Making Europe a Top Priority

Expanding the European single market, strengthening innovation

In terms of its innovative capacity, the EU has fallen behind the USA and, partly, also China. Draghi speaks (somewhat euphemistically) of an “innovation gap” emerging since the 2000s. However, the lack of productivity in Europe is no minor matter: “In the long run, productivity is almost everything” (Krugman, 1997). Without productivity growth, Europe will not move out of crisis mode.

An analysis of economic strength focuses on the conditions in the European single market. Economies of scale can be better realised in larger economic areas. In international negotiations, for example on standards or tariffs, the EU can use the access to the European single market as an asset. However, in many areas there is no genuine single market. National borders continue to apply for energy, digital products and many services.

Regulation: Reducing the intensity of regulation, focusing on innovation and medium-sized enterprises

Of the current burdens on the German economy, 70% are due to the implementation of EU directives (National Regulatory Control Council, 2024, p. 91). Efforts at the federal and state levels to give companies more freedom through “bureaucracy reduction laws” will have little effect if it is not possible to channel the European urge to regulate at the same time. Especially small and medium-sized enterprises (SMEs), which account for the major share of EU companies, suffer from regulation. In the digital sector, where Europe is lagging far behind, excessive regulation has favoured large companies at the expense of newly formed business and SMEs (Rzepecka et al., 2024).

Reducing bureaucratic costs is on the EU's agenda. Commission President von der Leyen has ordered a 25% reduction in reporting obligations in all areas (von der Leyen, 2023). However, it is not (only) the reporting obligations that are holding Europe back. The European Artificial Intelligence Act (AI Act) and the General Data Protection Regulation are slowing down start-ups, not because these businesses are subject to mandatory reporting, but because they are prohibited from using certain applications. The new German government should ensure that regulations are examined to see whether they strengthen small and medium-sized enterprises and lead to more innovation in Europe.

Deregulation is particularly necessary in the digital sector, where the innovation gap between Europe and the USA has now widened into an innovation chasm. It is necessary to make the AI Act innovation-friendly and coherent with other regulations such as the General Data Protection Regulation. Real-world laboratories can help to test the use of innovative solutions while temporarily suspending legal regulations. “Regulatory learning”, in which the provisions of the AI Act are adapted over time on the basis of the learning results, should be institutionally anchored in order to be able to do justice to the dynamic technological development of AI (Bertschek & Wambach, 2024).

Funding disruptive innovations

Germany's innovation landscape is a world leader in incremental innovations, the gradual improvement of existing concepts or products. Cooperation between companies, research institutions and universities is well established. Many companies in the car manufacturing, information and communication technology, chemical/pharmaceutical and mechanical engineering sectors – the most research-intensive industries in Germany – are global leaders. However, digitalisation and the resulting applications are often disruptive in nature (Hottenrott & Wambach, 2023), spurring the emergence of new business models or completely restructuring existing models. German companies are trying their hand at such business model innovations, but the proportion is lower than the potential of transformative processes would suggest (Rammer et al., 2024).

The reasons for Europe's weakness when it comes to growth companies are manifold and range from a lack of exploitation of scientific findings to regulatory hurdles and financing disadvantages in Europe. Unlike businesses in the USA and China, European companies operate in a largely fragmented market. Introducing a new legal form for innovative companies to facilitate Europe-wide expansion would help to overcome this fragmentation. In order to finance growth, forms of participation with greater flexibility are also required, such as shares with different voting rights, as well as the further removal of obstacles for IPOs.

To promote disruptive innovations, the European Innovation Council (EIC) should be developed into an agency along the lines of DARPA. The Defense Advanced Research Projects Agency (DARPA) is a subordinate agency of the US Department of Defense that is very successful in carrying out research projects. The EIC would have to be endowed with adequate financial resources and it should focus on high-risk projects. Since Europe has no large digital corporations like those in the US, public investment in the computing infrastructure is needed. This is underway, for example in the case of the European High-Performance Computing Joint Undertaking (EuroHPC JU). The aim is not to compete with the hyperscalers in the US and their enormous computing capacities; that would be impossible to achieve. Instead, these capacities are necessary for developing and maintaining the expertise required for research and development in Europe.

AI applications need data. Initiatives such as the European Health Data Space can help to enable the development of better diagnoses and therapies by combining (health) data. For all other areas, regional initiatives are preferable, since industry structures are very heterogeneous across the EU Member States.

