A Future Made in Europe

ROME – Over the last three years, the European Union, faced with the imperative of calming roiled markets and laying the foundations for a sound recovery, has concentrated largely on financial stability and reducing fiscal deficits and debt. Now, with financial tensions easing and confidence returning, Europe’s leaders should shift their focus in 2014 back to the real economy and the industrial base. February’s meeting of the European Council of Ministers will be a good place to start.

To decide the best way forward, Europe’s leaders should look to the past. Investment in manufacturing – historically one of the main drivers of growth in Europe – holds the key to revitalizing the European economy.

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Over the last decade, industrial policy has been sidelined in favor of the financial and service sectors. Manufacturing was deemed a pursuit of the past, and Europe was no longer considered a suitable location for competitive industry. Many European countries have since undergone deindustrialization. Industrial production in Italy, for example, has declined by about 20% since 2007.

Nonetheless, the industrial sector continues to play a key role in the EU economy, employing more than 34 million people and accounting for 80% of exports, while providing a substantial share of private investment in research and development. Industrial manufacturing thus affects every other sector of Europe’s economy, including the service sector.

In fact, despite policymakers’ shift in focus and emerging-economy competition, European countries remain among the world’s top performers in manufacturing, owing to the many firms that have managed to adapt and innovate. Such firms have enabled Italy to move beyond the “three Fs” – food, fashion, and furniture – to cutting-edge sectors like biopharma, mechatronics, and aerospace.

A similar shift toward higher-value-added manufacturing activities is occurring across the EU. These developments suggest that Europe’s future success will depend on its ability to combine its traditional economic strengths with strong innovation.

EU countries should be working to create the conditions that a thriving industrial sector needs. For example, Italy’s recently launched Destinazione Italia program will help Italian companies succeed by establishing a more predictable tax system, reducing bureaucratic red tape, and ensuring more effective contract enforcement by strengthening the civil-justice system. Such an environment would enable firms to grow, while attracting foreign and domestic private investment.

But national efforts alone are not enough. European firms are integrated into regional and global value chains. A component produced by a company in Brescia might go into equipment produced in Stuttgart, which might then be assembled as a final product in Malaga. In this context, no single country can reach its full potential unless all are successful.

The most effective approach to restoring European competitiveness would be to combine EU member countries’ individual strengths, thereby forming increasingly productive European supply chains – or capturing the top positions in global supply chains. This would require deepening the connections among national economies and fostering a genuine, unbounded single market that integrates different countries’ relative strengths.

To this end, more targeted policies at the EU level are essential. Remaining globally competitive will require investment in the key determinants of future industrial production: energy efficiency and technological innovation. Given this, the EU should pursue measures that support the competitiveness of energy-intensive industry, with a particular focus on reducing the energy-price gap with Europe’s industrial competitors, such as the United States and the emerging economies. An efficient internal energy market is vital to the delivery of affordable energy.

Another important initiative – a European Research Area – is already underway, and should be implemented by 2014. By creating a shared agenda for national research programs and facilitating the circulation of skills and scientific knowledge – allowing, say, a top-notch center for mechanical sciences in Italy to attract researchers from Finland or Portugal – the research area promises to create an optimal environment for innovation.

Beyond research and development, an innovation-driven industrial economy demands workers with specific, high-level skills. Meeting this demand requires EU policies that promote secondary, upper secondary, and higher education.

In order to create deeper, more integrated, and more multi-dimensional markets, the EU should place a high priority on free-trade agreements, especially the Transatlantic Trade and Investment Partnership currently being negotiated with the US. Such trade integration – and, eventually, a Transatlantic Common Market – could prove to be one of Europe’s most effective growth mechanisms, especially for small and medium-size manufacturing firms, in the coming decades.

European manufacturing companies also need much better access to finance. One of the most damaging legacies of the financial crisis has been persistent credit rationing. In some countries, half of all loan applications are rejected and financing costs have reached prohibitively high levels.

There is no reason why loans in Bozen (Bolzano) should cost twice as much as those in nearby Innsbruck; in fact, such arbitrary divergences merely undermine competition and cause economic stagnation. If EU leaders do not resolve this issue, including by pursuing a full-fledged banking union, the positive effects of reform efforts will quickly be nullified by the lack of new investment.

Reindustrialization – together with the fight against youth unemployment – should top Europe’s agenda in 2014, with the goal of establishing an industrial sector that accounts for 20% of GDP by 2020. This will be possible only through deeper EU integration. Indeed, ever-closer union represents Europe’s only hope of building a modern, innovative, and prosperous economy.

Read more from "2013: Reversing Gears" here, or on Kindle and iBooks.