Big is beautiful—so goes the claim of many European business leaders and German Economy Minister Peter Altmaier, when they talk about Europe’s corporate position in the world. The European Commission’s controversial February 6 blocking of a planned merger between the rail businesses of Siemens and Alstom has brought the issue of size back into the headlines—with Altmaier and his French counterpart Bruno Le Maire arguing that the merger was necessary to compete with giant, state-supported Chinese companies.

It’s true that EU companies remain highly competitive globally and very successful exporters. It’s also true that the EU continues to be a very open economy with a trade surplus. Yet, despite this, there is a fear that European companies find it increasingly difficult to be on top of the global value chains—or, put differently, to be global leaders. And despite the successes of European companies in general, there are only nine firms from the EU in the top 50 of the Fortune 500, compared with 21 firms for the United States and twelve from China.

The picture among the top 100 Fortune 500 global companies is even more gloomy: 37 firms from the US, 23 from China and 22 from the EU. Moreover, not one of the world’s top 20 technology firms, covering sectors that are central to the success of whole economies, is from the EU, while there are eleven firms from the US and nine from China.

Europe clearly lags behind its global competitors in the platform business, and forecasts are no better: 70 percent of the global economic impact of AI is expected to be concentrated in North America and China. Many argue that EU-based firms simply lack the critical scale to compete.

Careful Thinking Needed

How can this problem be addressed? Some argue that the EU should change its competition policy. Merger control should become less strict, according to a recent study by the Federation of German Industries (BDI) on China. Moreover, merger control should become more “dynamic,” i.e. it should take account of possible future competition effects, and more “flexible,” to address concerns beyond potential anti-competitive effects, such as environmental, social, or other concerns.

Europe’s merger control laws may or may not need reform. But asking the Commission to so suddenly abandon its approach and to go against the letter of the Merger Control Regulation is certainly wrong. Moreover, careful thinking is needed as to avoid undesired effects of political intervention in specific cases.

European consumers still benefit from relatively low mark-ups thanks to high competition, but this could be easily squandered if merger control were relaxed. And one should also not be naïve about the benefits that larger companies would enjoy when entering a market like the Chinese one, where access is highly regulated and limited.

Sharpening State-Aid Control

Rather, European companies and consumers would benefit more from the following measures than from lax merger control.

First, applying a form of state-aid control to foreign companies needs to be made more effective, both in our markets as well as extraterritorially. EU competition law should be applied in a non-discriminatory way, regardless of the origin of the firm; if the market is distorted, the case should be pursued. The Commission could become more assertive in its enforcement, but for that to be possible the EU’s legal framework would have to evolve significantly, a point also recently made by BDI.

The EU cannot apply state-aid rules to foreign governments, and there is currently no systematic, effective, or well-founded way for the application of EU state rules to firms that operate in EU markets but receive state support in other jurisdictions. Yet it is possible to imagine an instrument that could be applied to foreign firms that benefit from state support in a way that creates an unfair competitive advantage that European companies cannot match. EU law should seek to ensure a level playing field for all companies.

The WTO agreement on subsidies and countervailing measures provides a platform for international collaboration that could help the EU address subsidies that distort international trade. However, it suffers from three main problems: the notification of subsidies is not fully transparent, and its efficacy is limited; the remedial action is slow and complex; and EU state-aid rules apply to both goods and services, whereas the WTO rules apply only to goods. In economies increasingly driven by services, networks, and data, focusing only on subsidies in the goods sector is insufficient.

Investment control regulation can be used to restrict the entry of foreign corporations that receive distortionary state support. But a transparent process is needed in order to avoid the misuse of instruments. Their existence, as such, can discourage unwarranted behavior. Yet, they must be clearly restricted to well-defined concerns, such as security concerns, with objective criteria, to prevent becoming just a simple tools for protectionism.

Toward a Proactive Investments

Second, Europe should go beyond defensive measures and more actively pursue a strategy that bolsters investment and innovation in Europe, while creating the conditions for firms to scale up in a well-integrated single market.

Europe needs a multidimensional mix of policies to strengthen and deepen the single market, which is still fragmented when it comes to services. Sufficient market financing should also be ensured so that firms can expand their operations and compete efficiently on a global scale—for which integrated and deep capital markets, including for venture capital, are needed. There is also a need for more risk-taking and for enhancing business and investment conditions in a number of countries.