Tackling the Banking Union and Capital Markets Union

The capital market has a crucial role to play in the financing of innovations and the transformation. However, the European capital market has weaknesses in many respects. Unlike in the US, for example, (external) equity capital in Europe is much more expensive than debt capital. Yet equity capital is particularly needed by companies that have a high financing requirement as they go through the transformation process. European financing options for start-ups also lag far behind those in the US. A capital markets union can help to significantly improve access to financial resources, particularly equity, for European companies and start-ups (European Commission, 2020). A joint European supervisory authority for capital markets would make it easier for investors to invest in Europe (Véron, 2024). European financial products can contribute to mobilising Europe's high level of private savings for the transformation. At the same time, the European economy will remain heavily dependent on bank financing in the medium term. An intermediate step would therefore be to integrate the European banking system more closely with the capital markets, for example through securitisations (Brückbauer & Kirschenmann, 2024).

The Banking Union is also not completed. The lessons learned from the financial crisis, particularly with regard to risk management and resolution of banks, have not been sufficiently implemented. The German government should work to create the prerequisites for a comprehensive Banking Union that also includes a European deposit insurance scheme.

Expanding the single market for energy

The gas crisis has revealed not only Europe's dependence on Russia, but also the interdependencies in the energy market. European countries need each other. The transformation cannot be achieved without the consistent expansion of Europe's energy infrastructure. Germany, for example, will in future be an importer of (green) hydrogen produced in Spain, among other countries, where conditions for renewable energies are better. This requires a European hydrogen network (Federal Ministry for Economic Affairs and Climate Action (BMWK), 2024a).

In the electricity sector, too, national borders are often a major barrier. Germany should consistently push for the expansion of cross-border interconnections with neighbouring countries. However, this requires the energy market in Germany to be adapted: Many European neighbours have criticised cross-border electricity trading with Germany because the German electricity market is inefficient and sends distorted price signals. However, a regionalised price structure is necessary not only from a European perspective, but also for the restructuring of the German energy system, where the lack of regional price incentives and incentives for flexibility are two of the main issues (Hirth et al., 2024; BMWK, 2024b).

Strengthening emissions trading, making it a basis for regulation

European companies that incur high costs in avoiding CO₂ emissions suffer a competitive disadvantage compared to companies in third countries without these costs. In these cases, it is advantageous to relocate production to third countries, which makes sense neither in climate policy (‘carbon leakage’) nor economic policy terms. The EU wants to protect European companies by introducing a carbon border adjustment mechanism (CBAM) to achieve a level playing field. However, the CBAM has two fundamental problems. Firstly, there are gaps: Only certain groups of goods – aluminium, fertilisers, iron and steel, electricity, hydrogen, cement – are subject to a levy when imported into the EU. In addition, processed products are not included (Campolmi et al., 2024). Secondly, the CBAM in its current form does not solve the problem of unfair competition in third countries: European companies bear climate-related costs while their competitors do not. The original idea was to compensate companies exporting out of Europe – a border adjustment in both directions (BMI Advisory Board, 2021).

The weaknesses of the CBAM and the resulting competitive disadvantages are particularly relevant for Germany, which accounts for one of the highest shares of industry and exports in Europe. Without true border adjustment, it is advisable for the German government to strive to offset the competitive disadvantage for energy-intensive European companies that are in international competition, for example by allocating free allowances.

Preventing disadvantages in international competition

European companies that incur high costs in avoiding CO₂ emissions suffer a competitive disadvantage compared to companies in third countries without these costs. In these cases, it is advantageous to relocate production to third countries, which makes sense neither in climate policy (‘carbon leakage’) nor economic policy terms. The EU wants to protect European companies by introducing a carbon border adjustment mechanism (CBAM) to achieve a level playing field. However, the CBAM has two fundamental problems. Firstly, there are gaps: Only certain groups of goods – aluminium, fertilisers, iron and steel, electricity, hydrogen, cement – are subject to a levy when imported into the EU. In addition, processed products are not included (Campolmi et al., 2024). Secondly, the CBAM in its current form does not solve the problem of unfair competition in third countries: European companies bear climate-related costs while their competitors do not. The original idea was to compensate companies exporting out of Europe – a border adjustment in both directions (BMI Advisory Board, 2021).

The weaknesses of the CBAM and the resulting competitive disadvantages are particularly relevant for Germany, which accounts for one of the highest shares of industry and exports in Europe. Without true border adjustment, it is advisable for the German government to strive to offset the competitive disadvantage for energy-intensive European companies that are in international competition, for example by allocating free allowances.

