European Integration: Meeting the Competitiveness Challenge

9-708-421 REV: MAY 6, 2008 MICHAEL E. PORTER CHRISTIAN KETELS European Integration: Meeting the Competitiveness Challenge Growing out of the devastation of the European continent during World War II, European integration was in its sixth decade in 2004. The integration process was credited with moving Europe back among the most prosperous regions in the world, and overcoming tensions that had led to a succession of past wars. Europe s new supranational institutions were studied by policy makers around the world. Europeans generally appreciated the past achievements of European integration, but were divided in their assessment of the current state of the integration project. Some saw Europe as an alternative economic and social model that would soon surpass the United States in terms of global attractiveness. 1 Others argued that Europe was facing a fundamental crisis in terms of economic and political vision that needed to be overcome if Europe was to sustain its economic position and ultimately its political visibility. 2 Europe has used some of the increase in productivity to increase leisure rather than income, while the U.S. has done the opposite. A deep and wide ranging reform process is taking place [ ] driven by reforms in financial and product markets [ ] in turn putting pressure for reform in the labor market. Reform in the labor market will eventually take place, but not overnight and not without political tensions. These tensions [ ] will continue to dominate the news; but they are a symptom of change, not a reflection of immobility. Olivier Blanchard, The Economic Future of Europe, February 2004 [D]espite the considerable institutional achievements of the EU, its economic performance is mixed. While macroeconomic stability has considerably improved during the 1990s and a strong emphasis on cohesion has been preserved, the EU system has failed to deliver a satisfactory growth performance Failure to deliver on the Lisbon Agenda would endanger the present European contract [ ] threatening the very process of European integration. Europe s unsatisfactory growth performance during the last decades [is] a symptom of its failure to transform into an innovation-based economy. Letter by Andre Sapir to Romano Prodi, President of the European Commission, July 2003 Professor Michael E. Porter and Principal Associate Christian Ketels prepared this case. This case was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright 2007, 2008 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School.

708-421 European Integration: Meeting the Competitiveness Challenge As the Irish Taoiseach (Prime Minister) Bertie Ahern took over the Presidency of the European Council on January 1, 2004, for his six-month term, he knew that he had little time for a philosophical discourse; Europe needed action. Overview of Europe The European Continent stretched across four time zones from the Atlantic Ocean to the Urals and from the Scandinavian North Cape to the Mediterranean Sea. The population of Europe was largely Caucasian but there was a sizeable minority from former colonies as well as labor migrants from North Africa and the Middle East. Christianity was the dominant religion, with the border between Catholic South and Protestant North running from the North Sea through Belgium and Germany and back north to the shores of the Baltic. The region had developed many different cultures and national identities, intertwined through common historical roots and linkages. In recent history, the two world wars begun in Europe represented a shared traumatic experience among the Continent s communities. European integration traditionally covered an area much smaller than the European Continent (Exhibit 1). The nucleus of the European Union (EU) had included only six Western European countries: Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. Even after the extensions of the 1970s (Northern extension with the United Kingdom, Ireland, and Denmark), 1980s (Southern extensions with Spain, Portugal, and Greece), and 1990s (EFTA extension with Sweden, Finland, and Austria) the EU only covered Western Europe. On May 1, 2004, however, ten mainly Eastern European countries would join the EU and at least two more countries, Romania and Bulgaria, were slated for entry within the next three to five years. Croatia lead a group of Balkan countries perceived to follow them in different stages. By the end of 2004, the European Council, the highest body of the EU, had to decide on whether to open membership negotiations with Turkey, a country largely outside of the geographic boundaries of Europe that had formally signaled its interest in membership as far back as 1963. After the 2004 accession, the EU would include all of geographic Europe except the very East (Russia and the other former Soviet Union countries with the exception of the Baltic States), the Balkans, Switzerland, and Norway. All EU member countries were representative democracies, although the political systems, traditions, and practices varied widely. Six countries were constitutional monarchies (Belgium, Denmark, the Netherlands, Sweden, the United Kingdom, and Spain) while the others had elected presidents as Heads of State. Some of the European nation states, such as Germany and Italy, dated back only to the nineteenth century and their constituent regions had maintained strong individual identities, often expressed in federal systems of government. In other countries, such as the United Kingdom, France, and Sweden, central government had a long tradition and was the dominant political entity. In 2004, the population of the 15 members of the European Union had totaled 381 million, significantly larger than the United States; the mid-2004 accession countries would add another 75 million people (Exhibit 2). Population growth in the region has essentially been non-existent over the last decade, reaching 0.07% in 1999. Many of the European countries, Italy and Spain in particular, faced rapidly aging societies. The total net migration to the EU in the decade between 1990 and 2000 had accounted for 9.3 million people or 2.5% of the EU s population. Most EU countries were not perceived to be very open to immigrants and immigration had become a salient election issue in a number of EU member countries. With a total GDP of $11.24 trillion the pre-accession European Union was in 2004 roughly 95% of the economic size of the United States ($11.73 trillion). Germany was the largest economy with 24.5% 2

European Integration: Meeting the Competitiveness Challenge 708-421 of the EU s output. Within the Union, GDP per capita (adjusted by purchasing power parity (PPP)) was in most member countries slightly above $30,000. A few countries fell outside of this range, notably Luxembourg at $60,000 GDP per capita and Portugal at $20,500 GDP per capita. The accession countries tended to be much less prosperous, ranging from Slovenia at $22,250 GDP per capita to Latvia at $12,000 GDP per capita (all PPP adjusted). They would increase the total GDP of the EU by about 10%, moving it ahead of the United States in terms of total economic size. Many European nations rated highly on international rankings such as the Human Development Report, a comparison of social as well as economic metrics. Much of Europe had reputable public institutions, highly developed physical infrastructure, and extensive human resource development programs. The European continent had been the birthplace of the dominant legal systems in the world and judicial systems were well developed. European transportation systems were dense and high quality, both within countries and across national borders, with networks of roadways, highspeed train connections, and air- and seaports servicing all parts of the Continent. Europe s telecommunications networks were modern and Internet connectivity was high in most regions. Educational systems in many parts of Europe were well developed, and the systems of vocational training had contributed to a well trained workforce. Many European universities had a long history, some of them tracing their roots back to the thirteenth and fourteenth century. Financial systems differed widely, from the bank-based systems in Germany to the equity culture in the United Kingdom. Europe was ranked low overall on access to loans and risk capital (Exhibit 3 and 4). Individual European countries continued to have strengths in innovation, but on average Europe had developed less dynamically in the last decade than North America and some Asian countries. R&D expenditures were below U.S. and Japanese levels, mainly due to lower company R&D spending (Exhibit 5). While researchers from Europe had dominated the list of Nobel Prize recipients for the first half of the twentieth century, they had fallen behind their U.S. counterparts since then. In many European countries, universities tended to be seen as bureaucratic and unfocused. Much scientific research was concentrated in government-funded research institutions. 3 Within the EU, Northern countries were leaders in terms of R&D spending, on par with top global peers, while the Southern countries were far behind. Though some of the Nordic countries had matched the United States in international patent intensity (Exhibit 6), Europe overall lagged behind. A more detailed analysis of patenting quantity and quality by broad sector revealed European strengths in automotive, chemicals, consumer electronics and telecommunications, and weaknesses in IT and biopharmaceuticals. The separation of Europe into many nations with barriers to cross-border exchange had led to the development of many self contained economies focused on serving specific national rather than European markets. This had limited geographic specialization of activities, but some regions had developed strengths in particular clusters. Southern Germany had a strong reputation for cars and machine tools, Northern Italy developed key positions in areas from machine tools to fashion, often based on networks of small and medium sized companies, and the City of London in banking and insurance. More recently, Scandinavia had become known for strong performance in telecommunications technology. In countries like Denmark, Germany, and Italy small- and medium sized companies had significant export positions while in countries like France and Sweden exports were dominated by a smaller number of large companies. With limited national home markets, many European companies had a long tradition of operating in many foreign markets and adapting to differences in national rules and regulations. European companies were perceived to be focused on the higher-end of their markets, employing advanced engineering and scientific know-how as well as luxury brands rather than sophisticated mass marketing. 3

