Chartbook 318 How Europe became a failed model of state-capitalist relations. ... or Europe according to the Draghi report (2)

What is wrong with Europe’s economy? The Draghi report on European competitiveness offers multiple perspective on this vital question for the future of the continent. As outlined in the last post, Draghi’s report makes a compelling case that investment is too low and Europe’s innovation system is failing to turn Europe’s considerable scientific resources into global industrial leadership and business success.

But why is investment so low? If private investment in Europe as a share of GDP fell behind the US after 2010 this suggests that macroeconomic policy is important. The handling of the Eurozone crisis was an unmitigated disaster. The scarring of the European banking system has since helped to reduce the dynamism of credit. The Draghi report makes yet another call for the completion of the capital markets union.

But, ultimately, investment is driven not so much by credit supply conditions as by the demand for credit driven by the aggressive pursuit of growth and innovation by firms. The real question, therefore, is why that demand in Europe has been relatively weak. To answer this question requires one to delve into the history of particular businesses in particular sectors and the prospects for growth that they are able to unlock, or not. Part B of the Draghi report has much to say on this score.

This sectoral perspective is refreshing because it moves from the bland aggregates of macroeconomics to engage with the industrial and business logic of firms and producers. It moves us closer to answering the question, why is Europe’s brand of capitalist political economy so undynamic, or, as I put it back in January: “how has Europe become a “failed project of state-capitalist relations”?

Comparing the top-three corporate R&D spenders in the USA and the EU at three moments over the last twenty five years, gives us a stark overview of the differences between the US and European economies. Over the last twenty years in the USA, leadership in R&D has shifted dramatically from autos and pharma - the industries of the “second industrial revolution” (apologies to David Edgerton) - towards tech.

By contrast in the EU it is the German motor-vehicle industry that has remained at top spot for a quarter century. As the Draghi report comments:

The European automotive industry is R&D-intensive. More precisely, R&D spending amounts to around 15% of the industry’s gross value added (which qualifies it as ‘advanced manufacturing’). With a EUR 59 billion R&D budget (2021), it accounts for one third of European corporate R&D investment.

But this makes it all the more alarming that Europe’s position in this vital industry is eroding so quickly. Since 2000, EU-based vehicle production has fallen by 25 percent.

As the Draghi report comments, Europe’s traditional internal combustion engine vehicles risk becoming roadkill. The industry is clearly undergoing a vast shift in technology and for all the R&D being expended by VW, Daimler and Bosh, it is not European firms that are leading the way.

At the same time as vehicle production in the EU weakened, EU vehicle imports from China have increased strongly. China is now the largest source of car imports into the EU in terms of the number of cars (a fivefold increase from 114,000 vehicles in 2017 to 561,000 in 2022). In 2022, China accounted for 14% of the vehicles imported into the EU, making it the biggest non-European supplier. In particular, the EU is lagging in the fast-growing ‘New Energy Vehicle’ space (BEVs and PHEVs). European brands accounted for only 6% of BEV sales in China in 2022 (compared to 25% of ICE vehicle sales). Conversely, Europe is leaving room in this area of the market. Chinese brands accounted for almost 4% of BEV sales in the EU in 2022, up from just 0.4% three years earlierxiv. Moreover, Chinese carmakers’ market share for EVs (BEV and PHEV) in Europe has risen from 5% in 2015 to almost 15% in 2023. By contrast, the share of European carmakers in the European EV market (new registrations) has fallen from 80% to 60% during the same period.

Not only are Europe’s cars increasingly out of date. European producers are also struggling to keep up with the pace of innovation and investment in productive investment. Though China’s labour costs are lower than those in Europe, China’s automotive manufacturers lead the world in the installation of the latest generation of robots.

By comparison with the automotive industry, where Europe is still a major player. Its presence in the big tech industries is increasingly marginal. Europe as a market for ICT has fallen below the 20 percent mark, whereas the US share has grown from 30 to 38 percent.

In sectors like telecommunications, Europe is characterized above all by fragmentation. This may be good for consumers in the short-run, helping to drive down the price of cell phone services. But it also crimps investment and threatens to leave Europe going forward as a consumer and regulator of other people’s technologies.