More progress towards a European defence industry

The EU's defence spending has fallen from over 3% to just under 2% since 1960. Since 2015, it has been on the rise again. In 2022, approximately 240 billion euros were spent, roughly in line with China's spending of 275 billion euros and about three times Russia's spending. However, the European defence sector has fundamental weaknesses. As Letta and Draghi also emphasise in their reports, the European defence industry is too fragmented (Letta, 2024; Draghi, 2024). For instance, EU Member States use twelve different types of tanks, while only one model is produced in the United States. Potential economies of scale are underutilised. Fragmentation leads to duplication and, due to a lack of standardisation, to poor interoperability.

Another deficit is the non-utilisation of the defence industry as a driver of innovation and growth. The USA spends 16% of its considerably higher military expenditure on research and development, whereas this share is only 4.5% in the EU. The civil and defence sectors can mutually reinforce each other: Innovations in the military sector are often later found in the civil sector. Conversely, many innovations, particularly in the form of technical innovations, are used in the defence sector that have their origin in the civil sector (Bertschek et al., 2024).

Joint procurement by EU Member States would strengthen the European defence industry. This is an opportunity for Germany, as German companies are market leaders in many areas. A (desired) consolidation in the defence sector would go hand in hand with joint procurement. The ‘poles of competence’ proposed by Draghi would lead to greater specialisation among industrial locations in order to better achieve economies of scale and synergies. “European Defence Projects of Common Interest” can contribute to more research and development in the defence sector and beyond.

Setting up a European Supply Security Office

A large proportion of the processing of critical raw materials takes place in China.  Most of these critical raw materials come from just a few countries. The dependencies in strategic industries such as the semiconductor industry vary at the different stages of the value chain.  In many sectors, it is unclear to what extent companies are already ensuring supply chain security through their own measures, such as supplier diversification and stockpiling, and where further intervention by the public sector is necessary. Stress tests used in the sectors with regard to geopolitical risks, along the lines of the stress tests in the banking sector, can help to identify systemic risks and supply security vulnerabilities. A European Supply Security Office (Draghi's report refers to a “Supply Chain Assessment Board”) should be set up to provide data on supply chains, develop stress tests and prepare draft proposals for security measures (BMWK Advisory Board, 2023).

Tapping into European Funds

The financing requirements for meeting the challenges facing the German and European economies are enormous. The Federation of German Industries (BDI), for example, recommends additional public spending of around 40 billion euros per year in Germany, particularly for investments in infrastructure, building renovation and to support the transformation (BDI, 2024). Draghi considers an additional 800 billion euros of investment per year to be necessary for Europe, which corresponds to around 4.5% of the EU’s GDP.

The current EU budget is not nearly enough to meet these challenges. Policies that guarantee the Member States clearly calculable and visible returns continue to predominate in the European budget. The Common Agricultural Policy (CAP) and the cohesion policy each account for around 30% of the EU budget and contribute little to solving Europe's major problems.

Scaling down the CAP and cohesion budgets

In the upcoming negotiations on the post-2027 Multiannual Financial Framework (MFF), the German government should advocate reducing the shares of the CAP and cohesion policy in the EU budget in order to free up significant proportions of the budget for new strategic priorities. Cohesion policy has a limited effect in achieving regional convergence and suffers from being overburdened with other objectives (Asatryan et al., 2024). The CAP should be redesigned with a stronger focus on incentivising environmental goods by reducing unconditional per-hectare premiums with their often problematic distributional effects (Heinemann & Weiss, 2018). The funds thus released would be available to finance new spending priorities in the area of European public goods, such as defence, research and migration. A “European Public Good Pillar” could be created in the MFF for this purpose. The criterion for allocating funds would be the clear prospect of a high European added value for the measures financed.

European debt only under stricter budget rules

Mitigating financing bottlenecks in the EU budget by creating new EU debt comes with its own problems. The EU budget is not financed from EU tax sources, but from national contributions. One consequence of this is that new EU bonds do not represent a safe asset. Bond markets value EU bonds as less safe than German government bonds (Heinemann, 2024). The EU's reputation as a creditor is only as good as the quality of the Member States that promise funds for the EU budget also in future. Especially the large countries in the EU must therefore regain significant fiscal leeway before an expansion of EU debt is conceivable. A hardening of European budget rules would contribute to this.

The need for investment at the European level is enormous. An expansion of Europe’s infrastructure (energy networks, railways, roads and broadband lines) is necessary. The reconstruction of Ukraine – also a European task – needs to be financed. The EU would be well advised to create the conditions for setting up such investment programmes.

This article originally appeared at Wirtschaftsdienst (in German).