708-421 European Integration: Meeting the Competitiveness Challenge Government played a significant role in most European economies, with the United Kingdom a notable exception after reforms which began in the 1980s. 4 Government expenditures across the EU averaged 48% of GDP in 1999 and a significant share of the workforce was employed in the public sector. Traditionally governments had owned companies in areas like utilities, transportation, postal and communication services, and some financial services. Southern European countries also had some legacy of state-owned conglomerates in other parts of the economy. Government ownership of companies had, however, been reduced through privatizations in the 1990s and where it remained, companies had been incorporated with government influence limited to that of a normal owner. Taxes were used as a means of income redistribution much more so than in the United States. Publicly mandated social welfare systems, invented in Germany at the turn of the twentieth century and soon adopted throughout Europe, provided health care, pensions, and unemployment benefits. The Eastern European countries about to enter the EU in April 2004 were expected to challenge this model with much lower taxes and less developed social systems. In Western Europe, social policy budgets tended to be high, although the level of some types of social insurance, for example, unemployed benefits, had been reduced notably since 1990. Europe was also perceived to have heavily regulated labor markets, often with strong unions and centralized wage bargaining, and extensive regulation of many product markets. In 2004 Ireland, the United Kingdom, and Luxembourg were the three members of the European Union among the ten freest economies in the world economy identified by the Cato Institute. 5 History of European integration The European economies had dominated the world economy for centuries before being surpassed by the United States and later some Asian economies in terms of dynamism. Trade across Europe had always been significant, and institutions like the Hanse, a group of cities stretching from the United Kingdom through Northern Europe into Russia, had emerged to facilitate cross-border trade and investment. European nations, in particular Spain, Portugal, the Netherlands, the United Kingdom, and France had developed global networks of colonies which accounted for much of world trade. In the eighteenth century Western Europe had begun to industrialize rapidly, the process most accelerated in England. Many European regions, from the British Midlands to the Basque country and Catalonia, the North-East of France, the German Ruhr area, and the former Czechoslovakia, had long traditions in manufacturing. World War I and the economic crisis that followed had disrupted European trade relations. The social hardships of this period threw many regions in turmoil and contributed to the rise of totalitarian regimes in parts of Europe. World War II left Europe with a decimated workforce, a largely destroyed economic infrastructure, and huge social challenges. Large companies in industry and finance were nationalized in countries like France and Italy. In Germany, even the center-right party discussed a program highly critical of the capitalist system. In the United Kingdom, a labor government was elected on a platform of greater social benefits and an expanded government role in the economy. The foundation for European integration was laid in the immediate aftermath of World War II. Sir Winston Churchill set the tone in a speech given in Zurich on September 19, 1946, arguing for a United States of Europe. At the heart of Churchill s vision for Europe was the reconciliation between France and Germany, countries that had been at war three times between 1870 and 1945. Churchill s thinking influenced a number of initiatives, such as the creation of the Organization for European Economic Cooperation OEEC (1947) and the Council of Europe (1948). The founding conference of the OEEC in June 1947 ushered in another critical initiative: U.S. Secretary of State George Marshall offered $20 billion for the reconstruction of the devastated European economies 4

European Integration: Meeting the Competitiveness Challenge 708-421 conditional on Europe coming together as a plan for how to use this aid. The Marshall Plan was soon accepted by the Western European economies while countries under Russian control in Central and Eastern Europe abstained; a clear sign of a dividing line across the European continent that would persist for more than 40 years. Individual European countries approached European integration from different perspectives. For Germany, integration was crucial to becoming accepted again among European nations. For France, the opportunity to leverage Europe in order to retain its global prominence was an important consideration. The Benelux countries and France were concerned about controlling Germany while allowing its economy to develop sufficiently to pull the European economy forward. Italy saw the opportunity to link up with the more developed economies of Western Europe. The United Kingdom was hoping for a liberal economic regime that would drive growth and limit the financial burden of its military presence in Germany without limiting national sovereignty through new European institutions. 6 In May 1950, five years after the end of the war, the French Foreign Minister Robert Schuman 7 proposed a common European market for coal and steel: "Through the consolidation of basic production and the institution of a new High Authority, whose decisions will bind France, Germany and the other countries that join, this proposal represents the first concrete step towards a European federation, imperative for the preservation of peace." 8 Schuman argued that the new institution should use a combination of open competition and indicative production and investment plans to enable fast growth of sectors that were seen as crucial for the development of the European economies. The Schuman-plan was quickly accepted by the governments of Belgium, France, Germany, Italy, Luxembourg, and the Netherlands, and on April 16, 1951, the European Coal and Steel Community (ECSC) was created, eliminating trade barriers in these areas by early 1953. Jean Monnet, the French President of the new High Authority, stated in 1952 his expectation that "the fusion (of economic functions) would compel nations to fuse their sovereignty into that of a single European State. 9 " The United Kingdom, invited to join only after the proposal had been made public, decided to remain outside. 10 In 1954, European integration efforts hit a first roadblock, when the French National Assembly failed to support the creation of a European Defense Community. Defense cooperation shifted to the North Atlantic Treaty Organization (NATO) in 1955 when Germany joined the organization founded seven years earlier by Belgium, Canada, Denmark, France, Iceland, Italy, Luxembourg, the Netherlands, Norway, Portugal, the United Kingdom, and the United States. The Suez crisis in 1956, where France and the United Kingdom were forced to abort their intervention under pressure from the United States, was interpreted by the French as a clear sign that European integration was necessary to create a power base independent from the United States. The Emergence of the European Community In 1957, the six European Coal and Steel Community (ECSC) member countries signed the Treaties of Rome to create the European Economic Community (EEC) and EURATOM (see Exhibit 7 for a timeline of European integration) and lay the foundations of an ever closer union among the peoples of Europe." 11 The two new institutions were each headed by a Council of Ministers as the legislative body, supported by a Commission as a secretariat and executive body. In the policy areas covered by the Treaties of Rome the Council took decisions with qualified majorities that were legally binding for all member countries. A European Parliamentary Assembly, renamed to European Parliament five years later, was created with members delegated from national parliaments. The European Court of Justice was created to interpret European laws and treaties. Each member country delegated one judge to the Court. (See the Appendix for a more detailed description of European institutions). 5

