European competitiveness: the role of institutions and the case for structural reforms

Prepared by Marinela-Daniela Filip, Daphne Momferatou and Susana Parraga Rodriguez

1 Introduction

Competitiveness has returned to the top of the European agenda. Sustainable, long-term economic growth supports price stability and gives monetary policymakers more room for manoeuvre.^[1] Long-standing challenges related to low productivity growth, burdensome regulations and demographic headwinds have been exacerbated by geopolitical tensions, trade fragmentation and the prospect of persistently high energy prices. Recent reports by Mario Draghi and Enrico Letta have highlighted these challenges and the need for urgent and concrete action that will enable Europe to catch up and maintain a competitive edge over its global competitors.^[2],[3] The priority of the incoming European Commission is to speed up the rate of reform and investment, placing a particular focus on innovation, decarbonisation and strategic autonomy.^[4]

Competitiveness is a complex and multi-faceted concept that can be defined in various ways. Although there are multiple factors that interact with and influence competitiveness, the only sustainable long-term strategy to maintain a high level of competitiveness is robust productivity growth. This also boils down to ensuring that citizens enjoy a high standard of living. In light of current geopolitical tensions, competitiveness also needs to go hand-in-hand with resilience, i.e. the ability to withstand and adapt to shocks. By reducing those foreign strategic dependencies that create uncertainty and dampen investment, Europe can strengthen both its competitiveness and its economic security.

This article focuses on the role institutions can play in boosting productivity growth through investment, innovation, and the green and digital transitions, thereby improving the competitiveness of the European economy. It follows on from previous Economic Bulletin articles that have focused on the external dimension and the potential implications energy shocks and corporate investment might have for European competitiveness.^[5] Sustainable, long-term growth and economic competitiveness and resilience are underpinned by favourable institutional frameworks and complementary, high-quality physical infrastructures. Achieving sustainable economic growth and maintaining a competitive edge while advancing the green transition depends on key factors such as productivity growth, firm dynamism (generally the rate at which firms enter, grow and exit the market), investment, innovation and digital technology diffusion. The macroeconomic and geopolitical environment, including demographics and trade relations, also influences institutions and infrastructures and frames the broader policy options and priorities.

The remainder of this article expands on the role key institutions play in ensuring competitiveness in the current macroeconomic and geopolitical environment. The next section briefly discusses measures of Europe’s productivity gap compared with other leading economies and links it to shortcomings in firm dynamism, investment, innovation and the diffusion of digital technology. Section 3 takes a detailed look at the role institutions play in supporting the broader framework in which European firms operate, grow and innovate, and highlights areas in need of reform. Box 1 provides a targeted examination of the complementary physical infrastructures and networks. Section 4 concludes by joining the call for urgent and concrete structural reform and policies to enhance Europe's competitiveness and resilience.

2 Productivity growth, firm dynamism, investment and innovation

Several studies show that low productivity growth in Europe is at the heart of the challenges it is facing in terms of competitiveness and that this is largely related to developments in the information and communication technology (ICT) sector. In the last few decades, productivity gains have gradually been slowing in many advanced economies.^[6] Weaker productivity growth in Europe compared with the United States (US) stems mainly from the lower productivity and lower economic weighting of ICT-intensive industries. Chart 1, panel a, illustrates that after catching up with the United States until 1995, the euro area productivity gap started to widen. These productivity differences reflect both lower capital deepening and total factor productivity (TFP) contributions to growth in GDP per hour worked.^[7] Insight into whether this can be explained by the ICT revolution having less of an effect in Europe than in the United States can be obtained by studying the differences at sectoral level. Gordon and Sayed analysed the developments in the United States and a set of EU countries using industry-level data.^[8] For the period 1995-2005, they found that, in contrast to the United States, Europe experienced a slowdown in productivity growth due to several factors, including a scarcity of ICT investment, a failure to capture the efficiency benefits of ICT and performance shortfalls in specific industries including ICT production, finance and insurance, retail and wholesale, and agriculture.

