Europe’s Competitiveness Crisis: Constructing Comparative Advantage and Building State Capacity

CSDS POLICY BRIEF • 15/2026

By Salih Isik Bora

15.6.2026

Key issues

• Trade is undoubtedly a driver of specialisation and growth. That said, unrestricted free trade perpetuates existing network effects in the world economy.
• The EU’s liberal orientation was a sensible approach when Europe benefited from a technological and industrial head start over much of the world.
• Neo-mercantilism, premised on the construction of comparative advantage through public policy, might be more suited to manage Europe’s current predicament of relative decline.

Introduction

As encapsulated by the 2024 Draghi Report, European policymakers’ preoccupation with a competitiveness crisis has reached new proportions in the last few years. With the divergence of economic growth patterns between the two sides of the Atlantic and the “second China shock”, Europe appears to be squeezed between the world’s two superpowers. On the one hand, Europe is struggling to create innovative companies in new industries. Practically all of the added value in Europe’s digital economy goes to Silicon Valley firms who enjoy monopolistic positions across several sectors ranging from cloud computing to artificial intelligence.

On the other hand, Europe is slowly but steadily losing market share in sectors where it had been historically dominant. Whereas Europe accounted for 63% of chemicals, 66% of machinery and vehicles and 70% of electrical and electronics exports in 1962, these numbers have dwindled respectively to 52%, 33% and 23%, with much of the lost shares heading to East Asia. These shares are still very significant compared to Europe’s share of the world population and GDP (even though they are somewhat inflated because they take into account intra-European trade). That said, they are vulnerable. China appears well positioned to keep eroding Europe’s traditional niches of excellence through a combination of technological disruption and activist industrial policy.

Against this backdrop, “cutting red tape” has become a leitmotif among both national governments and European Commission officials who throw blame at each other for complicating the lives of European entrepreneurs through complex rules and procedures. The reasoning is that the United States (US) and China are – each in their own way – unconcerned about the various social, environmental or normative concerns that European policymakers harbour. The US is a society built around the appetite for risk and reverence for unbridled markets. China, on the other hand, is an “engineering state”: a technocratic dictatorship willing to do whatever it takes to achieve manufacturing dominance.

There is truth to the fact that the EU is a much more procedural polity than either China or the US. That said, calls to cut red tape are missing the point. Europe’s emphasis on regulation is not the cause of Europe’s competitiveness crisis but merely the symptom of a deeper problem: the lack of state capacity. The reason that EU policymaking is so procedural is that European policymakers – whether it is the Commission or national governments – often have to use regulatory instruments to pursue goals that are ordinarily achieved through centralised administrative powers. In stark contrast, China (but also the US) discretionarily restructure their economies for the pursuit of strategic goals.

The EU is built so differently from nation-states like the US, China and European nation-states themselves because the grand bargains that shaped it – the 1986 Single European Act and 1992 Maastricht Treaty – are premised on the idea that market integration does not require state capacity to function, save the regulatory state capacity to enforce a “level playing field” between economic actors. This mode of market governance resulted not from naiveté, but from the rationale that Europe was a core industrial region of the world economy and did not need state intervention to be globally competitive. Today, this rationale no longer holds. A new economic paradigm more aligned with Europe’s position of relative decline is needed. Even though changing the institutional “hardware” of the EU is unrealistic, some selective “software” changes would go a long way.

This CSDS Policy Brief starts by outlining neo-mercantilism: an intellectual tradition emphasising states’ role to construct comparative advantage through public policy. The brief then argues that neo-mercantilism presents solutions to Europe’s competitiveness crisis that may be more viable than free market liberalism, at least in sectors where Europe is lagging behind. Indeed, the shift of global manufacturing toward the Indo-Pacific had much to do with a local variant of this neo-mercantilist tradition: the East Asian developmental state. Subsequently, the brief highlights avenues for Europe to build state capacity at both the national and EU levels.

Neo-mercantilism and the East Asian developmental state

Political discourses on cutting red tape tell a misleading story about Europe’s competitiveness crisis. This story is, of course, convenient. In the age of right-wing populism, many politicians are incentivised to pit self-reliant small businesses and entrepreneurs against a much-fantasised “technocratic elite”. This line of argument reflects an outdated optimism about how, left to their own devices, free markets will ensure Europe’s prosperity. The truth is far less comfortable. With its significant lead in the technologies of the First and Second Industrial Revolutions and military alliance with the world’s hegemonic power, Europe enjoyed a privileged position in the geoeconomic pecking order. Relatedly, its attachment to free markets reflected less a matter of principle and more a position of strength in the world economy.

