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.
Which Business Models Breed Success?
Despite the drawbacks of the shareholder model, westerly winds remain forceful in the form of pressure exercised by American and British investors, strategy consultants, investment bankers, financial analysts, credit rating agencies, and financial journalists who are adamant that any other way of conducting business is inferior. European public companies have by and large succumbed to these pressures. However, the vast majority of European companies do not rely on stock markets to finance their activities and can escape the straightjacket within which American and listed European companies are forced to operate.
As a result, Europe enjoys a crucial advantage in the form of the availability of a wide range of enterprise models: from cooperatives to family businesses, state enterprises to foundations. Companies enjoy considerable freedom to choose the most appropriate form of governance and management, organizational structure and culture, as well as planning and remuneration systems. They can cater to the requirements of the markets they serve, the technologies they apply, and the labor markets on which they depend. Such flexibility translates into economic advantage, particularly because the requirements of companies change from one stage in their development to another.
The best way to capitalize on this flexibility in governance and organization is to create transparency, to encourage Europe-wide competition between various enterprise models, and to support research into, and experimentation with, new models. Fortunately, the European Commission has already focused attention on the major contributions made by European cooperatives and small businesses and has introduced a number of action programs to strengthen their respective positions, ranging from the facilitation of cross-border cooperation to help with the financing of high-tech start-ups.
More can be done. As the requirements of companies change with growth and maturity, more attention should be devoted to the facilitation of migration from one legal entity to another. There is also a real demand for the legal structuring of EU cross-border partnerships. Of particular importance are companies in the new Central European member states. The inroads of American and British economic advisors, investment banks, and strategy consultants have been considerable. The European Union should provide access to experts with alternative views on business development.
Sources of Finance
Although European exchanges also act as conduits for pressure exercised by shareholders, there is still a significant degree of difference between the supervision and management of European and American bourses. Moreover, given the larger role of insurance companies and pension funds in trading on European exchanges, a modicum of common sense has prevailed in many deals since the financial community has to cater to these large customers and their future commitments.
In this light, the 2007 takeover of Euronext, the combination of the bourses of Paris, Brussels, and Amsterdam, by the New York Stock Exchange is a considerable setback. Some experts claim that the federative model of Euronext will survive the takeover, but that remains to be seen. Marketing and sales efforts aimed at drawing more individual investors into the exchange will increase, which means more irrational and ill-informed trading, increased opportunities to manipulate stock prices at the expense of the small shareholder, more volatility, and as a result even greater discrepancies between the market capitalization and the economic value of companies.
American bourses are also far more aggressive in trying to increase their share in corporate finance. They have every intention of taking full advantage of the benign regulation of European stock markets. The larger the total market capitalization of the companies on their big boards, the higher the turnover of stocks and the larger the lucrative markets for options and derivatives.
A world thus emerges in which the whole financial community has an interest in stock price volatility. Bourses and intermediaries increase their turnover while investment banks and private equity capitalize on the exit and break-up opportunities that under and overvalued companies provide. Contrary to their public pronouncements, individual companies also benefit from the volatility of their stock price and the resulting higher turnover. The higher the turnover, the greater the exit opportunities for short-term investors and the more these same investors feel confident stepping in. Higher turnover means more financial analysts will follow the stock, which keeps the company in the public eye, and the combined result of all this is a higher share price. It is telling that the average holding period of NYSE-listed stocks was reduced from eight years in 1960 to 11 months in 2005 and has decreased since.
Playing defense, the European Commission and the European Central Bank have had a major role in preserving and stimulating diversity among European bourses. Fortunately, many European bourses are more efficient than their American counterparts, and all have the good fortune of using the euro, the most stable currency in the world. Given the detrimental side effects of a stock market listing, the fact that European companies base only 15 percent of their capital requirements on stock markets can hardly be overestimated (compared to 75 percent for US companies). The less a company depends on the stock market, the more freedom it has to choose the most appropriate enterprise model. In light of this, it should be seen as a strategic advantage that European companies finance most of their investments from their cash flow.