708-421 European Integration: Meeting the Competitiveness Challenge The EEC aimed to create a common market through the elimination of all internal tariffs, the use of a common external tariff for manufactured goods, and common policies on agriculture. This would give the increasingly strong German manufacturing industries (the German economic miracle or Wirtschaftswunder was in full swing) better access to European markets, provide the French agricultural sector with stable market conditions, and enable everyone to participate in the higher growth that the integrated market would fuel. The elimination of internal tariffs on goods and adoption of common external tariffs, to be implemented for all goods by 1969, became a reality 18 months ahead of plan. The Treaty also defined guidelines for a European competition policy that were clarified through specific regulations in 1962. 12 The Commission had jurisdiction when a cartel or an abuse of dominant market positions affected cross-border commerce; otherwise national competition authorities retained responsibility. Exceptions could be granted, however, when the collaboration of companies was considered to have strong economic benefits, such as encouraging innovation. The common agricultural policies (CAP), in effect since 1962, defined intervention prices at which the Commission would buy any surplus production if market prices approached them 13, set import tariffs to secure a price advantage for products from EEC member countries, and provide subsidies for the production of specific crops. Surplus production was sold using export subsidies or destroyed. In the following years, agricultural production and productivity increased rapidly and the EEC moved from being a net importer of agricultural products to one of the largest exporters. EURATOM provided a platform for joint activities to promote the economic use of atomic energy. It became one of the first area in which European institutions supported cross-border cooperation in research activities. Most of them, like the European Space Research Organization founded in 1962, had a membership that went beyond the membership of the EEC. At this time, the EEC itself had no research policy activities of its own. In 1967, the ECSC, the EEC, and EURATOM were merged to create the European Community (EC), a name chosen to symbolize that the ambitions of European integration went beyond economics. The executive branches of the three institutions were merged as well, creating the Commission of the European Communities. The 1950s and 1960s were a period of strong economic growth in Western Europe (see Exhibit 8). In 1950, when Europe was still reeling under the devastation of World War II, European GDP per capita had been at 52% of the U.S. level. By the end of the 1960s, European GDP per capita had risen to 70% of the U.S. level with an annual GDP per capita growth rate 1.21% higher than registered by the United States. Trade within Europe increased substantially, and labor shortages in Germany and the Benelux countries were eased by labor migration from Southern Europe and, in the case of Germany, from Eastern Germany. Wages remained modest relative to productivity, especially in countries like the Netherlands and Germany that had centralized wage bargaining systems. 14 Economic success made ECC and later EC membership increasingly attractive. In 1960, the United Kingdom had taken the initiative to create the European Free Trade Area (EFTA) with Austria, Denmark, Ireland, Norway, Sweden, and Switzerland. The U.K. government was concerned about the loss of political sovereignty that EEC membership would imply and about the impact of its policies on the Commonwealth. In particular, higher EEC import tariffs on agricultural goods were seen as disadvantaging the United Kingdom s traditional sources of such products from Australia, Canada, and New Zealand. While the United Kingdom remained skeptical about the political integration process, it soon changed its assessment of the economic benefits of EEC membership. Its applications to join the EEC were, however, blocked by a French veto in 1961 and 1967 before the United Kingdom eventually joined in 1973, together with Denmark and Ireland. The new members 6

European Integration: Meeting the Competitiveness Challenge 708-421 were seen as a welcome contribution to economic size, but France in particular was concerned that the new members could bring a more liberal economic philosophy. Later enlargements would expand the EC south to include Greece (1981) as well as Spain and Portugal (1986), countries with young democracies that had just emerged from military dictatorships. While the economic impact of these southern enlargements was small, they fit well with the political ambitions of European leaders to integrate all of Europe. The 1970s brought an end to the strong economic growth in Europe as in many other regions of the world. Macroeconomic volatility increased, fueled by the decision of the U.S. government to abandon the Bretton Woods-System in 1971 and the oil crises in 1973 and 1979. Wage pressure also rose, as unions became more assertive. In the mid-1970s, European leaders set up the European Regional Development Fund. The fund dedicated an initially small share of the EC s budget to poor regions for investments in roads and communications, investment attraction, and job creation. The European Monetary System (1979) In 1975, German Chancellor Schmidt and French President Giscard d'estaing proposed to strengthen macroeconomic coordination through annual meetings of the leaders from the largest economies (the G-7). The European Monetary System (EMS) was created in 1979 to keep exchange rates within predefined bands; Central Banks were required to defend these bands using their foreign exchange-reserves. Initial members were Belgium, Denmark, France, Germany, Ireland, Italy, Luxembourg, and the Netherlands (Spain entered in 1989, and the United Kingdom in 1990). Despite some success in macroeconomic coordination, the late 1970s and early 1980s were a period best remembered for Eurosclerosis, a combination of inflation, unemployment, and low growth. The slow growth experienced globally hit Europe particularly hard. The catch-up to the United States in terms of GDP per capita slowed to a crawl and even reversed in 1982. In 1979, the European Parliament was for the first time elected directly by citizens from all EC member countries. Participation in the elections was lower than in national elections and decreased further in later elections. National political debates often dominated the election campaigns. Political leaders who would dominate European politics for the next decade were elected in the United Kingdom (Thatcher, 1979), France (Mitterrand, 1981) and Germany (Kohl, 1982/83). The initial response of European policy makers to the downturn was defensive: Taxation and social security contributions were increased to sustain the European welfare model. Efforts were launched to reduce working hours and introduce attractive early retirement schemes, hoping that unemployment would fall. 15 Non-tariff barriers and voluntary export restraint agreements were used to limit foreign, especially Japanese, market penetration in sectors such as automobiles and electronics. The economic problems led political leaders to sometimes put national interests first in European negotiations. Heads of state clashed openly in the EC budget negotiations. In March 1984, U.K. Prime Minister Margaret Thatcher famously slammed down her handbag and demanded: "I want my money back!," a wish that was granted two months later when the United Kingdom got an annual rebate on its EC budget contribution. The United Kingdom had argued that it was disadvantaged because it received limited benefits from the EC s agricultural policies which consumed about half of the EC budget. During the 1980s, attempts were made to limit the size of the agricultural budget by introducing production quotas for particular food products (1984) and setting a limit on overall agricultural spending (1988). 7

708-421 European Integration: Meeting the Competitiveness Challenge The Common Market Project (1986) In 1985, Jacques Delors, the powerful French President of the European Commission, proposed the creation of a Single market by January 1, 1993, to further integrate the European economies. The proposal found broad support among EC member countries with differing economic philosophies. Countries like France sought the emergence of larger European firms that could compete more effectively on global markets. Countries like the United Kingdom and Germany welcomed the further opening to competition. The Common Market project was formally ratified in the Single European Act (SEA) of 1986, which called for the implementation of the Four Freedoms : Free movement of goods, services, capital, and people. The influential Cecchini-Report, commissioned by the EC to analyze the economic impact of the common market, forecasted a 2.5% to 6.5% improvement in GDP through better allocation of resources. The SEA set goals but did not define specific policies. The Commission soon started to propose a large number of initiatives to remove physical, fiscal, and technical barriers to market integration. Physical barriers, mainly border procedures, had been justified as necessary for economic, health, and security reasons: Under Article 115 of the EC Treaty (1968), member countries had the right to impose quantitative import quotas on non-member countries, enforce national health standards on incoming goods, and deny free cross-border travel to criminals. 16 Driven by the SEA, Article 115 was modified to allow only the EC as a whole to impose quantitative import restrictions. Remaining border controls for VAT collection and health controls were simplified. The Schengen Conventions, signed in 1990 by Belgium, France, Germany, Luxembourg and the Netherlands, abolished border controls altogether by 1995. By 2002, all EU members (plus Iceland and Norway), with the exception of Ireland and the United Kingdom, became parties to these Conventions that also eliminated passport controls. Fiscal barriers to commerce existed mainly in the form of differences in VAT rates. The Commission proposed to reduce the differences in VAT rates, and the gap between the highest and lowest rate for normal goods shrank from 17% in 1992 to 10% by 1998. 17 Overall tax regimes remained an area of policy firmly under national control. Technical barriers, such as differences in product regulations, import and export procedures, professional standards, competition rules, etc. proved to be by far the most complex area to address. Companies and citizens from member countries already had the right to demand equal treatment according to the local laws in the country in which they operated. EC member countries could not discriminate on the job market, in procurement decisions, or other areas against non-nationals from other EC countries. However, a license to operate or to sell a product in one EC country did not automatically imply the right to do the same in another; each country required an individual approval according to the respective national rules. The Commission proposed that a product should be acceptable everywhere in Europe when it complied with the rules and regulations in one member country. The European Court of Justice supported this view in the famous Cassis de Dijon case. This decision only affected trade in goods, however, and did little to open national markets for services. Competition law was also extended. The 1990 merger regulation clarified the rules covering mergers and acquisitions involving large companies or companies from different member countries. Cross-border mergers had significantly increased in number in the late 1980s. Between 1990 and 1994, 285 merger transactions were notified to the Commission. 18 Throughout the early 1990s, a significant backlog of cases developed. 8

European Integration: Meeting the Competitiveness Challenge 708-421 Since the late 1980s, the Commission had launched a number of directives aimed at the liberalization of regulated markets, especially telecommunications, postal services, transportation, and energy. These markets were historically viewed as either natural monopolies due to economies of scale or strong network effects, or as industries in which the public s interest was preserved by equal access to services across geography and social groups. Across Europe these markets were gradually opened, bringing significant reductions in prices and many new services. Differences in the speed of deregulation across countries, however, often resulted in political friction; in the energy market, for example, German companies complained about acquisitions made by Electricité de France (EdF), the French state-owned near-monopoly utility, in the German market. The Commission started to more aggressively apply competition laws to scrutinize state aid to companies. All such programs by government agencies at all geographic levels had to be approved. State aid to firms was generally prohibited but there were exceptions when state aid contributed to the economic development of disadvantaged regions or facilitated structural change in a region. The Commission aimed to limit competition among regions for foreign investment in the form of attractive financial incentives, and set limits to the level of state aid that could be given and reduced the role of financial aid as a competitive tool for attracting foreign investment. Politically, this often made the Commission the scapegoat for domestic policy makers that had to explain to local constituencies why they could not intervene to subsidize specific jobs and companies. In 1988, the Commission increased funding for its own regional policies, now called Structural Funds. 19 The Commission also started to launch initiatives in many specific industries and policy areas seen as critical for market integration, a process that would occupy the Commission for many years to come. Government procurement, a market which amounted to 12% of European GDP in the late 1980s, was to be opened to EC-wide bidding without national preferences. The proportion of public contracts actually awarded to bidders from other Member States increased from 6% in 1987 to 10% in 1998. The SEA also extended qualified voting in the European Council to issues of work security and health. The United Kingdom had been skeptical, but accepted the decision as part of the overall package to implement the Common Market. In the years that followed, a large number of directives were issued (27 until the end of 2002) and some commentators argued that work security and health were being used as the entry port to address a much wider set of social policy issues that should not be regulated at the European level. 20 Professional training and educational degrees remained a patchwork of national rules. Employees often needed to pass a local exam in order to work in their area of expertise in another EU country. Many such rules and regulations involved regional and local governments as well as industry associations, chambers of commerce, and other public-private bodies. The Commission launched some initiatives, for example the Erasmus program (1987) that provided financing for students studying for up to one year in another EU member country. However, little progress was made in harmonizing national rules and regulations up through the late 1990s. The first large R&D programs were launched in the second half of the 1980s, focused on providing subsidies for research collaboration of companies and research institutions from different European countries. 21 ESPRIT ran from 1984 to 1994 and was focused on microelectronics, a reaction to the perceived gap that had opened up between Europe and its competitors in the United States and Japan in this area. EUREKA was an answer to U.S. President Reagan s Strategic Defense Initiative; it was based on company collaboration supported by groups of national governments with no involvement of the European Commission. The Single European Act provided a legal platform for the Commission to develop more broad-based European R&D programs that were organized in four- 9

708-421 European Integration: Meeting the Competitiveness Challenge year Framework programs. The first Framework programs were focused on basic ( pre-competitive ) research. The increasing role of European policies had led to a growing number of cases being brought to the European Court of Justice. In 1988, a lower court, the Court of First Instances, was created to increase capacity. In the second half of the 1980s, intra-european trade increased and the number of cross-border mergers reached record levels. Europe started to catch-up again with the United States in terms of prosperity and productivity. Labor migration within Europe, however, continued to be low. The Maastricht Treaty and the European Union (1992) The dramatic political changes in the early 1990s the fall of the Berlin Wall in 1989, German reunification on October 3, 1990, the independence of Central and Eastern European countries from Soviet control, and the collapse of the Soviet Union in 1991 transformed Europe. At a number of meetings between 1989 and 1991 European leaders discussed steps for further economic and political integration. French President Mitterrand and U.K. Prime Minister Thatcher were skeptical about Germany s commitment to European integration. German Chancellor Helmut Kohl was determined to further strengthen the ties between the EC member states, and make it easier for Germany s European neighbors to accept German Reunification. The macroeconomic repercussions of German reunification and the collapse of the Soviet Union created a major external shock for the European economies that challenged the existing exchange rate system EMS. Massive fiscal transfers to Eastern Germany increased demand for European, especially German, products and services. The German Central Bank (Bundesbank) raised interest rates to limit the inflationary pressure. With other European currencies tied to the Deutschmark through the EMS, the German move created pressure on other countries to also raise interest rates, threatening to create recessions in those countries. A dramatic currency crisis in September 1992 forced the British Pound out of the EMS that it had only joined in 1990. High interest rates and resulting strong currencies dampened domestic as well as foreign demand for European goods and services, and labor market conditions in many European countries deteriorated. On February 2, 1992, the Treaty on the European Union was signed in Maastricht (Netherlands). The treaty defined the establishment of an economic and monetary union and the development of the social dimension as two of its key objectives. Chancellor Kohl commented in April 1992 that "the European Union Treaty introduces a new and decisive stage in the process of European union, which within a few years will lead to the creation of what the founding fathers dreamed of after the last war: the United States of Europe." 22 The Treaty on the European Union laid down the core objectives for the Union, including the goal to promote economic and social progress and a high level of employment and to achieve balanced and sustainable development, in particular through the creation of an area without internal frontiers, through the strengthening of economic and social cohesion and through the establishment of economic and monetary union, ultimately including a single currency in accordance with the provisions of this Treaty. (Article 2) The treaty defined Foreign and Security Policy, Justice and Home Affairs, and Economic and Social Policies as the three pillars of EU policies. It introduced the EU citizenship and confirmed the EU s acquis communautaire, the collection of previously established EU rules and regulations. The objectives of the treaty were not radically different from the objectives laid down in earlier treaties. In fact, new treaties never replaced older ones, but updated them with new descriptions of European areas of responsibility, and of the organizational structures and responsibilities to govern them. 10