Chart 1

Labour productivity and real investment by asset type

a) Labour productivity

(USD 2010, purchasing power parity per hours worked)

b) Real investment by asset type

(percentage of real GDP)

Firm dynamism is weaker in Europe than in the United States. While firm dynamism has suffered a secular decline in both Europe and the United States, the latter has seen the formation of relatively more new firms and a lower number of bankruptcy declarations in recent years.^[9] In Europe, the average age of firms at the frontier, i.e. the most technologically advanced and productive firms within a particular industry, has increased substantially in recent decades. In the early 2000s frontier firms in manufacturing were on average 14 years old compared with over 20 years old today.^[10] Labour productivity growth tends to decline as firms age, which may point towards a lack of competition and a low churn rate at the productivity frontier in Europe. Indeed, there appears to be a connection between the lack of competition from new, innovative firms and the survival of mature firms at the frontier.^[11]

Reducing financial constraints would support the development of innovative, young and small firms. Compared with their United States counterparts, Europe’s young, high-growth firms have a smaller economic footprint, with too few of them growing quickly and eventually making it to the top.^[12] These firms often face more severe financial constraints than their established counterparts due to investor risk aversion, a lack of relationships of trust and a reliance on intangible assets, which are more difficult to collateralise.^[13] Business dynamism has also been found to be lower in regions where the population is older (see also Section 3 below).^[14] Overall, the result is a European corporate ecosystem of relatively small and ageing firms that are unable to compete globally.^[15] Part of the solution lies in further integrating and developing capital markets in Europe, including risk capital markets such as venture capital, to complement the banking sector and enhance risk-taking capacity.^[16]

Increasing investment, particularly in intangibles such as research and development (R&D) and in the diffusion of digital technology, could improve Europe’s productivity. As shown in Chart 1, panel b, the euro area allocates a smaller proportion of its GDP to ICT equipment and intellectual property products than the United States, with the gap widening in recent years.^[17] In addition, Europe focuses on marginal improvements in already mature technologies rather than in breakthrough innovation, meaning it is stuck in the “middle-technology trap”.^[18] In terms of digital uptake, recent firm level analysis for the euro area shows that the adoption of digital technologies could lead to an increase in firms’ productivity in the medium term. But the effect of digital adoption is heterogenous across firms and sectors, and not all digital technologies deliver significant productivity gains. One way to increase the productivity benefits of digitalisation could be more efficient and effective institutions and governance structures, and complementary skills.^[19] At the same time, enhancing European firms’ scaling up could advance their digitalisation.^[20]

Although the EU is lagging behind in R&D expenditure, its green innovation activity is still comparable to that of other major regions. In the EU, the expenditure on R&D as a percentage of GDP has been hovering around 2% in the last decade. This is much lower than in the United States and Japan, for example, and most recently was also below that of China (Chart 2, panel a), with most of the gap stemming from the private sector.^[21] On the positive side, green innovation activity in the EU (in terms of international patent families) remains comparable for now with that of other countries, such as Japan and the United States. China, however, has been catching up at a fast pace and surpassed other major regions in 2021 (Chart 2, panel b).^[22] If Europe wants to maintain its strong role in cleantech innovation, it will have to focus on patenting and scaling up, and to tackle regulatory fragmentation to ensure it reaps the full benefits of the Single Market.

Chart 2

Expenditure on R&D and cleantech innovations

a) Gross domestic expenditure on R&D	b) Cleantech innovation by country of origin
(percentage of GDP)	(number of international patent applications)

3 Institutions

Institutions play a pivotal role in fostering a dynamic business environment, investment, innovation, and therefore productivity and competitiveness. Defined broadly, institutions encompass the formal and informal rules, norms and organisations that provide the structure for social, political and economic interactions. Research by the 2024 Nobel Laureates Acemoglu, Johnson and Robinson emphasises the importance of inclusive institutions that provide broad access to economic opportunities and protect individuals against abuses of power.^[23] In addition to ensuring the rule of law and reducing corruption, institutions that support human capital development, such as educational systems, are crucial for enhancing competitiveness. Well-functioning institutions in these areas also ensure a skilled workforce, which is indispensable for productivity growth and innovation.^[24]

Legal and regulatory frameworks

Legal and regulatory frameworks significantly influence the business environment and firms’ investment decisions. Although most regulations are designed with the aim of protecting people’s health and the environment, they may have unintended economic and social consequences. Complex planning and approval procedures can be serious obstacles to investment, especially for small firms and in the context of the digital and green transitions. Regulations limiting the entry of firms into product and services markets, or constraining the use of certain technologies or data, can hinder the adoption of new technologies by increasing costs for new high-technology firms, therefore reducing competition and constraining technology spillovers.