Today, the EU has dozens of telecom players serving around 450 million consumers, compared with a handful in the US and China, respectively. EU companies lack the scale required to provide citizens with ubiquitous access to fiber and 5G broadband and to equip businesses with advanced platforms for innovation. The EU has a total of 34 mobile network operators (MNOs) and 351 non-investment-based virtual operators (MVNOs), compared with three MNOs in the US (plus 70 MVNOs) and four MNOs in China (plus 16 MVNOs)02. The EU fixed broadband market – where the top three operators hold a joint share of 35% across Europe – is also less concentrated than that of the US (with a joint share of 66%) or China (with a joint share of 95%). Lower prices in Europe have undoubtedly benefitted citizens and businesses but, over time, they have also reduced the industry profitability and, as a consequence, investment levels in Europe, including EU companies’ innovation in new technologies beyond basic connectivity. … Investment as a percentage of revenues is at the same level as – or even higher than – other blocs’, with the differential due to the lower absolute revenues. Studies suggest that the EU is above the optimal number of operators in the telecom sector, also due to its capital intensity, and that industrial policies have the potential to promote further consolidation without necessarily leading to price increases for consumersx. … The investment levels required to support EU networks are estimated at around EUR 200 billion to ensure full gigabit and 5G coverage across the EU. But Europe’s per capita investment is markedly lower than other major economies …..

As Draghi’s report comments: “The total market capitalisation of the EU’s telecom sector fell by 41% over from 2015 to -2023 to reach around EUR 270 billion, compared to over EUR 650 billion in market capitalisation for US telecom operators.”

In cloud computing there is a similarly huge gulf between Europe’s providers and the US giants.

In AI development there is a risk, according to the Draghi report, of Europe becoming entirely dependent on models developed abroad.

Currently, AI is adopted by only 11% of EU companies (vis-à-vis a 2030 target of 75%), and 73% of foundational models developed since 2017 are from the US and 15% from China. … The strong position of the US is mostly due to the scale of cloud hyperscalers (internally or through tight partnerships, like the one between Microsoft and OpenAI) and the availability of venture capital. In 2023, an estimated USD 8 billion in venture capital investment was made in AI in the EU, compared to USD 68 billion in the US and USD 15 billion in China. The few companies building generative AI models in Europe, including Aleph Alpha and Mistral, need large investment to become competitive alternatives to US players. This need is currently not met by the EU’s capital markets, pushing EU companies to seek overseas funding. Taking the top global AI start-ups worldwide, 61% of global funding goes to US companies, 17% to Chinese companies, and only 6% to those in the EU. Moreover, the EU has a low total number of new data scientists vis-à-vis the US and China. … The EU’s weak position in developing AI means that, in the future, it may not fully leverage its competitive advantage across several industrial sectors, with the risk of EU companies’ market and value share potentially eroded by non-EU-players. Remarkably, this includes reaping in full the benefits of the digitalisation of industrial processes in the automotive industry (as detailed in the Automotive Chapter) and in robotics for advanced manufacturing. The EU’s robotics industry has registered strong growth in the past decade, with 82,000 industrial robots installed in 2021, making Europe the second largest market after China and a major supplier worldwide – today almost half of the over 1000 service robots suppliers worldwide are European, although 73% of all newly deployed robots are installed in Asia and only 15% in Europe. … while the ambitions of the EU’s GDPR and AI Act are commendable, their complexity and risk of overlaps and inconsistencies can undermine developments in the field of AI by EU industry actors. …As in global AI competition ‘winner takes most’ dynamics are already prevailing, the EU faces now an unavoidable trade-off between stronger ex ante regulatory safeguards for fundamental rights and product safety, and more regulatory light-handed rules to promote EU investment and innovation, e.g. through sandboxing, without lowering consumer standards. … For cutting-edge generative AI models, it is estimated by the OECD that the EU invested EUR 0.2 billion, compared to USD 21.5 billion by the US.

Quatum computing is the next ultra high tech sector that the Draghi report worries about. Once again, the problem is not that Europe is absent from this field of development. It has a relatively strong position in internationally relevant research.

In the quantum race, the EU can rely on key strengths such as large public investment, excellent skills and research capabilities. With EUR 7 billion allocated so far, the EU ranks second only to China worldwide for public investment in quantum. Moreover, the EU has the highest absolute number (over 100 000) and largest concentration of quantum-ready experts (231 experts per million inhabitants) worldwide, excellent research in quantum scientific publications, with multiple Nobel prizes, as well as strong academic and research infrastructure focussed on quantum technologies. Finally, between 2000 and 2023, the EU ranked second worldwide (at around 16%) in quantum patenting – based on international patent families – behind the US (32%) but ahead of Japan (13%) and China (10%)12 [see Figure 7]. The EU has developed a comprehensive plan to further support the development of quantum companies, including the Quantum Flagship program for R&D&I support, EuroQCI to develop and deploy a pan-European quantum communication infrastructure, and the deployment plan of a pan-European quantum computing infrastructure under the Euro-HPC Joint Undertaking

So this sounds promising, but as the Draghi concludes: “Europe suffers from very limited private investments in quantum technologies vis-à-vis other geo-blocs.”