This position of strength is no more. The ongoing shift of economic activity toward the Indo-Pacific creates a self-reinforcing process in which scale, proximity, capital, talent and industrial ecosystems increasingly accumulate within East Asian economies rather than Europe. Once such dynamics reach a certain threshold, they generate powerful network effects that are difficult for late movers or slower-growing regions to reverse. The US lead in sectors such as cloud computing and artificial intelligence (AI) is very similar. Silicon Valley achieved network effects that will be impossible to surmount through market forces.

Neo-mercantilism is an intellectual tradition whose insights fit better with Europe’s current predicament than free trade. At its core, neo-mercantilism emerged as a reaction to the Smithian liberal view that free trade was mutually beneficial. Its early proponents, such as American founding father Alexander Hamilton (1757-1804), German political economist Friedrich List (1789-1846) and Chinese nationalist leader Sun Yat-Sen (1866-1925), were all from late industrialising countries that faced a challenging geopolitical environment. They viewed liberalism as an ideology that perpetuated the domination of early industrialisers, chiefly Britain. Accordingly, free trade perpetuated hierarchical network effects where one side specialised in manufacturing and locked the other into less lucrative extractive activities.

To overcome such a disadvantaged position in the global division of labour, neo-mercantilist thinkers advocated for a high-capacity state able to steer markets away from the short-term pursuit of profit and into long-term technological upgrading. Accordingly, if private actors are left to their own devices, they tend to perpetuate economic and political subordination toward more advanced economies. This prominent role of the state corresponded not to Soviet-style economic planning but to “embedded autonomy” – a state able to insulate itself from private interests and, at the same time, open to the flow of information from businesses. Neo-mercantilism should also not be confused with “autarky”. While its earlier statements by Hamilton, List or Sun Yat-Sen were indeed preoccupied with self-sufficiency, this need not be the case. Indeed, the most emblematic 20^th-century variant of neo-mercantilism, the East Asian developmental state, is resolutely outward-looking. The developmental state model, the main reason why manufacturing has shifted toward the Indo-Pacific in the first place, is based on export-led rather than import-substituting industrialisation.

This model was initiated in post-World War II Japan under American occupation, where the Meiji-era focus on late development was rechannelled from its militaristic origins into competition over world markets. As the pioneering specialist of the Japanese developmental state, Chalmers Johnson explains, the newly created Ministry of International Trade and Industry corresponded not so much to an ordinary Ministry of Commerce as to a Ministry of Defence strategising over Japanese firms’ position in global trade as an existential matter tantamount to national defence. As a country in an unforgiving geopolitical environment and with few natural resources, Japan had to export to earn hard currency. An even more impressive feat was later achieved by South Korea and Taiwan, which, through activist industrial policy, underwent some of the most impressive cases of economic upgrading in history as their exports became increasingly technology-intensive and their GDP grew exponentially. In less than a lifetime, South Korea and Taiwan went from exporting rice to textiles to advanced electronics and automotives.

The seemingly unstoppable rise of Chinese manufacturing is inspired by this earlier East Asian experience. Following the initiation of a new era of reform by Deng Xiaoping in 1979, a new generation of reform-minded bureaucrats has discarded China’s prior import-substitution and self-reliance policies and instead embraced the export-led model of the developmental state. Evidently, China’s ability to upgrade its economy relied on industrial policy on a massive scale. Through its control over the country’s financial system – notably through ownership of all of the largest banks -, the Chinese state steered market forces toward the sectors it deemed strategic. China’s ability to leapfrog European carmakers by adapting to technological disruption had to do with the fact that the government made use of carrots and sticks in order to shape the behaviour of private firms. In stark contrast to Europe’s incumbent automotive industry, which procrastinated on electrification, Chinese firms were compelled to follow green transition goals set by Beijing.

In essence, Japan, South Korea and Taiwan (and later China) have all used state capacity to upgrade their own economies toward higher value-added sectors. Although trade had an indispensable role in their success, they did not adhere to a laissez-faire vision which, in all likelihood, would have never allowed them to escape their subordinate position in the world economy. Instead, they have constructed comparative advantage through public policy and made themselves indispensable in global value chains. In the following section, the brief highlights avenues for the EU to develop similar forms of state capacity.