Chart 3

Long-term barriers to investment - 2023

(percentage of firms identifying different categories as a major barrier)

The complexity and variability of regulations across EU Member States create barriers to entry and increase compliance costs for businesses, making Europe less attractive compared with more streamlined regulatory environments like the United States. The European Investment Bank (EIB) Investment Survey has identified long-term barriers to firms’ investment decisions (Chart 3). More firms in Europe report major long-term barriers to investment than in the United States. While the availability of skilled staff is identified as the biggest barrier in both the EU and the United States, about twice as many firms in Europe report challenges such as higher energy costs, difficulties in accessing funding, and deficits in transport and digital infrastructure (see also Box 1). In a similar vein, more firms in the EU say that business and labour regulations are a major barrier to investment. While the difference does not seem to be very large, the EU average masks extensive heterogeneity across EU countries (see Chart 4, panel a). A similarly heterogeneous picture emerges regarding corporate restructuring processes, which need to be simplified, shortened and more harmonised. In 2019 the average time to resolve insolvency in the EU was double (around two years) that in the United States (Chart 4, panel b).

Chart 4

Burden of regulations and time to resolve insolvency

a) Burden of regulations

(x-axis: score; y-axis: percentage of firms)

b) Time to resolve insolvency

(number of years - 2019)

The regulatory landscape in the United States is generally considered more business-friendly and focused on minimising bureaucratic hurdles to encourage innovation and investment. For example, the United States has a more flexible approach to environmental regulations and a less stringent data protection framework compared with the EU's General Data Protection Regulation. This can make it easier for companies to operate and invest in new technologies and green initiatives. According to the World Bank's Doing Business 2020 report, the average time to start a business in Europe varies considerably across countries and in many it is significantly longer than in the United States, highlighting the less efficient and fragmented regulatory processes in the EU.^[25] The International Monetary Fund estimates that overall trade costs within Europe are equivalent to a sizeable ad valorem tariff of 44% for the average manufacturing sector compared with 15% between US states, and as high as 110% for services.^[26] A large part of these high costs in Europe is related to regulatory entry barriers, which remain particularly high, especially for services.

The recent reports by Enrico Letta and Mario Draghi also point to regulatory burden and fragmentation, which limit the ability of EU companies to scale up and compete internationally. Completing the Single Market and streamlining and harmonising business regulations where appropriate will be key to changing this. Examples include proposals to create a new business code as a 28^th regime for European innovative companies (with a harmonised and limited set of regulations that would allow innovative firms to expand quickly across the entire EU), and steps towards harmonising national insolvency frameworks.^[27] More expedient and harmonised procedures for cleantech applications could be another area to explore. A first step in this direction is the unitary patent system launched in 2023, which makes it possible to acquire patent protection in 17 EU Member States by submitting a single request to the European Patent Office.

To address long-term barriers to investment related to access to financing, deeper capital markets and financial integration are essential. This could help create a unified and thus deep and liquid capital market, enabling firms to access a diverse range of funding sources, including venture capital. Increased access to risk capital could enable companies to boost investment in intangibles and R&D, including breakthrough innovations, while supporting financing for the green and digital transitions. A detailed discussion into these issues is beyond the scope of this article but is extensively covered in other ECB publications.^[28]

Governance and administrative capacity

High-quality public institutions, as reflected in the efficient functioning of public administration, law enforcement and transparency, are prerequisites for the successful design and implementation of sound economic policies. One way to identify areas where improvements are needed most is to look at the World Bank’s Worldwide Governance Indicators (WGI) data set. It summarises how companies, citizens and experts view the quality of governance. About half of EU countries have seen a deterioration in their composite ranking in the WGI over the last decade, and on average the current quality of EU institutions is below that of institutions in the United States and Japan (Chart 5).

