Interest in EU competitiveness is nothing new. Safeguarding Europe’s advanced position in the world economy was one of the motivations behind the EU’s single market programme of 1987-92. Since then, interest in EU competitiveness has risen further for several reasons, spurred particularly by the growing global role of countries like China.

“Strengthening EU competitiveness” may be a useful rallying cry to create momentum for growth-enhancing policies, but we must be clear about what it usefully means and what it does not. To set out my vision for growth in Europe, I will stress first that policymakers and the public at large should see international trade as a mutually beneficial exchange of goods and services, not as a zero-sum game in which of one country’s benefit, say that of China, comes at the expense of others. I’ll also argue that productivity and innovation are critical to reaping the benefits from this exchange, and in this context I’ll emphasise that policies that don’t cost European taxpayers a single euro are at least as important as policies requiring public funds. Lastly, I will highlight that promoting sustainable and inclusive growth has to take into account the importance of the services sector.

There’s no question that companies of the same industry are in direct competition with each other, and that gains in market share by one tend to come at the expense of its competitors. So it follows that the payroll and the earning of a company will rise if it outperforms its competitors. And because of the difficult situation a many good companies find themselves in today, many people conclude that for their country to prosper it needs to outperform other countries. Not surprisingly, the competitiveness of countries understood in this way continues to motivate a wide range of policy initiatives, including industrial policies to create and defend national champions and support for a variety of so-called strategic industries.

There are two problems with this. First, empirical evidence fails to support the view that public backing for an industrial project enlarges a country’s share in world trade. All too often, government interventions based on strategic-trade considerations simply provide intellectual cover for protecting domestic industries, which harms other countries, and in the end the country that is trying to promote its own industries. Second – and more important – the company-country analogy is fundamentally flawed, as has been pointed out most eloquently by Paul Krugman, the 2008 Nobel Laureate in economics. When a company becomes more competitive it crowds out its rivals, and they get nothing in return. By contrast, when a country becomes more productive and succeeds in raising its exports, it acquires the means to import more, so other countries’ exports rise too. In fact, the company-country analogy completely overlooks the fact that ultimately the reason for a country to boost its exports is to be able to raise its imports, whereas the motivation for a company to outperform its competitors is never to need to buy anything from them.

So external competitiveness is what Krugman calls a “dangerous obsession” if based on the company-country analogy. But it becomes a meaningful concept if it refers to productivity. Productivity growth and innovation are beneficial, not because they help a country to compete with other countries but because they let countries produce and consume more, or produce and consume the same with fewer resources. Understanding competitiveness in this sense is a pre-requisite for successfully designing and implementing a growth agenda for Europe.

The strong emphasis on innovation is more than rhetoric. A considerable body of literature – pioneered by Harvard economist Philippe Aghion and his colleagues – suggests that innovation is the key driver of economic growth in advanced countries like many of the EU’s member states. Before setting out how to spur innovation, it is worth adding that any growth strategy in this age of climate change must reconcile environmental and economic demands. What’s more, the benefits of economic growth need to be fairly distributed, and Europe 2020, the EU’s growth strategy for the coming decade aiming at smart, sustainable and inclusive growth, recognises both demands.

Turning to policies that could spur innovation and thus growth, it is tempting to see an important role for government expenditure. And it is true that there is scope for increasing public spending on basic research and development (R&D) and on education and for providing financial incentives for private R&D. But it is also true that policies with no direct impact on a government’s budget have considerable potential to boost innovation. First and foremost, the literature referred to above has found that exposing companies to strong domestic and foreign competition is instrumental in stimulating innovation. The underlying mechanism may be complex, but the essence is simple: faced with strong competition, innovating is a means for companies to survive; faced with extinction they typically try to innovate, thereby igniting the “free-market innovation machine”, an expression coined by New York University economist William Baumol. It is intriguing in this context to go back to the company-country analogy discussed earlier, because while this analogy implicitly recommends that European companies should be helped in their struggle with foreign competitors, the Aghion-Baumol insight suggests that by contrast exposing companies to vigorous competition stimulates innovation and so economic growth.

All in all, budgetary support for R&D policies and competition rules that keep companies on their toes while granting successful innovators appropriate patent protection, should be combined to spur innovation in the EU economy. In recent decades, Europe has not moved as rapid and vigorously on these fronts as one would wish, but it is clearly not too late to quicken the pace. The scope for unleashing productivity growth seems to be particularly great in the services sector.

Our everyday experience makes us inclined to take innovation as coming in the form of more sophisticated and/or higher quality goods and production processes. And although industry – the sector that delivers these goods – is arguably an important source of innovation and economic growth, any agenda for stimulating economic growth in Europe must include the services sector for three important reasons.

First, because it accounts for about two-thirds of total value added, the services sector is by far the most important part of the EU economy. And in employment terms it is larger still. Second, since the 1990s output growth in the EU has been primarily driven by expansion of the services sector. Third, the evidence is that productivity growth in the EU’s services sector has been lagging behind developments in the United States (even given the possibility that pre-crisis productivity growth in U.S. financial services was partly virtual and not real). This suggests that there is still much untapped potential to boost innovation and productivity in Europe.

More than in other sectors, one would like to see productivity growth in services that results from quality-improving innovation rather than the quantity-enhancing variety, as the latter yields higher output with given resources or the same output with fewer resources, notably labour. Think of health, education, and care of the elderly. There is consensus that productivity growth in the provision of these services should not result in fewer employees delivering the same service (or the same number of employees taking care of more patients, pupils and students, and elderly).

This points to a prominent role for what economists call intangible capital – a factor of production needed in addition to tangible capital and labour. Intangible capital results from investment in R&D, but it is also the result of investing in workers’ skills, improvements in organisation, better processes, new designs and so on. Recent research suggests that countries where the services sector has made a large contribution to productivity growth have invested considerably in intangible capital, so it is the extent of intangible investment, particularly in the services sector, that would appear to show the way to a country’s success in becoming a more innovative economy. It is a route the EU as a whole would be well advised to follow.