECB, recently dropped a bombshell report on European competitiveness. From its first words, it delivers hard news. Rather than opening with a self-congratulatory rundown of all the ways that Europe is innovative and competitive, it starts with a blunt statement that it’s not:

Europe has been worrying about slowing growth since the start of this century. Various strategies to raise growth rates have come and gone, but the trend has remained unchanged.

Across different metrics, a wide gap in GDP has opened up between the EU and the US, driven mainly by a more pronounced slowdown in productivity growth in Europe. Europe’s households have paid the price in foregone living standards. On a per capita basis, real disposable income has grown almost twice as much in the US as in the EU since 2000.

The first page of the report makes clear both the situation and the stakes (emphasis added):

Europe largely missed out on the digital revolution led by the internet and the productivity gains it brought…

If the EU were to maintain its average productivity growth rate since 2015, it would only be enough to keep GDP constant until 2050 – at a time when the EU is facing a series of new investment needs that will have to be financed through higher growth…

This is an existential challenge…

We have reached the point where, without action, we will have to either compromise our welfare, our environment or our freedom.

In short, this is not a feel-good document. Draghi and his team deserve a lot of credit for resisting the temptation to write one more report stressing the health of the EU’s innovation landscape or vibrancy of its startup ecosystem. This document instead stresses how bad things are, using a potent combination of words, numbers, and pictures.

Here’s one of those pictures. It depicts a postwar surge that stalled out around the turn of the century, then became a decline:

The report makes clear the consequences of the productivity plunge: “On this trajectory [of productivity growth and labor force growth, overall economic] growth in Europe will stall.”

Draghi’s report covers a lot of ground, including trade and energy policy. I’m going to concentrate here on digital innovation, because I agree with the report that “Europe’s position in the advanced technologies that will drive future growth is declining.” Falling (farther) behind on AI and the other technologies reshaping economies these days is about as bad for national competitiveness as falling (farther) behind on the steam engine during the first industrial revolution.

And Draghi makes it clear that Europe has fallen behind — that “The EU is weak in the emerging technologies that will drive future growth.” Here’s part of the report’s brutal litany of facts:

• Only four of the world’s top 50 tech companies are European.¹

• Europe is stuck in a static industrial structure with few new companies rising up to disrupt existing industries or develop new growth engines. In fact, there is no EU company with a market capitalisation over EUR 100 billion that has been set up from scratch in the last fifty years, while all six US companies with a valuation above EUR 1 trillion have been created in this period.

• Between 2008 and 2021, close to 30% of the “unicorns” founded in Europe – startups that went on the be valued over USD 1 billion – relocated their headquarters abroad, with the vast majority moving to the US.

A Chasm that Must be Crossed

All of that is bad. What’s worse, I think, is that the best available evidence tells us that things aren’t going to improve in the years ahead — that the "Europe has turned the corner on tech innovation” view I hear a lot these days is poorly grounded in reality. Here’s the scariest picture in the whole report (which is saying something):

There’s currently a US-EU funding gap of around 80% at every stage of VC funding. It’s hard to overstate the importance of this gap, because it’s hard to overstate the importance of venture capital to the high-tech ecosystem. As far as I can tell, all of the largest tech companies in the US — all of them — were financed at least in part by VCs. You’ve got to go pretty far down the list before you find any that weren’t.

Draghi understands that if Europe wants more large tech companies it needs lots more tech startups and lots more venture capital. This point is important enough to merit bold text in the report: “Europe’s lack of industrial dynamism owes in large part to weaknesses along the “innovation lifecycle” that prevent new sectors and challengers from emerging.”

So far, so good; I’m nodding in agreement as I’m reading a clean argument that

A) Europe is lagging badly and needs more tech innovation. This means that

B) Europe needs more tech startups. Yet

C) Funding for tech startups is lagging badly in Europe. Therefore

… and here’s where I stopped nodding my head and started banging it on my desk. Because the Draghi report’s “therefore” — its central recommendation for boosting the technology sector (and therefore its growth, competitiveness, etc.) — is to increase government R&D spending because in Europe “Public sector support for [R&D] is inefficient due to a lack of focus on disruptive innovation and fragmented financing, limiting the EU’s potential to reach scale in high-risk breakthrough technologies.”

Where the Problem Isn’t

To understand why those words frustrated me so much, here’s another graph from the report:

In Europe, public sector support for R&D is actually higher than it is in the US, when expressed as a percentage of total GDP. Europe spends less in absolute terms, but total government R&D spending in the EU is still within 20% of what it is in America. So it’s hard for me to believe that shortfalls or inefficiencies in this spending are the key factor holding back the European “innovation lifecycle,” as a homespun analogy makes clear:

Let’s say I own a farm and am unhappy with my crop yields. I know much better results are possible, since my neighbor’s farm has yields about five times larger than mine. When we compare notes I learn that I’m irrigating my crops with a bit more water per hectare than she is (but because her farm is bigger than mine she’s using more total water). I also see that she’s using a different irrigation system.

After digesting this and other information I come up with a plan to boost my yields. The centerpiece of this plan is… switching to her irrigation system.