Chart 5

Worldwide Governance Indicators

(score ranging from -2.5 to 2.5)

Administrative capacity is also part of governance and a particularly critical factor in facilitating investment during the green and digital transitions. The European Commission has recognised the importance of robust administrative frameworks in driving these transitions. The European Green Deal and the 2030 Digital Compass highlight the need for strong administrative systems to ensure that funds are allocated efficiently and that projects meet stringent environmental and technological standards.^[29] The recent experience with the Recovery and Resilience Facility (RRF) also highlighted the obstacles to the timely and effective absorption and use of funds related to administrative capacity bottlenecks, which was in part related to the RRF’s complex reporting and control system.^[30] Well-developed administrative capacity can streamline the application, permit and screening processes, thus reducing the delays and uncertainties that often hinder investment.

Education and upskilling/reskilling to offset negative demographics

Educational systems play a key role in strengthening human capital and innovation. To enable technological change and innovation and to take advantage of the associated opportunities they offer, high-quality education systems alongside effective upskilling and reskilling programs are crucial. The latest results from the Programme for International Student Assessment (PISA) underscore the need for Europe to continue improving its educational outcomes (Chart 6). According to the 2022 PISA results, several European countries, such as Estonia, Ireland and Finland, performed well on average in science, mathematics and reading. Compared with 2018, scores in most EU countries deteriorated significantly. This can only be partially attributed to the COVID-19 pandemic, as scores were already falling pre-pandemic.^[31] Significant disparities in educational performance remain in the EU, which continues to lag behind the United States and Japan.

Chart 6

OECD Programme for International Student Assessment (PISA) results

(scores)

In addition to education systems, reskilling and upskilling are essential to adapt to the rapidly changing demands of the labour market driven by the digital and green transitions. The European Skills Agenda for sustainable competitiveness, social fairness and resilience emphasises the importance of lifelong learning and continuous skills development.^[32] The Agenda aims to equip the workforce, including managers, with the skills needed to thrive in emerging industries and to support the EU’s goals in the digital and green transitions.^[33] Europe needs to intensify its focus on education and skills development to catch up with the United States in technological innovation and diffusion. As mentioned at the beginning of Section 3, having skilled employees is also a major long-term barrier to business investment in Europe. The European Centre for the Development of Vocational Training (Cedefop) highlights the importance of skills intelligence and workforce planning. More integrated and forward-looking strategies in Europe to address skills shortages and mismatches are needed to achieve a more technologically advanced, greener and fairer future.^[34] The importance of skills to address challenges on the competitiveness front is also highlighted in the Letta report, including the simplification of degrees and improved certification recognition across Europe.

Negative demographic developments represent a challenge for Europe’s labour supply both in terms of quantity and skills. However, the relationship with productivity growth is less certain. In the years to come, older cohorts will make up an increasing part of the labour force. Their retirement will result in a reduced labour supply and shortages of certain skills, while there is no conclusive evidence of productivity gains from the younger cohorts being more formally educated.^[35] Acemoglu and Restrepo^[36] show that higher capital investments, such as greater adoption of robots and other automation technologies, could mitigate and even reverse the negative relationship between age and productivity. At the same time, older workers may be ill-equipped for a work environment which is rapidly adopting new technologies.

Migrants are an important part of the European labour force and can help boost the labour supply and productivity, particularly against the backdrop of ageing populations.^[37] Research shows that migration can have positive effects on productivity and long-term economic growth.^[38] In recent years, amid high labour market tightness in Europe, migration has helped alleviate labour shortages and moderate wage growth, particularly in the hospitality, support services and construction sectors where entry barriers based on qualifications or language are lower.^[39] Nonetheless, addressing the high degree of overqualification and skills mismatches experienced by migrants compared with permanent residents and nationals, could further help address labour and skills shortages and raise labour productivity gains.^[40] The lower educational attainment levels of second-generation students in some countries also highlight problems related to the success of immigration or integration policies.

