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Competitiveness Revisited

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It has become the economistʼs holy grail – but competitiveness is too nebulous to guide policy. Increasing productivity should be Europe’s real concern, and this requires a comprehensive reform agenda.

Employee Lothar Baum explains how a 'Data Mining' 12 million pixel wide screen works before the BOSCH's official opening ceremony of the company's new center for research and advance engineering Campus Renningen in Renningen, Germany, October 14, 2015. REUTERS/Michaela Rehle - RTS4ESW

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Loss of competitiveness is now widely (and wrongly) accepted as a primary cause of the crisis in the eurozone, and making Europe “more competitive” has become a priority among policymakers. What is remarkable, however, is that there is no agreed definition of what competitiveness is – and most implicit meanings are wrong. 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 prioritizing reforms, the already existing imperfections of Europe’s economies and the current macroeconomic backdrop. Finally, increasing competitiveness requires more, not less democracy.

The notion of competitiveness currently en vogue applies business concepts such as profits and competition to countries and international trade. For firms, competitiveness is relatively simple to explain: companies compete with each other, in part on price, in part on quality and innovation. The winners of this competition make a profit, while the losers rethink their strategy – or go out of business.

False (and not so False) Analogies

For countries, almost none of this applies. Countries do not make profits. A trade surplus, often understood as a kind of national profit, is not a 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 direct 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. 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 with an undervalued currency, for example, or by suppressing wages. But both approaches carry costs. Lowered exchange rates and suppressed wages reduce real domestic incomes 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, investment or credit. The last few years 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. It has lost almost half a trillion euros on its 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 possible, thereby also creating 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 the term 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 to become more competitive.

What an Index Cannot Tell Us

An index such as the one used in the WEF’s global competitiveness report is a useful starting point for measuring competitiveness. 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 vary from country to country, even when these countries are at similar stages of development. The reason is that no country will ever have a perfectly competitive, first-best set of institutions, policies, and factors – if such a first-best even exists. Becoming more competitive therefore means changing 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 expanding 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 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 even make matters worse. For example, labour market liberalizations in the midst of a downturn can exacerbate a drop in demand unless exports pick up the slack. Conversely, minor structural reforms, such as Germany’s labor 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 in areas that can immediately unleash investment without hurting demand further and thus reinforcing deflation.

Finally, improving competitiveness is not a goal, but rather a process. A country needs to constantly reassess its policies and institutions and target reforms at the most binding constraints limiting productivity growth, whatever those might be at the time. The best forum for this constant deliberation is a well-functioning, pluralist democracy.

Steps to Be Taken

Such a comprehensive concept of competitiveness would suggest certain steps in Europe as a whole and in the individual member states.

At the European level, the acute lack of demand, especially in the eurozone, makes it hard for structural reforms to pay off; the European Central Bank needs to be bolder in its monetary policy, and Europe needs to rethink its fiscal policies to ensure sufficient aggregate 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 could 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 new firms often have particular trouble financing their expansion in Europe, as they lack the collateral to convince banks to fund them, and equity financing and venture capital markets are underdeveloped in Europe.

To increase productivity, European policymakers should focus on areas where a larger market size and increased competition between firms can boost investment and innovation – and thus productivity. One example would be tradable services. Here, Europe has lagged 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 and support for a free and pluralistic press, areas in which the member states vary dramatically at the moment. The EU could 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. For example, taxing inherited wealth or land more strongly to finance favorable tax treatments for start-ups and proper entrepreneurial risk-taking would boost Europe’s innovative capacity. Member states should end the favorable tax treatment of debt relative to equity to encourage 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, states should invest more in research and development with the explicit aim of maximizing innovation 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 the few rather than the many. 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.

N.B. A slightly longer version of this original article can be found on the Center for European Reform’s (CER) website.

Read more in the Berlin Policy Journal App – January/February 2016 issue.

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