Source: IMF – News in Russian

July 19, 2025

Washington, DC: Europe’s economy remains resilient with record-low unemployment, headline inflation broadly at target, and a stable financial system. However, policymakers face mounting challenges, including trade tensions, rising demand for defense spending, and the need to ensure energy security, all while addressing subpar productivity, rapid aging, and weak medium-term growth. The most effective solutions require decisive EU actions. Deepening the EU single market is the key tool available to policymakers to enhance investment, innovation, and productivity. A better-integrated EU single market, in turn, calls for a joint provision of key public goods including for energy connectivity and defense—including through the multiannual financial framework. This can help internalize positive cross-border externalities of investments, leverage economies of scale, and avoid costly duplicative national efforts. Ensuring orderly growth-friendly fiscal consolidations designed to address country-specific risks is critical to preserving fiscal sustainability and managing long-term spending pressures associated with aging and increased spending on security. Diversifying economic ties and expanding rule-based trade integration can further bolster competitiveness and strengthen economic resilience. Safeguarding price and financial stability continues to be the bedrock for addressing these longer-term challenges. 

Outlook and Risks

The euro area economy is navigating an increasingly challenging global environment of higher tariffs, elevated trade policy uncertainty, and geopolitical risks. The April 2025 World Economic Outlook (WEO) projected growth to remain moderate at 0.8 percent in 2025, picking up to 1.2 percent in 2026. Trade tensions and elevated uncertainty have dimmed the outlook for domestic demand and exports, outweighing an anticipated boost from higher defense and infrastructure spending. In addition, the geopolitical situation in Europe is expected to dampen sentiment and weigh on investment and consumption, despite looser monetary policy and projected gains in real income.   

Headline inflation is close to 2 percent and, under staff’s April WEO projections, is expected to remain broadly at target with weak energy and core goods inflation offsetting elevated services inflation. Ongoing nominal wage growth moderation amid subdued activity and firmly anchored inflation expectations is expected to gradually lower services inflation. As a result, core inflation is projected to decline to 2 percent later than headline inflation, in 2026.

Risks to growth are on the downside. Trade policy uncertainty, further tariff escalation, or geopolitical tensions could weigh on demand and growth more than expected. These would likely outweigh possible positive impacts of unanticipated further fiscal easing if more countries were to boost defense spending. The April 9^th announcements of a pause in US tariffs constitutes a small upside risk to the April 2025 WEO projections as they lower the effective tariff rate on EU exports to the US.

Risks to inflation are two-sided. Lower-than-expected non-energy goods prices because of trade diversion, weaker-than-expected activity and wages, as well as the recent euro appreciation could pull inflation lower than in the baseline. On the other hand, fiscal spending could turn out larger or more inflationary than assumed in the baseline, while geopolitical tensions, supply chain disruptions and tariff escalation could lead to faster increases in import prices, and wage growth may not moderate as strongly as expected. 

Structural constraints weigh on the medium-term outlook. Risks of persistently elevated trade policy uncertainty, an escalation of tariffs, still high and volatile energy prices, and the shifting geopolitical context all add to pre-existing challenges from aging, skills shortages, and weak productivity trends.

Policy Priorities

Given the challenges outlined above, a comprehensive policy strategy for decisive EU level actions on multiple fronts is needed. The goals include strengthening potential growth amidst aging and a more difficult external environment, ensuring new public spending priorities are met without risking fiscal sustainability, and safeguarding broader macro and financial stability.

Structural and Trade Policies

To bolster productivity growth and resilience in the EU, it is crucial to enhance innovation and facilitate the scaling up of firms (Draghi 2024; Letta 2024; Adilbish and others 2025). The key lever available to achieve this is deeper integration of the EU single market. Staff analysis finds that remaining barriers within the single market are equivalent on average to a 44 percent tariff on goods and 110 percent on services (Adilbish and others 2025). More integration will unlock gains from specialization within the EU, as global value chains reconfigure and enable firms to capitalize on economies of scale. 