Box 1
Physical and digital infrastructures in Europe

Physical and digital infrastructures complement the intangible institutions around which society is organised. High-quality infrastructures support a well-connected economy by facilitating the efficient movement of goods, services and people.^[41] Sufficient and well-maintained physical and digital infrastructures and networks make economies of scale possible and lower production costs. Transport, telecommunications and energy grids are particularly relevant drivers of economic growth and thus competitiveness.^[42] Nevertheless, European countries require a significant amount of investment to upgrade their physical and digital infrastructures.

Given Europe’s geography, land transport infrastructures, such as roads and railways, are essential for seamless regional integration and trade. Chart A illustrates that, on average, the quality of transport infrastructure in Europe is lower compared with the United States and Japan. Modernising and enhancing Europe’s train network could reduce bottlenecks, improve cohesion within the Single Market and support sustainable logistics to support the green transition.^[43] There is still untapped potential for many direct train connections across major European cities that are instead often covered by flight connections, which have a much larger carbon footprint.^[44]

Chart A

Transport infrastructure indices - 2019

(index from 0 to 100)

With technology advancing rapidly, digital infrastructures and telecommunications are of particular importance today. However, Europe is still a long way from achieving its connectivity targets, particularly regarding high-speed internet and 5G coverage.^[45] Fragmented national telecoms markets in Europe hinder progress on digital connectivity. This fragmentation contrasts with more unified markets in the United States and China, which benefit from fewer and larger operators. As a result, Europe suffers higher communication costs and the slower innovation and diffusion of advanced digital technologies, including artificial intelligence, which are crucial for the digital transition.^[46]

Finally, Europe’s fragmented energy grid, with few connections and large disparities in investment and regulation across countries, implies a toll on the green transition to renewables. This fragmentation exacerbates regional disparities in energy costs, reducing competitiveness for industries reliant on affordable energy.^[47] A resilient energy grid is also crucial for achieving energy security, especially amid heightened geopolitical tensions. A cohesive European energy market with a resilient grid would lower costs for consumers and bring more stability to energy prices, which in turn facilitates monetary policy.

4 Conclusion

Europe faces critical challenges in boosting productivity, investment and innovation, and therefore its competitiveness and resilience. Long-standing challenges related to low productivity growth, burdensome regulations and demographic headwinds have been compounded by geopolitical tensions, trade fragmentation and the prospects of persistently higher energy prices. Addressing these challenges requires comprehensive structural reforms targeting higher regulatory efficiency, enhanced governance and administrative capacity, improved quality of education and skills’ matching, and modernised infrastructure. The population is shrinking, and our societies are ageing, so sustaining the workforce will rely on higher participation rates, especially among women and older people, alongside well-designed immigration policies to address labour shortages and support long-term growth.

Mario Draghi’s proposals for enhancing European competitiveness and Enrico Letta’s proposals for empowering the Single Market highlight the need for coordinated action at the national level supported by more EU where it adds the most value.^[48] National policies must prioritise increasing productivity growth through measures that support business dynamism, the adoption of technology, the financing of private investment and breakthrough innovations, and that address labour shortages and skill mismatches. At the EU level, the re-focusing of policy required could be facilitated by coordination based on agreed EU priorities. In addition, EU-level action is needed to provide essential public goods, including affordable and greener energy, breakthrough research and digital infrastructure for a wider diffusion of advanced technologies, especially artificial intelligence. “More Europe where it matters” also requires deepening the Single Market and strengthening cross-border, market-based risk sharing.

This article joins the call for urgent and concrete structural reforms in Europe. The interplay between institutions, infrastructures and competitiveness underscores the need for transformative policy action. Addressing structural barriers, including inadequate physical and digital infrastructures and skill mismatches, while increasing access to finance, would enhance the potential for growth. Structural reforms would then also facilitate the smooth transmission of monetary policy to the whole euro area economy and thereby help preserve price stability in the euro area.^[49] At the same time, such reforms and policies need to be shaped with a view to supporting the green and digital transitions and ensuring economic and social resilience to geopolitical tensions and possible future shocks. Crucially, improving the social acceptability of reforms and ensuring balanced regulation are key to their success.^[50] Overall, policies need to be carefully designed, striking a balance between regulation and flexibility. This should ensure the protection of public interest without compromising on innovation and investment and therefore contribute towards sustainable improvements in European productivity and overall living standards.