As has been indicated already, the most fundamental contribution the European Union could make is to help companies increase their cash flows, not their profits. Cash flows are driven by increased revenues and improvements in productivity. In the European context this means more intra-community trade and more transfers of soft and hard technology in the form of investments across EU borders. The European Union's daily grind of lifting small and large barriers to trade and investment is a great strategic advantage and deserves more appreciation and political recognition.
A second increasingly important way to circumvent bourses is the stimulation of business partnerships. Family companies are well-versed in using this route as an alternative source of finance. Rather than focusing on crossborder mergers and acquisitions, where economic value is destroyed 80 percent of the time, the European Union should facilitate cooperation among European companies and help them achieve growth and flexibility at lower risk.
As third and fourth sources of corporate finance, bank loans and private equity are also superior to stock market financing. The creation of economic value takes center stage with all its associated advantages for the company. Banks focus on interest coverage, the number of times a company can cover interest payment out of its cash flow. Private equity investors look for increased revenues and better use of capital. In both instances, knowledgeable professionals join management in the pursuit of value. It is therefore no surprise that companies that use private equity grow faster and create more jobs than listed companies.
Recently, there have been far too many instances of economic value being destroyed by private equity. But instead of discrediting a whole industry, it would be much wiser to face the problems and resolve them. For example, the European Union could use its influence to extend the German tax regime, which does not allow corporate interest payment on loans imposed on them by their owners to be deducted from taxable income. It falls to the European Union to improve the transparency of capital markets and to increase competition among the providers of capital.
Low Transaction Costs
Intra-European trade can still grow substantially. Moreover, EU-wide corporate partnerships in all shapes and forms are required to combine expertise and assets, to improve productivity, and to develop new markets and new products. As a result, transaction costs in the broadest sense of the word become more and more important.
In the United States, business partners are allowed to do anything that is not explicitly prohibited by law or in their contract. This legally and culturally enshrined premise, in combination with the peculiar ways in which case law is administered, produce a business world driven by antagonism -- with control at a premium and cooperation a second-rate solution. Conflicts are often settled by litigation at very considerable expense. The cost of legal support is impressive -- and still rising. Compensation for damages and punitive damages has taken on grotesque proportions. Cases linger for many years in an endless quest for relevant legal precedents and are given a broad scope for appeals on procedural grounds. But the greatest economic damage is caused by missed business opportunities: companies and their shareholders become risk-adverse and avoid promising areas for business development.
So far, European companies have enjoyed relatively low transaction costs of this nature. Partners are generally aware that building trust is a precondition for economic gain. The legal systems on the continent provide contracting partners flexibility and protection thanks to the civil code, which in modern times has clear advantages over case law. For example, the relatively strong legal position of the weaker of the two contracting parties is crucial in an economy in which large companies engage large numbers of small innovative companies in a variety of ways.
If and when their contract cannot resolve a dispute between partners, a professional judge will rule on the basis of the original intentions of the parties and their obligation to take the interests of each other into account. Punitive damages have only recently been introduced but appear to still be confined to gross negligence. In most European countries rulings can be appealed only once, settling the issue definitively within a reasonable timeframe. Increasingly, arbitration and mediation are being used to settle disputes.
Key EU policies have added benefits. In a completed internal market, increasing numbers of transactions, investments, alliances, and takeovers will cement the use of the civil code in economic life. This should help to counter the inroads of British corporate and contract law on the continent and the aggressive marketing of large British law firms. Rational managers of continental companies should resist the choice of UK law as an unhappy compromise if neither partner feels uncomfortable going to court in the jurisdiction of the other.
Patents and Innovation
There is far too much emphasis on the patent system as a way of enticing companies to invest in research and development. The reasoning is that only the protection of intellectual property will tempt companies to use shareholder money in ventures with a highly uncertain payoff. One implication of this is that interesting lines of research-that could add economic value-are abandoned if findings cannot be legally protected. In addition, the patent system has been degraded to the exploitation of legal definitions of novelty and originality. In this system, companies start the evaluation of opportunities to obtain a license by looking for ways to circumvent the patent on which the license is based. There are also far too many companies and traders that abuse their position as exclusive license holders or create havoc by challenging patents on dubious grounds, assuming that sooner or later the owners who have businesses that depend on these patents will buy them off.
