How far can investments in R&D fuel economic growth in Europe?

For more than a decade, there have been growing concerns about Europe’s place in the global economy as it struggles to cope with the consequences of the worst financial and economic crisis of the past 80 years and return to robust economic growth. The crisis exposed deep weaknesses in Europe’s financial sector and vulnerability in many countries’ debt-fuelled growth strategies. What followed was the failure, bailing out or nationalisation of many banks, the tightening of credit markets and fears that the eurozone may not continue as a single currency bloc.

Faced with this instability, Europe’s leaders have spent much of the last decade in crisis management mode, where urgent matters like keeping the euro afloat or negotiating the conditions of national bail-outs have been allowed to overshadow important long-term questions of how to reignite economic growth and job creation.

While some uncertainty still remains in the financial sector, notably linked to the Asset Quality Review and stress tests that the European Central Bank will undertake in the coming months, we can find some positive signs in Europe’s recovery. Ireland, for one, has successfully left its bail-out programme. In Spain, differences in the sovereign debt spread between core and periphery countries has narrowed drastically to less than 200 basis points. And European stock markets are certainly more confident and bullish than in past years with gains of around 20 per cent in one year for some countries.

But Europe’s situation is still far from rosy. After enduring a double dip recession, economic growth in the EU generally remains low. The IMF forecasts only 1% for 2014 – well below the U.S. forecast of 2.8%. Access to financing remains scarce, borrowing has become prohibitively expensive for some countries and companies (notably SMEs in peripheral countries), and unemployment is stubbornly high – especially among the youth – with more than one out of two young people unemployed in countries such as Spain and Greece.

Against this backdrop, Europe now needs to refocus its energy on fuelling economic growth and creating new, productive and sustainable jobs. It’s widely accepted that a country’s ability to sustain long-term economic growth, especially in natural resource-constrained economies, hinges on their success in raising productivity. Europe’s overall productivity growth has been slow since the mid-1990s, especially when compared to other advanced economies like the U.S. For the EU-15 before the 2004 enlargement, labour productivity declined from an annual rate of 2.4% during the period 1973-1995 to 1.5% during the period 1995-2006. This contrasts with the U.S. labour productivity growth from 1.2% during the period 1973-1995 to 2.3% during the 1995-2006 period. What’s more, during the years of the recent financial and economic crisis, this gap grew even wider as labour productivity increased by 1.6% for the 2009-2012 period and only 0.6% for the eurozone in the same period.

There are several explanations for this sluggish European productivity growth. For one, the relatively small share of technology-producing industries in Europe has not helped, nor has less development of highly productive information and communication technologies or slower multi-factor productivity growth. These are all related to smaller R&D investments in Europe. Since the economist Solow’s seminal work in the 1950s, productivity gains have been closely linked to R&D investments, with some estimates attributing up to 80% of productivity gains to R&D investment.

Compared to other advanced economies, Europe underinvests in R&D. Despite the stated target of reaching a R&D investment equivalent to 3% of the European Gross Domestic Product (GDP) by 2010 and then 2020, Eurostat puts R&D investment in the European Union at 2%, compared to 2.77% in the U.S., 3.26% in Japan or 3.74% in South Korea. In addition, emerging economies like China, with an investment of 1.84%, are rapidly catching up, having recognised the importance of R&D to its second economic transformation into a knowledge-based economy.

In this context, one may wonder if boosting R&D would resolve Europe’s productivity and competitiveness gap, putting Europe on a more solid economic footing and creating the badly needed jobs. And if so, how far can investments in R&D fuel economic growth? Would that be sufficient? Can R&D investment be regarded as the panacea to ensure a strong and stable recovery for Europe?

The answer to this question is that R&D investment will be important, but not in itself sufficient, to ensure growth in Europe. A more nuanced analysis is needed. Certainly, continued and stable investments in R&D are an important element of fostering innovation and raising Europe’s productivity and competitiveness. To translate this knowledge into innovation, however, Europe needs to create the conditions that allow for a rapid uptake and use of this knowledge. These include a framework to support high levels of competition that incentivise the commercial use of new knowledge, a regulatory and legal framework that allows inefficient companies to fail in an ordered manner and frees up production, and human and financial resources for more productive activities.”

At present, Europe’s market remains fragmented. Full competition has not been achieved in important areas such as services or network infrastructure, e.g. energy, telecommunications. Moreover, labour markets, despite some notable exceptions, still are relatively rigid in most Member States; As a result, innovation-led entrepreneurship continues to face important bottlenecks in comparison to other countries. Addressing these weaknesses, by fulfilling the internal market and implementing the necessary reforms in product and labour markets as well as in the regulatory and legal framework, would help create more favourable conditions for innovation in Europe.

Above and beyond R&D, there are other types of investments that are also important for fulfilling Europe’s innovation, productivity and growth potential. For example, investments in education and training schemes would ensure creativity and a quick and constant adaptation of available skills to a rapidly changing economy. Furthermore, the application of advanced management techniques in companies that support the uptake, transformation and development of new ideas into tangible products and processes are also important and complementary investments that cannot be disregarded.

Europe’s future economic growth and capacity to ensure productive jobs will depend on its ability to strengthen its innovation system by investing in R&D and other knowledge-enhancing investments. Its success in creating the right conditions for this knowledge to be translated into new economic activity will also be key. After several years of fire-fighting the fiscal and financial fallout from the crisis, Europe is now in a position to set the foundations for growth and reconnect with its citizens by providing more and better opportunities for all. Implementing these necessary reforms will require political vision and courage to overcome vested interests.