COMMISSION STAFF WORKING DOCUMENT 2026 European Macroeconomic Report Accompanying the document Recommendation for a COUNCIL RECOMMENDATION on the economic policy of the euro area
Date: 2025-11-25
Institutions: Directorate-General for Economic and Financial Affairs, European Commission
Subjects: EU banking union, EU budget, economic growth, economic policy, economic reform, euro area, fiscal policy, innovation, macroeconomics, single market

EN 

  EN 

   EUROPEAN COMMISSION  Strasbourg, 25.11.2025  SWD(2025) 957 final  COMMISSION STAFF WORKING DOCUMENT 2026 European Macroeconomic Report Accompanying the document Recommendation for a  COUNCIL RECOMMENDATION on the economic policy of the euro area {COM(2025) 957 final}  
 
 
CONTENTS 

Executive Summary 

1. 

Economic landscape 

2.  Macro financial risks 

3. 

EU savings in the context of geoeconomic risks 

4.  Macroeconomic impacts of defence spending 

References 

LIST OF TABLES 

4.1. 
4.2. 
4.3. 

Procurement by EU Member States from EU and non-EU sources (EUR billion) 
Time horizons for the development and production of weapons systems 
Modelling assumptions for the two components 

59101112131416181920212223242930313233343536373739404143464750515256585859606266 

LIST OF GRAPHS 

1.1. 
1.2. 
1.3. 
1.4. 
1.5. 
1.6. 
1.7. 
1.8. 
1.9. 
1.10. 
1.11. 
1.12. 
1.13. 
1.14. 
1.15. 
2.1. 
2.2. 
2.3. 
2.4. 
2.5. 
2.6. 
2.7. 
2.8. 
2.9. 
2.10. 

Global long-term trends affecting the euro area and the EU 
Unemployment and GDP 
Wages and inflation in the euro area 
EU’s extra-EU trade invoicing shares by currencies 
Fiscal developments in the euro area, the EU and other international peers 
Euro area policy mix 
Public investment and direct and spillover impacts of RRF funds 
Growth and innovation 
EU Production volume of EII and other manufacturing sectors 
Innovation and venture capital investment 
The electricity market 
The Single Market 
Economy-wide PMR indicator 
EU trade agreements 2025 
Saving rates and market sizes. 
Current account in the euro area and net lending in the EU 
Current account and NIIP across EU countries 
EU current account and current account in the euro area and other large world economies 
Decomposition of HICP inflation in the euro area and of GDP deflator in the EU 
Decompositions of ULC growth and cumulated inflation differentials in EU countries 
Real effective changes rates in the EU 
Price level versus potential GDP per capita, in central and eastern European Member States 
Decomposition of changes in private debt 
Household finances: cost of borrowing and net interest income 
Non-financial corporations finances: evolution of profits and vulnerabilities 

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2.11. 
2.12. 
2.13. 
2.14. 
3.1. 
3.2. 
3.3. 

3.4. 
3.5. 
4.1. 
4.2. 
4.3. 
4.4. 
4.5. 
4.6. 
4.7. 

Government finances 
Yields in 10-year government bonds 
Banking sector: profitability, capital ratios and asset quality 
House prices and housing supply 
The EU external surplus reflects high private savings, while the US deficit mirrors its fiscal stance 
The EU allocates savings abroad, while the US needs foreign savings for funding 
EU households have recorded higher financial savings flows than their international peers, and allocate them 
mostly in deposits 
Despite higher financial savings, EU households’ wealth levels remain relatively low 
EU households' financial asset allocation vis-à-vis counterpart-sectors, adjusted flows from 2023 to 2024 
Defence expenditure in the EU and other international players 
Market capitalisation and venture capital investment 
Defence-related companies: location of headquarters and industrial production 
Size of the military work force and employment in EU defence-related sectors 
Defence-related educational attainment and evolution of job hirings 
Euro area fiscal stance and fiscal adjustment needs 
QUEST Simulation results, reaching the NATO 5% of GDP target by 2035, EU27 

LIST OF BOXES 

2.1. 
3.1. 
4.1. 
4.2. 

Economic uncertainty and the corporate sector 
Higher perceived US dollar risk 
R&D spillovers 
Simulation results of the extra 1.5% of GDP component 

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66 

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67 

LIST OF ANNEXES  

A1 

The European Union and euro area in the world 

63Error! Bookmark not defined. 

 
 
 
 
 
 
 
EXECUTIVE SUMMARY 

The  euro  area  and  the  European  Union  are  navigating  an  increasingly  complex 
international landscape. Shifting geopolitical dynamics, rapid technological advancement, rising 
climate  risks,  an  ageing  society,  and  low  productivity  are  affecting  economic  prospects.  These 
developments  present  significant  challenges  but  also  transformative  opportunities  for  the  euro 
area and the EU, underscoring the critical importance of robust macroeconomic policy frameworks.  

This  new  European  Macroeconomic  Report  (EMR)  analyses  these  challenges,  and  it 
provides a comprehensive overview on these aspects. By providing solid analysis it aims to 
inform  strategic  policy  choices  to  strengthen  the  euro  area  and  EU’s  resilience  in  the  face  of  a 
rapidly evolving global order. This year’s report is divided into four chapters. The first two chapters 
provide  an  overview  of  the  macro-structural  landscape  and  review  the  risks  of  macroeconomic 
imbalances  with  special  attention  given  to  the  economy  of  the  euro  area.  The  thematic  chapters 
three  and  four  are  respectively  examining  the  allocation  of  savings  and  the  macroeconomic 
impacts of defence spending.    

At  the  backdrop  of  strong  headwinds  in  recent  years,  the  euro  area  and  the  EU  have 
continued  to  grow,  albeit  at  a  modest  pace.  Member  States  have  recovered  their  pre-
pandemic  income  levels  and  unemployment  rates  have  reached  historically  low  levels.  The  EU 
budget,  particularly  the  Recovery  and  Resilience  Facility  (RRF),  has  played  a  crucial  role  in 
supporting public investment and driving growth. However, as outlined in Chapter 1, growth remains 
constrained by sluggish productivity, which threatens the European economy's long-term prosperity 
and  global  influence.  The  rise  of  emerging  market  economies,  at  times  engaging  in  unfair 
competition practices, and persistently high energy costs further weigh on the competitiveness of 
EU producers. The first chapter finds that to unlock new opportunities and drive growth, the euro 
area  and  the  EU  need  to  focus  on  three  key  areas:  supporting  innovation  by  increasing  R&D 
spending and leveraging human capital; further deepening the Single Market and expanding trade 
partnerships;  and  unlocking  private  investment  to  finance  the  Union  priorities  through  initiatives 
such as the Savings and Investment Union. Long-run growth also depends on EU’s ability to bolster 
its  economic  security  and tackle  dependencies in  numerous  strategic value  chains.  By  addressing 
these  challenges  and  capitalising  on  its  strengths,  the  EU  and  the  euro  area  can  reinforce  their 
global standing and ensure long-term growth and prosperity. The euro area also stands to benefit 
from growth drivers linked to the single currency. These include the creation of a digital euro and 
an  enhanced  international  role  of  the  euro,  which  would  also  serve  to  boost  Europe’s  economic 
sovereignty.  Overall,  the  euro  area  and  the  EU's  ability  to  adapt  to  the  changing  geopolitical 
landscape and to seize opportunities linked to the transition to a digital and decarbonised economy, 
and the need to strengthen our security will be crucial in determining its success. 

In  order  to  ensure  macroeconomic  stability  and  balanced  growth,  a  number  of 
vulnerabilities must be addressed. These are examined in Chapter 2.  First, the euro area and 
the  EU  have  consistently  run  an  external  surplus,  making  them  more  vulnerable  to  external 
developments  and  hindering  domestic  growth  prospects.  This  trend  reflects  an  excess  of  savings 
over  investment,  with  households  as  the  main  contributors.  While  abundant  savings  provide  the 
means  to  fund  European  priorities  and  strengthen  the  economy,  they  are  often  invested  abroad, 
highlighting  the  need  for  deeper  and  more  integrated  capital  markets  in  Europe.  Second, 
government debt dynamics are becoming more challenging as the favourable differentials between 
interest rates and nominal GDP growth of recent years are diminishing.  Moreover, Member States 

1 

 
 
face  increasing  defence  spending  needs  and  significant  investments  in  the  digital  and 
decarbonisation transitions. Ageing populations are putting further pressure on pension, health, and 
long-term care spending. To address these challenges, medium-term fiscal  strategies are needed 
to  strengthen  debt  sustainability.  This  will  require prioritising  spending  and  rationalising  spending 
programmes, mobilising revenue, and implementing structural reforms to boost growth. Third, the 
chapter also discusses how inflation differentials are a particular concern within the euro area and, 
if persistent, they can undermine the effectiveness of monetary policy. At the same time, housing 
affordability has become a macroeconomic issue in many countries. House prices are rebounding, 
as low investment keeps housing supply muted. 

The euro area and the EU are characterised by high private savings. Chapter 3 discusses 
how savings are largely channelled to the US, with no clear signs of a shift away from this trend. 
An  analysis  of  EU  capital  flows  shows  that  a  significant  portion  of  European  savings  originates 
from  households,  whose  savings  rates  are  consistently  higher  than  those  of  their  international 
peers. European households tend to favour traditional investment channels, such as bank deposits, 
and rarely invest directly in capital markets. Instead, most of their financial wealth is intermediated 
through  the  financial  sector,  which  ultimately  channels  about  half  of  these  savings  into  assets 
abroad.  This  limited  investment  by  households  in  European  firms  reflects  the  fragmented  and 
underdeveloped nature of Europe's capital markets. Advancing towards a genuine Capital Markets 
Union is therefore essential. A multifaceted strategy is needed to strengthen the EU economy and 
enhance  the  attractiveness  of  the  euro  as  an  international  currency.  This  can  be  achieved  by 
improving  the  efficiency  and  resilience  of  the  financial  sector  and  promoting  more  effective 
intermediation of household savings to support EU companies and investments. By doing so, the EU 
can unlock the potential of its savings and drive economic growth and stability. 

The  increase  in  government  spending  on  defence  capabilities  is  a  critical  dimension  in 
the current macroeconomic landscape in the EU. This issue is examined in Chapter 4. Russia’s 
aggression  on  Ukraine  and  adverse  geopolitical  developments  have  led  to  a  significant 
deterioration  of  European  and  global  security.  The  chapter  finds  that  a  significant  expansion  of 
industrial  capacity  in  the  EU  is  required  to  meet  the  new  security  needs.  Efficient  and  effective 
spending requires a coordinated approach among EU Member States. Pooling procurement efforts 
could help achieve economies of scale, which would give Member States more buying power and 
encourage  the  expansion  of  the  European  defence  industry’s  production  capacity.  An  increase  in 
defence  spending  can be  compatible  with  fiscal  sustainability if  financed  in the  medium  term by 
reprioritising government expenditure and increasing revenue. New model simulations suggest that 
meeting NATO's updated spending target could moderately increase GDP in the euro area and the 
EU. However, the impact of this increase varies significantly depending on several factors, such as 
import  content, the degree  of  frontloading,  the  share  of  infrastructure  spending,  and  the  level  of 
debt  financing.  In  fact,  the  increase  in  defence  spending  has  positive  effects  especially  if  the 
additional defence spending focuses on domestic investment and R&D, rather than just imports or 
current  spending.  The  impact  of  higher  defence  spending  on  total  employment  is  expected  to  be 
modest, while it could have implications on skills shortages in specific occupations.  

2 

 
1. ECONOMIC LANDSCAPE  

The  European  economy  is  navigating  a  complex  international  landscape,  marked  by  shifting 
geopolitical  dynamics,  rapid  technological  advancements,  and  increasing  climate  risks.  The  euro 
area and the EU economies have proven resilient, absorbing large shocks while continuing to grow 
at  a  modest  pace.  However,  the  current  environment  presents  both  significant  risks  and 
transformative  opportunities  for  the  Union,  underscoring  the  need  for  robust  macroeconomic 
surveillance and adaptable policy frameworks.   

The changing economic landscape presents significant challenges to the 
euro area and the EU  

The euro area and the EU are navigating an international landscape marked by elevated 
uncertainty  and  evolving  security  challenges  (1).  The  geopolitical  order  is  shifting.  In  recent 
years,  trade  barriers  have  been  increasingly  used  as  a  geopolitical  and  industrial  policy  tool, 
undermining  the  rules-based  trade  system.  This  trend  has  been  accelerated  due  to  the  US’s 
unilateral decision to significantly raise import tariffs (Graph 1.1.a and Box 1.1 on recent trade 
developments).  At  the  same  time,  the  continued  ascent  of  emerging  economies,  particularly 
China,  has  altered  the  economic  landscape.  Russia’s  war  of  aggression  against  Ukraine  also 
demonstrates  the  reality  of  security  risks  in  Europe.  The  euro  area  and  the  EU  have  proven 
remarkably  resilient  in  recent  years,  absorbing  large  shocks  while  continuing  to  grow,  albeit  at  a 
modest pace, which demonstrates the strength and adaptability of its economy. 

The challenges and transformations facing the euro area and the EU are compounded by 
pre-existing trends. First, digitalisation and rapid technological advances, including the progress 
in the field of artificial intelligence (AI) and decarbonisation (Graph 1.1.b), are redefining industries 
and business models. Second, climate-related risk is also becoming an increasingly pressing issue 
in Europe, with more frequent and severe natural disasters  (Graph 1.1.c). At the same time, the 
acceleration  in  global  warming  calls  for  progress  with  the  decarbonisation  of  economic  activity. 
Lastly, major demographic shifts  are taking place, marked by  a shrinking working-age population 
and increasing dependency ratios, with important implications for the EU economy, labour market 
and social security systems (Graph 1.1.d).  

3 

 
 
Graph 1.1: Global long-term trends affecting the euro area and the EU 

Notes: Graph b): LCOE stands for levelized cost of electricity. These are reported without subsidies or tax credits; Graph 
c): The 30-year moving average for total and insured economic losses is calculated by pooling all weather- and climate-
related events. 
Source: Graph a): Economic policy uncertainty; Graph b): Bloomberg NEF; Graph c): European Environmental Agency; 
Graph d): European Commission services based on Eurostat and OECD data and EUROPOP population projections. 

4 

 
  
  
(Continued on the next page) 

5 

Box 1.1: The reshaping of global tradeThis box examines how recent changes in US trade policy are reshaping global trade dynamics and examines how Chinese trade is diversifying with impacts on the EU as well. In 2025, the US triggered one of the sharpest shifts in trade policy in decades. The US announced a broad package of import tariffs, pushing the effective import tariff rates from 2.4% in 2024 to around 17.9% by October 2025 (Graph 1.a). The anticipation of US tariffs has triggered a surge in global trade in 2025-Q1 and a strong albeit temporary impulse to global merchandise trade activity. Many US firms frontloaded their purchases and US goods imports rose nearly 18.4% q-o-q in 2025-Q1. Consequently, global merchandise trade expanded by 4.5% y-o-y in the first quarter, well above the 2.3% annual growth recorded in 2024. However, by April the effect reversed: US imports declined by 20% m-o-m and continued to decline in 2025-Q2, dragging down global trade momentum. The tariffs have been felt most prominently in US–China trade. Chinese exporters frontloaded shipments in early 2025. Exports to the US then fell sharply as the escalating trade conflict in April resulted in tariffs peaking at 145% and despite the temporary tariff reduction during a truce extended until November (1). In spite of this China’s total exports overall have shown remarkable resilience growing by 8.6% y-o-y in 2025-H1. Transhipment activity is playing a significant role in sustaining export levels, with “connecting countries”, particularly in Southeast Asia, serving as key hubs for re-exporting Chinese goods. Moreover, China is diversifying its exports, with most regional export markets posting rapid growth during the first half of the year (Graph 1.b). Overall, these trends more than compensate for the decline in Chinese exports to the US.   Graph 1: US import tariffs and China export diversification    Notes: Graph b): Regional aggregates are Sub-Saharan Africa (SSA), Middle East and North Africa (MENA), ASEAN members (ASEAN), South Asia (SA), Gulf Cooperation Countries (GCC), non-EU Europe (EnonEU), Latin America and Caribbean (LAC), European Union (EU), Oceania (OCE), East Asia (EA), USMCA members ex-US (USMCA), Eastern Europe and Central Asia (EECA). Source: Graph a): The Yale budget Lab; Graph b) China’s Customs Administration. Shares of China in EU imports have increased marginally in 2025 for total goods, but more significantly for manufactured goods. To investigate the diversion of Chinese goods, imports from China must be analysed against a broader trend in imports, that are likely to follow EU domestic demand. China accounted for 22.1% of total EU imports (2) in the first 8 months of 2025 (Graph 2.a), marginally up from 20.8% in 2024, 20.9% in 2023 and 21.1% in 2022. The increase in China shares was  (1) In 2024, before the increase in US tariffs, Chinese goods exports to the US amounted to approx.  14.7 percent of China goods exports and approx. 13.3 percent of US goods imports. (2) EU imports and exports mean in this box extra-EU imports and exports. 0510152025301900191019201930194019501960197019801990200020102020%a) US Effective Tariff RateUnited StatesEastern Europe & Central AsiaMexico & CanadaEast AsiaOceaniaEuropean UnionLATAM & CaribbeanOther EuropeGCCSouth AsiaASEANMENASub-Saharan Africa-15-10-50510152025%b) Change in China export value -Jan-Jul25 vs Jan-Jul24 
 
  
 
Box (continued) 

The euro area and the EU have remained resilient  

Despite  strong  headwinds,  the  euro  area  and  the  EU  have  continued  to  grow  over  the 
past  years.  By  the  end  of  2022,  most  Member  States  had  recovered  their  2019  income  levels, 
recouping the income losses experienced during the pandemic. Since then, the euro area and the EU 
economy have grown at an average pace of 0.7% in 2023-24 and they are expected to grow by 
1.3%  and  1.4%  respectively  in  2025.  The  performance  of  the  euro  area  and  EU  was  driven  by 
domestic  demand,  sustained  by  easing  financing  conditions,  the  rollout  of  the  Recovery  and 
Resilience  Fund  (RRF),  a  sound  financial  sector  (see  Chapter  2),  and  robust  labour  market 
outcomes.  Importantly,  the  unemployment  rates  in  the  euro  area  and  the  EU  are  currently  at 
historically low levels (Graph 1.2.a). 

6 

particularly noticeable in other manufactured goods whose share reached post-COVID highs in the second quarter (3).  EU imports from China expand at elevated rates in 2025 amid initial signs of rising competitive price pressures. The EU is one of the most likely directions of diversion of Chinese goods – given the size of the market. Early signals point to elevated imports dynamics in 2025 (compared to historical averages), though no immediate evidence of the impact of the tariff surge from April. Volume of total imports from China were up by 12.1% y-o-y in the 8 months of 2025, visibly above growth in recent years, thought for some categories (chemicals) the increase was markedly higher. Elevated import volumes were accompanied by the deepening price (unit value) deflation (Graph 2.b). Annual rate of change of Chinese imports prices fell from 0.8% y-o-y in the first quarter of 2025 to -1.9% in the second and -3.7% on average in July-August.   Graph 2: EU imports from China   Notes: Graph a): Seasonally and calendar adjusted values of imports. Shaded area represents a higher tariff environment. 2012-2024 annual averages; monthly values in 2025; Graph b): Unit values (prices). Shaded area represents a higher tariff environment. 2016-2024 annual averages; monthly values in 2025. Source: Eurostat.   (3) The EU Commission Trade Diversion Monitor increasingly identifies growth in Chinese goods imports as “potentially harmful” in 2025. China has been identified as a source of potentially harmful increases to a much higher extent than other regions, with affected sectors including textiles, wood productions, chemicals, basic metals, machinery and equipment and transport equipment.  0102030405012141618202224Feb-25Apr-25Jun-25Aug-25% of total ex-EU imports of EU a) Shares of China in extra-EU imports of EU: Values of importTotal - all productsRaw materialsChemicals and related products, n.e.s.Machinery and transport equipmentOther manufactured goods2025 monthlydataAnnualaverages-20-100102030401618202224Feb-25Apr-25Jun-25Aug-25Y-o-Y % changeb) Annual change in EU imports from China: PricesTotal - all productsRaw materialsChemicals and related products, n.e.s.Machinery and transport equipmentOther manufactured goods2025monthlydata Annualaverages 
 
 
 
  
 
 
Income  convergence  within  the  EU  has  continued  in  recent  years,  although  not  in  all 
countries. Between 2019 and 2025, GDP per capita grew  faster than the EU average in several 
lower  income  Southern  and  Central  and  Eastern  Member  States  (Licchetta  and  Mattozzi,  2023) 
(Graph  1.2.b).  EU  funds  have  played  a  significant  role  in  supporting  growth  and  investment, 
strengthening  social  and  territorial  cohesion  in  these  regions.  In  some  lower  income  countries, 
however,  convergence  appears  to  have  stalled.  This  is  the  case  in  Estonia  and  Czechia,  where 
income  levels,  measured  in  PPS,  relative  to  the  EU  have  remained  largely  unchanged  in  2024 
compared  with  2019  (see  Chapter  2).  Several  Northern  Member  States  have  recorded  below-
average improvements, with income levels declining in some cases.  

Graph 1.2: Unemployment and GDP 

Notes: Graph a): The min-max range is calculated for the period January 2000 – September 2025 (latest reading); Graph 
b): Red lines represent EU GDP per capita, constant prices (PPS) in 2019 (vertical) and the percentage growth of the EU 
GDP per capital, constant prices (PPS) between 2019 and 2025 (horizontal). 
Source: European Commission. 