The EU’s R&D spending is still at only 2 percent of GDP, compared with 2.8 percent overall in the US. Moreover, North America and Asia are the front-runners in private investments on Artificial Intelligence. This dark picture is a direct result of a lack of an effective strategy, not only for European investment but industrial policy as a whole. The EU’s global competitors long ago adopted ambitious AI plans, where industrial policies and public/private investments have a prominent role. And after Brexit, the state of AI in the EU will be worse, as London remains in the lead for AI companies. This makes a European strategy all the more important.

Strengthening Europe’s Universities

Finally, it should not come as a surprise that Europe is losing the technology race, given that its universities lag behind the top performers. For example, in mechanical engineering, the best German university, Aachen, ranks only in the group of 51–75-best worldwide, well behind twelve Chinese universities, according to the Shanghai ranking. Outside the United Kingdom, only Milan and Leuven rank ahead of Aachen among EU-based universities. Do Germany, France, or the EU have a strategy to address this problem?

Global competition is indeed becoming tougher, in particular with China increasingly leading in key technology sectors. And Europe needs to face that competition. Defensive instruments to address state-subsidy concerns are part of the solution; relaxing merger control is probably not the answer. But the real question is whether the EU will strengthen its single market, increase R&D spending, regain its leadership of universities and design a true and integrated AI strategy.

Big may be beautiful, but the strategic priority for the EU should be to become a front-runner in innovation and the adoption of new technologies. For that, it needs investment, research, and education rather than European champions.

The post Red Herring & Black Swan: European Champions? appeared first on Berlin Policy Journal - Blog.

© REUTERS/Fabian Bimmer

The German export-oriented economic model is under attack this year: Germany is caught between tough American protectionism and aggressive Chinese industrial policy. The US government is threatening to impose painful sanctions on key German export goods, such as automobiles, while China’s industrial policy is focused on acquiring important industrial technologies, and eventually replacing existing foreign technology leaders in the automotive, engineering, and chemical industries.

Because of the sizes of their markets, the United States and China unquestionably have the tools to hurt Germany’s export-oriented economy. The new German government under Angela Merkel will have to counter the effects of the US-Chinese squeeze.

First, German dependence on exports to the United States and China must be reduced. The focus should be on strengthening growth forces – and not just in Germany, but Europe as well. All euro area countries except France, Finland, Cyprus, and Belgium have current account surpluses, , and Germany’s surplus amounts to almost 8 percent of its GDP. The euro area as a whole has a surplus of around 3 percent of GDP. These external surpluses are no longer sustainable in a world in which the US president is threatening to launch a trade war and the World Trade Organization can no longer regulate open markets in key economies.

Germany’s capital investment is lagging behind. Even without this acute pressure, it would be in Germany’s interests to set domestic growth forces free. German business investment has been weakening for years. German gross investment in the industrial sector has been lower even than in France or Italy since the start of the millennium. A timely and feasible step would be to massively improve the rules for depreciating assets on capital, software, and research investments in the German tax code. This is all the more necessary now as US corporate tax reform will allow companies to immediately depreciate 100 percent of their expense for equipment and building upgrades.

Beyond reforming the tax code and lowering other regulatory barriers, Germany will have to accelerate the development of public infrastructure. Improvements are urgently needed for the country’s roads and public transport infrastructure, as well as its data infrastructure and broadband network. Schools and universities could use more funding as well. The increased availability of both private and public capital will also help raise wage levels in Germany. After all, capital complements most labor activity. This set of measures would promote domestic growth and reduce dependence on exports; the resulting growth in Germany would also help its EU partner countries by increasing demand for their products.

Promoting Infant Industries

Second, German innovation policy must also make a real leap forward, especially in the digital economy, so as not to leave the future of technological change entirely to others. American and Chinese IT corporations are in the process of dividing up world markets, setting technological standards that will be associated with huge licensing revenues in the future. They are also making significant advances towards the technology of the (near) future: artificial intelligence.

At the moment, neither Germany nor Europe has a lot to offer in terms of a digital economy. The EU’s Digital Single Market is not progressing. As early as 2019, Europeans will become painfully aware of the shortcomings in their networks’ innovation policies when the Chinese company Huawei begins to install 5G mobile technologies in Europe, a prerequisite for networked industrial production and autonomous driving.

Europe needs a much more ambitious and active digital innovation policy, one that includes the targeted promotion of European “infant industries,” for example through the development of larger venture capital markets. Research shows that scaling companies is more difficult in Europe than in the US due to lower access to venture capital in all industries. With regards to critical infrastructures, there should be no taboo on the targeted support of currently weak European 5G developers, such as Nokia or Ericsson. If European semiconductor and mobile network companies disappeared from the markets, after all, dependencies on US and Chinese technology providers would not only create security risks, but would permanently reduce European innovation capacities.

