LONDON – Interest in the European Union’s competitiveness did not begin with the euro crisis. Safeguarding Europe’s advanced position in the world economy was, after all, a key motivation behind the creation of the single market. Since then, interest in EU competitiveness has risen further, spurred in particular by the challenge posed by countries like China.

In order to ensure sustainable and inclusive economic growth in Europe, policymakers and the public must, above all, regard international trade as a mutually beneficial exchange of goods and services. Productivity growth and innovation are critical to reaping the benefits of this exchange, and, to ensure both, policies that cost European taxpayers nothing are at least as important as policies requiring public funds.

The first step is to stop viewing international trade as a zero-sum game that costs some countries as much as it benefits others. Obviously, companies within the same industry are in direct competition with each other, and gains in market share by one tend to come at the expense of competitors. So it follows that the payroll and earnings of a company will rise if it outperforms its competitors.

Unfortunately, many people believe that their country’s prosperity requires that it outperform other countries in the same way. This understanding of international competitiveness continues to motivate a wide range of policy initiatives, including industrial policies to create and defend “national champions” and support a variety of so-called strategic industries.

There are two problems with this approach. First, there is little evidence to support the view that industrial policies enlarge a country’s share in world trade. All too often, government interventions based on strategic-trade considerations simply provide cover for protecting domestic industries, which harms other countries – and ultimately the protectionist’s own economy.

Second, and more important, analogizing companies to countries is deeply flawed. When a company becomes more competitive, it crowds out its rivals; they get nothing in return. But when a country becomes more productive and increases its exports, it acquires the means to import more, so other countries’ exports rise. Indeed, increasing imports is the ultimate reason for a country to boost its exports, whereas a company is motivated to outperform its competitors so that it never needs to buy anything from them.

Thus, external competitiveness is what the Nobel laureate economist Paul Krugman calls a “dangerous obsession” – at least to the extent that it is based on the company-country analogy. But if competitiveness refers to productivity, it remains a meaningful concept. Productivity growth and innovation benefit countries not by helping them to compete with other countries, but by enabling them to produce and consume more, or to produce and consume the same amount with fewer resources.

Understanding competitiveness in this sense is a prerequisite for successfully designing and implementing a growth agenda for Europe. Indeed, a considerable body of research – pioneered by Harvard economist Philippe Aghion and his colleagues – suggests that innovation is the key driver of economic growth in advanced countries.

This implies, first and foremost, the need to expose companies to strong domestic and foreign competition. Faced with strong competition and the threat of extinction, companies typically try to innovate to survive. The EU would thus do well to combine budgetary support for R&D policies with competition rules that keep companies on their toes, while granting successful innovators appropriate patent protection.

In recent decades, Europe has not moved vigorously enough on these fronts, but it is not too late to pick up the pace. Here, the services sector holds the greatest promise.

Our everyday experience inclines us to regard innovation in terms of more sophisticated and/or higher-quality goods and production processes. And, indeed, manufacturing is arguably an important source of innovation and economic growth. But any agenda aimed at stimulating economic growth in Europe must include the services sector.

Indeed, services account for about two-thirds of total value added in the EU economy. In employment terms, the services sector is larger still. Moreover, since the 1990’s, output growth in the EU has been primarily driven by expansion of services.

At the same time, productivity growth in the EU’s services sector has been lagging behind developments in the United States (even given the possibility that pre-crisis productivity growth in US financial services was partly notional). This suggests that there remains untapped potential to boost innovation and productivity in Europe.

Of course, the best type of productivity growth in services results from innovation that improves quality rather than increases quantity with the same or fewer resources, notably labor. Think of healthcare, education, and care for the elderly. Productivity growth should not result in fewer employees taking care of more patients, students, and old people.

In raising productivity in services, what economists call “intangible capital” becomes ever more important. Intangible capital results from investment in R&D, but it is also the result of investing in workers’ skills, organizational improvements, better processes, new designs, and so on.

Countries whose services sectors have made a large contribution to productivity growth have invested significantly in intangible capital, pointing the way to success in boosting innovation. This is the route that the EU should follow.

Read more from our "Free Trade in Troubled Times" Focal Point.