Employment  has  been  an  important  driver  of  growth.  The  EU  employment  rate  reached  a 
record  76.1%  in  2025–Q1,  including  thanks  to  high  participation  rates  from  young  people  and 
women.  Real wages have grown in nearly all Member States, gradually returning to levels observed 
prior to the inflation surge (2). By 2024-Q2, in the euro area, wage growth had closed the gap that 
had  been  formed  following  the  pandemic  between  real  wages  and  productivity  (Graph  1.3.a). 
Additionally,  the  2024  EU-SILC  survey  found  a  decline  of  1.2  and  0.1  million  people  at  risk  of 
poverty or social exclusion was recorded in the EU and euro area, respectively. The resilience in the 
labour market is particularly notable in some Member States and illustrates that firms and workers 
adapted to changed circumstances (European Commission, 2025l). It also suggests that the various 
structural reforms adopted by Member States over the last decade are showing positive results and 
have made their economies more flexible and resilient (3), including measures aimed at enhancing 
labour  market  participation  (4).  However,  recent  data  shows  that  employment growth  has  slowed 
down, and the labour market is loosening (see Chapter 2). 

In the euro area, inflation continues to moderate (Graph 1.3.b). Since Spring 2025, inflation 
in the euro area has fluctuated around levels broadly consistent with the ECB inflation target. Euro 
area headline HICP inflation reached 2.1% in October 2025, after declining earlier in the year, while 
core inflation remains at its lowest levels in over three years. The recent appreciation of the euro 
(see Chapter 2) and stabilising wage growth are expected to support further easing of underlying 
price  pressures.  While  inflation  expectations  remain  well-anchored  overall,  household  inflation 
perceptions  have  remained  persistently  high.  Survey-based  measures  indicate  that  consumers 
perceive  inflation  to  be  roughly  twice  its  actual  level.  This  apparent  disconnect  can  likely  be 
attributed to the large rise in price levels during the period 2021–2023 and the structural increase 

7 

051015202530TotalYouthTotalYouthEUEA%a) Total and youth unemployment rates in the EU and euro area since 2000Min-maxSept-25BEBGCZDKDEEEIEELESFRHRITCYLVLTLUHUMTNLATPLPTROSISKFISE-4.01.06.011.016.021.026.031.036.0020406080ppt. change GDP per capita, constant prices (PPS)2019-2025GDP per capita, costant prices (PPS), EUR thousands, 2019b) Real GDP per capita in 2019 and 2025 in EU Member StatesEALinear (EU)Linear (EA) 
  
in inflation attention it has produced (Buelens and Lindén, 2025). While this perceptions gap does 
not  automatically  affect  inflation  expectations,  it  may  however  facilitate  their  de-anchoring  in 
reaction to inflation shocks. Furthermore, it may  weigh on consumer sentiment and lead to more 
precautionary behaviour. 

Graph 1.3: Wages and inflation in the euro area 

Notes: Graph a): Real wages are adjusted using the HICP deflator. 
Source: Graph a): European Commission calculations based on Eurostat; Graph b): Eurostat. 

The euro appreciated significantly in 2025, driven by a combination of  factors. From its 
trough  in  February  2025  to  October  2025,  the  euro  nominal  effective  exchange  rate  (NEER) 
appreciated by 7.3%, largely on account of a considerable strengthening against the US dollar and 
the Chinese renminbi (which tends to follow the US dollar). The weakness of the dollar in 2025 was 
due to a combination of macroeconomic factors, including changing yield differentials, revised US 
growth  expectations,  and  a  perceived  increase  in  the  riskiness  of  US  financial  assets  linked  to 
heightened economic policy uncertainty in the US (See Box 3.1 in Chapter 3). Similarly, the euro 
real  effective  exchange  rate  (REER)  appreciated  by  6.8%  over  the  February-August  period,  with 
various REER measures indicating that, in real terms, the euro remains close to its long-run average 
although slightly above it.  

In the short term,  the immediate effect of an appreciation of the euro is a favourable 
terms of trade effect before further adjustments take place. More than half of EU imports 
are invoiced in US dollars, implying a cheaper price in euros, provided that prices are fixed in the 
short  term  in  the  currency  of  invoice.  This  is  particularly  the  case  for  petroleum  and  related 
products, and to a lesser extent for manufactured goods (Graph 1.4.a). On the exports side, more 
than  half  of  extra-EU  exports  are invoiced in  euro, with  only  about  30% in  dollar  (Graph  1.4.b); 
this insulates most export revenues from exchange rate risk, but makes EU exports priced in euros 
more  expensive  for  foreign  buyers,  eventually  leading  to  price  adjustments  and  possible 
reallocation  of  resources. While  the  fixed  prices  assumption  could  hold in  the  short  run,  over the 
medium  term  prices  will  adjust  depending  on  demand  elasticities  and  pricing  practices.  The  final 
change  in  relative  prices  will  determine  the  extent  of  sectoral  reallocation  that  may  take  place. 
Should the euro position remain strong, it could impact the overall cost-competitiveness. This could 
particularly affect Member States with low and medium-tech exports, which are more exposed to 
substitution.  

8 

-238132002-20192122232425Pps.b) Inflation breakdownFoodEnergyNon-energy industrial goodsServicesHeadline (%)85909510010511011512012513019202122232425Index 2019Q1 = 100a) Nominal and real wagesNominal wageReal wage (HICP defl.)Price index (HICP)Real productivity 
  
Graph 1.4: EU’s extra-EU trade invoicing shares by currencies 

Source: Eurostat. 

Fiscal positions of EU Member States have improved since the pandemic, but challenges 
remain.  In  2024,  the  EU  government  debt-to-GDP  ratio  declined  to  about  81.9%,  standing  9 
percentage  points  below  its  2020  peak,  while  the  euro  area  recorded  a  similar  improvement. 
Looking ahead, the EU debt-to-GDP ratio is projected to increase to 84.9% in 2027 (91.3% for the 
euro  area),  however  remaining  well-below  the  levels  shown  by  its  international  peers  (Chart 
1.5.a).  This  projected  increase  in  the  debt  ratio  is  due  to  ongoing  primary  deficits,  including  the 
increase  in  defence  spending.  Moreover,  the  increase  in  refinancing  rates  is  leading  to  higher 
interest expenditure  (Graph 1.5.b) and hence  a less favourable interest-growth (r-g) differential. 
Looking ahead, long-term spending pressures from areas such defence, pensions, health, and the 
green  and  digital  transitions  as  well  as  from  climate  change  related  events  are  also  going  to 
increase,  putting  additional  fiscal  pressure  on  the  sustainability  of  public  finances  of  many  EU 
Member States (IMF, 2025b).  

Graph 1.5: Fiscal developments in the euro area, the EU and other international peers 

Notes: Graph b): The implicit interest rate is calculated as the ratio of interest expenditure to the outstanding debt. 
Source: European Commission. 

9 

0102030405060708090100Primary goodsexcludingpetroleumPetroleum andrelated productsManufacturedgoodsTotalb) Extra-EU imports currency invoicing shares, EU, 2024EURUSDOther EU currenciesOther0102030405060708090100Primary goodsexcludingpetroleumPetroleum andrelated productsManufacturedgoodsTotala) Extra-EU exports currency invoicing shares, EU, 2024EURUSDOther EU currenciesOther 
  
 
  
 
Overall, the policy mix in the euro area since 
2020  has  been  consistent  with  prevailing 
(5)  After  an 
macroeconomic  conditions. 
expansionary  stance  following  the  pandemic,  the 
fiscal  stance  turned  broadly  neutral  in  2023  and 
slightly  contractionary  in  2024  in  the  euro  area, 
supporting  the  fight  against  high  inflation  by  the 
ECB. The monetary policy rate in the euro area has 
come  down  closer  to  its  long-term  value  and  the 
euro  area  fiscal  stance  (6)  is  expected  to  be 
broadly  neutral  in  2025  and  2026  (Graph  1.6). 
Since 2025, the euro area fiscal  stance has been 
influenced by the adjustment requirements of the 
new  EU  fiscal  framework  aimed  at  improving 
fiscal  sustainability  and  the  activation  of  the 
national  escape  clause  that  provides  flexibility  in 
2025-28  for  higher  defence  expenditure.  Beyond 
2028,  higher  defence  spending  commitments  will 
require  additional  fiscal  adjustments,  in  addition 
to  the  pressure  exerted  by  the  financing  of  other 
priorities (see also Chapter 4).   

Graph 1.6: Euro area policy mix 

Notes:  Monetary policy is measured as the overall 
change of the ECB deposit facility rate in the year, until 
June for 2025. The fiscal stance profile in 2020-2023 
does not include the temporary impact of COVID-19 
emergency measures. 
Source: European Commission and ECB. 

The  EU  budget  has  significantly  supported  public  investment.  Public  investment  has 
increased  noticeably  in  recent  years,  especially  as  compared  to  the  post-global  financial  crisis 
developments  (Graph  1.7.a).  The  available  estimates  indicate  that  half  of  the  increase  in  public 
investment between 2019 and 2025 has been related to investment financed by the EU, mainly via 
the RRF (European Commission, 2024c) (7), The full economic impact of the RRF is yet to be realised 
and  will  depend  on  Member  States  catching  up  on  implementation  delays.  These  benefits  are 
expected  to  continue  beyond  2026,  with  important  spill-over  effects  across  Member  States  (8) 
(Graph 1.7.b)  and financial  instruments encouraging more private investment. Assuming the full 
implementation of all the Recovery and Resilience Plans (RRPs) (as of mid-January 2025), in 2020-
30  the  RRF-funded  investments  are  estimated  to  increase  the  EU  GDP  by  over  EUR  685  billion 
(around  4.9  %  of  GDP  (9),  with  direct  and  intra-EU  spillovers  impact  combined  (European 
Commission,  2025m).  According  to  the  most  recent  ECB  study,  when  the  long-term  impact  of 
structural reforms is considered, the potential output gains could reach up to 1.3% of GDP over the 
period of 2020-33 as compared to a counterfactual scenario without the RRF. 

10 

-2-1012320232024202520262027Monetary policyFiscal policyReal GDP growth 
  
Graph 1.7: Public investment and direct and spillover impact of RRF funds 

Notes: Graph b): Direct impacts of the national RRF envelopes are immediate boost in production and employment 
 in national recipient industries and the increased demand for inputs from domestic supplier industries. Spillover impacts 
are additional boosts and increased demand in national recipient economies deriving from external RRF envelopes. 
Source: Graph a): European Commission; Graph b): Michels et al. (2025) using the JRC FIDELIO model.  

The euro area and the EU face structural challenges 

While  the  euro  area  and  the  EU  have  shown  resilience  in  the  past  years,  their  modest 
productivity  growth  affects  their  growth  prospects.  Relative  to  the  US,  both  the  euro  area 
and  the  EU  have  recorded  less  total  factor  productivity  (TFP)  growth  and  less  capital  deepening 
over  the  past  decade,  implying  weaker  labour  productivity  growth  (Graph  1.8.a)  (10).  Structural 
factors  behind  these  weaknesses  have  been  discussed  in  the  Draghi  report,  including  the  role  of 
weak private investment in the EU  compared to its sizable investment needs and skills gaps and 
mismatches among the working-age population (11).  

The  productivity  growth  gap  with  the  US  has  widened  after  the  COVID-19  pandemic, 
although  an  important  part  of  this  increase  has  likely  been  cyclical  in  nature  (12).    The 
growing gap coincided with the energy crisis in Europe. The relative productivity growth slowdown 
has  manifested  itself  through  both  a  more  muted  contribution  of  capital  deepening  and  TFP. 
Concerning capital per worker, investment ratios remained relatively resilient in the euro area and 
the EU, but they recorded a strong post-pandemic increase in the US. Weak TFP growth in the euro 
area  and  the  EU,  by  contrast,  has  been  mainly  associated  with  varying  capacity  utilisation  and 
labour  hoarding.  Employment  remained  resilient  in  the  EU  also  given  lower  wage  growth  and 
declining real wage costs. 

The  increased  productivity  growth  gap  since  2023  may  also  be  associated  with 
structural  factors.  While  most  of  the  structural  conditions  explaining  the  longstanding 
productivity  gap  have  not  changed  post-COVID—e.g.,  in  terms  of  innovation  output  and  inputs, 
regulatory  and  policy  frameworks—the  sectors  that  typically  record  high  TFP  growth  rates  and 
those  that  account  for  the  bulk  of  the  EU-US  TFP  growth  gap  in  the  past  20  years  (mainly 
information  and  communication  technology  (ICT)  manufacturing  and  services  and  professional 
services)  have  been  expanding  faster  in  the  US  than  in  the  euro  area  and  the  EU,  thus  further 
widening the existing gap in terms of these sectors’ share in total GDP.  Innovation in Europe  has 
predominantly  focused  on  established  technologies  and  ‘mid-tech’  industries  (manufacturing) 
rather  than  transformative  innovations  in  digital  technologies  (European  Commission,  2024d) 

11 

 
  
(Graph  1.8.b).  Moreover,  the  private  investment  gap  in  ICT  industries,  including  AI,  has  further 
increased in favour of the US economy.  

Graph 1.8: Growth and innovation 

Notes: Graph a): Based on the European Union's Commonly Agreed Methodology for the elaboration of potential GDP 
projections. EUCAM T+10 provides a medium-term extension for the short-term T+2 forecasts and illustrates future 
growth paths if the trends of recent years were to persist into the future. The method is based on a production function 
approach, and the projections of its components - labour, capital and productivity - are determined by statistical time 
series processes and structural anchors or stabilisation rules. Both the nature of the assumed time series processes and 
the anchoring or stabilization ensure that the projections are not a simple extrapolation of current trends. 
Source: Graph a): “Output Gap Estimation Using the European Union's Commonly Agreed Methodology: Vade Mecum and 
Manual for the EUCAM Software”, Discussion Paper 148, European Commission.; Graph b): DG Research and Innovation, 
Common R&I Strategy and Foresight Service, Chief Economist Unit, based on data from the 2023 EU Industrial R&D 
Investment Scoreboard. Adaptation of Figure 2.1-9 in SRIP (2024). 

Slow  labour  productivity  growth  together  with  unfavourable  demographics  translate 
into  weaker  GDP  growth.  GDP  growth  in  the  US  has  not  only  benefitted  from  stronger  labour 
productivity  growth,  but  also  from  stronger  employment  growth  in  recent  years.  The  US  has 
recorded stronger population and labour force growth than the EU – with the US population having 
increased  by  roughly  20%  since  2000.  In  contrast,  the  EU  population  has  increased  by  just  5%, 
while  it  has  increased  by  8%  in  the  euro  area.  The  US  labour  force  increased  by  18%,  while  it 
increased by 12% and 15% in the EU and euro area respectively (13). Total GDP growth is important 
beyond  average  living  standards  (also  proxied  by  labour  productivity)  as  it  affects  fiscal 
sustainability, and notably the ability to repay debt and finance spending that is not proportionate 
to population size. Sluggish total GDP growth also means that the EU and euro area lost weight in 
the global economy. Productivity growth at the pace experienced since 2015 would only suffice to 
keep the level of real GDP of the EU economy constant by 2050, given demographic projections.  

The  European  economy's  sluggish  productivity  growth  and  unfavourable  demographics 
pose  a  pressing  threat  to  its  long-term  prosperity  and  global  influence.  With  the  US 
continuing to pull ahead, the EU's competitiveness gap is not only widening, but also jeopardizing 
its ability to finance its social model, ensure fiscal sustainability, and maintain its position on the 
world stage. If the EU fails to take ambitious action to address its productivity and competitiveness 
challenges  -  including  catalysing  private  investments  and  supporting  the  activation  of  the 
underrepresented groups in the labour market complemented by attracting talent from abroad - it 
risks  being  left  behind  in  the  global  economy.  This  could  have  far-reaching  consequences  for  its 
citizens'  standard  of  living,  its  economic  security,  and  its  ability  to  shape  the  global  agenda.  The 
persistent  productivity  gap  can  also  drive  the  current  account  surplus  and  hence  may  also 
contribute to macro-financial risks (14). 

12 

 
  
The  rise  of  emerging  market  economies  is  also  challenging  the  competitiveness  of  EU 
producers.  EU  goods  in  global  markets  face  increasing  competition  as  emerging  market 
economies—particularly  China—have  grown  more  competitive  in  sectors  formerly  dominated  by 
advanced  economies,  increasingly  producing  substitutes  rather  than  complements  to  advanced 
economy output (Al-Haschimi and Spital, 2024). China occupies a unique place given its market size 
and its manufacturing and export capacity; it is often at the forefront of the most technologically 
advanced segments such as drone, robotics and AI, sometimes outpacing the EU. 

transition 
is  expected 

Graph 1.9: EU production volume of energy 
intensive industries  and other manufacturing 
sectors 

In parallel, EU firms have faced persistently 
higher  energy  costs  in  recent  years.  Since 
mid-2021,  energy  prices—especially  for  gas  and 
electricity—have  been  elevated  despite  easing 
since the  2022-23 peaks,  remaining  above levels 
before Russia’s invasion of Ukraine and generally 
above  those  of  main  trading  partners  (see  also 
Graph 1.11.a below for electricity). Higher energy 
prices have increased production costs particularly 
in  energy-intensive 
industries,  with  negative 
repercussions  for  production  levels  (Graph  1.9) 
(15).  The 
towards  a  decarbonised 
economy 
to  deliver  sustained 
reductions  in  energy  production  costs  although 
additional 
in  clean  energy  and 
infrastructure is needed in the short and medium 
run, including to strengthen the EU electricity grid 
and  to  increase  the  flexibility  of  the  system  (16). 
According  to  Commission  estimates,  reaching  the 
Fit-for-55  objectives  would  entail  additional 
private  and  public  investment  of  about  EUR 320 
billion  per  year  between  2021  and  2030 
(excluding  transport),  compared  to  the  historical  2011-2020  trend.  Investments  into  the  EU  net 
zero manufacturing capacity will also be needed which would require around EUR11 billion annually 
between  2023-30  (17).  While  substantial,  these  investments  will  help  to  deliver  over  time 
structurally  more  predictable  and  less  volatile  energy  costs,  reduced  fossil  fuel  consumption  and 
import dependence and thereby strengthen competitiveness and security. 

Notes: Energy intensive industries (EII) is defined as the 
highest concentration of energy use across the industry, 
including chemicals, iron and steel, food and beverages, 
cement and concrete, and forest products. 
Source: Eurostat. 

investment 

Avenues to boost EU long term growth  

The  EU  should  focus  on  innovation  and  knowledge,  markets,  and  funding  to  unlock  new 
opportunities,  drive  growth,  and  stay  ahead  on  the  global  stage,  while  ensuring  its  economic 
security.  

Innovation and knowledge  

Increasing R&D spending, especially in cutting-edge technologies like AI, semiconductors, 
and  biotechnologies,  could  boost  productivity  in  the  EU,  while  contributing  to  its 
strategic autonomy. While the EU and the euro area have recently increased their  R&D spending, 
they  both  still  lag  behind  global  leaders  in  R&D  intensity,  with  a  rate  of  2.1%  of  GDP  in  2023, 
compared to 2.6% in China, 3.6% in the US, 3.4% in Japan, and 5% in South Korea (Graph 1.10.a). 
Given  its  small  size  and  dependence  on  public  funding,  the  venture  capital  (VC)  sector  in  Europe 

13 

 
  
cannot  replace  comprehensive  R&D  support  (Graph  1.10.b).  The  VC  ecosystem  in  many  EU 
Member States is fragmented, undercapitalised, and overly reliant on public subsidies, which limits 
its capacity to back long-term, high-risk research and development at scale (Mack, 2024) (see also 
Chapter 4). 

The  green,  digital  and  security  transitions  present  opportunities  for  European 
businesses. The shift towards green investment in the infrastructure and energy sectors, including 
increased  electrification  and  EU  integration  of  national  energy  networks,  is  expected  to  boost  EU 
energy  independence  over  time,  reduce  reliance  on  fossil  fuels  and  lower  energy  costs. 
Technological  advancements  are  reshaping  production  processes,  with  electrification  based  on 
clean  energy  from  renewables  being  a  key  pathway  for  their  decarbonisation  (Roser,  2020).  This 
global  shift  to  renewables  is  making  clean  energy  both  environmentally  and  economically 
beneficial, with solar and wind now often the cheapest new electricity sources in many regions. In 
2024, around half of electricity production in the EU came from renewable sources (IRENA, 2025), 
compared  to  around  a  quarter  in  the  US  (Graph  1.11.b).Integrating  substantial  amounts  of 
weather  dependent  renewable  energy  will  require  significant  investments  in  electricity  grids  and 
non-fossil  flexibility  which  are  an  integral  part  of  the  cost  paid  by  end-users  (see  also  above) 
(18).The  digital  transition,  including  developments  in  AI,  is  also  set  to  improve  productivity  and 
reduce  operational  costs  (19).  However,  the  increased  use  of  AI  presents  a  new  challenge  as  it  is 
expected  to  drive  up  energy  demand  worldwide  (20).  The  transitioning  to  higher  levels  of  defence 
spending  could  also  deliver  important  economic  benefits,  provided  funds  prioritize  EU  production 
and  are  addressed  to  the  most  productive  segments  that  also  happened  to  have  been 
underinvested for a long time (see Chapter 4).  

Graph 1.10: Innovation and venture capital investment 

Notes: Graph a): Gross domestic expenditure on R&D (GERD) includes total (private and public) expenditures; Graph b):  
Venture capital is made up of the sum of early stage (including pre-seed, seed, start-up and other early stage) and later 
stage venture capital. The EU series has been computed based on data available for 25 Member States. 
Source: Graph a): Eurostat; Graph b): OECD.  

