By Kerry Capell

When Germany's Bayer (BAY ) invented aspirin in 1897, it also invented the modern pharmaceutical industry. But unless the Continent's bureaucrats sit up and take notice, Europe's drug industry could end up someplace else: in the labs and boardrooms of the U.S.

An exaggeration? Well, consider these two recent events. Swiss drugmaker Novartis (NVS ) on May 6 announced it is sinking $250 million into a new research and development center in Cambridge, Mass. That makes it the latest in a string of European drugmakers that have chosen the U.S. over Europe for major R&D investment in the past decade. A day after Novartis' announcement, the European Commission released a damning report on the state of the European drug industry.

Few in the industry are surprised by the EC's conclusions. "You can almost hear the sucking sound as all the money goes across the pond," says Barrie James, senior vice-president at Cambridge Pharma Consultancy in Cambridge, England. In 1990, European drugmakers on average invested 73% of their R&D budgets within the European Union. By 1999, it had fallen to 59%.

The Europeans just want to be where the action is. Drug sales in the U.S. have been climbing by 15% a year for the past decade, bolstered by the free-market pricing of drugs. That's nearly double the rate in Europe, where government-imposed price controls are in force.

But the real allure of the New World is the quality of its science. Besides corporate R&D, the U.S. also draws on the research of top universities, the best hospitals, and the federal government, a power base Europe can't match. Two-thirds of the new drugs introduced in the past five years originated in U.S. labs.

As recently as 1990, Europe and the U.S. each commanded about a third of the global pharmaceutical industry. Today, Europe's cut of the $364 billion market is down to 21%, while the U.S.'s has risen to almost 50%.

This shouldn't be. The European Union is an even bigger market, based on population and output, than the U.S. And some of the finest drug researchers on the planet are European. Europe needs to exploit these strengths better to rescue its industry and give it a reason to stay European. Here's how:

-- Create an agency to coordinate research. Europe needs its own version of America's publicly funded National Institutes of Health (NIH). Right now, universities, hospitals, and government labs in France compete with their opposite numbers in Germany, Britain, and elsewhere--a surefire way to duplicate efforts and waste precious financing. A European NIH could designate research centers focused on specific areas of disease or science and encourage them to share their findings with others.

-- More public funding. The NIH's $23 billion annual budget is 50 times the amount allotted for R&D under an EU initiative. Brussels might want to consider a modified version of the Bayh-Dole Act. Introduced two decades ago, the U.S. legislation made it easier for universities to commercialize their publicly funded research.

-- Reward innovation with tax breaks. Special tax breaks for startups are a must if Europe is to close the gap with the U.S. in biotech, which is where American scientists are getting the bulk of their new discoveries. National governments could also help level the playing field by bringing the tax treatment of options in line with that in the U.S. If the high European tax rates on options were lowered, drugmakers on the Continent might have an easier time retaining top talent.

-- Reinforce patent protection. The U.S. has a long track record of upholding scientific patents. Europe, on the other hand, got around to introducing EU-wide legislation on biotech patents only in 2000--16 years after the U.S. Ten of the EU's 15 members have yet to implement it.

The EC has hinted at a few of these recommendations in its recent report. But many in the industry believe its proposals don't go far enough--and may ultimately create more bureaucracy. One way or another, European governments, drugmakers, and academics have to figure out how to create an environment that encourages scientific innovation. The alternative is the Americanization of what was once the most European of industries.

Capell covers Europe's pharmaceutical industry from London.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE