European public goods are key to tackle the economic challenges of 2023

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2022 left a difficult legacy for the European Union (EU)’s economic outlook. Four interrelated challenges will need to be addressed from early 2023. First, stagflation: despite a resilient labour market, surprisingly strong growth in the first three quarters of 2022, and an improvement in confidence indicators, the risks of excessive inflation and subdued growth persist. Second, a tight monetary stance could result in a fragmentation of European financial markets. Third, Russia’s invasion of Ukraine has exacerbated the energy crisis, highlighting the necessity and the difficulty of pressing ahead with the green transition as laid out in the national Recovery and Resilience Plans (RRPs). Fourth, the competitiveness challenge highlighted by the United States industrial policies, centred on the Inflation Reduction Act, has brought to the fore the EU’s wideningrising technological lag in the digital transition and the risk of setting off a race for distortive subsidies.

The threat of the European economy being caught between high inflation rates and a lasting period of weak growth (that is, stagflation) originates from the supply side. The European Central Bank (ECB) is reacting to prevent a de-anchoring of inflation expectations. However, being unable to alleviate supply-side constraints, restrictive monetary policies compress aggregate demand and, thus, depress economic activity. Moreover, an anti-inflationary strategy relying solely on restrictive monetary policies has two potential down sides: first, by leading to a worsening of the interest rate-growth rate differentials, it adversely affects the dynamics of public debt-to-GDP ratio, notably of the most fragile EU’s member states; second, the resulting increases in policy interest rates and decreases in the liquidity supplied by the ECB to the banking sector will trigger credit restrictions thereby negatively affecting economic activity. The penalisation in the production of investment goods will worsen the medium-term gap between aggregate demand and supply. The combined outcome will be a worsening of the sustainability of public finances via both the numerator and the denominator of the public debt ratio, and a lingering upward pressure on inflation.

Green, digital and underfunded

Low growth and financial constraints are likely to hinder both the green and digital transitions. At least half of the over €800 billion in resources made available to EU’s Member States by means of Next Generation-EU (NGEU) should be used for reforms and investments in the two transitions. These transitions change the composition of the labour demand, thereby requiring the re-skilling of the labour force, a higher technical education of the new human resources, and a forced exit of poorly and low skilled workers. While European labour markets have shown surprising resilience, this evolution and the protection of those left out from the new economic organisation will be challenging in policy and financial terms.

The estimated additional investment for pursuing the twin transition amount to some €650 billion per year until 2030. Hence, while substantial, the resources provided by NGEU remain a fraction of the funding needed to achieve the EU’s environmental goals and to narrow its technology gap relative to the US and China. The remaining financial resources should be covered by national public spending and private funding. However, this will be impossible without reducing the stock of high public debt on GDP in the EU’s most fragile countries and building an efficient European financial market.

Given the very high debt ratios in several EU countries, governments cannot borrow to provide the resources necessary. Instead, they should consolidate government finances to avoid destabilising financial markets. The reform of the EU fiscal rules proposed by the Commission will provide incentives for reallocating public spending towards growth-enhancing investment. Nonetheless, a large share of the funding will have to come from the private sector. Unfortunately, private sector funding will be hard to encourage without more efficient capital markets. Also, the energy crisis is pushing most EU countries to sustain both the consumption and production of traditional energy sources. These national policies due to contingent energy difficulties make the green and digital transitions even more strategic.

The dynamics triggered by the three challenges analysed are accentuated by the United States’ industrial policies introduced as part of the Inflation Reduction Act, which generate a strong political push for a further relaxation of European state aid rules. However, it is widely recognised that an indiscriminate openness to state aid would worsen divergences among individual EU countries due to the different national fiscal capacity. What is at stake is the integrity of the EU Single Market.

How to spend it

To react effectively to these four challenges, the EU should renew the political cohesion and leadership underpinning the ‘NGEU spirit’ but adapted to today’s challenges. In 2020, that approach resulted into the coordination between expansionary monetary and fiscal policies, articulated at the national and centralised level. The latter intervention focused mainly on loans and transfers made by the European Commission, on behalf of the EU, to member states more in need. Today, this same spirit would ask for a policy mix that should strengthen the production of adequate European Public Goods (EPGs), rather than conditional support to national budgets. The EU should engineer a supply side counter-shock able to offset, at least partly and in combination with the national reforms of the RRPs, the negative shock caused by the pandemic and aggravated by the energy crisis.

Cross-border projects on energy and digital infrastructures are typical EPGs that are currently underfunded. Vehicles for financing are, among others, the creation of a Sovereign fund and a hydrogen bank, or a revamping of the so-called Important Projects of Common European Interest (IPCEIs). If appropriately strengthened through a centralised financial support, the IPCEIs could activate streams of European innovations. While it will take time for those investments to come to fruition, they will affect expectations and improve trust. As a result, the burden of fighting inflation would not be left to the ECB alone, thus reducing the risks of an economic contraction severe enough to inflict lasting damage to investment and employment and compromising the future activity level and the sustainability of national public debts.

The second challenge is reducing the risk of financial fragmentation associated with tighter monetary conditions. Here again the confidence building impact of renewed political cohesion would be of great help. In this respect, two goals should be pursued: the rapid approval of the Commission’s proposals to reform the EU fiscal rules, and the strengthening of the European financial markets. The strengthening of financial markets requires, in its turn, the completion of the Banking Union and the deepening of the Capital Markets Union aimed at mobilising the liquidity trapped in the households’ financial portfolios and at easing firms’ access to non-banking financing.

An efficient European financial market is crucial also to handle the third challenge. In 2023 (and in the following three years), the green and digital transitions will require the successful implementation of the RRPs and an effective use of the additional resources allocated to REPowerEU. The twin transition should, however, also crucially mobilise private investment to finance projects that are ‘long in terms of ideas, but short in terms of collaterals.’ Deepening Capital Markets Union is key in this respect.

Finally, as to the US Inflation Reduction Act, it should be stressed that the EU’s response cannot be limited to the relaxation of state aid discipline. This could reduce the European technological lags but at the cost of widening differences within the EU: a transatlantic divide would be replaced by a European divide. Here also, strengthening the supply of EPGs would be a crucial step towards a centralised and effective industrial policy in the EU incentivising innovative investment.

Our conclusion is that the production of strategic EPGs represents the backbone of an effective response to the four challenges of 2023 and it would lessen the associated policy trade-offs. Such a response requires forward-looking political leadership confining (presumed) short-term national benefits to the background in favour of longer-term common benefits.


Marco Buti is Head of Cabinet of Commissioner Paolo Gentiloni, who is responsible in the European Commission for economic affairs and taxation. He is writing in his personal capacity.

Marcello Messori is Poste Italiane Professor of European Economic Governance at the Department of Economics and Finance, Libera Università Internazionale degli Studi Sociali (Luiss), Rome. He is writing in his personal capacity.