I hope she’d be a good enough friend and neighbor to tell me that that move is unlikely to make much difference. After all, our irrigation systems are already pretty similar.

Instead of focusing on the things that we’re doing close to the same, I should instead concentrate on the biggest differences. How is her approach to farming most dissimilar to mine? Those differences are much more likely than irrigation to be the sources of the 5x yield gap.

The Root Cause of an Anemic Crop

If the crop we’re trying to grow is a vibrant ecosystem of high-tech companies at all levels of size and market capitalization, one big difference between the US and EU is clear: it’s governmental intervention in that ecosystem not with funding, but with laws and regulations, and other constraints, restrictions, and burdens on companies.

Is this the biggest difference? I don’t know how to answer that question. The cultural differences are also big. Being involved in a failed company, for example, is much more of a black mark on a career in Europe than in the US.² I keep hearing from younger Europeans that this is still the case, even if it is easing a bit. The US also has a much more flexible labor force across the economy, not just in the tech sector, and that flexibility supports American economic dynamism.

But regulatory differences feel larger and more significant to me than cultural or labor force ones. Laissez-faire America vs. dirigiste Europe is an old chestnut, but a valid one. And recently Europe has discovered a special passion for tech dirigisme. Within the EU GDPR came into force in 2018, the Digital Services Act in 2022 the Digital Markets Act in 2023, and the AI Act earlier this year. That’s a lot of major regulation to hit any sector in such a short time.

There’s a view within Europe that this accumulation of tech regulation actually strengthens the competitiveness of the region’s tech companies. As Margrethe Vestager, currently the Executive Vice President of the European Commission for A Europe Fit for the Digital Age, put it when proposing the AI Act, “With these landmark rules, the EU is spearheading the development of new global norms to make sure AI can be trusted. By setting the standards, we can pave the way to ethical technology worldwide and ensure that the EU remains competitive along the way.”

Maybe? But probably not. Instead it’s likely that we’ll see more of what GDPR brought to the region (as summarized by tech policy analyst Adam Thierer): less entrepreneurship, less VC investment, worse financial performance among companies targeting European customers. greater market share for large American incumbents (who could afford to pay all the lawyers, lobbyists, and engineers needed to respond to GDPR), and other “unintended and unheeded welfare-reducing consequence[s].” A team looking at the Android app ecosystem presented their findings in terms of tradeoffs: “GDPR reduces consumer surplus and aggregate app usage by about a third. Whatever the privacy benefits of GDPR, they come at substantial costs in foregone innovation.”

A Modest Proposal for Radical Change

These findings aren’t kind to the Vestager view of Europe writing “landmark rules” around technology that accomplish multiple laudable goals and also “ensure that the EU remains competitive.” The research instead supports Draghi’s view that dire tradeoffs loom unless Europe makes major changes. His report contains a stark warning (emphasis added):

Europe’s fundamental values are prosperity, equity, freedom, peace and democracy in a sustainable environment. The EU exists to ensure that Europeans can always benefit from these fundamental rights. If Europe can no longer provide them to its people – or has to trade off one against the other – it will have lost its reason for being.

The only way to meet this challenge is to grow and become more productive, preserving our values of equity and social inclusion. And the only way to become more productive is for Europe to radically change.

I agree, which is why I felt let down by the Draghi report. On issues of innovation and technology its recommendations aren’t nearly radical enough. They’re not even pointed in the right direction. Fiddling with the already-flowing irrigation system of public R&D spending isn’t going to cause any meaningful change.

Maybe increasing that spending would help, and maybe directing more of it from Brussels instead of national capitals would help. But doing both of those things optimally won’t meaningfully close the VC investment chasmgap between the US and EU. Which means, pretty inescapably, that doing them won’t help create the kinds of large, young, innovative high-tech companies identified in the report as key to Europe’s future prosperity.

So what will? What shifts in the European tech ecosystem would I recommend? Pretty simple ones. Simple to say, anyway, but hard to enact.³ My proposed radical change is for the EU to adopt a hands-off, laissez-faire attitude toward tech regulation.

The view that global leadership in regulating a sector is a good way to ensure global leadership in innovation and value creation within that sector is wrong. It runs counter to both simple logic and ample evidence. Right now Europe is providing more of that evidence. Empirical economics researchers might consider this good news, but we members of team Liberal Democratic West shouldn’t.

Epilogue

But doesn’t tech need regulation? Of course it does. Any sector as large and important as tech is going to need oversight and governance. I’ll dive into what I think is the right approach to those critical tasks in future posts here. A decent starting point is my talk last year at Web Summit, where I describe the opposing philosophies of upstream governance and permissionless innovation, and make the case for permissionlessness:

https://www.youtube.com/live/V7KaghTZHgk?si=3hRFGpr1HMAoqT-H&t=1366

1. This ranking is based on an inclusive definition of “tech” companies. Ericsson and Nokia are on the list, and they make gear for telcos. Schneider is also included; they make industrial electronics.

2. Among my friends in Northern California, the great majority have been involved with at least one startup that didn’t make it. No one out there finds this notable; it’s just part of a US West Coast tech career.

3. At least as hard to enact as more debt-financed public R&D spending. The German Finance Ministry has already signaled its opposition.