Leverage  on  human  capital,  notably  through  upskilling,  reskilling,  and  enhancing  the 
quality  of  the  education  and  training  systems  could  boost  competitiveness.    Lifelong 
learning, flexible training programmes, and public-private partnerships are key to providing workers 
with skills in clean energy, digital literacy, and AI. EU Initiatives like the Union of Skills, the Digital 
Europe  Programme, the  Digital  Education Action Plan and the Net Zero Academies are helping to 
drive  this  effort,  with  the  latter  providing  specialized  training  in  clean  energy,  sustainability 
practices, and clean technologies. In this respect, it is important to consider how increased defence 
spending,  and  the  expansion  of  the  defence  industry  might  affect  the  labour  market,  potentially 

14 

1.52.02.53.03.54.04.55.05.514151617181920212223% of GDPa) Gross domestic expenditures on R&D EUEAUKUSJPKOCN00.050.10.150.20.250.30.350.40.450.5USCAKOUKEU (25MS)EA (17MS)JP% of GDPb) Venture Capital Investment (avg. 2013-2023) 
  
aggravating shortages in high-skilled technological fields (see Chapter 4). Enhancing the quality 
of education and training systems and aligning education systems and labour market policies with 
future  needs—including  via  policies  to  support  labour  force  participation,  enhancing  workforce 
mobility and targeted legal migration—is crucial for employability, competitiveness, and a just and 
inclusive  transition  (European  Commission,  2025j).  Properly  designed  social  protection  and  social 
inclusion schemes can act as automatic stabilisers, thus supporting household incomes and having 
a stabilising effect on the overall demand for goods and services. Combined with effective labour 
activation measures,  they  can  be  an  important  tool  to  meet  the Union’s  2030  employment  skills 
and poverty targets and support integration into the labour market of untapped labour potential.  

Graph 1.11: The electricity market 

Notes: Graph a): *NP stands for Nord pool market (NO, DK, FI, SE, EE, LT, LV). **EPB5 stands for European Power 
Benchmark. ***USA is based on most representative US power Hubs. **** Average first half of 2025. 
Source: Graph a): European Commission based on S&P Global Platts, Japan Electric Power Exchange (JEPX), Indian 
Energy Exchange Limited (IEX) India, Australian Energy Market Operator (AEMO); Graph b): European Commission. 

Beyond  productivity  gains,  strengthening  Europe’s  economic  security  is  an  essential 
precondition for sustained long-run growth. Ensuring reliable access to critical raw materials, 
diversifying supply chains, and building strategic industrial capacities—particularly in energy, digital 
infrastructure  and  defence—helps  reduce  vulnerabilities  to  external  shocks.  While  these 
investments  may  not  always  yield  the  highest  short-term  returns,  they  are  vital  to  preserve  the 
stability and resilience on which future growth depends. 

Markets 

As global trade becomes increasingly fragmented, the EU is looking more closely at ways 
to further deepen the Single Market. The Single Market has been the most important source of 
welfare  and  productivity  in  Europe,  benefitting  all  Member  States  and  the  EU  citizens  (European 
Commission, 2025k). Between 1995 and 2022, trade costs within the Single Market decreased by 
almost 40%, making internal EU trade significantly cheaper compared to trade with third countries 
such  as  the  US  (21)  (Graph  1.12.a).  However,  the  Single  Market  remains  incomplete,  with  high 
transposition and conformity deficits (22) not meeting EU targets despite progress over the last four 
years  (Graph  1.12.b).  To  unlock  the  Single  Market’s  full  potential  (23),  further  liberalisation  and 
progression  in  areas  like  services,  digital  and  energy  markets,  and  public  procurement  (24)  are 
needed. The Single Market Strategy aims to remove existing barriers and prevent new ones, with a 
focus  on  the  ten  most  harmful  barriers.  The  upcoming  Single  Market  Roadmap  to  2028  will 
contribute  to  this  goal,  setting  key  milestones  for  progress  in  areas  like  capital,  services,  energy, 
telecoms,  the  28th  regime,  and  the  fifth  freedom  for  knowledge  and  innovation.  Deepening  the 

15 

050100150200250300350ITFRNLDEUKEPB5**ESJapanNONP*AusUSA***India€/MWha) Global developments in electricity pricesAvg 21-172225****0%20%40%60%80%100%909396990205081114172023b) Electricity production in the EU by sourceWindOther renewablesSolarHydroOther non-renewablesCoalGasNuclear 
     
Single Market could also compensate for the impact of global market fragmentation, by scaling up 
EU businesses and maintaining a level playing field. 

Graph 1.12: The Single Market 

Notes:  Graph a):  Bilateral trade calculated using the Inverse Gravity Framework (Novy 2009), based on the World Bank 
Trade Costs Dataset. Graph b): The transposition deficit is measured as the percentage gap between the number of Single 
Market directives adopted by the EU and the number of those transposed by each Member State; the conformity deficit is 
measured as the percentage of directives incorrectly transposed. The EU targets for the transposition and conformity 
deficits are, respectively, 1% and 0.5%. 
Source: Graph a): Pasimeni and Dura (2025); Graph b): European Commission. 

Graph 1.13: Economy-wide PMR indicator 

Simplifying  the  regulatory  environment  can 
bring  significant  economic  benefits.  Although 
regulations  are  crucial  for  addressing  market 
failures  and  promoting  equity  and  fairness,  they 
can  impose costs on citizens and companies (25). 
Restrictive regulation may also hold back private-
sector  innovation  and  investment  (26).  Although 
product  market  regulation  in  the  EU  Member 
States  is  not  more  restrictive  on  average  than  in 
(27), 
non-EU  OECD  countries 
disparities exist across the Member States, raising 
costs  of  doing  business  in  the  Single  Market. 
Surveys  show  that  fast-changing  legislation  and 
for 
policies  are  among 
companies  operating  in  EU  countries,  alongside 
taxes  and  complex  administrative  procedures 
Similarly, 
(European 
according to the 2024 EIB investment survey, approximately two-thirds of the surveyed firms in the 
EU  consider  regulatory  environments,  including  business  regulations,  to  be  an  obstacle  to 
investment, with around half regarding it as a major obstacle. This proportion is higher than in the 
US,  while  the  opposite  holds  for  labour  market  regulation  (European  Investment  Bank,  2024).  In 
response to these concerns the Commission has put  forward proposals to simplify EU regulations 
and procedures (28). 

Notes: Low values denote good performance; range 0-6. 
Source: OECD Product Market Regulation database. 

(Graph  1.13) 

top  concerns 

Commission, 

2025d). 

the 

16 

0.00.20.40.60.81.01.21.41.61.820182023AverageEU countriesNon-EU OECD countries 
     
 
 
 
  
Graph 1.14: EU trade agreements 2025 

of 

The 

largest 

network 

geopolitical 

partnerships. 

landscape 
The 
provides  additional  incentives  for 
the  EU  to  expand  and  diversify  its 
trade 
EU's 
prosperity  relies  on  open  trade,  cross-
border investment, and resilient supply 
chains. Over the years, the EU has built 
the 
trade 
in  the  world,  boasting 
agreements 
agreements  with  76  countries  and 
enjoying  46%  of 
its  trade  under 
preferential  terms  (29).  In  response  to 
the  shifting  geopolitical  environment, 
the  EU  is  pursuing  a  multifaceted 
approach,  stabilising  its  relationship 
with the US through a new Framework 
Agreement,  while  expanding  its  global 
trade  network 
through  agreements 
with  Mercosur,  Mexico,  and  Indonesia 
(Graph 1.14).  

Funding 

Notes: 
* European Economic Area (EEA) / Overseas Countries and Territories 
(OCT). 
** Free Trade Agreement (FTA), Deep and Comprehensive Free Trade 
Agreement (DCFTA), Enhanced Partnership and Cooperation 
Agreement (EPCA), Partnership and Co-operation Agreement with 
preferential element (PCA). 
+ The updated agreements with Tunisia, and Eastern and Southern 
Africa are currently being updated; the updated agreement with Chile 
is under ratification. The DCFTA with Georgia does not apply in South 
Ossetia and Abkhazia. 
The designations employed do not imply the expression of any opinion 
whatsoever on the part of the EU concerning the legal status of any 
country, territory, city or area or of its authorities, or concerning the 
delimitations of its frontiers or boundaries. 
Source: European Commission. 

Europe’s  abundant  savings  offer  a 
robust  foundation  to  finance  its 
own priorities. The household savings 
rate—which  in  2014  stood  at  14%  of 
disposable  income  in  the  EU  and  15% 
in the euro area—shows that Europe is 
not  short  of  resources  to  finance 
investments (Graph1.15.a). However, due to the fragmented financial markets, European savings 
are often invested abroad (see Chapter 3), rather than in European businesses. By deepening its 
capital markets, Europe can turn its savings into a strong driver of competitiveness, allowing firms 
to  grow,  innovate,  and  compete  globally.  Currently,  equity  accounts  for  only  about  82%  of  euro 
area  GDP,  compared  to  more  than  255%  in  the  US,  showing  the  scope  for  catching  up  (Graph 
1.15.b). This “listing gap” limits European firms’ ability to expand and innovate, while households 
remain  under-represented  in  capital  markets  and  companies  rely  on  bank-based  funding.  The 
Savings and Investment Union (SIU) initiative, launched in 2025, aims to deepen EU capital markets 
and  to  channel  Europe’s  savings  into  productive  investments.  Key  measures  include  mobilising 
savings by supporting retail  participation in  the capital market and incentivising European private 
and institutional investors to channel funding to productive and innovative firms within Europe. 

Innovative financing could bridge the investment gap and accelerate the deployment of 
strategic technologies. Sector-specific investment funds, supported by EU guarantees  from the 
InvestEU  programme  and  co-financed  by  Member  States,  could  provide  the  capital  needed  for 
breakthrough  technologies  with  longer  development  cycles.  Additionally,  creating  incentives  for 
pension  funds  and  insurance  companies  to  invest  in  European  infrastructure  and  innovation 
projects would help redirect savings in institutional assets back into the European economy. Finally, 
the  Strategic  Technologies  for  Europe  Platform  (STEP)  was  established  to  bolster  critical 

17 

 
 
 
 
technologies in  three  sectors  relevant to  the green and  digital  transition:  digital  technologies  and 
deep  technology  innovation;  clean  and  resource  efficient  technologies,  and  biotechnologies.  STEP 
uses  resources  across  11  EU  funding  programme  and  individual  projects  can  benefit  from 
cumulative funding under several instruments on the EU budget. 

Graph 1.15: Saving rates and market sizes 

Notes: Graph a): 2024 data point for the US is missing; Graph b): 2021 latest data available. 
Source: Graph a): European Commission; Graph b): OECD. 

The 2028-2034 EU budget offers a strategic  opportunity to align capital with  Europe’s 
priorities.  Compared  to  the  2021-27  EU  budget,  the  Commission  proposal  for  the  2028-34 
Multiannual  Financial  Framework  (MFF)  assigns  more  funding  to  initiatives  aimed  at  boosting  EU 
competitiveness, research, and innovation, with an envelope of EUR 451 billion. Initiatives such as 
the  European  Competitiveness  Fund  and  Horizon  Europe,  supported  by  a  broader  Savings  and 
Investment  Union  agenda,  would  ensure  that  public  resources  stimulate  private  investment  and 
help overcome fragmentation in EU financial markets.  

Additional avenues to boost long-term growth in the euro area 

As the euro area keeps expanding, its economic profile increasingly mirrors that of the 
EU  as  a  whole.  Since  its  creation,  the  euro  area  almost  doubled  in  membership  from  11  EU 
Member States in 1999 to 20 in 2023. It will rise to 21 members from the beginning of 2026 when 
Bulgaria will adopt the euro.  Bulgaria’s entry marks a major step toward deeper integration of its 
economy and society into the Union. The euro has contributed to strengthen the EU Single Market 
and  boosted  the  competitiveness  of  the  participating  members  by  removing  exchange  rate  risks 
and  lowering  cross-border  transaction  costs,  and by  triggering  progress in policy  and institutional 
convergence. Today, the euro  area accounts for 84.6% of the EU economy  and for 11.9% of the 
world economy.  

The  digital  euro  can  provide  a  true  pan-euro  area  payments  infrastructure.  The  EU 
payments landscape is generally vibrant and well developed, however, some of its key segments, 
such  as  payments  at  point  of  sale  and  e-commerce,  are  dominated  by  a  few  international  card 
schemes. Given the systemic importance of digital payments in a rapidly digitalising economy, the 
large  dependence  of the euro  area  payments  infrastructure  on international  providers  presents a 
risk for the European strategic autonomy. In recognition of this and following the implementation 

18 

050100150200250300350EAUKCAUS% of GDPb) Size of different markets in theEuro Area and other peersListed sharesDebt securitiesLoans79111315171921231012141618202224% of Disposable Incomea) Gross Household Saving Rate in the EU, euro area and USUSEUEA 
  
of  the  Instant  Payments  Regulation  in  the  euro  area,  successful  European  private  payment 
solutions,  both  domestic  and  regional,  have  recently  increased  their  efforts  and  investments  to 
ensure their interoperability in order to create a viable alternative to international cards at point of 
sale. By providing an EU-governed, pan-euro area infrastructure, the digital euro will further reduce 
this  dependence  and  enable  scaling  up  domestic  and  regional  payment  solutions  across  the  euro 
area.  By  providing  a  common,  secure  and  interoperable  digital  payments  infrastructure,  it  would 
create  the  foundation  for  the  development  of  new  business  models  and  innovative  financial 
services,  such  as  conditional  payments  and  integration  with  digital  identity  frameworks.  This,  in 
turn, would foster a more competitive and innovative European payments ecosystem, facilitate the 
scaling-up of domestic and regional payment solutions across the Single Market.  

Strengthening the international role of the euro offers an important avenue to bolster 
growth and resilience in the euro area. Since its launch, the euro has been a key international 
currency widely used for global trade invoicing, financial transactions, and official reserve holdings, 
second to the U.S. dollar across most metrics (30). In recent years, the euro’s international role has 
remained  broadly  stable  (ECB,  2025a),  with  a  share  of  about  20%  in  global  foreign  exchange 
reserves and 25% in foreign currency-denominated debt (bonds and loans). Its use in invoicing the 
euro area exports has remained robust—around 59%—though less so for imports (51.8%).  

The  euro’s  international  standing  reflects  both  underlying  strengths  and  persistent 
limitations.  The  euro  area  meets  many  conditions  associated  with  an  internationally  successful 
currency:  it  is  one  of  the  largest  global  economic  and  trading  blocs,  maintains  a  track  record  of 
price stability, and benefits from the credibility of a strong and independent central bank. However, 
its potential to expand its global role  is held back by  institutional fragmentation—particularly the 
absence  of  a  unified  issuance  of  sovereign  debt  and  limited  progress  on  capital  markets 
integration. The lack of common defence capabilities also plays a role.  

A stronger international euro would contribute to Europe’s influence in a changing world. 
Greater global demand for euro-denominated assets would raise seigniorage revenues and foster 
deeper, more liquid European financial markets, reducing dependence on non-EU  institutions. This 
would  lower  borrowing  costs  for  euro  area  governments  and  firms,  expanding  fiscal  space  and 
supporting  investment.    An  expanded  use  of  the  euro  in  trade,  including  commodities,  would  cut 
exchange-rate risk for European exporters and importers. Strategically, reducing reliance on third-
country financial infrastructures would strengthen monetary sovereignty and, in turn, foster a wider 
international use (see also above on the digital euro).  It would enhance the EU’s capacity to project 
influence  globally,  from  enforcing  sanctions  regimes  to  structuring  international  financial 
assistance. In an era of geopolitical fragmentation and weaponised finance, reinforcing the euro’s 
global standing is therefore central to Europe’s strategic autonomy and soft-power influence. 

Recent shifts in the global monetary system create new opportunities for the euro. The 
gradual move towards a more multipolar system - driven by heightened geopolitical fragmentation, 
concerns  over  U.S.  policies,  and  declining  demand  for  U.S.  Treasuries  -  could  open  space  for  the 
euro to play a more prominent role (see Chapter 3).  While the international role of a currency is 
market-driven and cannot be shaped by a single measure, targeted policies may play an important 
role in fostering the conditions that make a currency more attractive. In absence of a single euro 
area  sovereign  issuer,  other  policy  levers  remain  available  to  enhance  euro’s  attractiveness. 
Building  a  strong  Investment  and  Savings  Union,  through  a  deeper  Capital  Markets  Union  and  a 
completed Banking Union can improve the integration, scale,  and efficiency of European financial 
markets,  facilitating  cross-border  investment  and  strengthening  the  euro’s  financial  ecosystem. 
Enhancing  the  role  of  the  euro  in  strategic  sectors  such  as  energy  and  other  commodities,  and 
emerging-market  finance—through  trade  agreements  or  investment  partnerships—can  also 
increase  its  international  use.  Finally,  continuing  with  the  enlargement  of  the  euro  area  would 

19 

 
further  strengthen  the  currency’s  international  standing  by  deepening  its  economic  and  financial 
base, expanding the pool of euro-denominated assets.  

While further internationalisation of the euro brings advantages, it also entails specific 
costs  and  responsibilities.  More  specifically,  a  greater  global  role  for  the  euro  increases  the 
expectation  that  the  Eurosystem  will  have  a  responsibility  and  obligation  in  contributing  to 
international financial  stability, particularly in times of crisis. This includes providing euro liquidity 
to  non-euro  area  countries  through  instruments  such  as  swap  lines  and  repurchase  agreements. 
Moreover,  rising  global  demand  for  euro-denominated  assets  may  lead  to  currency  appreciation, 
which  could  weigh  on  the  European  competitiveness.  Another  risk  is  the  so-called  external 
constraint: increased exposure to volatile capital flows and speculative pressures, which could limit 
the ECB’s monetary policy autonomy. While the size and credibility of the euro area mitigate these 
risks to some extent, they nonetheless require careful institutional and policy coordination (Kenen, 
2011; Tokarski, 2024). 

(1)  The  scope  of  this  report  encompasses  both  the  EU  and  the  euro  area.  Unless  otherwise  specified,  the  policies  and  discussions 

referenced in this report are generally applicable to both the EU and the euro area. 

(2)  Czechia, Germany, Italy, Finland and France are the countries in which real wages still remain below their 2019 levels. 
(3)  For example, see Bettarelli et al. (2025). It suggests that reforms reducing the generosity of unemployment benefits have dampened 
the  response  of  unemployment  to  output  changes,  though  reforms  reducing  the  stringency  of  employment  protection  legislation 
may have amplified it. 

(4)  European  Commission:  Employment  and  Social  Developments  2025,  Employment  and  Social  Developments  in  Europe  2025  - 

Employment, Social Affairs and Inclusion 

(5)  The policy mix refers to the combination of fiscal, monetary, and structural policies that are used to achieve the economic objectives 

of a country or a currency area. 

(6)  The fiscal stance measures the fiscal impulse of budgetary policy to the economy, from the national budget and from EU funding. It 
is measured by the change in net expenditure by national budgets and spending financed by RRF grants and other UE funds relative 
to a 10-year potential GDP growth. It is broadly neutral at a value within -0.25%/+0.25% of GDP range. 

(7)  Over 2020 to 2024, EU countries reported RRF-related use equivalent to 46% of the total RRF grant allocation, amounting to 167 
billion. Gross fixed capital formation accounted for 21% of the reported use of RRF funds, while more than a half corresponded to 
capital  transfers.  Current  expenditure  represented  28%  of the  use, and other costs  the  remaining  1%.  In  parallel, Member  States 
have implemented a broad scope of structural reforms which are expected to reinforce resilience and boost productivity, with  40% 
of nearly 7 thousand milestones and targets already fulfilled and an additional 19% reported as completed by Member States as of 
the end of October 2025. 

(8)  Assuming full implementation of the 27 plans, the German economy stands to benefit from a medium-term stimulus of about EUR 
66 billion (1.6% of Germany’s GDP), more than twice the size of Germany’s Recovery and Resilience Plan. See Michels et al. (2025). 

(9)  2023 GDP, 2015 prices terms. 
(10)  Labour productivity growth consists of capital deepening and growth in total factor productivity.  
(11)  For example, see (i) Draghi, M. (2024); (ii) Nikolov et al. (2024). On investment patterns (tangible vs intangible assets and sectoral 

distribution), see also (i) Gros et al. (2024); (ii) Hanzl-Weiss and Stehrer (2024). 

(12)  For example, see Dias da Silva et al. (2024).  
(13)  Source: Would Bank Development Indicators.  
(14)  See e.g. A. Ifrim, R. Kollmann, P. Pfeiffer, M. Ratto W. Roeger, Europe’s trade surplus, international relative prices, and the productivity 

growth gap, https://cepr.org/voxeu/columns/europes-trade-surplus-international-relative-prices-and-productivity-growth-gap. 

(15)  To  address  the  problem  of  high  energy  prices,  the  Commission  has  adopted  the  Affordable  Energy  Action  Plan.  See  European 

Commission (2025b) 

(16)  For example, see (i) Bijnens et al. (2024); (ii) Archanskaia et al. (2024).  
(17)  Delivering  on  the  environmental  targets  would  require  an  additional  average  investment  of  about  €120  billion  per  year  over  the 
2021-2027  period.    See  European  Commission.  (2023).  Figures  expressed  in  2022  euros.  See  also  European  Commission 
Communication on the 2025 Environmental Implementation Review. Figures are expressed in 2022 prices. 

(18)  The extent of this impact on end-user costs will in part depend on effective planning and strategic investment in grid and renewable 
infrastructure.  By  minimising  the  need  for  additional  investments  and  maximising  their  utilisation  rate,  robust  planning  can  help 
mitigate costs for end-users.  