Towards a multilayered developmental state

The developmental state model and its applicability to Europe has already been brought to the agenda. Both scholars and practitioners have noted a resurgence of industrial policy in Europe. The EU’s regulatory toolbox has been repurposed to facilitate economic interventionism, with instruments such as the Important Projects of Common European Interest (IPCEI), the 2022 Chips Act and, most recently, the Industrial Accelerator Act. Notwithstanding the obstinate refrain about red tape and deregulation, the case for building state capacity is much stronger now than it was 10 years ago.

Against this backdrop, most observers concur that the biggest challenge impeding European industrial policy is the dispersal of powers between the European and national levels. Many prerogatives that have been vital for the success of East Asian states, not least fiscal resources, are at the level of member states and will remain so for the foreseeable future. Consequently, Europe’s industrial policy is said to advantage larger member states with the fiscal space to subsidise their industries. The member state for which this is the truest is Germany. For the abovementioned IPCEI instrument, for example, it is estimated that up to 80% of all aid was allocated by Germany, France and Italy, with Germany alone accounting for 55%. The return of industrial policy in Europe thus carries the risk not of creating a European techno-industrial ecosystem, but rather a further fragmentation along national lines.

A comparison with the Indo-Pacific, however, would suggest that political fragmentation is not necessarily an obstacle to ecosystemic integration. East Asian economies, after all, have developed not as part of an economic union but within a hierarchical order of sovereign states. Japan, the East Asian state that developed first, has sub-contracted lower value-added activities first to Korea and Taiwan and then to Southeast Asia. In a way not too dissimilar to the “flying geese paradigm” coined by Japanese economist Kaname Akamatsu, the region developed successively as one state upgraded and others competed to fill the rungs in the technological ladder that it left unoccupied (today, of course, China’s ambition to occupy all rungs simultaneously is challenging this preexisting order).

If Europe, with member states at very different levels of economic development, were to achieve success, it would most likely look quite similar. Indeed, this is precisely what had happened in the 1990s and 2000s with the automotive supply chain as German firms have increasingly divided production across Central European member states such as Hungary, Czechia and Poland, which incentivised them to relocate. An effective EU “multilayered developmental state” would thus entail not only Europe constructing comparative advantage toward the outside world but also member states competing to construct comparative advantage toward one another.

Conclusion: how Europe can construct comparative advantage

In most areas, national rather than European state capacity is a far more realistic and achievable objective. Member states need to develop policy levers, whether in taxation, social, migration or education policy, in order to render the economic environment more conducive to strategically relevant investments. Far from an obstacle, the institutional diversity of European states could provide room for experimentation and specialisation. The challenge for the EU would be not to prevent this competition and substitute it with a centralised industrial policy, but to channel it toward mutually beneficial directions. At the project conception stage, fora such as the Strategic Forum and the Joint European Forum can allow national policymakers to jointly identify strategic sectors. At the implementation stage, the EU can use competition policy to encourage member states to specialise in non-overlapping domains and to build “consortia” encompassing multiple member states based on their preexisting strengths. At the compensation stage, the EU can repurpose cohesion funds to mitigate the temporary disruptions that this “efficiency shock” will inevitably create.

There are also specific forms of state capacity that can only be developed at the European level. A particularly noteworthy example concerns the governance of foreign investment, an area in which the EU has gotten increasingly involved in recent years. Throughout the history of the EU, a key challenge was that foreign multinational corporations were often in a better position to take advantage of market integration than their European rivals. Already in the 1960s, the creation of the Common Market led to a phenomenal rise in American FDI (famously described by French essayist Jean-Jacques Servan-Schreiber in his 1967 book “The American Challenge”) as US firms expanded their operations much more quickly and effectively than Europeans firms.

Today, a key challenge for the EU is to ensure that member states’ industrial policies do not end up propping up the dominant market positions of Chinese firms. Viktor Orban’s Hungary was a particularly eloquent example. While the country is planning to host the largest electric battery manufacturing expansion in Europe, Chinese firms are responsible for 60% of this expansion. Against such risks, selective but stringent “European preference” policies are needed (along with EU-level capabilities to enforce them). The EU level of governance needs to act as an arbiter ensuring that national industrial policies do not simply consolidate Europe’s dependencies and allow footholds for foreign multinational corporations to extract most of the profits from Europe’s green, digital and geoeconomic transitions. In sum, Europe needs to combine national and EU-level state capacity to construct comparative advantage and retain its position as a core industrial region of the world economy.

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