How can we support an industrial revolution in the digital era?

Harald Gruber, the EIB’s head of division for digital infrastructure

When economists try to come up with solutions for the sluggish growth in Europe, they often think back to the industrial revolution, and ask whether the economic productivity boost it brought could be repeated. The European Commission has made “industrial revival” a target, and the World Economic Forum talks about the 4^th industrial revolution. Is it possible to “re-industrialize” the economy?

Last year, I wrote a paper “Proposals for a digital industrial policy for Europe” where I proposed some possible ways to make that happen. The key thing to understand is that industry has changed. And the products that industry in advanced economies produces have changed – they are now mostly digital. The factors of production have also changed – information is now industry’s key input.

An abundance of evidence shows that European industry lags behind in digitalisation – and we also know that industry can bring massive productivity growth. Therefore, policies to revitalise industry are clearly important. But where should we start?

I have identified six potential market failures that justify policies to intervene and support the digitalisation of industry in Europe.

1. Lack of digital infrastructure

Europe trails far behind in broadband infrastructure supporting ultra high speed internet access. According to OECD data, 30% of South Koreans and 23% of Japanese had fixed line fibre access by the end of 2016. The bulk of the EU countries, especially the larger ones, have a penetration rate below the OECD average of 6.4%. Telecommunication providers are not keen to invest in areas with low population density, and this may justify government intervention, such as subsidies.

2. Lack of digital skills

Fully 25 per cent of workers in Europe have low or no digital skills (Berger and Frey, 2016). The problem is magnified in older age groups, and in less prosperous regions. It is therefore necessary for Europe to devote more economic resources to combating digital illiteracy. In 2013, the EU spent 5% of GDP on education, less than the 6.2% spent by the US, the 5.9% by South Korea, and even the OECD average of 5.2% (OECD, 2015). In addition to making more training resources available, Europe also needs to provide flexible opportunities for workers to upgrade their skills.

3. Lack of sufficient private investment in digitalisation

It is difficult to invest in digital products: they are often untested and in new markets, so no-one really knows how valuable they are. The pecking order of financial theory (Myers & Majluf, 1984) suggests that equity would be the preferred way of financing these uncertain investments. Also, the long periods required for many digital investments to make a return match better with equity than with debt. But, unlike in the US, in Europe firms are financed predominantly by bank debt, as EIB research and others have shown. To remedy this, we need to change cultural attitudes towards risk among European entrepreneurs and investors. We should also consider public financial instruments supporting equity investments.

4. Lack of critical market size

Often, the winner takes all in investments for intangible, digital assets (Shapiro & Varian, 1999). How much is all? Well, that depends on the market size. In the US, there is a fairly homogeneous market compared to fragmented national markets in Europe (by language, but often also by regulation, etc). Once new ideas are tested and successful, they can quickly exploit a large market to generate sufficient cash flow to recover the initial investment. Digital technology companies starting out from a smaller home market suffer from an inherent disadvantage, but a drive to extend the EU’s single market to the service economy (i.e. Digital Single Market) could improve the situation.

5. Lack of innovation by SMEs

Studies such as Icks, Schröder, Brink, Dienes, and Schneck (2017) suggest that small and medium-sized enterprises, the backbone of European economy, are not at the forefront of digitalisation. They may not feel pressure to focus on digitalisation, or they may not have the financial or human resources to do so. Those constraints mean that they may be adapting to new technologies in a piecemeal fashion, and therefore missing out on the transformative power of digitalisation.

6. Lack of protection in cyberspace

Data has significant economic value, yet it is very sensitive. Data, especially information relating to individuals, is generally highly protected in Europe. Data protection may benefit all users if it prevents the illegitimate collection and use of information (such as the circumvention of intellectual property rights or the discrimination against individuals). However, data protection may end up costing Europe if our laws are stricter than is warranted and if we fail to make use of existing data to develop more advanced services. At the same time, failure to invest in cybersecurity may lead to a breakdown of markets or prevent companies from participating in markets.

The promotion of digital technologies should be an industrial policy goal in Europe. If we fail to do this, we will suffer wide-ranging economic consequences – and we will not be able to support the European model of economic and social welfare. Therefore, the appropriate public measures need to be debated, and undertaken now, to mitigate these six market failures.