A Resilient European Economy

Defying all doomsayers, the European economy is performing much better than expected. According to the European Commission estimates, economic growth in 2022 has exceeded 3 percent (more than half a percentage point above the summer forecast), unemployment is at a historical low of 6.5 percent, and industrial production has fallen much less than expected. In the Eurozone, which includes economies more affected by higher energy prices triggered by the Russian invasion of Ukraine (like Germany and Italy), the economy has slowed down, but annualized growth in the last quarter of 2022 reached 2.1 percent (in the United States it was 1.9 percent). The European Union is demonstrating its economic resilience.

Nonetheless, Europe faces a challenging 2023. Virtually unplugged from Russian energy, some European countries may fall into a technical recession in 2023 and inflation will probably continue to rise. But unlike the previous crises (the Covid-19 induced economic catastrophe and the 2008–2012 global financial crisis/Eurozone crisis), this economic contraction, if it takes place, will probably be mild and short. However, the European Union needs to take advantage of the resilience of its economy to accelerate structural changes in its growth model and its economic governance.

The Economic Collapse That Did Not Happen

It took more time for European economies to recover from the impact of the Covid-19 pandemic in 2021 than in the United States. But when the economy started to rebound, the Russian invasion of Ukraine in late February 2022 prompted a flood of pessimistic economic forecasts. Central and eastern European economies (especially Germany) had based their prosperity on a combination of cheap Russian gas and growing exports to China. The former was suddenly over, and the latter will have to be seriously revised because China was becoming a risky market for investment as well as a geopolitical rival that could no longer be trusted. With inflation at already high levels due to years of expansionary monetary and fiscal policies, economic prospects were gloomy, and some even talked about a revival of 1970s stagflation.

Fast forward to the beginning of 2023, and the economy has been much more resilient than expected. There is no doubt that, as a result of the war in Ukraine—which triggered a massive increase in energy and commodity prices worldwide and the zero-Covid policies (now abandoned) that accelerated China’s structural economic slowdown—European economic growth has slowed and will continue to decelerate. However, this is also happening in other parts of the world.

The good news is that the European Union has made good economic policy choices and has also enjoyed some unexpected tail winds (the situation is different in the United Kingdom, but here we are focusing on the European Union).

First, EU countries have implemented targeted expansionary fiscal policies. On top of the NextGenerationEU program of public investments, all governments have been taking measures to shield citizens and companies from the increase in electricity and gasoline prices. This has ensured that domestic demand (investment and consumption) has not been drastically reduced. These support policies, with some tweaks, will continue in 2023.

Second, monetary policy, while more restrictive than in the past, has still been expansionary. For instance, real interest rates, the result of nominal interest rates minus inflation, are still negative. With the U.S. Federal Reserve being much more aggressive in restricting liquidity, the euro has depreciated against the dollar, favoring Eurozone exports. Moreover, the limited increase in interest rates has not generated substantial reductions in credit nor a real estate market crash. The downside has been persistent inflation, which probably has already peaked in the United States but not in the eurozone. This could be problematic because it could force the European Central Bank (ECB) to increase interest rates further and keep them at higher levels for longer, but that is probably an issue for 2024.

Third, energy and commodity prices have fallen. For instance, gas prices, which skyrocketed following the Russian invasion of Ukraine, have almost returned to prewar levels, alleviating European economies. Additionally, policies to substitute Russian gas with other forms of energy, efforts to find alternative suppliers and, above all, savings from cuts in consumer demand, have worked remarkably well.

The European Union also launched the RePowerEU plan, a framework that allowed countries to take short-term measures to alleviate the difficulties of households and businesses. It also agreed on an embargo on Russian coal and oil, a price cap on Russian oil exports and, after intense negotiations, reached a decision to buy 15 percent of its gas jointly in 2023 and apply to it a price cap. As a result, the European economies probably face the 2023 winter with sufficient reserves to avoid energy cuts, especially if temperatures continue to be mild and French nuclear plants continue increasing electricity production (problems might arise in the winter of 2024, but that is still far away). Moreover, European countries have shown a remarkable capacity to react fast and respond cooperatively to energy challenges. In December 2022, they even passed a reform of the European Trading Scheme (ETS) to further reduce greenhouse gas emissions and launched the controversial carbon border adjustment mechanism (CBAM) to level the playing field between European companies and foreign competitors that produce under lower environmental standards.

Finally, the financial system looks stable. Despite slower growth, higher interest rates, and a euro-critical extreme right government in Italy, there are no signs of financial fragmentation or complications on the financial sector that could trigger sovereign debt problems. In fact, the mechanisms put in place to avoid financial crisis in the eurozone in the last decade, coupled with the new role that ECB is playing in the last years as a lender of last resort, seem to have convinced investors that the single currency is here to stay.

What Should Be Done Now

The European economy has not collapsed but faces serious structural challenges. European leaders should use this critical juncture to rethink its growth model and improve its economic governance schemes.

The growth model based on austerity and exports that European countries implemented to recover from the global and eurozone crisis of the past decade cannot be replicated. The tendency towards protectionism and deglobalization, the fragility of the multilateral trading system, and the domestic opposition to austerity in most European countries make this strategy politically unsustainable. Moreover, the European Union can only thrive in a world of great power competition and geopolitical tensions if it deepens its political integration, invests more heavily on an industrial policy that accelerates the digital and green transitions, and develops a coherent foreign and security policy.

All that requires more flexible fiscal rules, joint borrowing at the European level, and a permanent fiscal capacity to finance European public goods that strengthen Europe as a whole. Such dramatic changes have never explicitly been put on the table both because they are rejected by those who oppose an “ever closer union” and because they may require treaty change (equivalent to constitutional change in the United States), which has been considered politically arduous and risky. But with a war in European soil, the United States and China reinforcing their industrial policies with large subsidies, and a European economy that has proven resilient and that still has fiscal space (debt to GDP in the Eurozone is more than 20 percentage points lower than in the United States), Europe has a unique opportunity to take an ambitious leap forward.

To do so, it should transition from the German approach of a small, open economy that behaves like a “price taker” to the U.S. approach of a globalized economy with strong internal demand and the capacity to shape the international economic order.

Federico Steinberg is visiting fellow with the Europe, Russia, and Eurasia Program at the Center for Strategic and International Studies in Washington, D.C and a senior analyst at the Royal Elcano Institute.