European governments will therefore need to fundamentally rethink their innovation policies, and in particular their digital policies, in order to counter the rush of American and Chinese companies and innovations. The German coalition agreement does hint at the importance of research, but it gives the impression that rather marginal changes are being considered, when a qualitative change is needed. Company- and market-driven “innovation from below” will be necessary but insufficient; digital transformation requires new, state-financed infrastructures, targeted support measures, and educational offers as well as continuously adapted market rules provided by governments and parliaments. Public innovation policy must simply become more ambitious and think in terms of bigger goals and dimensions. Substantially strengthening research and development spending in the European and German budgets is only a first necessary step in this direction.

Screening Foreign Investments

Third, Germany should campaign for a robust foreign trade policy in Europe. On the one hand, this is about adequately examining security interests in foreign investments and acquisitions and flanking them with a pan-European coordination office. On the other hand, it is also about protecting strategic technologies from being taken over through market manipulation practices. For this task, the competencies of the EU Directorate-General for Competition should be strengthened. It is completely unacceptable that foreign top dogs operating with state funding from closed domestic markets should be able to drive European companies out of the European market.

Germany must stand up for open markets and fair trade practices more decisively than before through the EU’s Directorate-General for Trade, without weakening the European institutions through unilateral action. European Trade Commissioner Cecilia Malmström is doing a very good job, not only in her negotiations with the United States and China, but also in establishing new strategic trade relations with, for example, the Latin American Mercosur, along with a free trade agreement with Japan. Europe should build further partnerships and, at the same time, sharpen its trade policy instruments to defend itself in the case of conflict and represent European interests more effectively than before.

Germany can no longer avoid an economic policy correction in the face of the dual pressure coming from the United States and China. The new German government has to act now if it wants to defend domestic industries from unfair competition while releasing Europe’s own growth forces.

The post Squeezed Model appeared first on Berlin Policy Journal - Blog.

(c) REUTERS/Yannis Behrakis

Who Will Blink First, Alexis or Angela?

Opinion polls show that Greek citizens want to renegotiate terms with their creditors – but want to stay in the euro. This is the mandate that they gave Prime Minister Alexis Tsipras. The new Greek government has exercised brinkmanship in trying to achieve this: it unilaterally declared that it would not respect the agreement between Greece’s previous government and the country’s creditors, that it would increase government spending, and that it was insolvent at the same time.

The response has been predictable: the rest of the euro area – and in particular the European Central Bank and Germany – felt blackmailed and called Greece’s bluff. The ECB made access to its liquidity more difficult for Greek banks, while Chancellor Angela Merkel’s government has signaled it considers a Greek exit from the eurozone manageable.

What Have We Learned from Athens?

This response was necessary, but insufficient. A monetary system cannot function credibly if a small part of the union can hold the core of the system for ransom. A country cannot unilaterally decide to increase expenditure at the expense of other parts of the union and hope to receive funding for it. It also cannot unilaterally refute agreements between its previous government and its European partners.

Yet at the same time, ignoring the Greek vote is not an option. Greeks need to believe that their lives will improve. This perspective cannot be achieved via gambling, unilateral action, or blackmail; rather, it needs to be the result of domestic action and an agreement between the partners of the Eurogroup. The essential elements of a deal include serious domestic reform, such as reduced corruption, further preferential funding, a significant reduction in savings demanded by the Troika, and more certainty about the terms of the debt should growth rates disappoint.

The heated discussions about Greece show that a monetary union needs political collaboration and trust to work. There needs to be trust that agreed principles are followed – but also trust that the prescribed solutions will not destroy an economy. While previous Greek governments have put their country in a bad situation with irresponsible fiscal policies, too much of the adjustment burden during the crisis has been loaded onto the backs of the Greek citizens, and too little onto private creditors.

Where Did the European Fracture Start?

The euro area was always comprised of two groups of countries with substantially different socio-economic models, which means they had different macroeconomic policies and outcomes. There were the core countries such as Germany and France, which had continuously belonged to (or shadowed) the Exchange Rate Mechanism (ERM), introduced in 1979, and the peripheral countries like Spain, Portugal, and Greece, which had stayed mostly outside the ERM or joined late.

