On November 15th, the European Commission released its outlook on the EU economy for the next couple of years. It can be summed up in two words: timid wishes.
Presenting the outlook, Economy Commissioner Paolo Gentiloni looks like Oliver Twist from the Charles Dickens classic. Where the young boy humbly asks for some more food, Commissioner Gentiloni piously hopes for just a little bit more economic growth.
His timid attitude is appropriate: the entire case for economic growth in the Commission’s outlook rests on a little bit less inflation and a small decline in interest rates.
Frankly, if I had to present this report to the people of Europe, I would also be humbled. The expected adjustments in inflation and interest rates are modest, thus vouching for small increments in GDP growth. Normally, the economy would have other growth sources on tap as well, including high labor demand which raises money wages as employers compete for workers. However, with unemployment remaining in the 6-6.5% range (for the euro zone; 6% for the EU as a whole), there is little chance for Europe’s workforce to benefit from any excess labor demand.
This means, plainly, that the only generator of growth in the European economy, the real wage, is dependent on a return to price stability and the continuation of the ECB’s rate cut policy. Given that these two things happen—which is likely—the Commission predicts that the euro zone GDP will grow by 0.8% this year, 1.3% next year, and 1.6% in 2026. The numbers for the EU as a whole are slightly higher: 0.9%, 1.5%, and 1.8%, respectively.
These are modest numbers, to say the least. The Commission report suggests that they show that Europe is emerging from a protracted period of economic stagnation, but when the best real growth rate you can hope for in the next two years is 1.8%, your economy has not really left stagnation behind. It takes more than 2% real annual growth, sustained over an extended period of time, to break the shackles of stagnation.
It is understandable that Commissioner Gentiloni takes a humble approach to presenting the report. In doing so, he conveys more information to the public than what is in the economic statistics in his report. He signals, with more than his words, that Europe really does not have much to brag about, or hope for, in terms of economic future.
He is correct: in the report’s own numbers, there are no improvements in the economy for 2025 and 2026 that could not be washed away by even a moderate shift for the worse in some key variable.
With all this in mind, though, it is worth noting that the predicted modest improvements in the European economy over the next two years will indeed happen. The Commission report’s forecasted decline in inflation from 2.6% to 2.0% for the EU as a whole will at least maintain real wages; more substantive increases in household spending would come from an uptick in consumer confidence.
In short, Commission Gentiloni can rest assured that the modest GDP growth predictions are very likely to materialize.
At this point, though, the inevitable question arises: what must happen for the European economy to improve at higher rates than predicted by the Commission? Bluntly speaking: how far into the future can the EU economy survive without being sucked back into the stagnation quagmire it so desperately needs to leave behind?
In what is probably an attempt at drawing blood from a stone, the Commission outlook does express hope for an investment boom in the wake of lower interest rates. If this were to happen, it would indeed help the EU economy into a phase of stronger GDP growth. The problem is that there is not much to hope for here; generally speaking, for every €100 that businesses spend on capital formation, about €90 are motivated by increased demand for their products.
The influence of interest rates on investments is, at best, of the residual kind.
In the situation that the EU finds itself in today, a concerted effort at deregulating the economy would very likely have a stronger effect on corporate investments than any given drop in interest rates would have. This deregulation effort has to be centered around the vast array of ‘environmental’ regulations that ensnare businesses across the European continent. If it could also extend to labor laws, it would do miracles to improve the overall business climate, and thereby strengthen the incentives for investments.
As a benchmark estimate, regulations account for about €50 of every €100 a business pays in taxes. Some regulations are of course more costly than others but in general, there is a great deal of potential for improvements in Europe’s business climate, if only the appropriate authorities would take this potential seriously.
An even stronger potential source of economic growth lies in the reduction of the size of government. Across the EU, government spending consumes 40-50% of GDP, with taxes not far behind. At these levels, public sector outlays significantly intrude on the forces that generate economic growth; for every ten percentage points that that spending-to-GDP ratio rises above 40% of GDP, real GDP growth falls at least by one percentage point over time.
In other words,
- If government spends 40-50% of GDP, real GDP growth falls from, e.g., 2% to 1% per year;
- If government spends 50-60% of GDP, real GDP growth falls from, e.g., 1% to 0% per year.
Other factors also affect GDP growth, including but not limited to regulations. Since that is yet another form of government intrusion into the economy, it is fair to say that government is the biggest culprit in keeping the European economy from growing and generating more prosperity.
