Europe’s geoeconomic competitiveness challenge

MILAN – Economists tend not to worry too much about a country’s international competitiveness. Cross-border trade and investment generally benefit both sides, and faster growth in one country benefits others, which can tap its expanding market. It is domestic productivity, not the ability to outcompete others, that determines national prosperity. That is why, 30 years ago, Paul Krugmancalled competitiveness a “dangerous obsession.”

From a strictly economic perspective, Krugman was right. But, with the war in Ukraine still raging and China becoming increasingly assertive and despotic, European leaders can no longer view competitiveness through an exclusively economic lens; geopolitical considerations are becoming just as – or even more – important. To paraphrase the American political scientist Edward Luttwak, the “logic of conflict” now supersedes the “grammar of commerce.”

Accounting for geopolitics implies a very different standard for assessing an economy. That is because geopolitics is about power, which is necessarily relative. When it comes to power, size matters – but how well people live does not. In other words, in “geoeconomics” – to use Luttwak’s term – the economy is a source of power, not necessarily a source of well-being for the population.

This distinction matters, especially for the European Union. From a standard-of-living perspective – measured by GDP at purchasing power parity – Europe has been doing well in recent decades. Even the sluggish eurozone has kept up with the United States in terms of per capita GDP growth. In fact, Europe’s GDP per capita has been about three-quarters of America’s for over a quarter-century.

But the “European way of life” (to use European Commission parlance) is distinctly different from the American way of life: whereas Europeans have more time, Americans have more money. The question of which is better means little to an economist; that is for the individual to decide. From a geopolitical point of view, however, the answer is clear: more money implies more work, more productivity, more growth, and more power.

So, we are now judging Europe’s economy not by how well it enables people to live, but by its size relative to others. And by this measure, the EU is losing ground. At 1% per annum, GDP growth in the EU is the lowest among developed economies, and disappointing growth figures are nothing new. The EU’s share of the global economy is declining much more rapidly than the US share.

While this measure is strongly affected by exchange-rate movements, such movements even out over time. At today’s exchange rates – which are close to those when the euro was introduced – the US, with its GDP of $25 trillion, still accounts for about a quarter of the global economy (roughly $100 trillion), whereas the eurozone, with its much smaller $14 trillion economy, accounts only for about one-sixth. When the euro was created the difference was much smaller.

The consequences of this decline are far-reaching. For starters, any effort to establish the euro as a viable competitor to the US dollar as the leading global currency is unlikely to succeed. Moreover, the EU’s ability to leverage access to its market (the world’s largest, as it likes to boast) to advance European geopolitical objectives is declining. In fact, in terms of consumption expenditure, the EU market is already much smaller than that of the US and is slipping behind China.

Then there is military spending – perhaps the most direct link between raw GDP and geopolitical power. All NATO member states have committed to spend at least 2% of their GDP on defense. Many have not reached this goal, but even if they did, stagnating GDP growth would cause military spending also to stagnate. All this would be reflected in the strategic calculus of figures like Russian President Vladimir Putin and Chinese President Xi Jinping – likely in highly undesirable ways.

In this context, the fact that European living standards have held up, despite low growth, is no reason for complacency. To maintain and strengthen the EU’s geopolitical standing, leaders must find ways to revitalize the economy.

Some already recognize this imperative. Just last month, two former Italian prime ministers, Enrico Letta and Mario Draghi, issued blueprints for reform. The problem is that if there was an easy way to accelerate growth – one that did not carry political costs – it would have been embraced a long time ago. As Barry Eichengreen of the University of California, Berkeley, recently pointed out, Europe needs new ideas.

A second, even more fundamental problem is that the “logic of conflict” tends to lead to bad economic policy. In a conflict, a country must defend its own territory. This imperative can easily be translated into policies aimed at defending domestic industries against foreign competition. When Luttwak coined the term geoeconomics in 1990, he recommended that the US protect its manufacturing industry and adopt a more restrictive trade policy. But, as a recent International Monetary Fund study shows, protecting domestic industry is a recipe for stagnation, not growth.

Fortunately, US policymakers did not take Luttwak’s advice. Instead, they kept trade largely free (until recently) and allowed manufacturing’s share of the US economy to decline. This allowed other parts of the economy – notably, the digital sector – to expand. Today, the US is home to all the global high-tech giants, and it is the undisputed leader in cutting-edge sectors like artificial intelligence.

The lesson for Europe is clear: the logic of conflict should spur leaders to revitalize the EU economy, but it must not dictate how they do it.