Released on Monday, the study, by Andreas Schleicher from the Organisation for Economic Cooperation and Development (OECD), warns Europe to revolutionise its schools and universities and tackle class bias.
"The time when Europe competed mostly with countries that offered low-skilled work at low wages has gone. Today, countries like China and India are starting to deliver high skills at low costs," Schleicher wrote.
"This is profoundly changing the rules of the game," said the study, compiled for the Lisbon Council, a Brussels-based think-tank which aims to make Europe more competitive.
Schleicher claims that increased spending on education, particularly at secondary and tertiary school levels, brings economic benefits that outstrip inflation, not just for individuals but entire countries.
Schleicher points to the "miracle" of South Korea, which in the 1960s had lower income rates than all South American countries yet now has the highest rate of education - 97% - among people aged 25-34 in the industrialised world.
Meanwhile most of the big European economies, including Britain, France and Italy, are struggling to hold their rank while Germany has even fallen.
"France and Germany, which make up 35% of the European Union's 11.6 trillion euro economy, are no longer among the world's leaders in developing knowledge and skills," the study said.
S Korea has one of the highest
education rates in the world
Lessons can be learned further north, though.
Finland is credited with moving to the head of the PISA (Programme for International Student Assessment) list following a radical overhaul of its education system, said Schleicher, who leads that programme for the OECD.
High on the list of complaints was class distinctions - notably in Germany, France and Italy - that are preventing young people from getting ahead.
"Europeans from difficult socio-economic backgrounds don't receive the same educational opportunities as children from rich and middle-class families," the study said.
"In many countries, the data suggest that European schools reinforce existing socio-economic inequities."
"The time when Europe competed mostly with countries that offered low-skilled work at low wages has gone"
Germany is singled out for dividing children between vocational and academic tracks from as young as 10 years old.
"Those from white-collar families have a four-fold better chance of heading down the path to a tertiary institution.
Educators themselves are also targeted for refusing to change the way they work despite the recommendations of researchers.
"Education in Europe continues as a cottage industry, with practitioners working in isolation and building their practice on folk wisdom about what works," the study said.
To turn Europe around, Schleicher makes five main recommendations.
He said countries must set up a network of diverse, high-quality institutions free to respond to demand and accountable for their results.
Access to schools which are better and fairer has to be improved and public and private funding must be encouraged.
The OECD report supports public
and private funding of education
Universities must also evolve in a way that matches their strategies to those of modern enterprises, the report said, recommending that they be governed by bodies other than just academic ones.
"Europe's universities are unlikely to catch up unless our governments succeed in creating and maintaining a system of diverse, sustainable, and high-quality institutions with the freedom to respond to demand and the accountability for outcomes they produce," the study said.