Staff analysis highlights four key actionable priorities to help complete the single market and realize these ambitions (Arnold and others 2025). First, lowering regulatory fragmentation. For instance, a 28^th corporate regime—alternative to national regimes—that establishes uniform regulations and legal rules crucial for not only the formation and operation of firms, but also their dissolution can provide a voluntary EU-wide legal framework to support firms’ expansion without requiring them to navigate divergent national regulations. By offering an alternative viable solution to simplify the regulatory landscape, the 28^th regime can facilitate firms’ scaling up and enhance the efficiency of cross-border capital allocation, ultimately fostering innovation. Second, advancing the Capital Markets Union (CMU) to facilitate more efficient channeling of savings to risk capital for firms. For instance, increasing institutional investors’ familiarity with venture capital (VC) as an asset class and addressing remaining undue restrictions on their ability to invest in it can help meaningfully increase VC investment in the EU from a very low level currently (Arnold and others 2024). This, together with continued efforts to complete the Banking Union (BU)—critical for a more resilient and efficient banking sector—will build a well-functioning Savings and Investments Union (SIU). Lowering barriers to cross-border bank mergers and acquisitions would help augment bank finance, address long-standing concerns of structurally low profitability and high costs, and spur competition within the euro area’s banking sector. Third, enhancing intra-EU labor mobility (such as through extending the automatic system of professional qualification recognition) can offer productive firms greater access to talent and improve skills matching. Last, integrating the EU energy market, guided by a coordinated strategy for an energy system transformation, can help provide lower and more stable energy prices. Simulation results suggest that a few actionable steps along these dimensions could jumpstart the process of deeper integration and deliver a meaningful payoff by increasing the EU potential GDP level relative to baseline by around 3 percent over 10 years, benefiting every country. In this regard, the digital euro also has an important role to play. In addition to reinforcing monetary sovereignty in the growing presence of private digital currencies, the digital euro can help deepen the integration of financial services within the European market by streamlining and unifying cross-border retail payments. It can improve payment system efficiency, reduce transaction costs, and complement the SIU and the single market more broadly.

While deeper intra-Europe integration is one key element in boosting growth prospects, complementary policy actions are needed at the national level. Recently published staff analysis (Budina and others 2025) identifies domestic structural reform priorities for individual European countries. Successful implementation—by which countries aim to close 50 percent of their prioritized policy gaps with respect to the most growth-friendly regulatory settings—would entail sizable gains in GDP level of around 5.7 percent for the EU in the medium term. The prioritized reforms cover labor market and human capital (e.g., education and training), fiscal structural issues (e.g., tax policy), business regulation, and credit and capital markets.

An escalation of trade tensions poses important challenges to the EU. The EU would benefit from its continued advocacy for a stable, rules-based global trading system. Further diversifying economic ties can help strengthen supply chain resilience and capture efficiency gains from trade. Any new industrial policies should be limited to well-defined market failures and be coordinated at the EU level.

Fiscal Policy

Fiscal risks and optimal fiscal policy strategies differ across countries. For countries with high debt and limited fiscal space, significant fiscal adjustments are needed to mitigate risks, while countries with fiscal space can implement a more back-loaded fiscal adjustment. For the euro area economies excluding Germany, staff recommends improving the structural primary balance to a surplus of 1.4 percent of GDP in 2030—a cumulative improvement of 2.9 percentage points from a deficit of 1.5 percent of GDP in 2024. Achieving this requires an additional cumulative deficit reduction of close to 2 percentage points over 2024–30 relative to the baseline (typically predicated on current budgets and specified, concrete measures under consideration).

The needed deficit-reduction creates challenging tradeoffs because, at the same time, Europe faces high and rising spending pressures that are crystallizing faster than previously anticipated. Pressures from interest costs, an aging population, climate transition and energy security, and defense would reach 4.4 percent of GDP annually for the euro area economies in 2050 (Eble and others 2025). Member states should transparently account for rising spending pressures to lay out trade-offs within the fiscal framework and develop credible plans to ensure sustainability. 