(19)  For a discussion of the economic policy implication of AI, see  Korinek (2024), which highlights that transformative advances in AI 
could  fundamentally  reshape  economic  structures  by  diminishing  the  role  of  human  labour,  accelerating  productivity,  and 
challenging existing frameworks for income distribution, education, macroeconomic management, and global governance.  See also 
Acemoglu (2024), which stressed the risk that the impact of AI on total factor productivity may be overstated, as current evidence 
mainly  reflects  efficiency  gains  from  automating  simple,  easy-to-learn  tasks.  On  AI  diffusion  across  EU  countries  and  its  main 
economic implications, see also Simons et al. (2024). 

(20)  Computing  infrastructure  required  to  train  and  operate  increasingly  powerful  models consumes  substantial  amounts  of  electricity 

and risks driving up emissions if not met by clean energy sources (Korinek, 2024). 

(21)  Pasimeni  and  Dura  (2025)  have  found  that  trade  costs  within  the  Single  Market  have  decreased  twice  as  fast  as  trade  costs 

between the EU and the US.  

(22)  For  references  and  definitions  regarding  the  transposition  and  conformity  deficits  see:  https://ec.europa.eu/implementing-eu-

law/transposition-directives/en  

20 

 
 
 
(23)  For  example,  some  studies  indicate  that  even  modest  efforts  to  increase  services  trade  and  achieve  high  convergence  in 
implementing  Single  Market  rules  could  lead  to  gains  amounting  to  one-third  of  the  benefits  realised  since  1990.  See  Dura  and 
Pasimeni  (2025).  More  ambitions  deepening  of the  Single Market with  full  integration of  goods and  services  markets would even 
double the already achieved gains. See Fontagné and Yotov (2025). 

(24)  Public  procurement  accounts  for  about  16%  of  the  EU’s  GDP  (around  EUR  2.5  trillion  per  year),  with  with  over  250  000  public 
authorities as principal buyers in key sectors, such as: energy, transport, waste management, social protection and the provision of 
health or education services. Unlocking access to public procurement not only could yield significant gains (1% efficiency gain allow 
up to EUR 20 billion savings per year, but could be a powerful tool to create markets, especially in digital and defence sectors. See 
Draghi (2024), and Single Market and Competitiveness Scoreboard 

(25)  The costs of regulation fall into different categories such as administrative burden from reporting requirements, compliance costs 

from product and services standards, and financial costs from taxes and administrative charges. 

(26)  See for example: (i) Aghion et al. (2023); (ii) Coffey et al. (2020). For instance, each year German companies spend EUR 65 billion for 
administrative  compliance  costs,  along  the  total  alternative  cost  of  EUR  146  billion  from  untapped  output  potential  hindered  by 
regulatory environment. See also Falck et al. (2024). 

(27)  Available  OECD  indicators  measuring  the  quality  of  law-making  process  reveal  that  the  EU  institutions  are  among  the  best 
performers,  while  the  average  performance  of  EU  and  euro  area  countries  is  slightly  below  that  of  non-EU  OECD  countries.  See 
OECD (2025). 

(28)  The  European  Commission  has  made  reducing  administrative  burdens  and  streamlining  legislation  a  key  priority,  aiming  to  cut 
overall  administrative  costs  by  at  least  25%  and  by  35%  for  SMEs.  As  outlined  in  the  Annual  Overview  Report  on  Simplification, 
Implementation,  and  Enforcement,  the  Commission  adopted  six  “omnibus”  packages  in  first  half  of  2025,  supported  by  28 
implementation  dialogues  led  by  the  College  of  Commissioners  and  aimed  at  cutting  administrative  costs.  These  measures  are 
projected  to  save  8.6  billion  EUR,  placing  the  Commission  one-fifth  of  the  way  toward  its  five-year  target.  These  six  Omnibus 
packages have covered a broad range of files, including sustainable finance reporting, investment rules, the Common Agricultural 
Policy, digitalisation, defence, and the chemical industry. 

(29)  For more information on EU trade negotiations and agreements see https://policy.trade.ec.europa.eu/eu-trade-relationships-country-

and-region/negotiations-and-agreements_en  

(30)  For an historical perspective of the international role of the euro, see Terzi (2024). 

21 

 
 
2. MACRO FINANCIAL RISKS 

This chapter looks at how the EU’s economic vulnerabilities have been developing over 
the  last  year  and  presents  their  outlook  for  the  near  future.  It  is  a  complement  to  the 
analysis undertaken under the EU’s Macroeconomic Imbalance Procedure (MIP) and looks at overall 
economic developments that frame the country-focused analysis under the MIP. It considers both 
long-standing vulnerabilities and how they have developed, and new developments that could have 
consequences for economic growth or macro-financial stability in the future. It should not be read 
as a central scenario for the EU or the euro area; instead, its focus is on risks and developments 
that may merit a policy response, or closer surveillance.  

The EU’s savings-investment imbalance limits the Union’s growth 
potential 

The  euro  area  and  the  EU  have  long  run  an  external  surplus,  reflecting  an  excess  of 
savings  over  investment.  The  EA/EU’s  current  account  surplus—which  corresponds  to  the 
differences  between  domestic  savings  and  investment—rose  to  close  to  2¾%  of  GDP  in  2024 
(Graph  2.1.a).  This  increase  in  2024  is  the  result  of  falling  investment  alongside  stable  saving 
rates, as shown in  Graph  2.1.b. The current account surplus has  however declined relative to its 
pre-pandemic  level  and  is  expected  to  reduce  somewhat  further  in  2025.  While  the  Union’s 
relatively  high  income,  ageing  population  and  specialisation  in  manufacturing  are  consistent  with 
running a current account surplus, its level remains higher than the long-term balance implied by 
economic  fundamentals.  The  latter  point  to  a  current  account  of  0.7%  of  GDP  in  2024,  thereby 
implying an excess of current account of around 2 pps. of GDP (1). 

The household sector is the main contributor to economy-wide savings in the EA/EU, and 
its  contribution  has  been  rising.  As  shown  in  Graph  2.1.c  the  private  sector  is  the  main 
contributor  to  the  overall  surplus  of  the  EU  economy.  Household  savings  have  increased  since 
about  2018  and  were  again  the  factor  behind  the  increase  of  the  EU  current  account  surplus  in 
2024.  During  the  pandemic,  excess  household  savings—both  forced  and  for  precautionary 
reasons—resulted  in  a  sharp  rise  in  the  household  saving  rate  (Graph  2.1.d).  The  accumulated 
savings did not flow into substantially higher spending after the pandemic. While the saving rate 
fell over 2021 and 2022, it remained above its pre-pandemic level and has been rising again since 
2023, as consumption growth lagged income growth. The persistently high household saving rate 
seems  to  be  the  result  of  both  temporary  factors,  such  as  inflation  and  the  related  price 
uncertainty, interest rates, and weak economic sentiment, and structural factors, such as rising real 
incomes,  house  prices,  an  ageing  population,  and  shrinking  shadow  economies.  Chapter  3 
elaborates on the accumulation and allocation of EU savings. 

The  recent  fall  in  investment  is  driven  by  a  reduction  in  corporate  investment, 
accompanied by weak corporate borrowing. The reduction in overall investment in 2024 is in 
part  due  to  the  continued  normalisation  of  inventories,  but  it  also  reflects  muted  sentiment  in 
industry and a fall in private sector investment. Since 2019, corporate investment has fallen as a 
share of gross value added, and real investment shrunk in 2024. Manufacturing and construction 
have been particularly weak. Firms’ borrowing and investment decisions have been affected by the 

22 

 
 
uncertainty that started at the time of the pandemic and by the subsequent increase in financing 
costs (see also Box 2.1) (2). This low investment has been accompanied by weak credit growth, 
which  declined  below  pre-pandemic  trends  in  2023  and  2024  following  the  increase  in  lending 
rates. Recent data show the first signs of recovery at the beginning of 2025; bank loan flows to 
corporates have started to increase again but remain below their pre-pandemic levels.  

Graph 2.1: Current account in the euro area and net lending in the EU 

Source: Eurostat and European Commission forecasts and calculations. 

The  low  investment  that  underlies  the  current  account  surplus  limits  economic  growth 
over time. Current account surpluses mean that savings are invested elsewhere instead of  being 
used  to  finance  domestic investment. Chapter  3  sheds  light  on  the  destination  of  financial  flows 
from the EU, showing how household savings are routed to investments abroad. Low investment at 
home linked to various bottlenecks, limits the EA’s/EU’s growth potential. As a result, the financing 
for the massive investments needed  to enable European firms to adjust to new trading relations 
following changes to the world’s geoeconomic setup is reduced (3). The Draghi report on The Future 
of European Competitiveness assessed that improving Europe’s competitiveness and achieving the 
digital, social and sustainable transitions would require investments amounting to around EUR 750-
800 bn per year by 2030 (around 4.5% of EU GDP). Additional investments are needed to improve 
the EU’s defence capabilities. 

23 

19%20%21%22%23%24%25%26%131415161718192021222324% of GDPb) Net lending, EUNet lending/borrowingSaving rateInvestment rate-8-6-4-202468181920212223242525f26f% of GDPa) Current Account of the EAGoods, fcastServices, fcastGoods excl energyEnergy balanceServices excl travelTravel balancePrimary inc. bal.Second. inc. bal.Current accountTrade bal.0246810121416182000020406081012141618202224% of adjusted GHDId) Gross saving rate, households, EUFC consumptionNet FC formationFinancial saving (NFA)Gross saving rate (NFA)-8-6-4-2024681009101112131415161718192021222324% of GDPc) Net Lending/Borrowing by Sector, EUCorporationsGeneral governmentHouseholds and NPISHTotal economy 
           
 
The  stock  of  assets  held  abroad  is  a  source  of  vulnerability  to  external  developments. 
Due  its  current  account  surpluses,  the  EA/EU  has  been  accumulating  assets  abroad,  which  are 
reflected  in  a  positive  and  growing  net  international  position  (NIIP).  These  assets  are  subject  to 
risks, including from trade disruptions and trade policy uncertainty,  which may interplay with and 
compound  the  possible  reaction  by  financial  markets.  Initiatives  to  relocate  some  production 
capacities to the US may result in outflows of direct investment and affect economic activity in the 
most exposed countries, such as Ireland. A further, general escalation of trade tensions could result 
in  a  rerouting  of existing trade  linkages  and  have  strong  effects  on  assets  and  investments  held 
abroad. A diversion of capital flows resulting from weaning off the dollar as a safe-haven asset is 
a  possibility.  This  could  lead  to  augmented  capital  inflows  into  the  EA/EU.  In  that  case,  it  is  also 
important that such capital goes into productive investment. 

Within  the  EU,  external  developments  differ  across  countries  and  some  rebalancing 
between  debtor and  creditor  countries  has occurred.  There  are  large  differences  in  the  net 
positions and current accounts of EU countries (Graph 2.2). In 2024, the gap between creditor and 
debtor  countries  in  terms  of  current  accounts  and  NIIPs  (4)  has  narrowed  somewhat,  delivering 
some rebalancing (Graph  2.2.b). In the case of the  NIIP-to-GDP ratios,  nominal  GDP growth has 
been  the  main  driver  behind  the  narrowing  gap  between  creditor  and  debtor  countries,  as  EU 
countries  with  large  negative NIIPs  have  grown  more  quickly  than  those  with positive  NIIPs,  with 
favourable  terms  of  trade  also  playing  a  role  (5).  However,  the  persistent  gap  in  current  account 
balances  is  set  to  drive  the  stock  positions  further  apart,  as  nominal  GDP  growth  is  expected  to 
slow from 2025 on.  

Large differences in external positions across the euro area call for coordination as well 
as differentiation of economic policies due to the different needs and vulnerabilities of 
creditor  and  debtor  countries.  Some  countries  are  running  current  account  deficits  of  up  to 
some 8% of GDP like Cyprus or 6% of GDP like Greece or Slovakia, while others are running large 
current  account  surplus  of  up  to  9%  of  GDP  in  the  case  of  the  Netherlands  and  5%  of  GDP  in 
Germany. Countries with significant deficits can face risks if there is a change in market sentiment 
and  hence  need  to  reduce  their  borrowing  needs.  At  the  same  time,  reducing  those  deficits  is 
undermined  by  the  presence  of  surpluses,  particularly  within  the  euro  area.  Taming  demand  is 
often needed to correct large current account deficits, while policies stimulating domestic demand, 
particularly  investment,  are  needed  to  rebalance  the  large  saving-investment  discrepancies  in 
creditor countries. 

Graph 2.2: Current account and NIIP across EU countries 

Source: Eurostat and European Commission forecasts and calculations. 

24 

-35-25-15-551525354519202122232425% of  GDPa) EA Net International Investment PositionDEFRITNLESEL+IE+PTOther EA20Sum of EA MS-60-40-20020406080-6-4-20246801030507091113151719212325fNIIP, % of country group GDPCA, % of country groupb) Current account and NIIP for Creditors and Debtors Euro area countriesCA - CreditorsCA - DebtorsNIIP - CreditorsNIIP - Debtors 
       
The bilateral trade and income exposures of the EU have slightly changed over the past 
decade. The EU has maintained stable surpluses with Switzerland and the United Kingdom (Graph 
2.3.a). Trade intensity between the EU and United Kingdom has fallen since the United Kingdom’s 
withdrawal from the EU, with the trade in goods between the two being some 20% lower in 2024 
compared  to  2019,  but  the  trade  balance  does  not  seem  to  have  visibly  changed.  The  EU’s 
previously  large  surpluses  with  respect  to  the  United  States  have  fallen  considerably  since  2022 
given  the  increasing  EU  deficit  in  services  trade,  while  the  deficit  with  China  has  increased 
noticeably  since  mid-2024  (Graph  2.3.a).  In  particular,  in  2025,  EU  imports  from  China  have 
expanded  at  elevated  rates  amid  falling  import  prices  (see  Box  1.1).  The  EU’s  current  account 
balance with the rest of its trading partners is also strongly affected by energy prices. 

The developments in the EU’s external position take place against the broader context 
of  increased  global  external  imbalances  and  shifts  in  trade  policy.  Global  external 
imbalances—as defined by the IMF and measured as the sum of the absolute value of individual 
countries’  or  trading  blocks’  current  account  surpluses  and  deficits—rose  over  the  last  year  and 
have become a key topic in the global economic policy agenda. The surpluses of the EU, China and 
Japan all increased in 2024 (Graph 2.3.b). This partly reflects weak domestic demand, particularly 
in China, whose surplus has recently increased faster than the EU’s. In fact, the EU’s contribution to 
global  surpluses  has  declined  relative  to  a  decade  ago,  and  the  EU  surplus  is  even  forecast  to 
recede somewhat in 2025, whereas China’s surplus accounts for most of the widening in the global 
current account balances (6). The main contributor to the global  current account deficit is the US, 
accounting for around three quarters of the global current account deficit in 2024. The US current 
account deficit has doubled over the past five years, mainly due to strong domestic demand fuelled 
by large fiscal deficits, and widened further in 2024. 

Graph 2.3: EU current account and current account in the euro area and other large world 
economies 

Source: Eurostat and European Commission calculations. 

The inflationary period of recent years leaves behind cost competitiveness 
challenges for many EU countries 

The  recent  inflationary  period  was  sparked  by  the  rise  of  energy  prices,  but  domestic 
factors  became  the  main  drivers  since  2023.  Inflation  rose  with  the  re-opening  of  the 
economies  following  the  pandemic.  Although  the  commodities  price  shock  following  the  start  of 
Russia’s  war  of  aggression  against  Ukraine  triggered  its  acceleration  in  2022,  the  main  overall 

25 

-2.0-1.00.01.02.03.04.05.016171819202122232425% of global GDPa) EU current account balances with respect to trade partnersCHUKUSCNrestEU CA-2.0-1.00.01.02.01112131415161718192021222324% world GDPb) Current accounts in the euro area and other economiesEuro areaUSUKJapanChinaOil exportersOther surplus countriesOther deficit countries 
      
contributor  to inflation  over  the  last  five  years  have  been  domestic  wages  and  profits.  An  input-
output decomposition traces the effect that unit labour cost (ULC) and unit profit increases had on 
different prices, by following how increased input costs feed their way through the EU’s economies 
(7).  It  shows  that  ULC  and  unit  profit  increases  contributed  almost  three  quarters  of  the  total 
increase in prices for the EU  countries over the period 2020 to 2024  (Graph 2.4.a). Despite the 
marked surges in prices in 2022, the overall impact of energy and other import prices was smaller, 
not  least  because  there  was  stabilisation  or  reduction  in  those  prices  in  2023  and  2024.  The 
analysis shows also that these increases in value added (wages and profits) were passed through 
to  inflation  in  other  Member  States;  most  notably,  increases  originating  in  other  Member  States 
accounted  for  increases  in  prices  of  more  than  3  pps.  in  some  central  and  eastern  European 
countries since 2020 (Graph 2.4.b). 

Wage  growth  has  contributed  to  recovering  purchasing  power,  but,  in  the  absence  of 
offsetting  productivity  gains,  leads  to  marked  increases  in  unit  labour  costs.  Over  the 
years 2020 to 2024, the largest contribution to GDP deflator growth came from  ULCs, but it was 
closely  followed  by  unit  profits  (Graph  2.4.b).  Wages  have  increased  strongly  in  nominal  terms 
since 2022, supporting the recovery of purchasing power (8). In 2024, wages almost closed the gap 
in real terms with their 2019 levels. More recently, as signs of slack have started to appear in the 
labour market, wage growth has eased somewhat but continued to represent the main contributor 
to GDP  deflator  growth. Wage increases  remain very  high especially in Hungary,  Poland,  Bulgaria 
and Croatia, further compounding price pressures. The rise in wages has resulted in large increases 
in ULCs, as they have not been offset sufficiently by productivity gains. Instead, in some countries, 
productivity growth was negative, compounding the impact of wage growth on labour costs.  Over 
the forecast period however, the productivity gains are expected to slightly improve.  Overall ULCs 
have increased by close to 20% in the EA and the EU, and over 50% in some central and eastern 
European  countries  over  the  last  five  years  (Graph  2.5.a).  While  unit  profits  also  contributed 
substantially  to  the  deflator  over  2022  and  2023,  over  the  course  of  2024  they  clearly  slowed 
their growth, easing their impact on inflation. However, if continued for long, this may leave firms 
with less ability to absorb higher costs and hinder companies’ abilities to finance investments from 
own resources.  

Graph 2.4: Decomposition of HICP inflation in the euro area and of GDP deflator in the EU 

Source: Eurostat and European Commission calculations. 

While  inflation  has  fallen,  differentials  in  cost  and  price  developments  between  EU 
countries persist, adding to cumulated differences. Since the start of the inflationary period, 
differential inflation rates have resulted in the accumulation of large differences in prices and costs 
(Graph  2.5.b).  While  disinflation  has  progressed  and  the  euro  area  inflation  has  recently  been 

26 

-3-2-1012345671819202122232425Y-o-Y % changeb) EU GDP deflator decompositionULCUnit profitsUnit taxesGDP deflator-100102030405060DKLUITFICYELIEFRPTESMTSEDEBESIATNLHRLVSKEECZLTBGROPLHUPps.a) Private consumption inflation change 2019 to 2024, contributorsIntra-EU import cost passthroughIntra-EU value added passthroughOther direct imports pricesDirect energy import pricesDomestic unit profits (& taxes)Domestic unit labour costResidualConsumer inflation 
  
approaching  the  inflation  target,  for  some  of  the  countries  with  the  largest  increases  over  these 
years, inflation remains high and is forecast to remain above the EU average, compounding further 
the  total  price  rises  and  the  differentials  vis-à-vis  the  other  euro  area  and  EU  countries.  This  is 
especially the case for Romania, where headline inflation is expected to average 6.7% in 2025, and 
Estonia,  Slovakia,  and  Hungary  with  inflation  higher  than  4%.  Continued  significant  inflation 
differentials are a particular concern within the euro area, as they can undermine the effectiveness 
of the area-wide common monetary policy. 

Graph 2.5: Decompositions of ULC growth and cumulated inflation differentials in EU countries 

Source: Eurostat and European Commission calculations. 

Rapid  inflation  in  some  countries  was  compounded  by  nominal  exchange  rate 
appreciation, leading to sharper real appreciations. The appreciation of the euro is the other 
side of the coin to the depreciation of the USD since early 2025 and especially since April. Overall, 
nominal  exchange  rate  appreciation  has  led  to  an  increase  in  the  euro  area’s  HICP-based  real 
effective exchange rate (REER) of more than 7% since 2019, despite relatively lower inflation than 
in  main  trading  partners.  The  impact  of  the  euro  appreciation  is  different  across  euro  area 
members on account of different trade exposures and economic structures. With the exception of 
the Swedish krona and the Hungarian forint, all other EU currencies appreciated too, in some cases 
quite  strongly.  For  cases  such  as  the  Baltic  countries,  Slovakia,  Czechia,  Poland,  Romania,  and 
Hungary,  inflation  differentials  contributed  to  the  strong  REER  appreciations;  in  most  other 
countries,  inflation  lower  than  in  trading  partners  at  least  partly  tempered  the  REER  appreciation 
(Graph  2.6.a).  More  substantial  intra-EU  differences  are  evident  when  looking  at  REERs 
benchmarked by ULCs (Graph 2.6.b). In particular, in the Baltic countries, Romania, Bulgaria, and 
Poland, the REERs appreciated by over 15%, despite staying constant in the EU as a whole.  

