Why don’t EU companies innovate? Hidden Costs of Failure

Here’s a simple view of companies trying to innovate: You spend money, hire staff, try things out, and if you fail to make a profit, you take the losses, close the books, and go out of business. Below. But what happens if closing something incurs additional costs down the road? In such situations, companies may be reluctant to innovate because the costs of failure are higher.

Yann Coatanlem and Oliver Coste argue that this dynamic may help explain the lack of innovation in European technology companies. “Failure costs and competitiveness of disruptive innovation” (Bocconi University Institute for Economic Policy Decisions, Policy Briefing, September 2024.

They wrote: “It is now widely understood that the gap in R&D intensity between the European Union and the United States is driven by the technology sector. Private R&D in technology in the United States is now six times higher than in the EU.” They argue that European employment protection laws are the main factor causing these differences.

The details of employment protection laws vary between European countries, but they generally make it more difficult to fire workers and often require laid-off workers to be paid for several months after dismissal. (oECD data comparing employment protection by country can be found here.) When companies face such laws, over time they may find ways to hire external contract workers not covered by these laws, engage in further outsourcing and offshoring, invest in physical capital to reduce future hiring needs, etc. Respond in this way.

If a company makes money and is in a mature industry where employment levels do not change significantly over time, employment protection laws may have only a moderate effect. But new high-tech companies are a riskier proposition. You may need to hire a significant number of people now, but given the uncertainty you face, there is a realistic possibility that you will also have to lay off that staff. The author notes: “In one seminar, Gilles Saint-Paul showed that high costs tend to focus R&D investments on finished products rather than new ones. In open economies, countries with high levels of employment protection tend to specialize in well-established industries and leave new product innovation to countries with less employment protection.”

How much higher are the costs of these layoffs in countries with significant employment protection legislation? “Using a combination of financial analysis, empirical observations and limited existing literature, we estimate that the costs of restructuring (including costs that are significantly higher than severance packages) are around 10 times higher in countries with high levels of labor protection, such as Western Europe, than in other countries. Countries with low labor protections, such as the United States.” It’s not just a financial cost. “In many European countries, including Germany, France, Italy, the Netherlands, Sweden and the United Kingdom, large companies are required to engage in extensive negotiations with trade unions and works councils. These discussions include scope, motivation, timing, team selection for layoffs, severance pay, and in some cases, assistance with retraining or finding new jobs for employees.”

The resulting cost gap is reflected in corporate behavior.

The recent wave of technical layoffs highlights key structural differences between the European and American models. For example, in the United States, Microsoft laid off 10,000 employees in January 2023, with severance costs totaling $800 million, or $80,000 per employee, equivalent to an average compensation period of 5.9 months. Similar figures were observed in Meta (4.2 months), Google (7.5 months), and Twitter (3 months). What stands out about the American model is the agility of corporate decision-making. ChatGPT’s rapid success prompted an immediate response. Microsoft has streamlined its workforce and invested more in its own AI infrastructure, including investing $10 billion in OpenAI. Within months of halting its Metaverse efforts, Meta laid off 20,000 employees and ramped up its investments in AI.
Similarly, Google faced its search woes, halted a major project, laid off 12,000 employees, and ramped up its AI efforts by increasing its R&D investments to $43 billion in 2023, including hiring tens of thousands of engineers with AI backgrounds. In Europe, three technology leaders including Nokia, SAP, and Ericsson also announced restructuring plans. Nokia, Europe’s largest technology investor, has cut up to 14,000 jobs. Despite a 21% plunge in sales last year that necessitated immediate action, the restructuring will not be completed until 2026 due to regulatory constraints in Germany, France and Finland. Similarly, European software leader SAP announced 8,000 layoffs, with compensation spread globally over 18 months and more than three years in Europe. …

Could there be some ways in which job protection law advocates could support the general goals of such legislation while reducing costs? One simple possibility suggested by the authors is that employment protection rules could apply only to the bottom 95% or 90% of workers by salary. That is, it protects average and above-average workers, but not those at the top of the wage distribution. Another possibility is to put the money in an account that can be withdrawn when employees are laid off. Another possibility modeled after Denmark’s ‘flexictability’ approachThis means the government will cover the cost of income support, job search and retraining support, and businesses will retain the flexibility to fire as they wish. The rules for European companies negotiating with trade unions and works councils could also be clarified and simplified.