European Integration: Meeting the Competitiveness Challenge 708-421 The EU Treaty set out to establish a European Monetary Union (EMU), with a common currency to be called the Euro. The EMU proposed one currency instead of the system of national currencies with mechanisms to limit exchange rate movements among them. Monetary policy would be set by a European Central Bank, a politically independent institution with representation from the Central Banks of each of the nations that adopted the Euro. Article 105 of the EU-Treaty stated that the primary objective of the ECB shall be to maintain price stability. To insure this stability, prospective member nations had to meet a number of criteria: an inflation rate below 2%, a government deficit below 3% of GDP, public debt below 60% of GDP, and a history of stable exchange rates within the EMS. In 1996, these rules were strengthened under German pressure through the European Growth and Stability Pact, a system of controls that monitored public sector debt and deficits and empowered the EU to impose hefty fines on countries that missed the deficit and debt targets repeatedly. Throughout the second half of the 1990s, most EU countries made progress on lowering public deficits 23 and inflation. In May 1998, eleven members of the EU (Austria, Belgium, France, Finland, Germany, Ireland, Italy, Luxembourg, 24 Netherlands, Portugal, and Spain) were selected to enter the EMU (Greece would enter in 2001). Not all of these countries met the strict criteria for EMU membership (Italy and Belgium, for example, had public debt in excess of 100% of GDP) but membership was granted on the basis of progress putting these nations into compliance. Exchange rates defining the value of the common currency were fixed on January 1, 1999, and Euro banknotes and coins began circulating on January 1, 2002. The EU Treaty required the Union and its Members to ensure that the conditions for the competitiveness of [European] industry exist. 25 In the following years, the Commission started to draft policy papers on SME development, information society, innovation, and other measures to improve the general business environment, including the identification of so-called Trans European Network projects to close gaps in cross-border infrastructure. The funding available at the EU level for these measures was limited and the Commission largely focused on persuasion and policy dialogue with the member countries. 26 The EU Treaty also increased the role of European regional policies. At the Edinburgh Council in December 1992, the EU tripled the money allocated to Structural Funds and Cohesion Funds, the key instruments to support cohesion, the catch-up of poorer regions to the European average. The funds provided co-financing for infrastructure investments, SME development, investment incentives, and other local economic development efforts. They became the second largest item in the EU budget, accounting for about one-third of all spending. Structural funds provided up to 50% cofinancing development for eligible projects in regions lagging the EU GDP per capita average by more than 25% (so-called objective 1 regions) or facing economic difficulties from structural change (objective 2 regions). The Cohesion Fund, somewhat smaller in size, financed up to 85 % of eligible expenditures in countries with less than 90% of EU average per capita gross national product. Spain, Greece, Portugal and Ireland were eligible for cohesion funds initially, but Ireland was removed from the list by 2004 after reaching a prosperity level above the EU average. Later treaties clarified the institutional structures (Treaty of Amsterdam, 1997) and voting rules (Treaty of Nice, 2001). The increasing role of the EU in many policy areas was matched by efforts to strengthen the political structures of the Union to create more political accountability and legitimacy in the eyes of the European public. The ability of member countries to veto EU decisions was limited to fewer policy areas, and the authority of the European Parliament was strengthened. The rights of EU citizens to appeal decisions made by their own governments, and the right of the EU to appeal to the European Court, were strengthened. These changes ultimately reduced national sovereignty of EU member countries relative to decision powers of EU institutions. However, the number of cases in which individual countries were not willing to accede increased. 11

708-421 European Integration: Meeting the Competitiveness Challenge In the area of social policy, most EU member countries had wanted the Maastricht Treaty to extend majority voting to larger areas of labor relations, including work conditions and gender equality (but not wages or industrial action). The United Kingdom, however, refused to agree and these rules became part of a separate agreement, the Social Charta, signed by all other EU member countries. 27 In the following years, the Social Charta became the basis for a number of politically controversial directives, like setting up European-wide standards on part time work. 28 In 1997, a new U.K. government signed the Social Charta and ended the opt-out. In the mid-1990s, changes were made to the common agricultural policies (CAP), which had come under increasing criticism in the Uruguay-Round discussion on trade liberalization. Intervention prices were reduced and further constraints were imposed on total production, reducing the amount of exports at subsidized prices. Farmers compensation shifted to direct income support, so the cost of the CAP moved from consumers paying higher prices to tax payers; the CAP budget rose by 24% between 1992 and 1996. With worsening economic conditions and rising unemployment in the middle 1990s, political pressure increased to address labor market issues on the European level. Labor markets were an area that had remained largely under the control of national governments. Wage bargaining structures, the availability of unemployment benefits, and the extent of efforts to match jobs with applicants differed widely across countries. The Amsterdam Treaty of 1997 confirmed national sovereignty over labor market policies, but in article 126a also declared that employment as a matter of common concern. The Luxembourg Jobs Summit in 1997 identified four employment policy action areas for increased co-operation among EU member states: Employability, entrepreneurship, adaptability, and equal access. Many member states subsequently increased the share of their labor market expenditures for so-called active labor market policies such as training and temporary wage subsidies for hiring long-term unemployed. 29 Skills were identified as another critical area to address Europe s labor market challenges, giving new life to the efforts for integrating European rules and regulation for education and training. In 1999, the Bologna declaration launched a concerted effort for higher education that would lead to common standards in terms of degrees and educational programs. 30 Three years later, a similar effort was launched in the area of vocational training and life-long learning. Regulations for hiring and firing (Exhibit 9) and the level of unemployment benefits, however, remained areas with strong national differences. 31 On January 1, 1995, Austria, Finland, and Sweden joined the European Union. 32 All three were small, prosperous, and had been non-aligned in the East-West conflict. After the collapse of the Soviet Union they joined the EU while remaining outside of NATO. Economically they had been part of a Free Trade area with the EU for many years through their membership in EFTA. EFTA members Iceland, Norway, and Switzerland remained outside of the EU but implemented many of the EU s policy decisions and participated in many of its programs. Throughout the second part of the 1990s the EU also entered intensive negotiations with eight formerly Communist countries from Eastern and Central Europe (plus Malta and Cyprus) which were invited to apply for membership in 1993. They would be accepted for entry at the 2002 European Summit in Copenhagen, effective May 1, 2004. In early 1995, Jacques Santer, the former Prime Minister of Luxembourg, succeeded Jaques Delors as President of the European Commission. Santer was a compromise candidate between those that wanted Delors push towards stronger European institutions to proceed and others that wanted the EU to become a larger but less integrated entity. The Santer Commission suffered from its lack of clear support from member countries and was eventually forced to resign in 1999 amidst allegations of corruption. 12