The original and more important function of the patent system is the provision of access to what the world has learned at reasonable expense. The number of small and large licensing deals that are closed year after year is the proper measure for its success. There is no new step in biotechnology that does not depend on a string of technology platforms, procedures, and products that were developed in the past by academics and competitors. No company will refuse licenses to reputable companies with sound plans.
The question is how to capitalize on the four million patents in the world and the 800,000 patent applications annually added to the pool. Europe is well-placed to turn the patent system into the cornerstone of an open innovation policy. There has never been a better reason to remove the political barriers that have plagued the growth of the European patent system. The community-wide patent and a single patent court are crucial.
Electronic access to patent texts is already easy, but patent language is arcane and requires a combination of business acumen and scientific insight to appreciate its potential. The European Union could increase transparency by adding summaries in plain language to the patents. Of course, patents are a long way away from reliable new technologies. It is therefore important to make information available about the ways licensees have put a patent to good use. This is, at a minimum, in the interest of the licensor in his quest for more licensees. More importantly, it will stimulate innovation by crossing sector boundaries, as has already happened with findings to improve pumps, membranes, and excavation equipment.
The name of the game in stimulating medium-term economic growth is the creation of new combinations of tested technologies, services, and trademarks. The present emphasis on the development of new technologies can only contribute to growth in the long-term. The innovation exchange networks sponsored by the European Patent Office deserve more attention. Furthermore, Europe should play to its strengths as the world's leader in design and the sophisticated way it protects designs and trademarks. Enabling entrepreneurs to seek and find protection for combinations of different forms of intellectual property is an enticing prospect.
Open innovation calls for the stimulation of trade in intellectual property within the European Union and with other economic regions in the world. This goes to the core of the internal market and the stimulation of world trade. As matters now stand, European companies file more patents in the United States and Japan than vice versa. The approximately sixty billion euro that is presently exchanged between regions in royalties and licensing fees is only a modest beginning.
Home of the World's Largest Players
Large companies play a far greater role in transforming innovation into economic growth than is generally assumed. They own most of the world's intellectual property, patents, designs, and trademarks. Large companies have the financial resources to translate intellectual property into products and services that add economic value. They provide the continuity that is required for persistent step-by-step improvements. They are masters of marketing and control most of the sales and distribution channels. They can mobilize any team of specialists on all topics at short notice. They have experience in managing networks of companies and institutions. They dominate world trade and the transfer of technology. They are indispensable partners in designing industry standards and regulation.
Europe is the home of 60 of the world's largest 100 companies. This is a considerable advantage although many of its listed companies, particularly banks, are not sufficiently different from their American counterparts. It is crucially important that they remain part of the social and economic fabric of Europe, maintaining their own and tailor-made ways to conduct business. Europe's large and generally successful family-controlled conglomerates have a special responsibility to set standards that other large companies could emulate.
The fact that Europe is the recipient of 40 percent of the world's FDI bodes well; that large European companies seek their expansion in Europe is also encouraging. The battering that free market capitalism has received over the past year will also help. The need for the European Union to open up the common market remains as indispensable as ever. These new directions are intended to advance the private sector and to create the sustainable economic growth Europe needs in order to develop its own highly competitive brand of capitalism and to pursue its economic, social, and political objectives.
Since the outbreak of the credit and economic crisis, three of the six European advantages -- avoidance of the shareholder model by non-listed European companies, Europe's greater diversity in enterprise models, and more diversified sources of finance -- have taken on additional significance.
Of all the EU institutions, it would seem that the meeting between finance ministers of the countries that have adopted the euro is best placed to draft the new agenda. The Economic and Financial Affairs Council, which includes the finance ministers of the UK and most of the new members, will hopefully be divided from the outset. The same holds for the Competitiveness Council, with the added disadvantage that it yields very little power. The Commission has nailed its colors to the mast of the Lisbon process. Among the euro zone finance ministers it falls, as in times past, to Germany, a country endowed with a healthy skepticism of Anglo-Saxon economic prescriptions.
Editor's note: To read the footnotes that accompany this story, please visit IP Global Edition.