Different initial conditions in the core and the periphery, mainly in terms of interest rates, led to a credit boom in the periphery after the introduction of the euro, financed by capital flows from the core. The result were increasing different levels of competitiveness within the eurozone, which were insufficiently monitored and difficult to counter in the absence of the exchange rate instrument. As a result, current-account balances and net foreign asset positions diverged to an unprecedented degree between the core countries (in surplus) and those on the periphery (in deficit). When the financial crisis hit in 2008-09, private capital flows from the core to the periphery suddenly stopped, leaving a mountain of external (private and public) debt in the periphery owed to creditors in the core countries.

Why Did the Cracks Widen?

Instead of producing real and sustainable convergence between the core and the periphery, the single currency resulted in imbalances and was ill-prepared to deal with them. This shortcoming, along with deeply entrenched opposition to bank resolution in a system characterized by major inter-dependencies between political systems and financial institutions, was a major hindrance in getting to grips with a European financial-cum-sovereign-debt crisis.

Another weakness of the euro area’s economic governance architecture was that it lacked a mechanism to monitor and correct macroeconomic imbalances, except in budgetary policy. Enforcement of the deficit rules – limiting government deficits to 3 percent of GDP, among others – was inadequate, public debt sustainability received relatively little attention and private debt was completely ignored. Similarly, scant focus was trained on external debt – and current account imbalances.

When the global crisis triggered the European crisis, Europe’s policy system was largely unprepared. The initial policy response in 2009 was timely and coordinated, consisting of monetary policy easing and a substantial increase in fiscal deficits. But crisis management faltered after the May 2010 elections in Greece, which triggered the European debt crisis, and several stressed countries started losing market access.

What is the Situation Now?

So far, the overall crisis response has not produced the desired results. The banking union project may now be nominally complete, but it remains a work in progress. GDP has not grown since 2008, and unemployment rose from 7.5 percent to 12 percent in 2013. Inflation has fallen substantially, and in December 2014 area-wide deflation (of -0.2 percent) was recorded for the first time since 2009. Internal adjustment has proceeded, with current-account deficits shrinking substantially. However, current account surpluses have, if anything, increased in Germany and the Netherlands, reaching 7 percent of GDP and more in 2014. Some wage and price adjustment was implemented in the crisis countries, but relative prices between the three biggest euro-area countries – Germany, France, and Italy – have adjusted only marginally. The very low area-wide inflation rate has not helped: the lower it falls, the more difficult it becomes to achieve the necessary adjustment.

The extent of Greece’s difficulties and its inability to adjust effectively – through exports, for example, or decreasing wages – may render it an outlier, but the obstacles Greece faces are not qualitatively different from structural issues that have arisen throughout the currency union. Besides the severe macroeconomic imbalances at the beginning of the crisis, four common problems can be identified.

First, from 2011 to 2013, fiscal policy in the euro area was pro-cyclical. In 2014, fiscal policy was flat and did not counteract the continuing deterioration of the economy, public investment and R&D expenditure were cut during the crisis. Second, Europe has taken a gradual approach to bank resolution; unresolved banking issues continue to plague credit provision. Third, the ECB has been slow to respond to the deteriorating economic situation, and has tried to avoid taking risks. It also misjudged the situation twice, resulting in erroneous rate increases. And lastly, no serious and significant measures to address price divergence between Germany, France, and Italy have been undertaken.

What Has to be Done Now?

Progress needs to be made in three directions simultaneously. First, bank survival must be made independent of the stability of member states; second, divergences in competitiveness need to be ameliorated; and third, fiscal coordination should be further advanced.

At a famous summit in June 2012, the European leaders announced that they intended to “break the vicious circle” between banks and sovereign states. This was a new step in European integration. The creation of the so-called banking union is arguably the most significant deepening of policy integration since the start of the euro, and certainly since the start of the crisis. The aim was to make the financial system more resilient and weaken the link between banks and states.

To achieve this, three major steps had to be undertaken: first, bank supervision had to be moved from the national to the European level. Second, mechanisms for bank resolution, in particular for banks operating across borders, needed to be developed. Third, mechanisms were needed to reduce the risk for taxpayers and share the remaining risks across the union.

Are the New Powers of the ECB Enough?

Policy makers have made significant progress on all three, but the work is not finished. In particular, the link between national public resources and fragile banks will remain for quite some time. The biggest success so far is the creation of a strong and centralized supervisor in the European Central Bank, the Single Supervisory Mechanism. The ECB has not only hired 1,000 new experts for its banking supervision, it has also brought substantial transparency to Europe’s banks by assessing the quality of their balance sheets with stress tests, and harmonizing bank reporting. Banks that fell below certain thresholds for risk-weighted capital in these stress tests are increasing their capital to become more resilient. Yet important steps remain unfinished.

