Europe's Inherent Vigor EU Businesses Could Thrive Post Recession
Just as the financial crisis reveals the weaknesses of global markets and free-market thinking, the advantages of the European business model have become starkly evident. Should EU reforms build on these comparative advantages, Europe could emerge even stronger.
The credit crisis and the ensuing "great recessions" across the globe have eroded confidence in free-market capitalism. A reassessment of this economic model opens up an array of assumptions for questioning, beginning with the superior competitiveness of the United States vis-à-vis the European Union. It turns out that despite considerable advantages enjoyed by US companies and the substantial hurdles faced by their European competitors, European companies have long prevailed, both domestically and abroad. The sources of this anomaly lie in the overlooked strategic advantages of the economies of continental Europe that underwrite corporate performance.
If these advantages can be confirmed, new perspectives for economic policy and a new approach to strengthening Europe's competitiveness could emerge. It is often more economical to enforce what is strong than to shore up what is weak. This lesson should be applied to EU policymaking: Europe's agenda should include the identification, defense, and strengthening of the strategic advantages of European economies and the European private sector. This could help rejuvenate the Lisbon Process that despite much fanfare has contributed very little to its espoused objective, namely to make Europe the most competitive region in the world.
US Advantages, EU Success
Growth rates are an oft-cited indicator of economic success. But this measure is heavily distorted in favor of the United States because of differences in population growth, as well as statistical anomalies. The higher US growth rates since the shallow recession of 2001 can be largely contributed to an unprecedented and irresponsible Keynesian financial injection into the US economy. Substantial tax reductions, the lowest interest rates in history and, related to the latter, a feverish housing market, all conspired to boost consumer spending. Increased government expenditure also fuelled the economic surge.
The competitiveness of Europe's private sector in world markets is beyond question. The picture is presently distorted by the worldwide recession, but the WTO reports that in 2007 Europe maintained a 45 percent share of the world's exports to other economic regions. Europe maintains a trade surplus with the rest of the world, as well as a large and structural trade surplus with the United States both for merchandise and services.
European companies have been expanding aggressively and successfully in growth markets such as Central and Eastern Europe, India, and China, despite an unfavorable euro to dollar exchange rate. European companies have achieved this despite the substantial advantages American competitors enjoy on the US home market that provide an ideal platform for exports and foreign investments. These advantages include: one language, one legal system, fully-integrated markets for goods and services, structurally higher research and development spending, the world's most advanced information and communication technologies and financial service industries, an abundance of venture capital, flexible labor markets, and a widely supported political choice for economic growth over social cohesion.
Yet European companies have been doing well, even in the face of significant competitive disadvantages. The European Union, for example, remains the home of 27 legal systems and 27 tax codes, many official languages, different labor laws and practices, different roles of regional and local authorities, different forms of environmental protection, and diverse consumer protection policies. In addition, European companies still face a range of barriers to market entry. European economic integration is far less advanced than generally assumed. Notable success stories are the substantial growth of exports of goods within the European Union, the introduction of the euro, and the integration of financial markets. But in other realms, progress has been excruciatingly slow.
Europe is still rife with informal resistance to foreign investment as exemplified by the lax implementation of EU public procurement rules. Investment and takeovers across national boundaries are still modest in comparison to initiatives in home markets. European national economies have evolved into service economies, but exports of services are still at pitiful levels. The watered-down version of the service directive -- approved in 2006 after much wrangling -- is hardly providing a fresh start.
The overall effect is that very few companies operate on a European scale, which is defined as having significant sales or production units outside their home countries. Just look at the number of companies with a European works council (for consultation with management on corporate strategy and labor-related matters), though such a council is obligatory for any company with a minimum of 1,000 employees in the European Union or with at least 150 employees in two different member states, as recently as 2000 only 1,200 of the millions of European companies met those criteria. This is a surprisingly small number that indicates there is a world to be gained.
Six European Advantages
Europe must also enjoy strategic advantages that have hitherto been unrecognized as such in order to explain the strong relative performance of its private sector. Six such advantages follow, complemented by suggestions for EU policy changes that would further augment Europe's strengths.
In the Anglo-Saxon world, business can be characterized as follows. Corporations pursue a single objective: the pursuit of shareholder return on investment, or rather, the largest possible increase of the share price within the shortest period of time. A single official provides leadership, combining the roles of chairman and chief executive officer. In order to operate as closely as possible to the market, decision-making and accountability is heavily decentralized. This must be accompanied by very tight managerial and financial controls and by substantial financial incentives to keep individual and corporate interests aligned. Belief in the virtues of competition is deeply engrained throughout companies: it guides how to deal with the outside world and helps allocate scarce resources, such as capital and talent, to divisions and business units. Adversity is a virtue that mobilizes creativity and induces commitment.
Yet each element of the shareholder model is flawed. The choice for shareholder return on investment, for example, is highly detrimental to the well-being of the corporation. There is no longer a relationship between the market capitalization of the company (share price times the number of shares) and its economic value: the sum of all future positive and negative cash flows, year by year properly discounted for risk and uncertainty while taking the cost of capital into account. As a result, decision making on supervisory and management control (in the context of mergers and acquisitions), capital, and talent is distorted. Moreover, the premise that a persistent, preferably double-digit growth in profit per share will be rewarded by the stock markets is false.
My conclusion is that a dubious objective is being pursued in the wrong way. In addition, the primacy of profit per share, in combination with short CEO contracts and variable pay depending on achieving profit per share targets skews policymaking. It leads to policies that have a measurable effect before the expiration of the management contract. This explains the popularity of cost-cutting and acquisitions to reduce costs further as the surest ways to increase profits as well as the share buy back programs. It is all about the optimization of a ratio (total profit divided by the total number of shares) at the expense of long-term cash flows. This also helps to explain the reluctance of CEOs to commit to large and complex investment, to partnerships, and to research and development, all steps that would create substantial economic value but at the expense of short-term profits and bonuses. The ultimate paradox is that economic value is destroyed, or not created, in the interest of the shareholder.
Europe's agenda needs to focus on the creation of economic value as a sound and practical guide in regulating and stimulating the private sector. The microeconomic pursuit of economic value is consistent with the macroeconomic aim of sustainable economic growth. Policies to help companies achieve profit growth will not achieve the desired result and may even be counterproductive. All presumed causal connections between profit growth on the one hand and investment levels, job creation, and research and development expenditure on the other, were severed some time ago. Moreover, many European Union, European Investment Bank, and national programs aimed at stimulating innovation through subsidies, below-investment grade equity, and the like, could fall victim to the corporate pursuit of profit-per-share growth.