European Integration: Meeting the Competitiveness Challenge 708-421 As reforms slowly made their way through European and national implementation, intra-eu trade of goods and services grew by 3.9% annually from 1992 to 2002, reaching a value of $1.889 trillion or 21.9% of 2002 EU GDP. Exports to countries outside the EU accounted for 14.5% of EU GDP. The volume of European mergers increased rapidly; while the Commission was notified of 12 mergers in 1991, the number increased to 212 in 2003, after having peaked at 345 in 2000. The 1990s saw significant improvements in public sector balances and inflation rates. Labor mobility remained limited, particularly across borders but even within member nations. EU countries experienced far less internal migration than, for example, the United States. Countries and regions had tended to become more specialized and thus more heterogeneous over time. In terms of regional growth rates, there were signs of convergence. Initially poorer countries such as Spain and Ireland made progress in reaching or even surpassing the average level of prosperity in the EU. The Lisbon Agenda (2000) The U.S. economy experienced a period of strong growth in the second half of the 1990s, and European economies proved unable to keep up. The U.S. economy pulled ahead in terms of growth of GDP, GDP per capita, and, for the first time, GDP per employee and per hour worked. Europe also continued to register a decrease in the number of hours worked per employee while labor mobilization was still growing in the United States, further widening the GDP per capita growth gap. In the past, higher U.S. growth rates had been the result of higher immigration and increasing the participation of women in the labor market, while Europe depended on growth in labor productivity (Exhibits 10-12). After 1995, the United States experienced stronger labor productivity growth as well, often linked to the so-called New Economy. A number of EU reports highlighted the lower productivity growth in sectors related to information technology as an important source for the increasing productivity gap. A new group of European political leaders came into power in the latter 1990s. Jacques Chirac became French President (1995). Tony Blair in the United Kingdom (1997) and Gerhard Schröder in Germany (1998) led center-left parties to win elections in countries that had been dominated by center-right parties for more than a decade. Romano Prodi, former Italian Prime Minister and also from the center-left, became President of the European Commission in 1999. Prodi attempted to halt the erosion of the power of the Commission to shape policies. While European institutions were getting stronger legally, EU member countries and their leaders were reasserting their influence and becoming less willing to support joint EU policies if their national constituencies did not support them. At a special meeting of the European Council in Lisbon in March 2000, European leaders set a new strategic goal to become the most competitive and knowledge-based economy in the world economy. The Council noted the opportunities of globalization for Europe with its stable macroeconomic, political, legal, and social context as well as its high levels of workforce skill, but acknowledged the apparent failure of European economies to keep pace with the United States. European growth was insufficient and the employment rate was unacceptably low. The Lisbon Agenda included specific recommendations in two broad areas (Exhibit 13): 33 The first was the transition to a competitive, knowledge-based economy, based on improving the use of information technology, boosting research and development, and strengthening the coordination of fiscal policies. The second focus was on modernizing the European Social Model by making additional investments in education, strengthening labor market policies, and modernizing the systems of social protection. 34 The Lisbon Agenda defined an average annual growth of 3% as a realistic medium-term goal for Europe and concrete quantitative targets in areas such as, for example, raising the employment rate from 61% of working age population in 2000 to 70% by 2010 and 13

708-421 European Integration: Meeting the Competitiveness Challenge increasing overall R&D spending from less than 2% to 3% of GDP over the same timeframe. Target dates were set for specific action plans and reports. The Commission reviewed how its existing policies needed to be extended or adjusted. But European leaders realized that the responsibility for many important areas rested primarily with EU member countries. 35 It recognized that changes in one member country in the direction outlined by the Lisbon Agenda would be more effective if parallel efforts were under way in other member countries. 36 The EU thus devised the open model of coordination to encourage and improve national policies based on joint learning and benchmarking of best practices across Europe. Countries were free to define their own goals and action priorities, informed by the experience of others, and would then report on their achievements to the Commission at the annual Spring Meetings of the European Council. The Commission had no executive powers, but its benchmarking reports as well as its ability to provide funding for specific areas could influence member countries. The Commission published Broad Economic Policy Guidelines and Employment Guidelines that presented its view on appropriate policies. The Commission would prepare assessments of progress based on socalled structural indicators compiled by Eurostat, the European statistical office. Innovation policy was an example for these mechanisms at work. The Commission strengthened its existing policies, in particular the 6 th Framework Program to increase funding for cross-national research efforts in seven thematic areas (Biotech, ITC, nanotechnology/new materials, aeronautics/space, food safety, sustainable development, and social sciences) and support the mobility of researchers. The ambition was to use this funding ($23.5 billion ( 17.5 billion) spent over four years) to increase the level of cross-border cooperation among European researchers and move towards an integrated European Research Area. 37 Compared to previous Framework programs, the focus was now more on diffusion and market use of new technologies, not just invention. Funding moved increasingly to networks of excellence of strong research centers rather than allocating spending equally across all parts of Europe. The Commission also aimed to improve the innovation policy activities of member countries. It compiled annual reports on innovation performance across member countries, and organized assessments and workshops on specific national innovation policies to spread best practice. And it engaged member countries in discussion on their efforts to achieve an increase in overall R&D spending to 3% of GDP. The Commission prepared a Charter for Small Enterprise (Santa Maria de Feira, June 2000), a Strategy for eeurope (Seville, June 2002), and a Green Paper on Entrepreneurship (Brussels, January 2003) to encourage EU member countries to pursue more active entrepreneurship policies. It also launched the Multiannual Programme for Enterprise and Entrepreneurship 2001 2006 (MAP) that included the creation of European Info Centers to give SMEs better access to European institutions, a number of financial schemes by the European Investment Bank to improve access to risk capital, and projects to improve the dialogue on enterprise policy with member countries. 38 A 2002 Commission Paper on Industrial Policy provided the context for initiatives in, among others, pharmaceuticals ( G10 Medicines initiative ), aerospace ( STAR 21 ), and shipbuilding ( LeaderShip 2015 ). High-level groups of politicians and industry leaders analyzed these sectors and developed action recommendations to increase their competitiveness. The idea was to enable a more productive dialogue between companies and the public sector about competitiveness, though none of these recommendations were binding. The Commission also continued its existing efforts to integrate European markets, publishing a new Internal Market Strategy in 2003. There was a push to increase financial market integration, where integration had been much slower than in other parts of the economy. A Financial Services Action Plan was proposed in 2002, but progress was slow as some countries were concerned about foreign takeovers of their domestic banks. Cross-border trade of services, which by 2004 accounted 14