A first important question is whether the ECB, as a newly established supervisor, will be able to ensure that deposits can circulate freely within banking groups. During the crisis, national supervisors put limits on subsidiaries to reduce the exposure of depositors to capital flows and risks in other countries. This policy has rendered bank integration across borders less beneficial, and has undermined financial integration. Yet the idea of abandoning the policy altogether has implications for deposit insurance, and will therefore remain controversial.

And the Other Banks?

Another important question is how the ECB and national authorities will continue to clean up and restructure the banking system. And the role of private creditors in bank restructuring and resolution needs to be examined. Tough legislation has been put in place but enforcement may be less credible. If a bail-in is not enough to solve banking problems, fiscal resources will again be used. The joint funding mechanisms developed will only suffice for small to medium-sized banks. Bail-in and risk sharing will in any case not be enough to reduce the link between banks and national sovereigns – banks will also have to reduce their exposure to sovereign debt and other claims of the countries in which they are located.

Overall, the process of repairing and deepening financial integration in the EU, and the eurozone in particular, is bound to take time. The crisis has dented investor confidence. However, the establishment of a strong supervisor and the progress made on banking resolution should be considered game changers.

What Do We Need to Hold Things Together?

To address competitiveness divergence, the euro area needs a proper policy framework. Leaving adjustment to market forces alone is unlikely to work, as labor mobility in the euro area will remain much lower than in the United States. The framework should thus ensure that wages move in line with productivity. Such a system could be introduced in each euro area state. These national mechanisms would constitute national competitiveness councils, with a Eurosystem Competitiveness Council consisting of both national Competitiveness Councils and the European Commission. Its primary task should be to ensure that no euro-area country fixes a wage norm that would result in significant competitiveness problems for itself and/or others.

The fundamental question for the eurozone is whether to move ahead with fiscal integration, accepting that national parliaments would lose some power; or whether to implement full decentralization in which fiscal decisions are taken at the national level. This latter option would accept defaults without mechanisms to safeguard financial stability, and would therefore be politically, socially, and financially unstable.

A More Constraining Framework 

Europe needs a reform of the fiscal framework along the lines of “fiscal federalism by exception,” as originally proposed by Jean-Claude Trichet in his Charlemagne Prize speech of 2011. This puts the focus of fiscal surveillance on debt sustainability as well as ensuring a proper fiscal stance. The closer a country moves to unsustainability, the stronger the intervention would be, with the ultimate sanction being a complete removal of credit. This enhanced governance would be in addition to possible debt restructuring. The fiscal framework should also ensure that the sum of deficits in the euro area achieves a reasonable area-wide fiscal stance. The new framework would thus not only in extreme cases be able to overrule national parliaments in prohibiting borrowing, it would also have the right to force member states to run higher deficits if the eurozone economy hit a substantial recession. In other words, the notion of “fiscal federalism by exception” should be made a symmetric one.

The governance of fiscal surveillance could be organized in a Eurosystem of Fiscal Policy, with a governing council comparable to the eurosystem of central banks. At its centre would be a eurozone Finance Minister – or a European Budget Commissioner, as Wolfgang Schäuble has suggested. In normal times, fiscal deficits would still be managed on the national level, and the recommendations of the Eurosystem of Fiscal Policy would not be fully binding. But in exceptional circumstances it would take control.

Coordinate but Do Not Share Risks

It is important to note that this model does not imply the creation of a “federal budget”. All government spending would remain at the national level. It is also important to note that the proposal does not foresee risk sharing beyond the current ESM capacities. It is essentially an improved framework for fiscal policy coordination. A much more far-reaching step would be to establish a fiscal mechanism for proper risk sharing across countries, such as a European unemployment insurance mechanism. This would introduce real risk-sharing. But this would arguably only be possible if labor market conditions were to be significantly harmonized.

If anything, the Greek case demonstrates that the euro area needs to increase integration and improve its coordination framework. A monetary union cannot credibly work if any member can act unilaterally. The banking union needs to be completed, competitiveness divergences need to be kept in check as labor markets will remain largely national, and fiscal policy needs to ensure debt sustainability, while defining a proper fiscal stance for the eurozone in recession.

Pia Hüttl, a research assistant at Bruegel, contributed to the article. 

Read more articles from the April 2015 issue FOR FREE in the Berlin Policy Journal App.

The post Euro Puzzles appeared first on Berlin Policy Journal - Blog.