27 

-40-20020406080IEITCYELFIFRMTBEESDENLATPTSKSILUHRLVEELTDKSECZPLBGHUROEAEUEANon EAAgg.% changea) ULC decomposition, 2019-2024Productivity (neg. contrib.)Real compensationInflationULC-505101520253035LTEEHRLVLUSKSINLPTDECYATELIEBEESMTITFIFRHUROBGPLCZSEDKEANon-EAPps.b) Cumulated inflation differential vs. EA, 2020-2024GDP defl.Headline HICPCore HICP 
      
Graph 2.6: Real effective changes rates in the EU 

Source: Eurostat and European Commission calculations. 

Recent  cost-competitiveness  dynamics  can  have  implications  for  macroeconomic 
performance and stability. Over time, high price and cost levels and widening differentials can 
put pressure on the external  sector, requiring adjustments through exchange rates outside of the 
euro area and/or through the more painful channel of internal devaluation. So far there has been 
some deterioration in export performance for a number of EU countries—particularly for Belgium, 
Germany, and Luxembourg, and Finland—but these are not the ones that have exhibited the highest 
cost-competitiveness deteriorations. Over the past five years, the economic backdrop has been very 
volatile,  making  it  difficult  to  trace  the  impact  of  deteriorating  cost-competitiveness  positions  on 
the  external  sector  and  at  the  macro  level,  as  the  overall  picture  is  distorted  by  denominator 
effects, terms of trade, and other non-cost competitiveness factors (9). Moreover, global trade has 
clearly  grown  more  slowly  in  recent  years,  also  on  the  back  of  geopolitical  fragmentation,  after 
earlier  decades  of  strong  expansion,  and  that  weakness  is  particularly  sharper  in  manufacturing 
goods,  while  services  exports  have  held  up  better.  Nevertheless,  the  impact  may  be  seen  on  a 
longer-term  horizon  and  if  risks  do  materialise,  difficult  adjustments  will  be  required.  The 
imposition of US tariffs can lead to further pressures, further harming the price competitiveness of 
particular industries and countries.  

Several Member States with very high inflation have experienced some stalling of their 
economic convergence. The EU countries with the highest price and cost increases over the last 
five  years  are  those  in  central  and  eastern  Europe  (Graph  2.5.b)  (10).  These  countries  displayed 
higher-than-average  price  growth  already  before  the  current  inflationary  period,  which  can  be 
explained  by  their  economies’  convergence  to  higher  levels  of  income.  As  Graph  2.7  shows,  all 
these  countries  are  better  off  in  terms  of  GDP/capita  in  PPP  in  2024  than  in  2005,  with  the 
strongest  progress  occurring  in  those  with  the  lowest  starting  points.  However,  since  2020, 
economic convergence has stalled in Czechia and Estonia, and only marginally advanced in Latvia, 
while price and cost increases have accelerated. In these countries, economic convergence does not 
appear to be a plausible factor behind the recent strong cost and price wage dynamics. Conversely, 
the  rising  cost  and  price  dynamics  could  be  a  factor  in  stalling  the  convergence  and  hampering 
competitiveness and may make it more difficult for these countries to return to a converging path. 

28 

-30-20-100102030LTEELVHRSILUATPTNLSKESDEBEFRFIMTIEITCYELBGROPLCZHUDKSEEUEAEuro areaNon-EAAgg.% changeb) Change in ULC-based REER, 37 part. 2019-2024ΔNEERΔrel. ULCΔREER-20-15-10-50510152025EELTLVSKHRNLATDEBEMTSICYESITFRPTELFILUIECZPLBGROHUDKSEEUEAEuro areaNon-EAAgg.% changea) Change in CPI-based REER, 42 part. 2019-2024ΔNEERΔrel. HICPΔREER 
  
Graph 2.7: Price level versus potential GDP per capita, in central and eastern European Member 
States 

Source: Eurostat and European Commission forecasts and calculations. 

The overall indebtedness of EU countries has been falling, reducing risks, 
but increased average borrowing costs are a challenge for governments 

Despite  some  reduction  in  recent  years,  private  debt  ratios  remain  elevated  in  the  EA 
and  EU.  Both  household  and  corporate  debt  ratios  have  fallen  every  year  since  2021,  driven  by 
both high nominal GDP growth acting on the denominator and by muted credit flows in the context 
of rising financing costs (Graph 2.8). The EU average household debt-to-GDP ratio has decreased 
from  58%  in  2021  to  50%  in  2024,  while  the  NFC  debt-to-GDP  ratio  has  dropped  from  83%  in 
2021 to 72% in 2024. Going forward, the recovery in credit flows and lower nominal GDP growth 
will provide less support to the deleveraging of the private sector.  

Graph 2.8: Decomposition of changes in private debt 

Source: Eurostat and European Commission calculations. 

Households have recorded rising incomes and an increase in financial assets, on top of 
receding  debts,  supporting  their  ability  to  service  higher  interest  rates.  The  fall  in 
household debt has been compounded by an increased ability of households on average to service 

29 

201020244045505560657075405060708090Price level as % of EU27 averagePotential GDP per capita in PPP as % of EU27 averageBGHRROHUPL20102024505560657075808590955060708090100Price level as % of EU27 averagePotential GDP per capita in PPP as % of EU27 averageCZEELVLTSK-10-8-6-4-20246810111213141516171819202122232425fPps.b) Decomposition of y-o-y changes in debt-to-GDP ratios, NFC -EU27Credit flowReal growthInflationOther changesD/GDP, change-6-4-20246111213141516171819202122232425fPps.a) Decomposition of y-o-y changes in debt-to-GDP ratios, households -EU27Credit flowReal growthInflationOther changesD/GDP, change 
   
     
their  debt,  despite  higher  interest  rates.  In  2024,  the  real  value  of  households’  financial  assets 
exceeded its pre-pandemic level, while financial liabilities have dropped by around 7% in real terms 
since  2019.  In  addition  to  an  improving  net  financial  asset  position,  households  also  benefited 
lately from robust growth in real disposable income. At the same time, in several countries interest 
rates on new loans remain close to their peak values (Graph 2.9.a), following the overall  rise in 
interest  rates,  and  in  some  countries  with  predominantly  fixed  rate  mortgages,  interest  rates  on 
outstanding  loans  continue  to  increase.  However,  EU  household  balance  sheets  remain  overall 
robust.  The  household  sector  on  aggregate  has  a  positive  net  position  on  interest-bearing 
instruments, such that similar changes in interest rates on deposits and loans have an overall small 
but positive contribution to disposable income (Graph 2.9.b). 

Corporate profitability and debt service capacity have fallen, but very recently there are 
signs  of  an  impending  recovery.  Although  corporate  indebtedness  fell  in  2024,  corporate 
vulnerabilities  increased  as  firms’  abilities  to  service  their  debt  declined  (Graph  2.10.a).  Over 
2024, corporate savings fell and firms’ interest coverage ratios (11) continued to decline, in part due 
to  the  fall  in  profits  which  took  place  over  2023  and  2024  after  some  years  of  above-average 
profits (Graph 2.10.b). In addition, firms have been using up their cash reserves which they had 
accumulated during the pandemic and the high-profit period immediately after the pandemic, and 
their buffers have fallen. However, very recently there are indications that a turning point may have 
been  reached.  Data  from  early  2025  show  a  small  rise  in  unit  profits  as  well  as  an  increase  in 
economic  activity  and  firm  sentiment.  Borrowing  costs  started  to  decrease  from  their  post-
pandemic peak in late 2023 and early 2024, indicating an improvement in debt service capacity in 
the near future. Although these point to a potential recovery of the corporate sector, it should not 
be taken as a given yet. 

Graph 2.9: Household finances: cost of borrowing and net interest income 

Source: ECB, Eurostat and European Commission calculations. 

30 

024681012LVEEDELTIEELSKNLATBELUITCYHRFRPTSIFIESMTEAHUPLROCZDKSEBGEANon-EAAnnualized, weighted average, %a) Cost of borrowing2025-092021-06Peak since 2021-8-6-4-20246MTCYFRITELATDEPTBESIHRESLTSKLUIEFINLLVEEEAHUROCZPLDKSEBGEUEANon-EA% gross disposable incomeb) Net interest income, householdsInterest paid 2024Interest received 2024Net interest income 2024Net interest income 2021 
        
 
Graph 2.10: Non-financial corporations finances: evolution of profits and vulnerabilities 

Source: Eurostat, ECB, and European Commission calculations. 

31 

-20246810123536373839404142431516171819202122232425Unit profit growth, %-change to previous yearProfit share in % of GDPb) Profit share and unit profit growth Profit share - EA20Profit share - EU27Unit profit growth - EA20Unit profit growth - EU27-1.00-0.500.000.501.001.502021222324Standard deviations from long-term averagea) NFC vulnerabiliites ActivityDebt ServiceFinancingLeverageProfitabilitySentimentVulnerability Index+ 
       
 
Government  debt  dynamics  are  becoming  more  challenging,  as  the  favourable 
differentials  between  interest  rates  and  nominal  GDP  growth  of  recent  years  are 
vanishing.  Government  debt—which  remains  high  and  above  its  2019  levels  in  the  EA  and  the 
EU—has  been  declining  visibly  in  recent  years,  supported  by  high  nominal  GDP  growth,  despite 
persistent government deficits (Graph 2.11.a). This is now ending, and debt ratios are forecast to 
rise again in most Member States, and for the EA and the EU as a whole. This is mainly because the 
difference  between  interest  rates  and  nominal  GDP  growth  rates  is  narrowing,  or  even  turning 
positive  in  some  countries,  resulting  in  an  unfavourable  snowball  effect.  In  the  coming  years, 
governments’  budgetary  positions  will  be  the  main  driver  of  changes  in  debt-to-GDP  ratios.  For 
several countries, including some where debt currently exceeds 60% or even 90% of GDP, budget 
deficits are expected to remain large in 2026 based on currently legislated measures, which would 
lead to a further increase in debt (Graph 2.11.b).   

32 

Box 2.1: Economic uncertainty and the corporate sector At present, European firms are navigating a landscape marred by heightened uncertainty. The current geo-economic situation creates a complex environment for firms. Uncertainty can stem from various global and local sources. Graphs 1.a, b and c present a number of different measures, covering economic uncertainty, investor and financial market uncertainty, energy uncertainty and economic policy uncertainty (1). While they all show a recent rise in uncertainty, economic policy uncertainty stands out as being particularly high by historical comparison. Empirical studies show that firms respond to increased uncertainty by reducing borrowing and investment, in line with what has been observed across the EU (2). The high readings across these measures of uncertainty suggest that even though there are now the first signs of recovery in corporate borrowing, the risks are tilted to the downside and the recovery may be short-lived.   Graph 1: Measures of uncertainty     (1) Last observation: Panels (a) and (c) 25Q2, panel (b) 23Q3.  Source: Economic Policy Uncertainty Index   (1) The World Uncertainty Index (WUI) gauges global economic uncertainty based on news data and is constructed by analysing the frequency of the word “uncertainty” (and its variants) in reports from the Economist Intelligence Unit. See Bloom and Furceri (2022).  The financial market volatility index (VIX) reflects investor sentiment and financial market volatility and is constructed based on the 30-day expected volatility of the US stock market (Chicago Board Options). The Geopolitical Risk Index is based on Caldara and Iacoviello (2022a). Energy uncertainty indices are computed as the mean of economic uncertainty akin to the approach for the WUI and energy-related indices using energy-related keywords. See Dang et al. (2023). The Economic Policy Uncertainty index captures uncertainty arising from changes in economic policies. See Baker et al (2016). (2) See for example: (i) Londono et al. (2025); (ii) Gulen and Ion (2016); (iii) Julio and Yook (2012); (iv) ECB (2025b); (v) Caldara et al. (2020); (vi) Jurado et al. (2015); (vii) Caldara and Iacoviello (2022b); (viii) Correa et al. (2023); (ix) Kim, Lee and Lim (2023). 01002003004005006007008000507091113151719212325Indexa) Global measures of uncertainyWorld Uncertainty Index (WUI)Trade Policy Uncertainty (TPU)Financial Market Volatility Index (VIX)Geopolitical Risk Index (GPR)0100200300400500600700800900100000020406081012141618202224Indexc) Economic policy uncertainty DEEAESFRIT05010015020025030005070911131517192123Indexb) Energy uncertaintyGlobalDEESFRIT 
 
 
 
          
 
 
Graph 2.11: Government finances 

Source: Eurostat and European Commission forecasts and calculations. 

There is mounting pressure on the spending side of government budgets from different 
sources. As a follow-up to the ReArm Europe  Plan/Readiness 2030 initiative, Member States will 
have  to  achieve  and  sustain  higher  defence  spending  amid  a  deteriorating  geo-political  context. 
Currently, 16 Member States benefit from flexibility under the national escape clause to help this 
move towards increased spending on defence up to 2028, while safeguarding fiscal sustainability. 
In  addition,  the  transition  towards  a  digital  and  decarbonised  economy  requires  significant 
additional investment, including from the government sector. Finally, there are adverse underlying 
trends for public expenditure in the areas of old-age pensions, health care and long-term care due 
to  population  ageing.  In  that  respect,  the  latest  Ageing  Report  projects  that,  while  the  average 
increase in total age-related expenditure may be limited to 0.2 pps. of GDP from 2022 to 2030 for 
the EU as a whole,  for some Member States the cost  of ageing would increase by 1 to 3 pps.  of 
GDP.  Over  the  following  decade  (2030-2040),  age-related  spending  for  the  EU  as  a  whole  is 
projected to rise by another 0.6 pps. of GDP (European Commission, 2024a). 

Medium-term fiscal strategies will be needed to address these spending pressures while 
delivering  on  the  required  adjustment  to  secure  debt  sustainability.  Under  the  new 
European  economic  governance  framework,  Member  States  have  been  set  country-specific 
maximum growth rates for net expenditure for the coming years, geared towards the achievement 
of debt sustainability and taking into account the projected cost of ageing (12). However, in many 
Member States, accommodating the additional spending pressures mentioned above may require a 
higher consolidation effort than implied by these paths. Significant and competing spending needs 
demand a strong prioritisation and a reappraisal of the quality of public finances. The way forward 
would  have  to  reflect  each  country’s  situation  and  preferences  and  could  include  action  to 
rationalise  spending  programmes  and  mobilise  revenue.  Depending  on  its  composition,  the  fiscal 
adjustment  may  impact  economic  activity  and  price  developments,  leading  to  a  reduction  in 
demand. This highlights the importance of reforms to boost productivity and growth.  

Long-term  yields  for  euro  area  governments  have  been  volatile  in  2025,  with  some 
increases for the best rated debt issuers. EU  countries facing high debt, high deficits and/or 
short  debt  maturities  typically  have  high  gross  financing  needs  and  are  more  exposed  to  risks 
stemming  from  financial  conditions.  In  early  2025,  long-term  interest  rates  increased  somewhat 
for Germany, the best rated sovereign debt issuer in the euro area, and to a lesser extent for the 
other  euro  area  governments,  resulting in  a  narrowing  of  sovereign  spreads  within  the  euro  area 
(Graph  2.12.a).  The  narrowing  has  been  marginal  or  even  non-existent  for  countries  with  high 
debt  ratios  and  high  deficits,  in  particular  France,  Belgium,  and  Finland.  However,  these  overall 
benign developments should not be taken for granted, and negative developments in yields in large 

33 

BEBGCZDKDEEEIEELESFRHRITCYLVLTLUHUMTNLATPLPTROSISKFISEEAEU0306090120150-8-6-4-2024Government debt (% of GDP)Government balance (% of GDP)b) Govt balance and debt, 2026050100150200ELITFRBEESPTFIATHUSICYDESKHRPLROLVMTNLCZIELTSEDKLUBGEEEAEU% of GDPa) Government debt20192020202320242025f2026f 
   
countries,  including  outside  the  EU,  could  spill  over  across  developed  economies  and  to  private 
sector borrowers too (IMF, 2024b). 

For  the  EU  countries  outside  the  euro  area,  sovereign  yields,  which  were  already  high, 
have  typically  increased  somewhat  since  mid  and  late  last  year.  For  the  Member  States 
with  lower  ratings  on  their  sovereign  debt,  especially  Hungary  and  Romania,  yields  on  long-term 
government  bonds  and  spreads  vis-à-vis  the  best  rated  debt  of  the  euro  area  have  increased 
somewhat further in 2024 and 2025 (Graph 2.12.b). On the contrary, Poland has recorded slightly 
lower  spreads  on  long-term  government  bonds.  These  three  countries  face  additional  risks  as 
relatively  large  shares  of  their  government  debt  are  denominated  in  foreign  currencies,  meaning 
that borrowing costs may be impacted by variations in exchange rates, which are more likely the 
larger the external adjustment needs, which is especially the case of Romania. 

Graph 2.12: Yields in 10-year government bonds 

Source: Eurostat. 

The banking sector is resilient, but the non-bank financial sector has been 
expanding in recent years and could be a source of vulnerability  

The EA and EU banking sector has remained resilient, maintaining high profitability and 
strong capital ratios, although a small deterioration of asset quality may be underway. 
The aggregate return on equity of EA and EU credit institutions remained high in 2024 and 2025, 
as higher fees and commissions compensated for lower interest margins, and the common equity 
Tier-1 ratio of EA/EU credit institutions stabilised at high levels (Graph 2.13). The asset quality of 
EA/EU banks has been stable, although some small deterioration may be underway. The aggregate 
non-performing  loan  (NPL)  ratio  of  EA/EU  credit  institutions  increased  only  marginally  over  2024 
and  remains  low  (1.9%).  NPL  increases  were  concentrated  in  countries  with  low  levels  of  NPLs, 
while NPL ratios decreased in countries with higher legacy NPLs. The share of stage 2 loans slightly 
increased in the past four years, but banks reported a slight decrease in the first half of 2025.  

Exposures to real estate and sovereigns remain a source of vulnerability. Banking systems 
in some EU countries are significantly exposed to real estate with mortgages representing almost 
50% of banks’ assets. The high exposure of the banking sector to domestic sovereign debt remains 
another standing issue, as it increases risks of feedback loops in countries that are highly indebted 
or  rely  on  foreign  currency  funding.  Non-bank  financial  institutions,  namely  insurers  and  pension 

34 

-10123452122232425%a) Yields on 10-y govt bonds in selected EA Member StatesDEBEELESFRITPTSK-113579112122232425%b) Yields on 10-y govt bonds in non-EA Member States and in GermanyDEBGCZDKHUPLROSE 
      
funds,  also  have  major  exposures  to  CRE  and  sovereign  debt,  which  may  create  additional 
contagion risks in stress periods. 

The  commercial  real  estate  (CRE)  sector  remains  under  pressure,  with  only  a  modest 
recovery  in  2024  after  a  two-year  slump.  CRE  firms  face  profitability  constraints  driven  by 
high funding costs, rising capital expenditures, and muted rental income. Non-performing exposures 
linked  to  CRE  have  begun  to  rise,  although  the  increases  remain  moderate.  While  EU  banks’ 
aggregate  exposure  to  CRE  is  smaller  than  their  housing  portfolios,  it  is  significant  in  certain 
Member  States,  and  in  some  cases  large  relative  to  banks’  capital.  Intra-EU  exposures  dominate, 
and banks have limited direct exposure to the US CRE market, which has experienced more severe 
stress. Most EU CRE loans maintain conservative loan-to-value (LTV) ratios, often below 60%, but 
the illiquid nature of CRE assets means valuation losses could be magnified in period of stress.  

Graph 2.13: Banking sector: profitability, capital ratios and asset quality 

Source: ECB, Eurostat. 

The  non-bank  financial  intermediaries’  sector  (NBFI)  (13),  which  has  expanded  rapidly 
over  the  past  years,  is  exposed  to  specific  risks  and  its  interconnectedness  with  the 
banking sector is a source of vulnerability. NBFIs have gained importance over the past years, 
with assets increasing from 140% to 400% of euro area GDP over the period 1999-2024 (Pelizzon 
et al., 2025). The overall profitability, capitalisation and liquidity metrics for the various segments 
of the non-bank financial sector are healthy (14). However, parts of the NBFI sector are exposed to 
specific  risks  related  to leverage  and  liquidity  mismatch  and  NBFIs  have  significant  exposures to 
the US, increasing their vulnerability to adverse market developments  (ESRB, 2025). Furthermore, 
the  interconnectedness  among  NBFIs  and  between  them  and  the  banking  sector  is  a  possible 
source  of  propagation  of  adverse  developments  into  the  real  economy.  While  there  are  EU 
regulations  aimed  at  tackling  specific  risks  in  some  types  of  NBFIs  such  as  investment  funds, 
insurers  and  CCPs,  there  is  no  consistent  approach  to  macroprudential  supervision  for  NBFIs. 
Improving  the  adequacy  of  macroprudential  policies  for  NBFI  is  one  of  the  priorities  of  the 
European Commission in the current mandate (15).  

The EU financial  sector is subject to new risks that are difficult to quantify.  Cyber risks 
have  emerged  as  a  new  challenge  in  the  context  of  the  increasing  digitalisation  of  the  financial 
sector (16).  Looking  ahead,  the  growing  importance  of  crypto  assets  and  their  interconnectedness 
with  the  financial  sector  could  create  financial  stability  risks.  Climate  change  risks  and  climate 
transition risks are also a concern for financial stability. Climate change, such as extreme weather 
events, may damage infrastructure, disrupt supply chains, and can lead to significant economic and 

35 

0.00.51.01.52.02.53.03.54.002468101214161820202122232425%%a) Capital, profitability and asset quality ratios, EU significant institutions supervised by SSMStage 2 ratioTier1 ratioRoENPL ratio (rhs)BEDEEEIEELESFRHRITLVLTLUMTNLATPTSISKFIBGCZHUPLROSE468101214161820141618202224Return on equity in % (2024)Tier1 ratio in % (2024)b) Profitability and capital ratiosEU aggregateEU MedianDK 
        
financial  losses  (Bellia  et  al.,  2025).  Recognising  the  gravity  of  these  challenges,  supervisory 
authorities have started to incorporate climate risks into their stress testing framework (17). 

