Regional Economic Outlook for Europe, October 2024: A Recovery Short of Europe’s Full Potential

A Recovery Short of Europe’s Full Potential

Europe’s economy is recovering, benefiting from a strong crises’ response. Yet, the recovery is falling short of its full potential. Uncertainty about persistent core inflation, policy directions, and geopolitical conflicts, is dampening the near-term outlook. In the longer term, perennially weak productivity growth—a result of limited scale and business dynamism–-amid new headwinds from fragmentation and climate change are holding back growth potential. Steady macro policies are needed to navigate an uncertain environment. This requires transitioning to a neutral monetary policy stance and reducing fiscal deficits without jeopardizing the recovery. Policymakers also need to tackle barriers to higher potential growth. A larger and more integrated single market for goods, services, and capital will incentivize investment, innovation, and generate scale benefits. Deepening European integration will also strengthen economic resilience by insulating businesses and labor markets from global fragmentation pressures. These are formidable policy challenges, but now is the time to bring Europe to its full potential.

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REO NOTES

Note One: Europe’s Declining Productivity Growth: Diagnoses and Remedies

Europe’s widening productivity gap with the U.S. has deep firm-level roots. Compared to the U.S., Europe’s leading firms innovate and grow less, while young high-growth firms have a smaller footprint in the economy and tend to remain small. Bottlenecks like smaller markets and limited equity financing hinder leading firms to innovate and scape up, particularly in tech sectors. To unlock the potential of young high-growth firms, human capital investment and greater risk capital availability are needed. Beyond long-documented policy priorities—improving the design and coordination of public support to R&D, education systems—the chapter’s findings highlight the importance of removing intra-Europe barriers to factor and product markets integration for improving business dynamism and reviving Europe’s productivity growth. This regional agenda must be complemented by domestic reforms to lower barriers to firm entry, facilitate exit, and remove tax and regulatory disincentives to grow.

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Note Two: Accelerating Europe’s Income Convergence through Further Integration

Raising Europe’s growth requires economic convergence meaning that activity expands the fastest where opportunities are the largest. EU accession has been a catalyst for convergence in the past and could be so again in the future. During the early 2000s, the prospect of joining the EU, followed by actual membership, helped put the necessary conditions in place: effective integration and structural reforms opened economies and improved their connectedness, benefiting both old and new member states (MSs). Due to EU accession, average regional GDP per capita in new MSs increased by more than 30 percent, with larger gains for poorer regions. Productivity catch-up, driven by innovation and higher educational attainment, along with substantial capital investment, primarily through FDI, contributed equally. More recently, productivity growth slowed. Based on new estimates, Europe’s income gap to the US could be reduced by around 10 percentage points through a new enlargement round. If paired with deeper integration to reduce remaining barriers within the EU, benefits could be magnified.