Look at the Pharma sector, one in which Europe has for many decades held a relatively strong position. New development is driven above all by R&D spending. Where? In the United States! The US share is twice that of the EU.

The European defense sector has received a dramatic jolt from Russia’s invasion of Ukraine. In “main battle tanks, conventional submarines, naval shipyard technology and transport aircraft”, the EU is fully competitive in technological terms with any other suppliers in the world. However, as is true in so many other sectors, Europe fails to capitalize. Why? Because it does not “invest” enough in military equipment, it does not focus enough on R&D and these weaknesses are compounded by a fragmented market.

“the EU defence industry is suffering from a capacity gap on two fronts. First, overall demand is lower: aggregate defence spending in the EU is about one-third as high as in the US. Second, EU spending is less focused on innovation. Defence is a highly technological industry characterised by disruptive innovation, meaning that massive R&D investments are required to maintain strategic parity. The US has prioritised R&D spending over all other military spending categories since 2014. In the 2023, it allocated EUR 130 billion (USD 140 billion) for Research, Development, Test and Evaluation, amounting to around 16% of total defence spending. This category also saw the largest relative percentage increase in the defence budget. In Europe, total funding for defence R&D was EUR 10.7 billion in 2022, amounting to just 4.5% of total spending. Complex next-generation defence systems in all strategic domains will require massive R&D investment that exceeds the capacity of single EU Member States. The European defence industry is also fragmented, limiting its scale and hindering operational effectiveness in the field. The EU defence industrial landscape is populated mainly by national players operating in relatively small domestic markets. Fragmentation creates two major challenges. First, it means that the industry lacks scale, which is essential in a capital-intensive sector with long investment cycles. As a result, if EU Member States were to ramp up defence spending significantly, a supply crisis could occur with Member States competing between each other on the constrained European defence equipment market. Second, fragmentation leads to serious issues related to a lack of standardisation and the interoperability of equipment, which have come to light during the EU’s support for Ukraine. For 155 mm artillery alone, EU Member States have provided ten different types of howitzers to Ukraine from their stocks, and some have even been delivered in different variants, creating serious logistical difficulties for Ukraine’s armed forces. In terms of other products, for example, EU Member States operate twelve types of battle tanks, whereas the US produces only onex.

Finally, take the space sector.

The EU funds, owns and manages critical space infrastructure. It has developed world-class strategic assets and capabilities, with technical competences on par with other space powers in most areas. For example, in satellite navigation, Galileo provides the most accurate and secure positioning and timing information, also for military applications. In Earth Observation, Copernicus offers the most comprehensive data worldwide, including for environmental and climate change monitoring, disaster management and security. However, the EU has lost its leading market position in commercial launchers (Ariane 4-5) and geostationary satellites. It had to rely temporarily on the Space X rockets to launch the satellites for its strategic programme Galileo. The EU also lags the US in rocket propulsion, mega-constellations for telecoms and satellite receivers and applications, which is a much larger market than the other space segments.

Like the defence industry, the space sector is suffering from a marked investment gap with its major competitors. For the past forty years, investment has ranged between 15% and 20% of US levels. In 2023, public expenditure in Europe on space stood at USD 15 billion, compared with USD 73 billion in the US. China is expected to overtake Europe in the next few years, reaching an expenditure of USD 20 billion by 2030 [see Figure 5].

As a result, the Chinese space launch effort has grown to spectacular proportions whereas the European effort has languished. “Europe accounts for only 10% of all the approximately 6,500 institutional satellites (civil and defence) which are expected to be launched worldwide from 2023 to 2032.”

Since the Eurozone crisis it has been clear that relations between big business and EU governance are profoundly dysfunctional. In the 2010s conservative strategies of macroeconomic governance backfired disastrously. The Draghi report rams home the point that the EU for all the sophistication of its governance no longer provides European capital with the platform to face global competition at the scale of the US or China. The answer is not to be found in domestic deflation strategies at the expense of European workers, or crimping public spending. What is needed are bigger markets, more investment and more innovation. What is needed is a fundamental reorientation of policy towards demand and innovation-led growth. Defending the status quo, as European conservatives advocate both in industrial and fiscal policy, offers no safety, but only a recipe for further relative decline and dependence on technological innovation coming from the US and China.

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