The use of escape clauses to support member states’ ramp-up in defense spending should be restricted to its initial phase. Member states and the Commission should assess the impact of increased defense spending on debt sustainability on an ongoing basis and develop plans to put debt on a stable/declining path over the medium term. Also, it is crucial that care be taken in implementing the EU fiscal rules to ensure that countries with low fiscal risks that intend to increase spending to boost potential growth and enhance resilience should not be constrained from doing so by the rules. Eventually, a broader reassessment of key parameters may be needed to achieve an optimal balance between allowing countries with low fiscal risks to fulfill spending objectives that can also have favorable EU-wide spillovers, and ensuring that debt remains sustainable.

Coordinated efforts at the EU level and targeted investments can help address shared challenges in a cost-effective manner, supporting member states in managing fiscal tradeoffs (Busse and others 2025). Identifying existing investment gaps and areas where joint EU-level initiatives would deliver cost-effective solutions can provide a blueprint for priority actions—for instance, public goods investment including on innovation, clean energy transition, and collective defense. To support investments in these areas, the EU budget size will need to increase by at least 50 percent, if existing programs are to be maintained. Coordinated investments that better internalize positive cross-border externalities and minimize duplicative national efforts will generate net budgetary savings for member states. In the area of the clean energy transition, for instance, our recent work estimates that better EU-level coordination and planning can lower investment costs by 7 percent (IMF 2024). In addition, reforms are needed to make the budget more streamlined, responsive to evolving needs, and more effective by incentivizing good performance. A performance-based approach that links financial support to implementing national-level reforms that support EU priorities and enhance growth potential can deliver objectives more effectively, particularly in areas where incentives are currently weak, and outcomes are closely linked to efforts. Lastly, strengthening the financing framework of the budget with borrowing capacity and increased own resources will help meet the growing demand for EU level investment in shared priorities in a timely manner while spreading the fiscal burden over time.

Monetary and Financial Sector Policies

Since headline inflation is broadly at target, core inflation is slightly above 2 percent, and the output gap is mildly negative, a monetary policy stance close to neutral is justified. Barring further shocks that materially revise the inflation outlook, maintaining the policy rate at 2 percent will help keep inflation around target in the second half of 2025 and beyond. But the outlook is highly uncertain, and the policy path may need to be adjusted on the basis of incoming data or developments.

The concurrent Financial Stability Assessment Program (FSAP) found that the banking system generally appears adequately capitalized and liquid, but the authorities should closely monitor the vulnerabilities from the growing NBFI sector. Although financial stability risks linked to past monetary tightening are easing, a deteriorating business environment for corporates, especially those with trade exposures to the US, could weigh on banks’ otherwise healthy balance sheets. Moreover, new systemic risks have emerged, particularly from market volatility due to higher tariffs and banks’ exposures to NBFIs. Authorities should stand ready to address potential liquidity stress, including by preparing a framework for the provision of emergency liquidity assistance to NBFIs, paired with closer oversight.

Facilitating better data sharing among EU and national authorities will improve risk monitoring, particularly to close gaps that hinder system-wide analyses. A key policy priority is to improve system-wide risk monitoring of the financial sector beyond banks, including by closing data gaps arising from legal restrictions for sharing or timely access by supervisors, which currently limit the ability to undertake complete system-wide analyses.

Fragmentation continues to hinder the full benefits of the banking union and the development of a more resilient, deeper and integrated EA-wide financial system. Further steps to strengthen the euro area financial architecture include completing the Banking Union with the introduction of a common deposit insurance system; allowing a greater use of national deposit guarantee funds for resolution and making bail-in requirements more flexible; putting in place arrangements for the Single Resolution Fund to provide guarantees to enhance the provision of central bank liquidity in resolution, ideally with an EU fiscal backstop; fully implementing the international capital standard for banks (Basel III); and strengthening the resources and prudential powers of the European authorities overseeing NBFIs, including empowering ESMA to top-up national measures for substantially leveraged investment funds and to enforce cross-border reciprocation.

https://www.imf.org/en/News/Articles/2025/06/18/mcs-06182025-euro-area-imf-cs-of-2025-mission-on-common-policies-for-member-countries

MIL OSI