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By Dr. Sylvain Broyer, Chief EMEA Economist, S&P Global Ratings

 

 

 

 

The European economic recovery is a tale of resilience. Despite ongoing geopolitical tensions, volatile asset prices and no clear resolution of trade disputes, growth forecasts for this year have increased significantly. There is even a consensus that conditions are in place for growth to accelerate above potential over the medium term. S&P Global Ratings expects the eurozone economy to grow by 1.1 percent next year and 1.4 percent in 2027, driven by supportive fiscal and monetary policies, robust private-sector balance sheets and the economy’s shift toward digital transformation. Targeted reforms to lower the cost of capital and direct long-term pension savings toward financing innovation would help fill the glass.

Targeted reforms to lower the cost of capital and direct long-term pension savings toward financing innovation would help fill the glass.

Supportive policy mix

The European recovery is being propelled by a coordinated policy environment. Germany’s landmark decision to invest some 1.1 trillion euros over 12 years in infrastructure and defense represents a structural shift in fiscal policy. With 20 percent of Germany’s gross domestic product (GDP)—equivalent to 5 percent of the European Union’s (EU’s) GDP—on the table, even conservative assumptions of fiscal multipliers suggest this will elevate German growth to twice its potential by 2027–28. On top of that, EU and NATO (North Atlantic Treaty Organization) member states have committed to raising their defense spending, although by how much remains to be seen. Unlike in the United Kingdom, where fiscal stimulus is offset by restrictive monetary policy, the European Central Bank (ECB) has eased monetary conditions. With inflation returning to target, the ECB has slashed real interest rates to zero. This level appears to be more expansive than neutral, considering that it has fostered a revival in private-sector lending and a shift in savings toward liquid assets. What’s more, the ECB’s quantitative tightening is nearing completion. By the end of next year, it will likely no longer contribute to decompressing the term premium at the long end of the government bond market, as it did before. S&P Global Ratings estimates that ECB quantitative tightening has caused 10-year yields in European government bonds to rise by 20 to 30 basis points since 2023.

Strong private balance sheets

Household and corporate balance sheets across Europe have emerged stronger from the pandemic. This partly reflects the increase in public debt when governments transferred money to households and businesses to prevent a depression. It is also due to many companies raising profit margins following the 2022 energy shock. Since the pandemic, public debt rose by nine percentage points to 77 percent of GDP, but household liabilities declined by six points to 59 percent. The strength of balance sheets is a critical buffer against the many external shocks that the European economy has faced since the pandemic.

The labor market’s transformation and the AI boom

The labor market is another pillar of the European recovery. At a lower-6-ish percent, the eurozone’s unemployment rate is the lowest it has been in the past quarter-century. This is an even more impressive feat given that labor-force participation is on the rise and the economy has been largely stagnating over the past couple of years. This implies that four million more jobs exist than the economic output would suggest, out of the current 169 million. Obviously, this improvement is partly driven by companies hoarding labor, enabled by high profits and low real labor costs, occurring against the backdrop of an aging workforce and rapid changes in critical skills. According to a European Commission (EC) survey, 10 percent of companies still admit today to preferring to retain staff during downturns.

Labor hoarding is not the only reason for the labor market’s stratospheric resilience. The boom in artificial intelligence (AI) and US data centers is another. While Europe’s industrial sector has shed some 900,000 jobs over the last five years because of Chinese competition and high energy costs, the information and communications technology (ICT) sector has added nearly two million jobs. In Ireland, one of the hubs for European data centers alongside Frankfurt, London, Amsterdam and Paris, job postings related to AI have reached 7 percent of total online job postings. The ICT sector has contributed 0.4 percentage points to GDP growth annually since 2021—double its contribution during the early 2000s tech boom.

While tariffs on most European goods exported to the United States have increased eightfold this year, exports of computer services to the US, which remain outside the scope of the US/EU trade deal, provide an 18-billion-euro yearly surplus to the eurozone’s trade balance, compared to a 2-billion-euro deficit 10 years ago. For comparison, flagship exports of European goods to the US, such as cars and pharmaceuticals, do not provide more than a 30-billion-euro yearly trade surplus each.

Reform policies foster the European economy’s transformation

The fabric of the European economy is changing: fewer cars and chemicals but more tech. It is worth acknowledging that European policies have played a role in this transformation. By the end of 2024, the Commission reported that it had disbursed a total of €306 billion (around 2 percent of EU GDP) to member states (64 percent as grants and the rest as loans) under the Recovery and Resilience Facility (RRF) of its NextGenerationEU plan, which aims to foster the green and digital transitions. Developing the ICT sector is part of the NextGenerationEU strategy, as well as the EU’s long-term budget. For example, the 2.1 billion euros dedicated to Digital in the Connecting Europe Facility (CEF) and the 7.6 billion euros to the Digital Europe Programme are two lines of the EU’s long-term budget.

These EU funds have financed not only digital infrastructure but have also incentivized member states to conduct structural reforms. According to a report by the European Court of Auditors (ECA), countries such as Spain, Greece and even Belgium have used some financial incentives set by NextGenerationEU to implement significant labor-market reforms. How much the grants paid by the EU under the RRF have contributed to productivity growth remains a question mark. By contrast, there is clear empirical evidence that labor-market reforms have helped reduce structural unemployment and have improved the quality of employment contracts in the countries that have implemented them.

The half-empty glass

Despite its progress, the European recovery remains fragile. Medium-term growth projections, even after accounting for the historic German fiscal stimulus, lag those of the United States and China. These projections might be constrained by demographics, but low productivity is still an issue.

The tech boom in Europe remains lighter in terms of capital expenditure than that in the US—consider data centers, for example. That gap is unlikely to close despite EU-level policy initiatives to promote the digital transition as long as the cost of capital remains much higher in Europe than in the US—200 basis points (bps) higher, considering the differential in the equity-risk premium.

The record level of employment across Europe has not made consumers feel confident. Although real incomes are rising by 2.6 percent, consumer confidence remains below average, with spending growing at only 1.4 percent year-on-year. High food prices, political gridlock, angst over social decline and geopolitics, and pension concerns weigh on sentiment. It seems that any growth in consumer spending could easily be derailed by another blow to confidence. Moreover, who can say that the high labor content of the AI boom will last?

An appeal for further reforms, with the Savings and Investments Union (SIU) top of mind

Recent experiences with labor-market reforms in Spain and Greece, as well as EU initiatives to support the digital transition, clearly demonstrate that reform policies do contribute to Europe’s economic recovery. This effort should continue. It is time to act on former Italian Prime Minister Mario Draghi’s recommendations to restore EU competitiveness. The Commission has set its compass. One crucial avenue is to move forward with the Savings and Investments Union. Lowering the cost of capital by integrating capital markets, allowing ample EU savings to circulate more freely and cheaply across the economy, and channeling long-term pension savings toward innovation as fluidly as Swedish pension funds do would definitely help fill the glass.

 

 

ABOUT THE AUTHOR

Dr. Sylvain Broyer joined S&P Global Ratings in September 2018 as Chief EMEA Economist, based in Frankfurt. Before that, Sylvain was Head of Economics at the French investment bank Natixis and a member of the General Management of its German Branch. Sylvain has been a member of the “ECB shadow Council”, a panel of leading European economists formed by German economic daily Handelsblatt since November 2012. He is a member of different public sector advisory groups, including ESMA group of economic advisers since 2019. Sylvain holds doctorate degrees in Economics from the Universities of Frankfurt and of Lyon as well as a certification from the International Capital Market Association (ICMA). He teaches at the Paris Dauphine University, at the J.W. Goethe University Frankfurt for master classes and at Sciences Po Paris for executive education.