Yves here. This post discusses how the way Austrian businesses moved operations that involved high skill levels “offshore” to Eastern Europe. Over time, that resulted in a loss of competitive advantage as those countries developed both more technically capable workers and invested in R&D while Austria fell behind.

It’s not hard to see that this example applies to the US, although the effects are not as easy to discern because the US has such a large internal market that growth in services has somewhat offset the erosion of US know-how in other areas. A second advantage the US has had is being able to maintain a strong position in some sectors in the absence of much innovation, such as pharma. where the US and other major pharma players have become experts in rent extraction from intellectual property monopolies/oligopolies. And we also have a very large arms export business via client states, but as Russia’s recent performance showed, decades of feather-bedding has made the military-industrial complex a high cost vendor. Experts were apparently shocked at the performance of Russian hardware, which was clearly produced at much lower cost than ours.

Contrast this with the sectors where the US has been eating its seed corn. The denizens of the Acela corridor keep prescribing that more college students need to major in the STEM disciplines. Yet for over a decade, any reader of Slashdot will tell you that a staple of that site is forlorn computer sciences majors, either about-to-graduate or newly minted, who have found out that there are pretty much no entry level jobs in the US. India is growing the next generation of computer professionals, not the US, Similarly, the pay levels in most engineering jobs are not high enough to justify the cost of getting a degree….unless you go to law school and become a patent or other sort of intellectual property attorney. And how many IP lawyers does the US need? And even though many of them do do useful work, it’s not the end result that the DC policy wonks had in mind when they pump for college students to focus on careers that they fantasize both lead to better employment options and add to America’s economic prowess.

By Dalia Marin, Chair in International Economics at the University of Munich. Originally published at Project Syndicate

Austrian firms invested heavily in Central and Eastern Europe. They offshored the parts of the value chain that required specialized skills and produced valuable research. This resulted in lowered growth in Austria.

Austria was once lauded as Germany’s more successful neighbor, one of Europe’s fastest-growing countries. But its economy has been sputtering since 2012, with GDP up last year by a meager 0.7%; only Greece and Finland performed more poorly. And Austria’s unemployment rate has soared, from 5% in 2010 to 10% today.

These developments have their origins in how Austria engaged with Central and Eastern Europe after the fall of communism. At first, Austria benefited from the European Union’s eastern enlargement. International trade soared, Austrian firms invested heavily in the region, and Austrian banks opened subsidiaries there, financing these countries’ modernization. All of this was good for business, and the Austrian economy grew rapidly.

But a hidden dynamic ultimately turned the tables on this success. Central and Eastern European countries had low per capita income, but were rich in skills. Austria, far wealthier, was not. In 1998, 16% of Central and Eastern Europeans (including Russia and Ukraine) had academic degrees, compared to just 7% of Austrians. So, when Austrian firms invested in Eastern Europe, they did not just relocate low-skilled manufacturing jobs; they also offshored the parts of the value chain that required specialized skills and produced valuable research.

According to my research, from 1990 to 2001, Austrian subsidiaries in Eastern Europe employed five times as many people with academic degrees, as a percentage of staff, as their parent firms did. They also engaged 25% more research personnel in their labs.

This relocation of research activity lowered growth in Austria and boosted growth in Eastern Europe. Research spills over to the rest of the economy, as new knowledge diffuses into commercial activities. Tapping the knowledge produced by Austrian subsidiaries was one of the ways Eastern European economies were able to grow so quickly.

Today, Bratislava, Prague, and Warsaw – the location of most Austrian subsidiaries – have higher per capita incomes than Vienna. Indeed, according to the Hungarian economist Zsolt Darvas, in terms of purchasing power parity, all three cities surpassed Vienna in 2008. This is a remarkable development, given that Vienna has served as a reference point for these capitals for centuries.

Germany’s growth was not similarly affected, for three reasons. To begin with, after the fall of Communism, Austria reoriented its foreign direct investment almost exclusively to Eastern Europe, which accounted for nearly 90% of its FDI outflows. In Germany, just 4% of FDI moved to Eastern Europe in the 1990s, reaching 30% at the turn of the century. As a result, Austria became much more integrated with Eastern Europe.

Second, Germany was richer in skills than Austria. In 1998, the share of the German population with academic degrees was 15%, more than double the Austrian level. German firms did relocate high-skilled work to the east, but not to the extent that Austria did. As a proportion of the workforce, German affiliates in Eastern Europe employed three times as many people with academic degrees as their parent firms did. And German subsidiaries employed 11% more researchers than their parent companies.

Finally, many of the Austrian parent companies were themselves subsidiaries of foreign firms, while German firms were German multinationals, which transplanted their corporate culture to their Central and Eastern European subsidiaries. They employed more German managers relative to local managers, which gave them more control over innovation. Furthermore, most German investments were based on the transfer of an established technology; only 8% of the country’s FDI in the region involved cutting-edge research.

By contrast, Austrian firms adapted their business to the region’s environment and employed more local managers than Austrians. As a result, their subsidiaries were more autonomous in their innovation decisions. There was no mechanism that guaranteed that the knowledge created in a subsidiary also benefited the parent company.

If Austria is to return to its previous growth path, it will have to become more attractive as a location for innovation. And to do this, Austrian firms must employ highly qualified people in their research labs.

Educating a highly skilled workforce takes time, of course. But fortunately, Austria has another option: immigrants. Austrian policymakers could choose to follow Canada’s example and introduce a selective immigration policy that welcomes highly skilled migrants and refugees.

Austrians nearly closed the door on that option. Now they must recognize that what populists call a weakness could be Austria’s best hope for reviving growth.