House price growth has resumed, driven by low supply, an issue that 
needs to be urgently addressed 

House prices are rebounding. Over late 2023 and 2024, house price growth accelerated in most 
EU  countries,  with  house prices  growing  by  3.4% in  2024  and  5.4% y-o-y  in 2025-Q2 in  the  EU, 
after a retrenchment in late 2022 (Graph 2.14.a). This price recovery has been accompanied by a 
recovery in transactions, after a decline from 2022 to early 2024, as the market adjusted to the 
significant tightening of monetary conditions.  

Low investment, which keeps housing supply muted, is a major reason behind the rise in 
house prices. Over the last decade, the supply of new homes has failed to keep up with demand, 
and the construction of new homes has been at historically low levels. While investment in housing 
plunged  after  the  global  financial  crisis,  its  return  to  previous  levels  has  not  led  to  substantially 
higher  construction  of  new  homes  as investment  has  focused  on  renovations  (Graph  2.14.b).  In 
addition, widespread labour shortages and skills mismatches in the construction sector, regulations, 
increasing construction costs, as well as a sharp fall in building permits granted by local or regional 
authorities  have  acted  as  constraints  on  the  housing  supply.  Against  this  backdrop,  the  supply 
response  to  housing  demand  has  remained  muted  and  is  expected  to  remain  the  case  in  the 
foreseeable future, continuing to put pressure on prices.  

Recent  house  price  growth  is  stronger  than  what  can  be  explained  by  household 
borrowing.  Since  most  home  purchases  are  financed  through  mortgage  credit,  households’ 
borrowing capacity—which is largely determined by incomes and mortgage rates—has historically 
been  a  key  long-term  driver  of  housing  demand.  After  falling  over  2022  and  2023,  households’ 
borrowing  capacity  rose  in  2024,  against  the  backdrop  of  falling  interest  rates  and  continued 
income growth, supporting demand for housing. In some countries, interest rates are even negative 
in real terms on account of relatively high inflation, underpinning buoyant housing demand.  

Graph 2.14: House prices and housing supply 

Source: Eurostat, ECB, and European Commission calculations. 

Housing affordability remains a macroeconomic and social issue in many countries. Since 
2023, household income growth has exceeded house price growth in the EA/EU, leading to a fall in 

36 

23456782345678969800020406081012141618202224% GDPNumber of house completed per ths persons per yearb) House completions and investmentHouses completed, no. per ths persons per year, EU27Houses completed, no. per ths persons per year, EA20Investment in dwellings, % GDP, EU27 (rhs)Investment in dwellings, % GDP, EA20 (rhs)9010011012013014015016017025242322212019181716151413Index (2013 = 100)a) House prices and household incomeNominal house priceReal house priceHousehold income 
      
price-to-income  ratios.  Price-to-income  ratios  are  now  less  than  10%  above  their  2013  levels. 
However, this figure hides very strong national and regional variation. The surge in borrowing costs 
after 2022 has sharply reduced how much households can afford to buy using mortgage credit. . 
Moreover, in many EU countries, rental markets remain underdeveloped and do not provide a viable 
alternative to homeownership. Worsening housing affordability can have negative implications for 
labour mobility and labour market participation, access to higher education, and economic growth, 
and  can  disproportionately  impact  the most  vulnerable  groups.  High  house  price  growth  in  urban 
areas  can  act  as  a  disincentive  for  workers  to  move  to  these  more  dynamic  economic  regions, 
undermining economic activity, in addition to social consequences (Cousin et al., 2025).  

(1)  Current accounts in line with fundamentals (current account norms) are derived from reduced-form regressions capturing the main 
determinants of the saving-investment balance, including fundamental determinants, policy factors and global financial conditions. 
See Coutinho et al. (2018). The positive impact of swiftly growing NIIP of the EU explains part of the excess of the current account 
readings  vis-à-vis  the  current  account  norm.  In  addition,  the  recent  slowdown  in  credit  to  the  private  sector  pushed  the  current 
account balance slightly higher. 

(2)  The EIB investment survey indicates that while EU firms in summer 2024 expected to grow investment, particularly in high and mid-
tech industries, the share of firms expecting to increase investment halved compared to 2023 (European Investment Bank, 2024)  

(3)  Structural factors have been extensively discussed in Draghi (2024). . 
(4)  The gap in the current accounts is the difference between the (lower) average current account of debtor countries and the (higher) 
average  current  accounts  of  creditor  countries.  The  larger  the  gap,  the  more  it  contributes  to  the  difference  in  the  net  overall 
positions.  

(5)  This  has  contributed  a  rebalancing  of  the  previously  very  negative  net  external  positions  for  Greece,  Spain,  Croatia,  Cyprus,  and 
Portugal, which between 2020 and 2024 managed to boost their NIIPs by 20-40 pps. of GDP, boosted by nominal GDP growth. 
(6)  As  set  out  in  the  IMF’s  external  sector  report  “Our  assessment  for  2024  shows  that  about  two-thirds  of  the  widening  in  global 
current account balances is in fact excessive. The increase in excess balances is the largest in a decade, driven primarily  by China 
(+0.24 percent of global GDP), the US (-0.20 percent) and more modestly by the euro area (+0.07 percent).” (IMF, 2025a) 

(7)  European Commission, Economic  Spillovers and  Linkages  in  the  EU. Paper  Accompanying  the  2025  in  Depth  Reviews,  Institutional 

Paper 317 (LU: Publications Office of the European Union, 2025), https://data.europa.eu/doi/10.2765/808918. 

(8)  Nominal compensation per employee deflated by the HICP. For the EU it was still 0.9 pps below the 2019 levels, while for the  euro 

area, the gap was 0.4 pps below. 

(9)  European Commission (forthcoming), “After the inflation shock – taking stock of price competitiveness in the EU”. 
(10)  Bulgaria, Czechia, Croatia, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, and Slovakia. 
(11)  The  interest  coverage  ratio  is  calculated  as  gross  operating  surplus  over  total  interest  before  Financial  Intermediation  Services 

Indirectly Measured (FISIM) allocation; it measures how easily companies can pay the interest on their outstanding debt.  

(12)  Government  debt  will  decline  over  the  medium  term  in  all  Member  States  where  it  currently  exceeds  60%  of  GDP  if  the  net 
expenditure  paths,  and  assumptions  of  their  medium-term  fiscal-structural  plans,  materialise.  Overall,  the  plans  imply  lower  debt 
paths than a scenario at unchanged policies for most countries (European Commission, 2025e). 

(13)  Non-bank  financial  intermediaries  (NBFIs)  comprise  different  types  of  financial  institutions,  including  insurance  corporations  and 
pension  funds,  central  counterparties  (CCPs),  investment  funds,  money-market  funds,  and  financial  vehicles.    They  are 
heterogeneous in terms of business models, risk profiles, regulation and supervision. 

(14)  The European insurance sector has remained healthy in 2024, with improved profitability and stable and robust aggregate capital 
and  liquidity  positions  but  with  some  heterogeneity  across  Member  States.  The  European  occupational  pension  sector  has  also 
remained resilient. European  investment  funds  experienced  robust  growth  and  strong investor  demand  in 2024.  Equity  exchange-
traded funds (ETFs) attracted record net inflows, reflecting renewed investor appetite for equity exposure, while bond funds also saw 
a surge in inflows as interest rates declined. Money market funds (MMFs) remained an important liquidity vehicle.  

(15)  In particular, the Commission conducted a  targeted consultation assessing the adequacy of macroprudential policies for non-bank 

financial intermediation (NBFI). 

(16)  In  Europe,  the  finance  sector  is  the third  sector  most  targeted  by  cyberattacks  (after  public  administrations  and  transports),  with 

specific cyberattacks peaks linked to geopolitical developments, notably to Russia’s war of aggression against Ukraine 
(European Union Agency for Cybersecurity, 2024).  

(17)  The  ECB  carried  out  a  climate  stress  test  in  2022  and,  upon  a  Commission  request,  the  ECB  and  the  European  Supervisory 
Authorities  (EBA,  EIOPA  and  ESMA)  conducted  in  2024  a  one-off  EU-wide  climate  stress  test  against  scenarios  developed  by  the 
ESRB which incorporated the implementation of the Fit-for-55 package.   

37 

 
 
3. EU SAVINGS IN THE CONTEXT OF GEOECONOMIC 
RISKS 

Abundant  EU  savings  offer  an  opportunity  to  fund  European  priorities.  Its  large  current 
account surpluses make the EU a key global supplier of capital. Every year, around EUR 300 billion 
of savings flow out of the EU in net terms, funding investment abroad, mainly in the United States. 
The bulk of these European savings originates from households (1), which typically rely on financial 
intermediaries  rather  than  investing  directly  in  capital  markets.  This  section  examines  that  EU 
household savings flow abroad via financial sector intermediation, and that the fragmented capital 
markets  continue  to  impede  a  more  efficient  allocation  within  the  Union.  It  also  explores  how 
higher  perceived  risks  by  investors  may  affect  capital  flows  in  the  near  future.  The  Savings  and 
Investment  Union  seeks  to  mobilise  European  savings  for  domestic  investment,  by  overcoming 
market fragmentation within the Union, thereby supporting Europe’s long-term growth, security and 
resilience. 

European savings are largely invested abroad  

Persistently high private savings in the EU result in a large external surplus. As chapter 2 
elaborates, EU savings largely exceed domestic investments, leading to a current account surplus 
of  2.5%  of  GDP  in  2024.  The  private  sector  savings  have  strongly  increased,  lifting  the  EU’s  net 
lending  position  in  2024  well  above  its  pre-pandemic  average,  despite  the  increased  (but 
correcting) government borrowing (Graph 3.1.a). In contrast, the United States’ external deficit is 
driven  mainly  by  the  government’s  persistent  borrowing,  while  private  savings  remain 
comparatively weak (Graph 3.1.b).     

A  large  part  of  EU  surplus  savings  have  been  allocated  to  the  US.  Aggregate  EU  savings 
excluding amortisations account for ca. EUR 1.200 billion annually. Since 2015, an average net of 
more  than  EUR  300  billion  (ca.  25%)  of  these  EU  savings  flow  into  foreign  assets  each  year, 
reaching  EUR  437  billion  in  2024  (2).  These  savings  are  mainly  channelled  into  foreign  direct 
investment, equity, and bonds. Since 2020, the US has been the main destination for these funds, 
in  net  terms  (Graph  3.2.a)  (3).  European  savings  thus  play  a  significant  role  in  meeting  global 
demand for capital. A substantial portion is allocated to the US, with the EU financing around 40% 
of  the  US  external  deficit  between  2016  and  2024  (Graph  3.2.b)  (Milesi-Ferretti,  2025).  US 
financial  markets  remain  especially  attractive  for  European  institutional  investors  due  to  their 
liquidity,  and  strategic  investment  options  (ECB,  2025c).  In  addition,  they  offer  a  range  of  high-
quality, dollar-denominated liquid assets, supported by a long track of solid performance and high 
returns  (Davies  et  al.,  2020).  In  contrast,  Europe’s  more  fragmented  and  bank-based  financial 
system provides fewer financial investment opportunities (4).  

38 

 
 
Graph 3.1: The EU external surplus reflects high private savings, while the US deficit mirrors its 
fiscal stance 

Notes: Net lending/ net borrowing indicates whether an economy is a net provider or user of financial resources vis-à-vis 
the rest of the world. The US net lending/ borrowing position shows the latest available data, up to 2023. 
Source: Eurostat, OECD. 

The allocation of gross EU capital outflows shows currently no clear shift away from the 
US. While the net outflows by mid-2025  increased slightly compared to mid-2024 (Graph 3.2.a), 
gross financial outflows from the EU increased in the second quarter of 2025, to levels last seen in 
2022 (Graph 3.2.c). Looking at the US exposure, data also indicate no strong retrenchment in the 
recent  quarters  (Graph  3.2.a),  despite  the  dollar  depreciation  and  higher  perceived  risks  by 
investors in holding unhedged US assets (see Box 3.1).  

However, the composition of EU capital flows is changing. Up to the second quarter of 2025, 
net cross-border flows focused on deposits and equity, with a smaller emphasis on foreign-issued 
bonds  (Graph 3.2.d),  the  first  being  possibly  related  to  high  foreign  exchange  trading  volumes 
(BIS,  2025).  This  contrasts  with  the  development  from  2017  to  2022,  where  flows  were  mainly 
allocated towards foreign equity and bonds.  

39 

-20-15-10-50510151617181920212223b) Net Lending/ Borrowing by Sector -USCorporationsGeneral governmentHouseholdsTotal economy-20-15-10-5051015161718192021222324a) Net Lending/ Borrowing by Sector -EU27CorporationsGeneral governmentHouseholdsTotal economy 
  
Graph 3.2: The EU allocates savings abroad, while the US needs foreign savings for funding 

Notes: The EU financial accounts exposure vis-à-vis the US is adjusted for the portfolio investment liabilities, based on 
the International Transactions data by the Bureau of Economic Analysis (BEA). The split of EU financial accounts by equity 
(F51) and investment fund shares (F52) is based on euro area estimations. 
Source: Own calculations based on Eurostat, BEA. 

40 

 (500) (300) (100) 100 300 500 700171819202122232425in billion eurosa) EU financial accounts, exposure vis-a-vis US, four quarter sumUSRestTotal-1400-1200-1000-800-600-400-2000200171819202122232425in billion eurosb) US current account funding, exposure vis-a-vis EU, four quarter sumFinanced by rest of the world, excluding EUFinanced by EUCurrent account balance-1 000- 500 0 5001 0001 500171819202122232425in billion eurosd) EU financial accounts decomposition by categories, four quarter sumEquityDeposits, loans, trade credits, and other financial instrumentsBondsInvestment fund sharesDirect investmentFinancial accounts (net)-400-20002004006008001000120014001600171819202122232425in billion eurosc) EU gross capital outflows, exposure vis-a-vis US, four quarter sumUSRestTotal 
     
 
 
(Continued on the next page) 

41 

Box 3.1: Higher perceived US dollar risk The US dollar’s depreciation since February reflects macroeconomic factors and also heightened risk perceptions towards US assets. While the dollar exchange rate often tracks traditional macroeconomic factors such as expectations about monetary policy and economic momentum, the scale of the depreciation points to the role of other factors, in particular a perceived increase in the riskiness of US assets amid heightened economic policy uncertainty. At the same time, most estimates of the equilibrium real effective exchange rate suggest that the US dollar remains overvalued, implying further room for adjustment at least from the point of view of economic fundamentals (IMF, 2024a; IMF, 2025a). There are currently no signs of a persistent reversal of foreign capital inflows, but foreign investors have started hedging their dollar exposures more than in the past and there was a visible – albeit possibly temporary – weakening of the safe-haven status of the dollar over the spring, particularly following the so-called “Liberation Day”. Finally, structural-fundamental forces may also have played a role as market commentaries started to pay more attention to the overvaluation of the dollar and the funding of the US external balance. The behavior of US Treasury yields since the first quarter of the year is consistent with higher perceived risk among investors. Policy announcements since early 2025 triggered bouts of volatility, with tariffs and fiscal initiatives prompting selloffs in both Treasuries and the dollar. The initial effect of the trade policy announcements of the current US Administration in the direction of hiking tariffs to historically high levels was to dampen growth prospects, which in turn contributed to lower US bond yields in the first quarter of 2025. A rapid increase in US term premia took place between 4 and 11 April (Graph 1), signaling an increase in other real term premia and credit risk perceptions (1). Public disputes between the US President and the Federal Reserve and concerns over fiscal sustainability following the so called “One Big Beautiful Bill” (which contains tax and spending policies set to increase US government debt) further fed these pressures and also promoted an increase in inflation risk premia. The risk premium embedded in 10-year Treasuries drifted higher during the summer, underscoring that investors increasingly demand compensation for policy, inflation and credit uncertainty. Graph 1: Decomposition of 10-year US term premia  Source: PRISM model estimates. Temporary reversals in the relationship between US dollar asset prices and uncertainty indices revealed fragility in the dollar’s safe-haven role. The established correlations between the dollar, US asset prices, and measures of uncertainty broke down temporarily in the second quarter of 2025, indicating a shift in sentiment (Graph 2). In the past the dollar tended to strengthen alongside increases in volatility indices such as the VIX (a measure of stock market risk), reflecting its safe haven status. Following the April tariff announcements,  (1) Term premia estimates and decompositions are based on the PRISM model (Monteiro, 2025). In Graph 1, “other real term premia” is a residual component capturing pricing factors unrelated to credit and inflation risks. These can include the relative balance of bond supply and demand at a given maturity, the predominant direction of risks to real rates (upwards vs downwards) and market liquidity aspects.   
 
 
 
   
 
Box (continued) 

42 

however, this relationship briefly turned negative: rising uncertainty coincided with dollar weakness. Similarly, correlations between the dollar and US policy uncertainty indices became negative, indicating that higher uncertainty was increasingly priced as a dollar-specific risk rather than a driver of safe-haven demand. Rolling regressions suggest that these tensions were temporary, with correlations reverting over the summer, but they highlight investors’ uneasiness about the safe-haven role of the US dollar. Capital flows into the US recovered after April’s outflows, but increased hedging points to heightened risk perceptions. In April, the US recorded a net outflow of portfolio capital, but the inflows resumed in the following months confirming that there was no permanent flight from US assets. The April 2025 outflow of portfolio investment was significant but not unprecedented and was quickly offset by renewed inflows in May and June (as shown by the ratio of net foreign purchases over total sales of US equities, Graph 3). However, the resumption of inflows did not restore dollar strength, pointing to a change in how capital markets perceive and price US assets. A notable trend has been the increase in hedging the US dollar exposures: investors appear more concerned about exchange rate risks even when they maintain or increase their holdings of US securities (2). This hedging activity underlines that the depreciation of the dollar is not only about flows, but also about the perception of higher risk in holding unhedged US assets. Graph 2: Time-varying coefficient of the VIX uncertainty index from rolling regressions of the NEER USD Graph 3: Historical evolution of the ratio of net foreign purchases of US securities to total gross sales of US securities (1986-2025)    Source: Commission calculations, data from Bloomberg, policyuncertainty.com Notes: rolling regressions on daily percentage changes, time window 30 days, heteroskedasticity and autocorrelation-consistent standard errors Source: Commission calculations, data from US Treasury      (2) Data on hedging activity is not available, but indirect evidence is presented in Shin et al. (2025).   
 
 
 
 
   
 
 
European household savings consist mainly of bank deposits, earning low 
returns 

The  EU  is  a  net  exporter  of  capital,  and  the bulk  of  gross  European  savings  originates 
from  households.  The  external  surplus  reflects  the  fact  that  a  part  of  the  EU  savings  is  not 
invested in the EU but abroad. As elaborated in the previous section, the household sector accounts 
for  the  majority  of  the  savings  within  the  EU  (Graph  3.1.a).  Understanding  why  the  household 
savings ultimately flow abroad is therefore central to understanding the EU’s investment gap and 
financial intermediation efficiency (Draghi, 2024). 

European  households  have  higher  savings  than  their  international  peers.  In  2024,  EU 
household net financial savings (acquisition of financial assets) amounted to close to 10% of gross 
disposable  income,  around  two  percentage  points  above  pre-pandemic  levels.  Since  2016,  EU 
households have maintained higher net financial flows in relation to income compared to those in 
the  US,  UK,  or  Japan,  except  in  2019  and  2020,  when  the  US  experienced  a  temporary  surge  in 
household savings (Graph 3.3.b) (European Commission, 2025i). In the beginning of the pandemic, 
EU  households  have  built  up  substantial  savings  and  continue  to  do  so.  After  the  pandemic,  a 
motive for continued elevated saving rates may have been the efforts to rebuild financial buffers, 
as inflation has eroded the real wealth, and higher living costs absorbed much of the increase in 
nominal savings (European Commission, 2024b). 

Graph 3.3: EU households have recorded higher financial savings flows than their international 
peers, and allocate them mostly in deposits 

Notes: Information on net financial transactions of households for Japan, US and UK is only available up to 2023, shown 
as percentage of net disposable income, while EU is shown as financial asset transactions in percentage of gross 
disposable income. 
Source: Eurostat, OECD. 

Households  favour  bank  deposits  as  their  primary  form  of  financial  investment.  Before 
2020, households in the EU channelled on average around 60% of their financial flows into bank 
deposits  (Graph 3.3.a). During the pandemic, precautionary and involuntary excess savings were 
also  channelled  primarily  into  bank  deposits,  with  some  additional  flows  into  shares,  equity,  and 
investment funds. Deposit accumulation slowed markedly, and purchases of debt securities picked 
up over 2022/23. In 2024, a partial rebalancing occurred, with deposits regaining importance. This 
pattern  suggests  that  households  avoid  direct  risk-taking  and  might  reflect  a  combination  of 

43 

-505101520201620172018201920202021202220232024% of GDIa) Total asset acquisitionby EU households (transactions)Other assetsInsurance & pension entitlementsShares, equity, investment fundsDebt (securities and loans)DepositsNet fixed capital formationTotal asset acquistion-2024681012141618201620172018201920202021202220232024% of disposable incomeb) Net financial transactions of householdsEUDENLJPUSUK 
  
structural  factors  in  portfolio  choices,  such  as  income  and  wealth  levels,  age,  and  employment 
stability (European Commission, 2025i). 

