IMF | A Stronger Europe for Tougher Times

The world economy—and Europe with it—is hit once more by a shock: this time, the events unfolding in the Middle East.

Before Hormuz closed, Europe’s growth outlook was improving and we at the IMF were getting ready to upgrade our forecasts. Now, we see growth down and inflation up.

But still, some credit where credit is due: it could have been a lot worse. Thanks to its longstanding focus on renewables, Europe is better prepared than many others: more energy efficient, less oil dependent.

Nonetheless, the fact remains that we are cast into an era of shock upon shock, layer upon layer, one on top of the other: Covid, inflation, Russian gas, U.S. tariffs, and now the Middle East. It is like a layer cake, but it definitely doesn’t taste good!

Each shock is a new blow to European growth, to its ability to create jobs and prosperity for its people. And as the shocks overlap and their effects compound, so too does the economic damage.

Let’s face it: it’s a harsh world out there. Europe needs to toughen up.

But instead, it keeps lagging. I’m sorry to say it—we are all friends of Europe here—but that is the fact. When I came to Brussels in 2010 as EU Commissioner, Europe had the same nominal GDP as the United States; now, it is significantly lower, while China has caught up to it. After two decades of weak productivity growth, European income per person is 70 percent of America’s, and the gap is widening.

How could this happen? There are many reasons, but one is that far too many successful European innovators end up abroad and far too few new EU firms grow in size to become globally competitive. The average listed EU firm has a market capitalization of about half the U.S. average. And as for European peers to match the American AI “hyperscalers,” there are none to be seen. Europe’s strength—policy predictability—is diminished by regulatory fragmentation and national gold-plating.

With weak growth comes fiscal weakness. National budgets are under ever-increasing strain from long-term spending pressures, including the rising pension and healthcare costs of an aging population, the costs of the energy transition, and defense needs. Relative to now, the increase in annual public spending in these areas could reach 5 percent of GDP by 2040.

And so public debt keeps rising. Without policy action, we estimate the simple-average public debt load of EU member states will more than double to over 130 percent of GDP by 2040. The implication? Fragility. Vulnerability.

Yet the twist is that Europe knows very well what must be done: first, complete the single market, because that is Europe’s competitive edge and its main growth engine; and second, embrace smart budgetary policies to get the fiscal house in order, for strength and resilience.

First point: the single market. It has been repeated many times, but enormous untapped potential remains. For a start, the EU’s population is some 30 percent larger than that of the U.S.—and will grow even further as new members are admitted. So many educated, talented people: an amazing platform for growth.

But right now, Europe is not making the most of its size: far from it. We see too much conflict between EU and national rules and priorities, too many barriers to intra-EU trade, and too much fragmentation in European energy and labor markets.

The result? As Enrico shows us, trade in capital, electricity, and labor within Europe is far too costly. As a practical matter, today’s EU single market still embeds a patchwork of 27 national regimes, often living more in conflict than in harmony.

Europe can do better. The One Europe, One Market program offers an excellent blueprint: over 30 pieces of legislation. A comprehensive blueprint for progress.

The rewards could be substantial. We estimate that if reforms were to reduce internal frictions to levels comparable with the U.S. while member states galvanized national reforms, EU productivity could rise by as much as 20 percent in a decade. That would raise GDP per capita by some 35 percent—or more if paired with reforms in finance.

Higher trend growth would also contain the budgetary pressures that keep building, reducing the fiscal adjustment needed to sustain long-term spending needs.

Faster growth increases tax revenues, reduces safety net outlays, and lowers debt-to-GDP. For the average European economy, even modest growth-enhancing structural reforms could reduce by about one-fifth the fiscal consolidation needed to put debt on a declining path. The more ambitious the pro-growth reforms, the smaller the needed fiscal effort.

And that takes me to the second point I’d like to emphasize: fiscal responsibility.

To be concrete, let me zoom in on one example that is very much in the lens today: defense spending. Given the geopolitical realities, there is a consensus in Europe that it needs to rise substantially, on top of the material increase by more than 2 percent of GDP already delivered in recent years by some EU countries.

But policymakers should take note: there is a right and a wrong way to proceed. At the IMF, our most recent World Economic Outlook included a chapter studying major defense buildups across 164 countries since World War Two. On average, each episode involved about 2.7 percent of GDP in increased defense and security-related spending—similar to what NATO countries are now committed to deliver by 2035.

If such expansion is deficit financed, it leads to higher debt—which many EU countries simply cannot afford given their fiscal space constraints. For these countries especially, it is important that large and permanent increases in defense outlays be delivered in a budget-neutral manner, entailing tough tradeoffs in taxation and nondefense spending.

Equally, governments should strive to execute defense buildups in ways that maximize the uplift to growth. In the near term, larger defense outlays can boost domestic demand, but often with leakages to imports. The bigger question, however, is what happens in the long run. Here, our studies show that the potential boost to growth is modest—but that defense capital spending and defense R&D, if not crowding out other productive investment, can support productivity growth.

Main point: how it is done matters. If member states act alone—duplicating efforts, fragmenting procurement—the payoff would be way smaller. But if they coordinate on R&D and other items, use common procurement and standards, and are open to bidding by companies big and small, then market size expands and productivity can benefit.

This is why instruments such as SAFE—Security Action for Europe—and the EU’s Multiannual Financial Framework are so important. Not only do they pool resources, but they help countries minimize duplication and invest strategically. Done right, larger defense outlays need not increase national debt burdens.

Putting it all together, structural reforms and smart fiscal policy—today illustrated with the example of defense—can deliver.

So let me end by insisting that Europe can do it. Already, it has made huge strides in energy efficiency and energy security. Now, let it use the latest shock and geopolitical realities as a rallying cry to act.

Europe: complete the single market, because the strength of your growth depends on it, and manage long-term spending pressures, including in defense, because resilience depends on it. Be disciplined and firm. Be pragmatic. Build coalitions of the willing. Stop the finger-pointing between national capitals and Brussels. Bring citizens along with the reform effort.

In the spirit of Jacques Delors, you have reinvented yourself before. Toughen up and do it again!

Thank you