Bibliography

Asatryan, Z., Birkholz, S. M. & Heinemann, F. (2024). The Future of EU Cohesion. Finaler Bericht. Im Auftrag des Bundesministeriums der Finanzen (BMF).
BDI – Bundesverband der Deutschen Industrie e. V. (2024). Standort D mit Investitionen stärken.
Beirat BMWi – Wissenschaftlicher Beirat beim Bundesministerium für Wirtschaft und Energie (BMWi). (2021). Ein CO₂-Grenzausgleich als Baustein eines Klimaclubs. Gutachten.
Beirat BMWK – Wissenschaftlicher Beirat beim Bundesministerium für Wirtschaft und Klimaschutz. (2023). Leitplanken zur Stärkung der Versorgungssicherheit. Gutachten.
Bertschek, I., Bünstorf, G., Cantner, U., Häussler, C., Schmidt, C. M., Welter, F., Dauchert, H. & Requate, T. (2024). Synergieeffekte zwischen ziviler und militärischer Forschung klug nutzen. Wirtschaftsdienst, 104(10), 677–682.
Bertschek, I. & Wambach, A. (2024). AI in Europe – Is Regulation the Answer to Being a Laggard? The Economists’ Voice, 21(2), 379–385.
Bistline, J. E., Mehrotra, N. R. & Wolfram, C. (2023). Economic implications of the climate provisions of the inflation reduction act. Brookings Papers on Economic Activity, 2023(1), 77–182.
BMWK – Bundesministerium für Wirtschaft und Klimaschutz. (2024a). Importstrategie für Wasserstoff und Wasserstoffderivate.
BMWK – Bundesministerium für Wirtschaft und Klimaschutz. (2024b). Strommarktdesign der Zukunft.
Brückbauer, F. & Kirschenmann, K. (2024, August). Towards a More Realistic View on the Market Potential of EU Securitizations. ZEW Policy Brief, Nr. 13.
Campolmi, A., Fadinger, H., Forlati, C., Stillger, S. & Wagner, U. (2024, 3. März). A proposal to refocus the EU Carbon Border Adjustment Mechanism on preventing carbon leakage.
Draghi M. (2024). The Future of European Competitiveness Part A: A competitiveness strategy for Europe.
Europäische Kommission, Generaldirektion Finanzstabilität, Finanzdienstleistungen und Kapitalmarktunion. (2020). Primary and secondary equity markets in the EU: final report. Publications Office.
Heinemann, F. (2024). Die Schuldenfinanzierung von NextGenerationEU: Gekommen um zu bleiben? integration, 47(4), 294–312.
Heinemann, F. & Weiss, S. (2018). The EU Budget and Common Agricultural Policy Beyond 2020: Seven More Years of Money for Nothing? Bertelsmann Stiftung. Reflection Paper No. 3: Preparing for the Multiannual Financial Framework after 2020.
Hirth, L., Ockenfels, A., Bichler, M., Edenhofer, O., Grimm, V., Löschel, A., Matthes, F., Maurer, C., Neuhoff, K., Pittel, K., Wambach, A. & Zachmann, G. (2024, 10. Juli). Der deutsche Strommarkt braucht lokale Preise. Frankfurter Allgemeine Zeitung.
Hottenrott, H. & Wambach, A. (2023, 18. Dezember). Innovationsland – Ist das deutsche Modell noch im Takt? Gastbeitrag im Handelsblatt.
Krugman, P. (1997). The Age of Diminished Expectations (3. Aufl.). MIT Press.
Letta, E. (2024). Much more than a market – Speed, Security, Solidarity. Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens.
Nationaler Normenkontrollrat. (2024). Gute Gesetze. Digitale Verwaltung. Weniger Bürokratie. Jahresbericht 2024.
Rammer, C., Schubert, T. & Steines, L. (2024). Studie zu Geschäftsmodellinnovationen im Mittelstand (Abschlussbericht). KfW Bankengruppe.
Rzepecka, J., Fuksiewicz, A., Squillante, F., Alijošius, L., Godlovitch, I., Stamm, P., Wielgosch, J. & Lundborg, M. (2024). The Impact of EU Legislation in the Area of Digital and Green Transition, particularly on SMEs. Publication for the Committee on Internal Market and Consumer Protection, Policy Department for Economic, Scientific and Quality of Life Policies. European Parliament.
SVR – Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung. (2024). Versäumnisse angehen, entschlossen modernisieren. Jahresgutachten 2024/2025.
Véron, N. (2024). Capital Markets Union: Ten Years Later. Im Auftrag vom Ausschuss für Wirtschaft und Währung.
von der Leyen, U. (2023, 15. März). Rede von Präsidentin von der Leyen auf der Plenartagung des Europäischen Parlaments zur Vorbereitung der Tagung des Europäischen Rates am 23./24. März 2023.