Graph 3.4: Despite higher financial savings, EU households’ wealth levels remain relatively low 

Notes: Graph 3.4.a) OECD non-financial asset holdings and non-consolidated financial asset holdings 2023 for the 
household and non-profit institutions serving households sector (NPISH), 2022 for missing values. Buildings and land 
includes the value of non-residential buildings held by households (N111 and N211). Deposits refers to F2 excluding 
cash. ’Equity, bonds’ denotes equity (F51) and debt securities (F3). Funds/insurance groups mutual funds (F52) and 
insurance claims (F6). Other financial assets mainly comprise unlisted and other equity, typically entrepreneur stakes in 
companies. Other assets/claims groups other financial assets (like claims from loans. F4) and non-building produced non-
financial assets. Buildings and land figures are based on 2023 data, and where missing, 2022 data was used by updating 
with the headline house price index; Graph 3.4.b) OECD share of financial instruments in financial assets of households 
and NPISH in 2024. 
Source: OECD, Ameco. 

While EU households save more than their international peers, their total wealth levels 
remain comparatively low. This feature partly reflects the relatively low yields that accrue to EU 
households compared to other advanced economies. Indeed, EU households’ portfolios are mainly 
concentrated in low-yield, bank-based instruments, which bring lower returns and partly affects the 
wealth levels (Graph  3.4.a) (5). Real  estate and deposits together account for more than half of 
the  total  EU  assets,  while  the  exposure  to  higher-return  financial  assets  remains  modest  (6).  By 
contrast, households in the US and the UK have a more diversified portfolio with a larger share in 
financial  assets, including listed shares, bonds, investment funds, and insurance products  (Graph 
3.4.b).  This  reflects  a  greater  reliance  on  capital  markets  in  these  economies.  As  a  result, 
households in the US and UK generate more wealth through returns on riskier portfolios. However, 
households in UK have also increased their deposit holdings ratio over time, from around 23% in 
2016 to 34% in 2024. In Japan, deposit holdings account for more than 50% of the total financial 
assets of households. Some reasons might be low financial literacy and risk aversion of Japanese 
households, a legacy of bank-based financial policy anchoring deposit savings, and the illiquidity of 
the real estate market in Japan (Altman, 2019). 

There are also differences in portfolio choices among households within the EU. Countries 
such  as  Germany,  France,  and  Italy  rely  heavily  on  deposits,  as  well  as  mutual  funds  and  life 
insurance. Yet, the share of the latter two instruments in relation to total financial assets remains 
well  below  that  in  Anglo-Saxon  economies  (Graph  3.4.b).  The  Netherlands  is  one  of  the  largest 
exceptions to the EU pattern, with its mandatory second-pillar pension system and larger allocation 
to funds and insurance, which might also imply a stronger exposure to US equity markets than their 
euro area peers.  

44 

0200400600800100012001400EUUSUKJPDEFRITNL% of gross disposable incomea) Household wealthBuildings and landDepositsEquity, bondsFunds, insuranceOther assets / claims0102030405060708090100EUUSUKJPDEFRITNL% of financial assets (stocks)b) Financial asset allocationDepositsEquity and bondsFunds and InsuranceOther 
  
The financial sector channelled the EU household savings essentially 
abroad in 2024 

Households  rarely  invest  directly  in  capital  markets  or  foreign  assets;  instead,  they 
place most  of their financial wealth  in the financial sector.  These  financial  intermediaries 
then shape the destination of these financial savings, allocating most of them abroad (outside the 
EU) in recent years, and only a low share towards EU non-financial corporations (NFCs). This section 
tracks the channelling of household savings through the EU financial system from 2023 to 2024 
(7). 

European households allocated most of their financial savings to the financial sector in 
2024,  making  it  the  main  conduit  to  channel  them  abroad.  In  2024,  almost  70%  of 
households’  financial  savings  were  directly  channelled  to  financial  corporations  within  the  EU, 
namely banks, funds, insurers, and other financial institutions (Graph 3.5). Only about a fifth went 
directly  to  NFCs,  mostly  through  unlisted  equity  holdings,  which  represent  an  important  funding 
source  for  European  NFCs.  Less  than  10%  of  financial  savings  were  directly  invested  abroad.  In 
contrast, US households allocated around 50% of their financial savings to the financial sector in 
2024, while the NFC sector received 44% of these flows (8). This highlights the strong difference in 
direct allocation between the EU and the US.  

Graph 3.5: EU households' financial asset allocation vis-à-vis counterpart-sectors, adjusted flows 
from 2023 to 2024 

Notes:  Results based on preliminary data from a refactoring of the ECFIN-JRC 'Finflows' dataset. “Adjusted (financial) 
flows” refer to calculated financial flows derived from financial assets. They aim to approximate the underlying 
transactions in financial instruments, providing a clearer picture of financial activity from 2023 to 2024. The calculations 
for the ‘financial sector intermediation’ are based on the asset allocation for the total financial corporation sector. This 
may also reflect the impact of multinational enterprises operating via holding companies, households’ indirect investment 
choices via ETFs, and other effects. 
Household assets are defined as the total financial assets excluding currency (F21), financial derivatives (F7) and other 
accounts receivable (F8). The allocation of adjusted flows is shown in two steps: First, the direct allocation vis-à-vis 
counterpart sectors (blue). Second, the allocation of adjusted flows after the transformation by the financial corporations 
(yellow), which are based on the asset allocation share of the total financial corporation sector. 
Source: European commission calculations based on ECB, Eurostat, IMF. 

45 

 
 
Financial  corporations  intermediate  most  household  savings  and  preliminary  findings 
suggest  that  they  channel  about  half  of  them  into  assets  abroad  (9).  In  2024,  European 
households allocated  21% of their financial savings directly to EU NFCs. After accounting for the 
intermediation of European household savings by financial corporations, this share increases only 
slightly to a total of around 25%.  This illustrates that only a small portion of household savings is 
used by the EU financial sector to finance EU companies. NFCs in Europe also rely on intra-sectoral 
and cross-border funding. At the same time, the share of household financial savings invested in 
foreign assets increases from 8% directly invested to over 50% (Graph 3.5).  

The  limited  share  of  household  financial  savings  invested  in  EU  companies  reflects 
Europe’s  fragmented  capital  markets.  The  allocation  of  the  majority  of  EU  savings  abroad 
reflects  to  some  extent  geographic  risk  diversification  strategies  by  institutional  investors,  but  it 
also  results  from  the  comparatively  low  depth  and  liquidity  of  the  EU  capital  market.  The  low 
domestic  absorption  of  EU  savings  limits  the  ability  of  EU  firms  to  finance  themselves  on  the 
market and therefore has direct implications for the EU’s competitiveness (Draghi, 2024).     

Advancing towards a Savings and Investment Union would be key to 
efficiently mobilising capital for Europe 

Europe’s abundant savings are a unique opportunity to strengthen its economy and the 
international role of the euro. If effectively mobilised, these resources can underpin investment 
in  the  Union’s  long-term  priorities,  such  as  the  green  and  digital  transitions,  defence,  and 
innovation,  while  reinforcing  its  resilience.  The  analysis  above  shows that  households  continue to 
prefer  safe  and  liquid  instruments  within  the  EU,  while  financial  intermediaries  channel  a 
substantial  share  of  these  resources  abroad.  This  highlights  untapped  potential:  redirecting 
domestic  savings  into  domestic  investment,  consistent  with  the  objectives  of  a  deep  and  well-
functioning  Single  market,  could  become  a  powerful  engine  for  domestic  growth.  This,  however, 
requires  advancing  towards  a  genuine  Savings  and  Investment  Union  (European  Commission, 
2025n). Such reforms would not only strengthen Europe’s capacity to absorb capital flows but also 
underpin the international  role  of the euro, by  enhancing the depth, safety,  and attractiveness of 
euro-denominated assets. 

To advance toward a genuine  Savings and Investment Union and strengthen EU capital 
markets,  the  EU  and  its  Member  States  need  to  continue  pursuing  a  multifaceted  and 
ambitious  strategy.  First,  actions  in  relation  to  citizens  and  savings  should focus  on  enhancing 
individual  wealth  opportunities  through  accessible  savings  and  investment  products  and  a 
strengthened  financial  literacy strategy (10). Empowering citizens to better prepare for retirement, 
including  through  auto-enrolment  schemes,  will  not  only  improve  financial  well-being  but  also 
channel  additional  resources  into  capital  markets.  This  will  contribute  to  greater  market  depth, 
liquidity  and  resilience  by  broadening  the  investor  base.  Second,  in  the  area  of  investments  and 
financing, efforts should aim at facilitating equity investments by institutional investors—such as 
banks, insurers and pension funds—and at fostering the development of venture capital and growth 
funds.  These  measures,  together  with  steps  to  revitalise  the  securitisation  market,  will  help 
mobilise private capital  towards Europe’s strategic priorities, supporting innovation and long-term 
growth.  Finally,  deeper  market  integration  and  stronger  supervisory  coordination  are  critical  to 
improving efficiency and achieving economies of scale. Removing remaining cross-border barriers 
will  enhance  the  attractiveness  of  EU  capital  markets  as  a  stable  and  competitive  source  of 

46 

 
 
financing,  while  gradually  strengthening  listings  and  exit  opportunities  for  investors  in  venture 
capital, growth capital and private equity funds.   

Advancing  the  Banking  Union  project  would  also  strengthen  the  EU’s  financial  sector, 
enhancing  its  efficiency,  resilience,  and  ability  to  support  the  Capital  Markets  Union. 
Banks  are  central  to  capital  markets,  particularly  in  the  EU’s  bank-based  economy,  providing  key 
services  to  investors  and  issuers.  Yet,  the  sector  remains  segmented,  with  a  strong  home  bias 
towards national assets (or the liquid US market) rather than investing in other EU Member States. 
This fragmentation does not exploit the potential  for cross-border allocation of capital within the 
single  market  and  impedes  the  pooling  of  savings  for  investment  in  strategic  priorities.    It  also 
leaves  the  euro  area  vulnerable  in  times  of  stress.  Further  developing  the  Banking  Union—by 
advancing  crisis  management  and  deposit  insurance  reforms,  enabling  cross-border  pooling  of 
capital  and  liquidity,  and  creating  conditions  for  deeper  integration  of  banking  markets—would 
support the development of truly European capital markets.  

In this chapter, the term ‘households’ includes households and non-profit institutions serving households.   

(1) 
(2)  This figure reflects the EU’s net lending position, computed as the sum of the current account and capital account balance, which 
averages around EUR 300 billion since 2019 and reached EUR 437 billion in 2024. Note that its counterpart, the financial account 
balance,  which  measures  the  net  acquisition  of  foreign  assets,  reached  EUR  609  billion  in  2024.  The  discrepancy  reflects  a  high 
amount of statistical net errors and omissions.  

(3)  The euro area’s position as a US net creditor does not translate into higher income inflows from the US. This phenomenon is linked 

to profit-shifting by US multinational enterprises via financial centres such as Ireland and the Netherlands. See Emter et al. (2025).  
(4)  Gita Gopinath (2025) highlights the vulnerabilities in current economic structures and stresses the importance of preparedness and 

resilience to mitigate the impact of future economic shocks.  

(5)  For example, see: (i) European Commission (2024b); (ii) Draghi (2024). 
(6)  The distribution of household wealth differs across the euro area, with the poorest 50% holding a share of around 5% of the total 
net wealth according to the ECB’s distributional wealth accounts: https://data.ecb.europa.eu/data/datasets/DWA/data-information    
(7)  Direct savings allocation refers to the immediate counterpart sector, which receives the financial investments. The presented results 
are based on preliminary data from a refactoring of the ECFIN-JRC 'Finflows' dataset. “Adjusted (financial) flows” refer to calculated 
financial flows derived from financial assets. They aim to approximate the underlying transactions in financial instruments, providing 
a clearer picture of financial activity from 2023 to 2024.  

(8)  The estimates for the US households are based on Issuer-to-Holder (from-Whom-To-Whom) data, published by the Federal Reserve. 
Please note that the sectoral classification in the US financial accounts differs from the European System of Accounts. Access to the 
underlying data: https://www.federalreserve.gov/releases/efa/enhanced-financial-accounts.htm  

(9)  These results are preliminary and based on the allocation of assets for the total financial corporation sector. They may also reflect 
the  influence  of  multinational  enterprises  operating  via  holding  companies,  which  are  part  of  the  financial  sector,  as  well  as 
households’ indirect investment choices through ETFs. 

(10)  In  September  2025,  the  Commission  has  adopted  the  recommendation  on  increasing  the  availability  of  Savings  and  Investment 
Accounts,  as  well  as  the  Communication  on  Financial  Literacy.  These  two  initiatives  aim  to  foster  greater  retail  participation  in 
capital markets.  

47 

 
 
4. MACROECONOMIC IMPACTS OF DEFENCE SPENDING 

Several  adverse  developments  in  the  European  neighbourhood  have  led  to  a  significant 
deterioration  of  European  and  global  security.  To  boost  defence  capacity,  NATO  allies  have 
committed  to  a  significant  increase  in  defence-  and  security-related  spending  by  2035.  This 
chapter  focuses  on  macroeconomic  impact  of  the  increased  defence  spending.  Efficient  and 
effective spending requires a coordinated approach among Member States. The benefits of such a 
coordinated approach go beyond economic gains and also create positive spillovers in terms of a 
strengthened security situation for the EU as a whole. 

Composition of defence spending in the EU 

EU  Member  States  are  facing  an  important  multi-year  period  of  increased  defence 
spending  after  many  years  of  underinvestment.  The  primary  goal  of  increased  defence 
spending is safeguarding Europe’s security and protecting its borders, it also represents a valuable 
opportunity  to  ramping  up  investment  and  increase  the  potential  for  innovation  (Ilzetzki,  2025). 
Defence  spending  increased  over  the  last  decade  following  Russia’s  illegal  annexation  of Crimea, 
although  there  are  differences  among  EU  countries.  Defence  spending  across  EU  Member  States 
averaged 1.3% of GDP in 2023 (Graph 4.1.a) (1). The biggest increases in total defence spending 
in  recent  years  have  been  registered  by  the  Baltics  and  Poland,  demonstrating  that  the  Member 
States geographically closer to Russia have generally moved faster in this regard (Graph 4.1.b).  

Defence  spending  of  EU  Member  States  increased  less  than  in  other  international 
players. The US spent 2.9% of GDP on defence by in 2023. Almost 1% of US GDP was related to 
capital  expenditure  in  defence,  compared  to  0.4%  of  GDP  spent  by  EU  Member  States  in  2023. 
Moreover,  the  US  has  strengthened  its  position  as  the  top  arms  exporter  between  2015-19  and 
2020-24, reaching 43% of global arms exports (from 35%) European arms imports have surged by 
155%  over  the  same  period  (Graph  4.1.d)  (2),  indicating  that  EU  Member  States  have  favoured 
imported non-EU manufactured arms over EU sourcing, especially in artillery systems, air defence 
systems and multirole fighter aircrafts. Overall, less than 50% of defence procurement is sourced 
in Europe (Table  4.1) (BusinessEurope,  2025). Looking at other international  players, Russia and 
China have increased their defence budgets at significantly higher rates than the EU or the US over 
the last two decades (Graph 4.1.c).  

The  European  defence  industry  is  fragmented.  There  are  121  different  weapons  systems 
across the 27 Member States, compared to 21 in the US (Centrone and Fernandes, 2024). This has 
led  to  inefficiencies  and  limited  economies  of  scale  for  the  European  producers  of  defence 
equipment and hampers military interoperability. As US systems are integrated, NATO rely on their 
system rather than the fragmented and non-integrated systems produced in the EU. Overall, less 
than 50% of defence procurement is sourced in Europe (Table 4.1). 

48 

 
 
 
Graph 4.1: Defence expenditure in the EU and other international players 

Source: Graph a): Eurostat, Bureau of Economic Analysis; Graph b): Nato, Google Maps; c) SIPRI Military Expenditure 
Database; d) Commission services calculations based on the SIPRI Arms Industry Database.; b) Nato, Google Maps. 

Table 4.1:  Procurement by EU Member States from EU and non-EU sources 

Notes: Procurement data since February 2022. EUR billion.  
Source: Business Europe based on International Institute for Strategic Studies. 

49 

0.00.51.01.52.02.53.03.50102030405060708090100IEMTLUATPTBEESDECZITSISKEU27HRNLFIBGRODKFRSECYHUPLELLTEELVUS% of GDP% of totala) EU defence expenditure in the EU and the US (2023)Share of capital expenditureShare of current expenditureDefence expenditure as % of GDP (rhs)BEBGHRCZDKEEFIFRDEELHUITLVLTLUNLPLPTROSKSIESSE-0.50.00.51.01.52.02.5010002000300040005000Defence expenditure (% of GDP, 2024-2015)Distance from Moscow (km)b) Distance to Moscow vs Change in Military Expenditure over the last decade7012017022027032037008091011121314151617181920212223242008 = 100c) Military expenditureRussiaUSAUKEUChina010203040506070201920202021202220232024d) EU defence imports from the USTotal EU imports from the US (% of total US exports)Total EU imports from the US (% of total imports from the world)EU sourcingNon-EU sourcingArmoured fighting vehicles10.48.8Artillery systems310.5Air-defence systems36.894.5Multirole fighter aircraft18.253.3Combat ISR UAVs6.91.5Principal surface combatants36.4Submarine programmes33.5ASW and maritime patrol aircraft5.33.8Sum150.5172.4 
      
 
 
 
            
 
 
Fragmentation  across  Member  States  leads  to  cost  inefficiencies  in  defence  spending. 
The  lack  of  coordinated  procurement  and  dependence  on  non-EU  suppliers  carries  costs  ranging 
from  EUR 18  billion  to  EUR  57  billion  (6.5%  to  20.5%  of  all  the  European  military  spending) 
annually (Centrone and Fernandes, 2024). Market fragmentation gives national suppliers significant 
market  power,  and  the  small  orders  usually  placed  by  single  European  countries  result  in  higher 
unit costs. However, as production volumes increase, economies of scale can be achieved, leading 
to lower unit costs. Wolff et al. (2025) found that unit costs can fall by 10-15% with each doubling 
of production, and that cost reductions of 20-30% can be achieved as production experience grows.  

Certain modern military technologies are currently unavailable in the European defence 
industrial  base  (Wolff  et  al.  2025).  It  could  take  long  for  Europe  to  catch  up  with  the  US  in 
domains  such  as  air  defence  and  satellite  communication  (Table  4.2).  Moreover,  while  European 
companies  are  exploring  new  defence  technologies,  they  still  fall  behind  the  US  in  terms  of 
investment and innovation (Wolff et al., 2025). Between mid-2021 and 2024, total venture capital 
funding for defence start-ups in the U.S. was 2.4 times higher than in Europe (McKinsey, 2025). 

Table 4.2: Time horizons for the development and production of weapons systems 

Notes: For the next generation of battle tanks and the sixth-generation aircraft time horizon refers to first product 
deliveries. For other products, it refers to European autonomy.  
Source: Bruegel based on Kiel Institute, MGCS, and other sources. 

Intra-European  consolidation  in  the  production  of  defence  goods—which  would  result 
from a coordinated EU-wide procurement—could lead to a significant increase in demand 
for certain items, potentially reducing unit costs and prices by 50-90%. Evidence from the 
Second World War suggest that the supply response could bring significant cost reductions, helping 
to  alleviate  pressures  on  the  budget  from  rising  demand  (Harrison,  1990;  Streb  &  Streb,  1998; 
Herman, 2012; Lafond et al., 2022).  

Historical  evidence  for  the  US  has  shown  that  learning  by  doing  can  drive  large  scale 
increases  in  capacity,  but  current  labour  market  conditions  in  the  EU  may  serve  as  a 
constraining factor. Over the course of World War II, US shipbuilders and aircraft manufacturers 
saw enormous decline in costs which appeared to be correlated with growing experience (Ilzetzki, 
2024).  Similar  increases  in  capacity  for  EU  Member  States  may  be  constrained  especially  by 
different  labour  market  conditions.  In  fact,  the  pre-war  labour  market  was  characterised  by  low 
participation rates, particularly from women, which facilitated the increase in capacity during World 
War II. The current EU labour market, in turn, faces constraints from employment levels at record 
levels, demographic change, limited immigration, and issues relating to labour market integration 
of certain groups of society.  

The  market  capitalisation  of  EU  defence  producers  has  partially  caught  up  with  US 
defence producers. In 2022, market capitalisation of the Top 5 EU defence producers was about 
35% of that of the top 5 US defence producers. Latest data indicate that this value increased to 
about 65% (Graph 4.2a). This indicates that European defence companies are expanding rapidly 

50 

Time horizonNext generation of main battle tanks2040Sixth -generation aircraft>2045Air defence2030-2035Rocket artillery systems (like HIMARS)~2045Transport helicopters (like Chinook)2030Satellites (like IRIS for communication)2030Europe has 10 satellites, compared to 100s for the US2030-2035 
 
          
 
and gaining market share, and this trend is expected to continue. The sector’s growing relevance in 
investor’s  asset  allocation  might  also  reflect  the  market  belief  that  European  defence  producers 
can respond to increasing demand for defence products by EU Member States.  

Graph 4.2: Market capitalisation and venture capital investment 

Source: Graph a): Bloomberg; Graph b): Pitchbook 

Increasing venture capital investment into European defence companies also bodes well 
for  increasing  production  capacity  and  innovation.  Companies  in  the  sector  have  raised 
EUR 60 billion since the start of 2022, including  EUR 16 billion in the first seven months of 2025 
(Graph 4.2b). The US provided more than 65% of venture capital defence tech investment in Europe 
so far in 2025, up from 18% in 2023. The increase marks a sharp reversal from the previous year, 
when  more  than  half  of  VC  funding  for  defence  tech  in  Europe  came  from  domestic  investors 
(Financial Times, 2025).  