European Integration: Meeting the Competitiveness Challenge 708-421 for more than twice as much of European GDP as manufacturing, had been generally left out of previous integration efforts. So-called block exemptions that had exempted some industries from the general rules of the competition law were reviewed. In July 2002, the Commission approved new regulations that removed barriers to cross-border sales and multi-brand dealerships. 39 Overall, there was increasing convergence between the Europe and the United States in competition law and its application. Other changes motivated by Lisbon included additional investments to improve European networks for transportation, communication, and energy. There were numerous plans to improve entrepreneurship and reduce the regulatory burdens on especially small- and medium-sized businesses. In 2002, the European Commission also launched an expert group on clusters, documenting the numerous different approaches towards cluster development in the member countries. 40 Some countries, like Austria, Denmark, Finland, and Spain, had extensive experience with cluster initiatives, while others had only recently engaged in such efforts (United Kingdom, Sweden) or had no clear cluster development strategy (Germany). While no specific cluster-based policy was recommended to the Commission, the group called for a higher level of co-ordination across Europe on policies that had a clear cluster focus. The efforts of the European Commission to implement the Lisbon Agenda got mixed reviews throughout Europe: While member countries supported the investments in infrastructure, innovation, skills, and other areas, there was less consensus about Commission policies forcing countries to expose domestic companies to more competition or limit the ability of governments to support troubled domestic companies. The Sapir-Report, 41 an analysis of EU policies prepared for the Commission by a group of leading European economists, pointed out the discrepancy between the goals of the Lisbon Agenda and an EU-budget that allocated 40% of all funds to agriculture. In mid-2003, EU farm ministers adopted a reform of the common agricultural policies (CAP) to cap the absolute size of the agricultural budget and move spending almost entirely from subsidies for specific crops to subsidies tied to farm land. The new scheme would be gradually introduced between 2005 and 2012 to take farm land out of production. The EU structure had made clear delineation of responsibilities at the European, national, regional, and local level difficult. This had motivated the decision to establish a European Convention with the task of drafting a European constitution. The aim was to provide more clarity in the governance structure, while sending a signal that Europe was moving towards closer integration. Former French President Giscard d'estaing, who chaired the Convention from its start in 2002, faced opposing views on what the constitution should do: Some groups wanted to roll back EU responsibilities because its policies in areas like environmental protection or labor markets were seen as either too restrictive (a position popular in the United Kingdom) or too lenient (a view often heard in Scandinavia). Others, however, saw further harmonization as critical to avoid politically harmful competition within Europe; the Eastern European countries about to join the EU with their lower taxes and non-wage labor costs were seen as particular problematic by many in the old EU member countries. Europe in 2004 In 2003, the average European GDP per capita was at about 73% of the U.S. level, down from 80% in 1982. GDP per employee in Europe was at 77% and GDP per hour worked was 90% of the U.S. level. The Commission noted that the growth rate in productivity per employed person in Europe has been 15

708-421 European Integration: Meeting the Competitiveness Challenge going down since the mid-nineties and is now fluctuating between 0.5% and 1% versus 2% in the United States. As a result, the EU s efforts to catch up with the U.S. are at a standstill. Progress in a number of key policy areas related to the Lisbon Agenda was limited and differed widely among member countries. 42 The growth rate of manufacturing trade within the EU had fallen since the mid-1990s, and had even become negative in 2002. In 2002, 60% of all EU member countries exports went to other EU countries, down from close to 64% in 1992. 43 Price convergence, the difference between the highest and lowest price for a particular good across all EU member countries, had almost halted since 2000 even though price differences across regions continued to be about 20% higher than in the United States. In groceries and transportation, price differences across regions were more than 80% higher in the EU than in the United States. Opening of national markets in services was still limited; the EU Commission considered 53.6% of the EU market for services not integrated. Between 60 and 70% of EU member countries GDP was generated in services, but the need for national registration and many other administrative barriers continued to inhibit cross-border competition. The Commission had published reports about the service markets in 2001 and 2002 and was expected to submit a draft proposal for a Service Directive in 2004. European spending on R&D had edged up to 1.95% of GDP from 1.88% in 2000. 44 The gap of R&D spending as a share of GDP between the EU-15 and the United States had widened since 2000, driven by increasing public R&D spending in the United States, an area in which Europe had traditionally been in the lead. Especially in areas like patenting, the Nordic countries were outperforming other European peers. Overall, the EU had been stagnant on a composite index of innovation capacity compiled by the European Commission, while both the United States and Japan were on an upward trend. A symbol of this lack of progress was the failure to agree upon a European Patent. After decades of negotiations and a renewed push from the Commission, discussions had still not led to an agreement By the end of 2003, 70 directives had been adopted under the Lisbon Strategy, 40 of which were due for implementation by member countries. In its tracking of the Lisbon Strategy, the EU Commission reported that on average 58% of the directives had been implemented per country, and just seven directives had been implemented by all EU countries. A report by the European Commission noted that measures taken at the European level are only part of the formula for putting the Lisbon strategy on the right track; numerous reforms and investments, which are the responsibility of the Member States, have yet to be achieved. 45 Politically, the year 2003 had been a particularly difficult one. Germany and France had reported budget deficits above the 3% of GDP level laid down in the Stability and Growth Pact. In a controversial meeting in November 2003, the Finance ministers of EU member countries, a group including the representatives of France and Germany, had decided not to impose fines on the two countries as the Pact had demanded. The economic outlook for 2004 remained weak, and there was an increasing danger that Europe would lose momentum on macroeconomic policies. In December 2003, the Intergovernmental Conference was supposed to agree on the draft European constitution ended with the terse note that it was not possible to reach an overall agreement at this stage. The accession of ten new members was to occur on May 1, 2004. All structural funds were to be diverted to the new members and significant pressure would be added on the funds available for agricultural policy; developments that seemed unacceptable to many old member countries. New rules on the number of EU Commissioners representing the new member state as well as on the voting weights in the European Council had been agreed upon in the 2001 Nice Treaty. 16

European Integration: Meeting the Competitiveness Challenge 708-421 Bertie Ahern, Ireland s Prime Minister and President of the European Council, and his colleagues were also increasingly worried about changing attitudes towards Europe among the European public. While voters had for many years supported further European integration and had given politicians much leeway in pursuing policies along this path, the mandate of the electorate seemed to be wearing thin. Regular opinion polls by the European Commission suggested that support for European integration and its institutions were falling in many member countries. The future course of European integration was anything but clear. 17

708-421 European Integration: Meeting the Competitiveness Challenge Exhibit 1 European Union Members and Applicants, 2004 Finland Sweden Estonia Ireland United Kingdom Denmark Netherlands Latvia Lithuania Germany Poland Belgium Lux. Czech R Ṡlovakia Austria France Hungary Slovenia Romania Portugal Spain Italy Greece Bulgaria Turkey 13 Source: Adapted from http://ec.europa.eu/economy_finance/euro/origins/accession_map.gif, European Commission, 2006. Note: Acceding and Candidate Countries in Italics. 18

European Integration: Meeting the Competitiveness Challenge 708-421 Exhibit 2 Population, prosperity, size of the economy: European countries and global peers in 2004 Population (millions) GDP (PPP, in millions USD) GDP per capita (PPP, in USD) Austria 8.2 $270,207 $33,608 Belgium 10.3 $327,995 $32,192 Denmark 5.4 $175,162 $33,335 Finland 5.2 $164,571 $31,952 France 60.4 $1,907,108 $32,075 Germany 82.4 $2,438,524 $29,904 Greece 10.7 $247,083 $23,947 Ireland 4.0 $151,172 $39,981 Italy 58.1 $1,666,821 $28,760 Luxembourg 0.5 $26,848 $60,049 Netherlands 16.3 $528,782 $32,618 Portugal 10.3 $209,329 $20,474 Spain 40.3 $1,131,547 $29,044 Sweden 9.0 $285,022 $32,601 U.K. 60.3 $1,953,626 $32,952 EU-15 381.3 $11,483,798 $30,117 Cyprus 0.8 $16,540 $21,316 Czech Republic 10.2 $196,989 $19,226 Estonia 1.4 $18,940 $13,652 Hungary 10.0 $170,298 $16,975 Latvia 2.3 $27,951 $11,953 Lithuania 3.6 $46,160 $12,863 Malta 0.4 $7,549 $19,010 Poland 38.6 $504,501 $13,078 Slovak Republic 5.4 $80,504 $14,837 Slovenia 1.9 $42,751 $22,248 NMS-10* 74.7 $1,112,183 $14,891 EU-25 456.0 $12,595,981 $27,623 Japan 127.3 $3,892,780 $30,572 U.S. 293.0 $11,960,926 $40,818 Source: Compiled by casewriters using data from Groningen Centre for Development and Growth, Conference Board (2006). *NMS = New member states 19

