The Draghi Report: A Strategy to Reform the European Economic Model

Commentary by Federico SteinbergandMax Bergmann

Published October 2, 2024

The long-awaited Draghi report could serve as a roadmap for the new European Commission by proposing radical changes to the European Union's economic policy. The author, former prime minister of Italy and former president of the European Central Bank, Mario Draghi, has enormous prestige and legitimacy, and his proposals-although not necessarily new-are detailed, courageous, and ambitious and point out that the only possible way forward for the European Union is through greater integration. It is now up to the member states-some of which are very reluctant to accept far-reaching reforms, cede competencies, or coordinate policies-not to block them and to finance them adequately.

On September 9, Draghi presented his report "The Future of European Competitiveness," a 400-page document, ordered by the president of the European Commission Ursula von der Leyen. Its publication comes only months after the presentation of the Letta report, written by Italy's other former prime minister, Enrico Letta, which proposed deep changes to the European Union's internal market. However, Draghi's text is far more strategic and ambitious, addressing three key challenges for the European Union: closing the innovation gap with the United States, harmonizing decarbonization with competitiveness, and enhancing economic security by reducing dependencies.

The report acknowledges that the era in which the European Union relied on cheap Russian energy, boundless Chinese markets, and U.S. security is over. Combined with Europe's declining competitiveness and lagging in the fourth industrial revolution, the European Union needs a profound rethink of its growth model. While the diagnosis of Europe's competitive gap with the United States and China isn't new, Draghi's detailed proposals offer a road map for the next five-year term of the European Commission.

Innovation, Decarbonization, Competitiveness, and Security

The Draghi report comes at a moment of uncertainty about Europe's economic future. There are well-founded fears that Europe is losing economic ground to the United States and China, despite commentators' overstatement that Europe remains wealthy and prosperous. The return of expansive industrial policy by the United States and China has caught the European Union flat-footed. Europe's economic model has been premised on establishing an open and competitive market that benefits from free trade in a rules-based international system. Yet the emergence of expansive industrial policy in the United States and China, the corrosion of multilateral institutions, the focus on economic security, and the relatively slower productivity growth in Europe compared to the United States have led to significant concerns about the viability of Europe's economic approach.

In various steps, Draghi proposes an economic paradigm shift for Europe. He notes that there are significant economic deficiencies in Europe's economic makeup. Notably, there is insufficient investment in Europe, both public and private. European growth has been undermined by austerity economics following the 2008 financial crisis and the lack of a significant EU fiscal capacity. Additionally, there are deficiencies in Europe's single market, as Europe lacks an integrated capital market, meaning Europe lags behind the United States in venture capital investment.

The first challenge is innovation. Draghi notes Europe's strong innovation capacity but highlights that over one-third of its corporate "unicorns" relocate abroad, primarily to the United States, due to regulatory, financial, and training barriers. To bridge this gap, the report proposes several measures: creating a European Advanced Research Projects Agency (ARPA), incentivizing business angels and seed capital, involving the European Investment Bank, reforming pension plan regulations to channel European savings toward investment, and simplifying the research and development (R&D) framework program. It also suggests enhancing academic excellence, investing in research infrastructure, increasing R&D spending, and fostering a more innovation-friendly regulatory ecosystem. A focus on lifelong learning to upgrade workers' skills is also emphasized.

The second challenge is aligning decarbonization with competitiveness. The energy crisis has led to significantly higher energy costs in Europe, which is undermining European competitiveness. Thus, the effort to decarbonize is an economic necessity. Draghi argues that decarbonization can boost competitiveness if well-managed but risks undermining it if it is poorly executed, especially if dependent on subsidized Chinese technologies. With European firms already facing higher energy costs than their U.S. counterparts, this disparity threatens growth if clean energy benefits do not lead to lower prices. Draghi advocates for a reform of the European electricity market to pass decarbonization benefits to consumers and suggests European-level industrial policies in clean technologies and electric vehicles to maintain a level playing field. The report details sector-specific competitiveness measures for energy, clean technologies, key raw materials, automotive, pharmaceuticals, transport, aerospace, and high-tech sectors.

