The European economy stands at a crossroads. Structural issues like ageing demographics and slow innovation are reducing Europe’s economic weight globally. The cost of the climate transition is ramping up at a time when fiscal space is shrinking or non-existent. Real disposable income per capita has grown at half the pace of the US since the early 2000s, painting a stark picture of a continent struggling to maintain its economic dynamism.
Nowhere are Europe’s problems clearer than in the ‘The future of European competitiveness’ report. Spearheaded by Mario Draghi, former Italian prime minister and president of the European Central Bank, it was commissioned to address Europe’s lagging growth, productivity and competitiveness. The 400-page report offers a detailed analysis of the continent’s economic landscape, proposing crucial reforms to revive its global standing. But the main message is that Europe is in dire need of investment, both public and private.
Fiscal reform falls flat
A major focus of the Draghi report is Europe’s innovation deficit. Europe’s failure to scale in critical sectors, such as digital technologies, has left it trailing tech giants like Tesla in the US. The report points to several reasons for this: regulatory constraints, lack of financing mechanisms and a fragmented capital market system that limits growth in innovative sectors.
Contributors to the report pointed to the importance of public investment. The Stability and Growth Pact fiscal rules were suspended during the pandemic and energy crises, but they stopped being fit for purpose long before that. In April 2024, the EU Council reached consensus on new fiscal rules, which aim to balance fiscal discipline with flexibility for growth investments.
The changes from the original SGP are modest in scope. Under the new rules, fiscal sustainability will be measured by public expenditure as the annual fiscal policy target rather than the deficit. Member states also include net expenditure paths into their medium-term fiscal structural plans, which can be extended up to seven years with Council approval. These changes are seen as positive developments allowing member states more flexibility in managing their fiscal positions.
It’s hard to imagine that this alone will be enough to facilitate the levels of public investment needed in Europe. At an OMFIF roundtable on EU fiscal reform, one expert said that the reforms are a ‘step in the right direction’ but they ‘could have been bolder,’ noting that ‘the adjustment burden is tilted toward restriction’. They expressed concern that not enough is being done to ensure sufficient levels of internal demand in the euro area.
All panellists agreed that the success of these measures depends heavily on Europe’s ability to coordinate action across its member states. ‘If fiscal space falls short of what is needed, some common EU fiscal capacity or a common mechanism of leverage’ would also be needed, said one speaker. The Draghi report also maintains that ‘Some joint funding of investment at the EU level is necessary to maximise productivity growth, as well as to finance other European public goods.’
Unlocking investment to foster growth
In addition to a facilitative fiscal framework, private investment needs to be scaled up in the EU. This is a twofold undertaking, which will entail both attracting more foreign capital to the bloc as well as better mobilisation of European capital across the continent.
First, more should be done to attract foreign investment. Some of these measures are low-hanging fruit. In OMFIF’s ‘Competitiveness of European financial services’ report, the stability and predictability of governance within the EU was mentioned as an advantage by both policy-makers and investors. The geopolitical risk of investing in Europe is lower than in China or other emerging markets, or even the US.
In addition, Europe is a leader in sustainable regulation. Better ‘marketing’ of this could facilitate investment in electric vehicles and other green technologies. Reducing bureaucracy and waiting times for investors looking to operate in Europe should also be high on the policy-making agenda. In combination, these measures can contribute to a more attractive investment environment in Europe for foreign capital.
Second, better mobilisation of existing savings can unlock enormous investment potential. Savings rates in Europe are higher than in the US, yet this capital is not as efficiently channelled into productive investments due to the fragmented and underdeveloped capital markets. Without a cohesive capital market, startups in Europe often struggle to secure the financing necessary for growth, forcing many to seek investment abroad, particularly in the US.
The long-discussed but still unrealised capital markets union, an integration project aimed at unifying Europe’s fragmented financial landscape, is critical for Europe to address its financing gap. Creating a truly pan-European pension product could help pool capital that could then be channelled into domestic infrastructure or other long-term investments. Pension system reform would also secure higher returns for an ageing population and a growing burden on the pension system.
Action needed to overcome political inertia
Of course, there are political hurdles to overcome. The results of the European elections earlier this year have made reaching EU-level consensus on fiscal and financial integration much more difficult. Pro-integration sentiment is losing ground to nationalist and protectionist parties across the continent. While incremental changes like lifting regulatory barriers or promoting smaller-scale investment initiatives might gain traction, the broader and more ambitious reforms necessary to unlock Europe’s investment potential are unlikely without a shift in political sentiment. Critical ideas like a unified capital market or the creation of a pan-European fiscal tool are often met with resistance, reflecting the deep-rooted national interests that complicate EU-wide co-operation.
But the Draghi report makes it clear: Europe must act swiftly to close the economic gap with its global peers. There is no ‘returning to normal’ – we are in a fundamentally more challenging and antagonistic macroeconomic environment that will require a more coherent growth strategy going forward. The solutions are clear, but implementation will require bold, creative and decisive policy-making.
Taylor Pearce is Lead Economist, Economic and Monetary Policy Institute, OMFIF.
These themes will be discussed in a report by OMFIF and EY, publishing 28 October.