708-421 European Integration: Meeting the Competitiveness Challenge Exhibit 3 Business competitiveness, ranking of European countries and global peers, 2004 Business Competitiveness Index Business Environment Quality Company Sophistication EU-15 Finland 2 1 7 Germany 3 5 1 Sweden 4 6 5 United Kingdom 6 4 8 Denmark 7 3 9 Netherlands 9 9 6 France 12 16 10 Belgium 14 19 11 Austria 16 17 14 Ireland 22 22 22 Spain 26 26 25 Portugal 32 30 41 Italy 33 41 26 Greece 39 40 39 NMS-10 Estonia 27 24 33 Slovenia 30 32 27 Czech Republic 34 35 31 Lithuania 35 33 36 Slovak Republic 38 37 40 Hungary 40 36 47 Cyprus 43 39 56 Latvia 47 46 50 Malta 48 47 57 Poland 55 62 46 Top global peers United States 1 2 2 Switzerland 5 7 4 Japan 8 11 3 Singapore 10 8 13 Hong Kong SAR 11 10 15 Australia 13 12 19 Canada 15 13 16 Taiwan 17 20 12 New Zealand 18 15 20 Iceland 19 18 17 Norway 20 14 23 Source: Compiled by casewriters using data from Global Competitiveness Report 2004-05. 20

European Integration: Meeting the Competitiveness Challenge 708-421 Exhibit 4 Strengths and weakness of the business environment: Europe, the U.S., and Japan, 2004 Rank among 93 countries (rank 1 is best in the world) 1 10 EU-15 United States Japan 20 30 Clusters Competition Infrastructure Demand Condition Source: Case writer, based on Global Competitiveness Report 2004-05 Technology Capital Markets Skills Incentives Administration MOC European Competitiveness 04-05-04 CK 8 Copyright 2007 Professor Michael E. Porter Source: Case writer based on Global Competitiveness Report 2004-05. 21

708-421 European Integration: Meeting the Competitiveness Challenge Exhibit 5 R&D Spending over time in selected countries Source: European Commission, 2006. Note: Japan and Finland record almost identical figures. 22

European Integration: Meeting the Competitiveness Challenge 708-421 Exhibit 6 International patenting rates in selected countries Source: USPTO, 2004. Note: EU-15 member countries in solid color. 23

708-421 European Integration: Meeting the Competitiveness Challenge Exhibit 7 Milestones in European Integration Emergence of the European Community European Monetary System Common Market Maastricht Treaty Lisbon Agenda 1973 Northern Extension: 1981 1 st Southern Extension: 1986 2 nd Southern Extension: 1995 Ex-EFTA Extension: 2004 / 2007(?) Eastern Extension: Denmark, Ireland, UK Greece Portugal, Spain Austria, Finland, Sweden Eastern European countries 1957 Treaty of Rome 1968 Creation of the European Community (EC) 1979 European Monetary System 1986 Single European Act 1991 Maastricht Treaty 1997 Stability and Growth Pact 1999 EMU: Fixing of Exchange Rates 2000 Lisbon European Council MOC European Competitiveness 04-05-04 CK 2002 EMU: Euro coins in circulation 18 Copyright 2007 Professor Michael E. Porter Source: Case writer. 24

European Integration: Meeting the Competitiveness Challenge 708-421 Exhibit 8 European and U.S. prosperity over time GDP per capita, US-$, PPP-adjusted 45,000 GDP per capita, EU-15 as % of US 85% 40,000 80% 35,000 30,000 EU-15 in % of U.S. (Right Hand axis) United States (Left Hand axis) 75% 70% 25,000 65% 20,000 60% 15,000 55% 10,000 5,000 EU-15 Countries (Left Hand axis) 50% 45% 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 40% Source: Groningen Centre for Development and Growth, Conference Board (2006), case writer s calculations. 25

708-421 European Integration: Meeting the Competitiveness Challenge Exhibit 9 Flexibility of labor market regulations, 2004, selected countries Flexibility of labor market regulations, 2004 high EU members EU accession countries Other countries low U.S. Slovakia Denmark Switzerland Belgium UK Japan Czech Rep. Source: Compiled by casewriters using data from World Bank (2004). Ireland Norway Poland Austria Hungary Lithuania Netherlands Sweden Estonia Finland Latvia Italy Slovenia Germany Portugal France Greece Global average Spain 26

European Integration: Meeting the Competitiveness Challenge 708-421 Exhibit 10 Labor, market indicators, 2004, selected countries Age Group 15-64 in % of total Population Employment Rate, age group 15-64 Employment Rate, age group 55-64 Unemployment Rate, age group 15-64 Unemployment Rate, age group 15-25 EU-15 63.1% 64.7% 42.5% 8.0% 16.8% Austria 63.9% 68.5% 27.2% 3.9% 5.6% Belgium 61.4% 55.7% 22.5% 9.7% 22.9% Denmark 62.1% 72.3% 50.9% 6.7% 9.6% Finland 62.9% 60.3% 33.2% 15.4% 29.7% France 60.8% 59.1% 29.6% 11.1% 27.0% Germany 62.8% 64.7% 36.6% 8.0% 14.9% Greece 64.2% 54.2% 40.1% 9.2% 28.5% Ireland 65.4% 53.0% 38.8% 12.3% 19.5% Italy 61.7% 51.4% 29.3% 11.2% 30.3% Luxembourg 63.9% 59.9% 23.5% 2.9% 7.2% Netherlands 64.1% 64.0% 29.1% 6.6% 11.4% Portugal 63.7% 64.1% 46.8% 7.3% 16.5% Spain 64.4% 46.1% 32.6% 18.4% 39.7% Sweden 59.8% 70.2% 62.0% 8.8% 19.1% United Kingdom 61.5% 67.9% 47.4% 8.5% 15.3% United States 66.2% 71.5% 59.9% 5.5% 4.7% Japan 66.6% 69.3% 63.0% 4.7% 4.2% Source: Eurostat, U.S. Census, Japanese Ministry of Internal Affairs (2006). 27

708-421 European Integration: Meeting the Competitiveness Challenge Exhibit 11 Labor Productivity (GDP per hour worked) over time, EU-15 versus the United States GDP per hour worked US-$, PPP-adjusted 50 GDP per hour worked, EU-15 as % of US 110% 45 100% 40 35 EU-15 In % of U.S. (Right Hand axis) 90% 30 80% 25 20 70% 15 60% 10 5 EU-15 Countries (Left Hand axis) 50% 0 40% 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: Groningen Growth and Development Center/The Conference Board (2006), case writer s calculation. 28

European Integration: Meeting the Competitiveness Challenge 708-421 Exhibit 12 Labor Mobilization (Hours worked per capita) over time, EU-15 versus the United States Hours worked per Capita gap in %, EU-15 versus the U.S. 30% 20% 10% 0% Employees as % of Population -10% -20% Hours per Employee -30% 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: Groningen Growth and Development Center/The Conference Board (2006), case writer s calculation. 29

Exhibit 13 Action items in the Lisbon Agenda Transition to a Knowledge-based Economy Source: Lisbon European Council, Presidency Conclusions, Lisbon: 2000. Modernizing the European Social Model 708-421 -30-