The third challenge lies in investing and integrating Europe's defense industry. The report gives a brutally frank assessment of the poor state of Europe's defense industrial sector. Analyzing the sector through an economist's lens, Draghi highlights the sector's intense fragmentation when what it needs is scale and demand aggregation. Like the EU Defense Industrial Strategy, Draghi also highlights the amount of money spent on procurement outside of the European Union, which is as high as 80 percent. The report calls for more EU funding and an EU Defense Industry Authority to procure on behalf of EU countries, thereby aggregating demand and taking advantage of economies of scale. The report also calls for a European preference principle to "buy European" that could come with incentives-a recommendation that will make U.S. defense companies nervous.

Fourth, on economic security, the report stresses the need for greater EU strategic autonomy and economic security to reduce susceptibility to economic coercion by third countries. This requires increased defense spending, a more autonomous defense industry, and a policy for securing critical minerals. While acknowledging the high costs of autonomy, Draghi suggests mitigating these through cooperation among member states and trade agreements with non-EU member countries. The report also proposes a "foreign economic policy" that involves joint investments and purchases based on the European Union's large internal market. Contrary to U.S. protectionism, Draghi supports free trade agreements as tools to enhance security and derisking.

Financing the Plan

Draghi quantifies the additional annual investment needs at over €800 billion, or about 5 percent of EU GDP. While this topline figure is widely accepted by economists, it remains unclear whether there will be enough viable investment projects to absorb this funding. Financing these investments will require more private resources, which necessitates developing European capital markets and completing the Banking Union, along with greater public resources for joint projects funded by joint European debt. This would create a secure European safe asset, a contentious and politically divisive issue, particularly among northern member states. Draghi also highlights the need for simpler and more flexible regulation, criticizing the high regulatory costs for small and medium-sized enterprises. He calls for a "regulatory pause" in the next European institutional cycle, but this must involve better, impact-justified regulations with thorough consultations.

A review of European competition policy is also recommended to consider future competition and innovation, replace distorting state aid with European aid, and promote projects of joint European interest. The goal is to facilitate "European champions"-big companies capable of competing with U.S. and Chinese giants.

Prospects for Implementation

The ever-skeptical Brussels bubble has questioned whether the Draghi report will become policy. There are reasons for optimism that this report will not just become another long-forgotten report that gathers dust on the bookshelves of EU officials.

First, the European Commission president has embraced the Draghi report. This report reads like a road map for the next five-year term for the European Commission. Moreover, Draghi's intellectual and political authority will ensure that it is taken seriously in European capitals.

Second, Germany needs a new economic model. While leading German politicians have come out in opposition to one of the most prominent recommendations in the report-the call for more European debt and the creation of a safe European asset-Germany's economy is in desperate need of more investment. Unlike the previous decade, when Germany was economically strong and resisted bold EU proposals to revive Europe's economic fortunes, Germany today is the economic problem. Germany is experiencing slow growth and facing deep challenges in its manufacturing sector, especially from Chinese cars. As economic historian Adam Tooze assesses, "Defending the status quo . . . offers no safety, but only a recipe for further relative decline and dependence on technological innovation coming from the US and China."

Third, and perhaps most critically, there is a need to find funding both for Ukraine and to rearm Europe. This is an urgent challenge that European states have thus far proven unable to grapple with individually. With France struggling with a budget deficit above 5 percent and Germany pleading helplessness from its self-enforced austerity budget rules, European aid to Ukraine may collapse. To make matters worse, aiding Ukraine will be more costly because European states have largely given away a lot of their older stockpiles of equipment, meaning future aid from Ukraine will likely require buying new systems from industry.

Conclusion

The Draghi report offers a thorough reflection on the challenges facing the European Union with a clear sense of urgency and a strong pro-European stance. However, it arrives at a delicate political moment, with the radical right on the rise in most countries and a limited appetite for treaty changes or deeper integration. The report aligns well with the priorities of the new European Commission, which will start in December 2024, emphasizing trade-offs between competitiveness and certain European policies. As a potential road map for the next five years, it even covers issues like defense, traditionally avoided by economists. The main risk is that the report's valuable and practical proposals could be eclipsed by the never-ending debate over joint financing and Eurobonds, which face opposition from countries like Germany.

Federico Steinberg is visiting fellow with the Europe, Russia, and Eurasia Program at the Center for Strategic and International Studies (CSIS) in Washington and a Senior Fellow at the Elcano Royal Institute, D.C. Max Bergmann is the director of the Europe, Russia, and Eurasia Program at CSIS.

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