Graph 4.3: Defence-related companies: location of headquarters and industrial production 

Defence  capabilities  are  spread  across  much  of  the  EU,  including  the  CEE  region. 
Experimental,  analysis  (3)  on  the  basis  of  a  comprehensive  list  of  defence  companies  with 
production  sites  in  the  Union  shows  the  historical  connection  of  these  companies  with  a  few 
industrial regions in the EU (Graph 4.3) (4). Most of the headquarters are in Western Europe while 

51 

0.00.10.20.30.40.50.60.70.80501001502002503003502122232425Market capitalisation of Top 5 EU defence producers relative to Top 5 US defence producers EU Index (LHS)US Index (:LHS)EU market cap relative to US market cap (RHS)010020030040050060070080025242322212019Venture capital investment into defence start-ups Deal count USDeal count EU02040608010012014025242322212019Capital invested USCapital invested EU 
     
 
 
 
the  distribution  is  less  dense  across  Southern  Europe  and  parts  of  Scandinavia  (Graph  4.3.a). 
When focusing on plants and subsidiaries, the geography of defence production appears to be more 
widespread, with important clusters appearing in other European regions (Graph 4.3.b). 

The  regional  concentration  of  defence-related  companies  can  foster  technology 
spillovers  but  aggravate  regional  imbalances.  It  might  facilitate  the  expansion  of  defence 
industries by exploiting geographical spillovers or facilitating civilian industries that aim at shifting 
their production  to military  products.  On  the  other hand,  the  concentration  of  defence  production 
among a limited number of leading firms whose headquarters are located in specific regions of the 
EU might contribute to attract workers to these regions 

Employment in the defence sector 

Over  the  past  decade  the  size  of  the  military  armed  forces  in  the  EU  has  remained 
broadly  constant  (Graph  4.4.a).  According  to  the  EU  Labour  Force  Survey  (EU  LFS),  about  1.2 
million  people  were  employed  in  military  roles  in  2024,  which  represents  about  0.6%  of  total 
employment in the Union. This however varies greatly across EU Member States.  

Employment  in  the  defence-related  manufacturing  sectors  represented  a  small 
proportion  of  EU  employment  in  2024  (5).  Military-specific  sectors  focused  on  producing 
weapons,  ammunition  and  military  vehicles  employed  111 000  people,  or  0.06%  of  EU 
employment.  However,  considering  also  other  sectors  that  are  broadly  relevant  to  defence,  the 
number amounted to around 4.5 million workers or 2.3% of the EU employment (Graph 4.4.b). 

Graph 4.4: Size of the military work force and employment in EU defence-related sectors 

Source: Graph a): EU Labour Force Survey (lfsa_egai2d); Graph b): EU LFS special extraction. 

Tertiary  and  medium  educated  workers  are  overrepresented  in  the  military  workforce 
and  other  defence-related  sectors.  When  compared  to  the  overall  workforce,  the  military 
workforce is predominantly male  and has a younger average age. Additionally,  military personnel 
has on average higher levels of educational  attainment, which may be linked to the younger age 
profile  of  this  workforce.  Simiarly,  higher  levels  of  education  are  observed  in  several  defence-
related sectors (Graph 4.5a).  

52 

0.0%0.2%0.4%0.6%0.8%1.0%1.2%1.4%1.6%1.8%ELCYSILVITPLHRBGMTFREU27EA20ROSKHUESPTDKCZDELTBESEEEFINLATIEpercentage of total employment (15-64)a) Size of the military work force202420152.05%2.10%2.15%2.20%2.25%2.30%2.35%05001000150020002500300035004000450050002021202220232024Number of employed (ths)b) Employment in EU defence-related sectorsDual use service sectorsDual use manufacturing sectorsMilitary specific manufacturing sectorsShare in total employment (rhs) 
 
             
In  recent  years,  there  has  been  an  increase in  job  postings  for  specialised  roles in  the 
defence industry, but major defence companies signalled recruitment difficulties across 
the EU lately (6). In May 2025, job postings were 41% higher than in 2021, while the EU average 
was slightly lower than in 2021 (Graph 4.5.b). In particular, there has been an increase in demand 
for  certain  occupations  such  as  specialised  engineers,  IT  and  software  experts,  and  technicians 
involved in production, installation and maintenance, as well as metalworkers (7).  

The  long-term  impact  of  increased  labour  demand  in  defence  and  related  sectors  is 
likely to be limited, although it could exacerbate labour shortages for specific profiles in 
the  defence  as  well  as  in  the  civilian  sectors  that  are  competing  for  the  same  talent. 
While the impact on overall labour demand is expected to be limited, there is a growing need for 
highly  skilled  workers  in  areas  such  as  advanced  manufacturing,  aerospace,  engineering, 
cybersecurity,  and  R&D  in  emerging  technologies.  There  are  already  significant  shortages  of 
candidates with technical profiles. As defence competes with civilian sectors for the same talent, 
higher defence spending can exacerbate these shortages, push up wages, and create regional skill 
gaps. 

Graph 4.5: Defence-related educational attainment and evolution of job hirings 

Notes: The data covers all EU Member States plus Switzerland and European NATO members for which an indeed site 
exists. Note that 100 equals the average monthly postings in 2021. 
Source: Graph a): EU Labour Force Survey (lfsa_egais) and EU LFS special attraction; Graph b): Indeed database. 

Fiscal impact of national and EU funding of boosting defence capacity 

The urgent need to increase defence spending in the short-term requires debt financing 
in  a  context  of  heterogeneous  fiscal  space  across  the  EU.  The  activation  of  the  national 
escape clause of the Stability and Growth Pact provides Member States with the flexibility to ramp 
up core defence expenditure in line with the EU’s new fiscal rules (European Commission, 2025a). 
The national escape clause allows Member States to exceed the maximum net expenditure growth 
rates set out by the Council, provided that this excess is due to an increase in defence spending and 
safeguarding  fiscal  sustainability.  The  flexibility  is  framed  in  time  (up  to  2028),  scope  (defence 
spending  only)  and  size  (capping  it  to  1.5%  of  GDP,  based  on  the  increase  in  defence  spending 
compared  with  the  2021  level,  or  2024  if  lower)  to  avoid  endangering  fiscal  sustainability.  As 
explained  in  chapter  1,  this  implies  that  net  expenditures  other  than  defence  expenditure  are 
expected to follow the recommended net expenditure paths (Graph 4.6.a) (8). 

53 

0%20%40%60%80%100%Total economyMilitary workforce254–Manufacture of weapons and ammunition265–Manufacture of instruments and appliances for measuring, testing, and …303–Manufacture of air and spacecraft and related machinery304–Manufacture of military fighting vehicles711–Architectural and engineering activities and related technical consultancy (often …721- Research and experimental developmenton natural sciences and engineering802 - Security systems and service activitiesa) Educational attainment in the military workforce and defence-related sectors in the EU27 in 2024High (ISCED 5-8)Medium (ISCED 3-4)Low (ISCED 0-2)050100150200250202122232425b) Evolution of job hirings in EU defence industry vs overall economyOverallDefence companies 
          
Further  Union  instruments  are  available  to  help  Member  States  increase  defence 
expenditure.  The  new  instrument  SAFE (Security  Action  for  Europe)  is  designed to  provide  up  to 
EUR  150  billion  in  competitively  priced,  attractively  structured  long-maturity  loans  to  Member 
States. This new instrument has received strong demand by Member States exceeding the available 
budget of EUR 150 billion.  15 By end November, the national defence investment plans, describing 
the  use  of  the  possible  financial  assistance,  will  be  presented  by  Member  States  and  assessed 
individually by the Commission to ensure compliance with the rules governing the SAFE instrument 
(16).  The  loans  have  clear  eligibility  conditions  for  contractors  and  subcontractors  to  ensure  that 
investments  serve  the  Union's  security  and  defence  interests  and  bolster  the  European  Defence 
Technological  and  Industrial  Base  and  promote  common  procurement.  It  can  also  be  put  to  the 
direct benefit of Ukraine, the frontline of European defence.  

Defence projects would be further facilitated by the possibility to reallocate grants from 
EU  cohesion  policy  and  the  eligibility  of  defence  projects  for  EIB  lending.  The  legislative 
package  on  the  mid-term  review  of  Cohesion  policy  for  the  period  2021-27  enables  the  use  of 
cohesion  funds  to  foster  military  mobility  and  develop  resilient  defence  infrastructure  in  EU 
Member  States  and  regions,  including  the  eastern border  regions  affected by  the  Russian  war  of 
aggression against Ukraine. These regions will receive an exceptional one-off prefinancing if they 
dedicate  10%  of  their  funds  to  these  new  strategic  priorities.  Furthermore,  the  EIB  widened  the 
scope  of  its  lending  to  defence  and  security  projects  notably  by  proposing  an  adjustment  of  the 
Group’s  eligibility  criteria  to  ensure  that  excluded  activities  are  more  precisely  defined  and  as 
limited as possible in scope to align with the new policy priorities of the EU.  

Funds  available  through  the  Recovery  and  Resilience  Facility  could  also  be  used  to 
support  defence  expenditure.  With  the  final  stages  of  the  Recovery  and  Resilience  Facility 
approaching,  the  Commission  has  invited  Member  States  to  review  their  national  Recovery  and 
Resilience  Plans to include  only measures  achievable  by  31  August  2026  and  explore  alternative 
measures to use their remaining financial allocations. Revisions to the plans could support Member 
States’ investments in the defence sector, for example through voluntary national contributions to 
the forthcoming European Defence Industry Programme.  

Increased  defence  spending  supports  Ukraine,  which  is  now  part  of  the  EU  security 
architecture. The necessity of providing enduring support to Ukraine has been recognised by NATO 
in the Hague Summit Declaration and is explicitly included in the updated NATO commitments. The 
collective  support  to  Ukraine  could  incidentally  help  Member  States  to  meet  their  NATO 
commitment.  

The  ramp  up  of  defence  spending  by  the  Member  States  will  require  a  higher  fiscal 
adjustment after deactivation of the national escape clause. According to stylised scenarios, 
the higher government spending that results from higher defence expenditure during the period of 
activation of the national escape clause (2025-28) will require an additional required fiscal effort 
of 0.4 percentage points on average for the period starting in 2029 under the Union’s fiscal rules 
(European Commission, 2025c). This additional annual effort could however be more modest (0.25 
percentage points on average) if in the years after 2028 the Member States adopted plans (9) with 
an extended adjustment period of seven years. This illustrates the need to reshuffle revenue and 
spending  priorities  in  conjunction  with  fiscal-structural  reforms  in  the  interest  of  fiscal 
sustainability (Graph 4.6.b).  

54 

 
Graph 4.6: Euro area fiscal stance and fiscal adjustment needs 

Notes: Graph a) The fiscal stance in the forecast also reflects the use of the flexibility for higher defence spending within 
the NEC.  In 2027, it is based on unchanged policies. In 2027, according to the MTPs, a mechanical assumption implies 
that the fiscal stance will be affected by the phase-out of the RRF; Graph b): Based on simulations and do not consider 
the deficit resilience and debt sustainability safeguards for the second round of plans. They do not prejudge the actual 
adjustment requirements for future plans, which will be computed in due time, based on latest outturn data and forecast. 
Source: Graph a): European Commission services’ calculations on the recommended net expenditure paths and European 
Commission Autumn 2025 Forecast. Graph b): European Commission, Assessment of the Fiscal Sustainability Condition 
for Member States Requesting the Activation of the National Escape Clause, Institutional Paper 321, June 2025. 

Macroeconomic impact of boosting defence capabilities 

There  is  mixed  evidence  on  the  relationship  between  defence  spending  and  economic 
growth  .  Empirical  estimates  (vary  depending  on  factors  such  as  country  context,  time  horizon, 
spending  levels  and  methodological  approaches  Cepparulo  and  Pasimeni,  2024;  Sheremirov  and 
Spirovska,  2022).  Higher  government  spending,  as  suggested by Keynesian  economics,  can  boost 
demand and production. However, over time this could lead to higher interest rates, discouraging 
private  investment  and  eventually  offsetting  the  positive  effects  of  this  government  spending. 
Research on the multiplier effect  of defence spending shows varied results. Advanced economies 
tend to see more benefits than less developed countries. In the US, defence spending tends to have 
a  significantly  positive  impact,  whereas  the  effects  in  European  countries  are  often  negligible  or 
even negative. This difference is largely attributed to different levels of imported goods for defence 
procurement in the US and in most European countries. 

55 

-1.2-0.8-0.40.00.40.81.2LVPLFIHUEEHRBE*CZSILT*SKDE**BG*PTELDKPps.b) Adjustment needs in the second plans without extension (4-year adjustment in 2029-32) Additional adjustment implied by higher expenditure in 2025-2028Baseline scenarioTotal adjustment in the NEC scenario-0.100.000.100.200.300.400.500.600.700.800.902025202620272028a) Euro area fiscal stance in 2025-2028Based on MTPsAF25Contractionary/ ConsolidationExpansionary/Relaxation 
   
 
(Continued on the next page) 

56 

Box 4.1: R&D spillovers Increasing defence capabilities requires greater investment in defence, particularly spending in research and development (R&D). In many OECD countries, government spending on defense-related R&D represents an important form of public support for innovation (Graph A1). The United States has the highest share of defense-related R&D in total government R&D spending among OECD countries. EU countries fall substantially short of that. (European Defence Agency, 2025).  The literature has highlighted several channels for the transfer of defence-related innovations to civilian industries and products. Firms not involved in the production of defence equipment may benefit from research funded for military purposes through related research publications, patents, or workforce mobility (Cohen and Levinthal, 1990 ). Technology transfer programmes, such as the U.S. Defence Advanced Research Projects Agency, actively promote the commercialisation of military innovations (Fuchs, 2009); Terzi et al., 2022) and have led to the development of new technologies, including artificial intelligence. industrial linkages between firms involved in the production of defence equipment and other commercial firms. This may, therefore, contribute to the diffusion of advanced manufacturing techniques and materials.  Empirical analysis confirms that higher government spending in defence-related spills over to private R&D spending. Impulse response functions(5) suggest crowding-in of private R&D investment, with a cumulative increase of private R&D investment of close to 1.5% of GDP nine years after the public defence spending shock(6) (Graph A2) (Kraemer et al. 2025). (7) (8) Overall, these findings are robust when restricting the sample to the EU Member States, and in line with related studies (Antolin and Surico, 2025, for the US; Moretti, 2025, for OECD countries). The crowding-in effect remains visible when using patents as a proxy for private R&D spending to account for endogeneity concerns. Splitting the sample according to more innovative and less innovative countries shows significant country heterogeneity.(11) The magnitude of the crowding-in response is stronger for countries with a higher pre-shock level of public innovation spending (Graph A3).  (5) Estimated with local projections based on Jorda (2005).  (6) The considered shock corresponds to an increase in public spending on defense R&D equal to 1% of GDP. As shown in Graph A1, this value is well above current levels. However, it reflects the prospect of a substantial rise in overall defense expenditure (up to the projected 5% of GDP) and a significant expansion of its research component. The framework considers a one-off shock—a discrete 1% of GDP rise in defense R&D spending at time t. This approach, consistent with the econometric specification of the local projection model, allows to identify the dynamic response of private investment to an exogenous fiscal impulse. While actual policy will likely involve a gradual build-up of defense budgets, the estimated responses to a one-off shock provide a useful benchmark for understanding the short- to medium-term effects of a sustained increase. (7) The dataset is an unbalanced panel, with the maximum time span running from 1981 to 2022. The sample consists of data for Australia, Belgium, Canada, Denmark, Estonia, Finland, France, Germany, Greece, Italy, Japan, Korea, Netherlands, Norway, Portugal, Romania and Spain. Country selection for the sample is based solely on data availability, specifically the existence of time series spanning at least 30 years, which is necessary to meet the requirements of the empirical analysis. (8) This result also holds when restricting the sample to EU countries.  (11) The classification is based on the 2024 edition of the Global Innovation Index (Dutta et al., 2024), which ranks countries according to their innovation performance. Graph 1: Defence R&D spending   Source: OECD, IMF. 00.10.20.30.4USUKItalySpainGermanyFranceEUEA% of GDP 
 
 
 
   
 
Box (continued) 

Defence  spending  can  have  significant  spillover  effects  on  civilian  industries,  first 
through  equipment  demand  and  later  through  R&D-driven  innovation  and  investment. 
Sustained  investment  in  areas  like  infrastructure  and  R&D  can  have  a  lasting  impact,  gradually 
building  up  the  country's  capital  and  fostering  the  spread  of  innovation.  Research  suggests  that 
higher  government  spending  on  R&D  leads  to  higher  private  spending  on  R&D  and  increased 
productivity in the long term (Antolin and Surico, 2025; Moretti et al., 2025; Kraemer et al., 2025) 
(see Box 4.1) (10). 

Model simulations shed light on the range of macroeconomic effects of higher defence 
spending  under  different  assumptions.  For  this  purpose,  the  Commission’s  QUEST  model  in  its 
two-region version (EU and rest of the world) provides a coherent framework to assess the effects 
across scenarios. The model is well suited for this type of analysis, as it captures the interactions 
between fiscal policy, monetary policy, trade, and private sector behaviour (Motyovszki et al., 2024) 
(11). 

The two components to NATO's targets are simulated separately. The so-called “core 3.5%” 
of GDP, which raises spending from the current level of around 2% of GDP to 3.5% of GDP by 2028 
for  essential  military  needs,  and  an  extra  1.5%  of  GDP  on  broader  defence-related  initiatives. 
Analysis done in the Commission’s Spring Forecast (SF25) assessed the macroeconomic impact of 
achieving  the  “core  3.5%”  of  GDP  (12).  Notably,  the  simulations  presented  in  SF25  highlight  the 
potential  economic  implications  of  a  higher  import  share  of  “core”  defence  spending  (e.g. 

57 

This divergence suggests that the positive spillover of defence-related R&D spending on other industries increases when the level of defence-related R&D is durably high.   Graph A2: Impulse response to a contemporaneous government defence R&D expenditure shock (% of GDP) Graph A3: Impulse response to a contemporaneous government defence R&D expenditure shock (% of GDP)   Source: Kraemer et al. 2025. Dependent variable: cumulative change in R&D financed by the private sector (as % of GDP). Shaded areas represent 90% confidence intervals.  Source: Kraemer et al. 2025. Dependent variable: cumulative change in R&D financed by the private sector (as % of GDP). Shaded areas represent 90% confidence intervals.    
 
   
 
 
associated with military equipment purchased outside  the EU).  Box 4.2 reports modelling results 
on the “extra 1.5%” of GDP on broader defence and security-related spending. 

Meeting  NATO’s  5%  defence  spending  goal  could  moderately  increase  EU  GDP,  though 
outcomes  vary  widely  across  scenarios  (Graphs  4.7.a,  4.7.b).  The  primary  goal  of  increased 
defence spending is, as discussed above, security not economic growth. Nevertheless, considering 
both  components  (i.e.  the  “core  3.5%”  and  the  “extra  1.5%”)  EU  GDP  is  projected  to  increase  by 
about  0.8%  by  2035.  This  increased  spending  would  also  lead  to  a  higher  debt-to-GDP  ratio. 
Importantly,  the impact on economic activity is uncertain and could differ significantly depending 
on how the spending is designed and implemented. The relatively modest total GDP effects reflect 
that  the  additional  spending  is  partly  financed  through  offsetting  measures,  the  impact  of 
aggregate demand partly “leaks” abroad via imports and is dampened by higher interest rates that 
crowd out private demand. The debt-to-GDP ratio would also be somewhat higher due to the initial 
financing via additional borrowing. 

The  economic  contribution  of  the  two  components  varies  over  time,  with  the  initial 
increase  driven  by  front-loaded  “core”  defence  spending.  However,  over  time,  its  impact 
fades  as  higher  taxes  are,  in  the  model,  introduced  to  bring  down  the  accumulated  debt.  By 
contrast, the “extra 1.5%” spending for broader defence and security contributes more modestly at 
first, given the assumption on a more gradual spending profile. Over time, it can yield longer-term 
benefits if directed toward productive investment and implemented as additional spending.  

Table 4.3:  Modelling assumptions for the two components 

Source: European Commission.  

The range of simulated outcomes underlines that policy design, including import shares, 
spending  composition,  and  financing,  plays  a  key  role.  Graph  4.7  further  illustrate  how 
sensitive the outcomes are to different assumptions (see also Table 4.3), with the shaded areas 
indicating the range of simulation results across scenarios. The benefits would be larger if spending 
relies more on domestic production and is financed in ways that weigh less on economic activity, 
while a focus on less productive uses could reduce the overall impact.   

58 

TimingReach 3.5% of GDP within 4 years (increase from around 2% of GDP defence spending per year to 3.5% by 2028)Distributed over a longer period, reaching 1.5% of GDP in 10 years (by 2035)FinancingInitial debt financing (based on the application of national escape clauses)Ex-ante budget-neutral thanks to offsetting measuresComposition10% of spending directed towards highly productive projects20% of spending directed towards highly productive projectsAlternative scenariosHigher import share, higher R&D and infrastructure shareDifferent financing assumptions, higher R&D and infrastructure share 
 
      
 
Graph 4.7: QUEST Simulation results, reaching the NATO 5% of GDP target by 2035, EU27 

Notes: Graph a): This figure reports the level of EU real GDP in percent deviation from a no-policy change baseline. The 
variables are reported in levels. Scenario range: combined impact across alternative spending, financing, and composition 
assumptions; Graph b): This figure reports EU government’s debt-to-GDP ratio in percentage point deviation from a no-
policy change baseline. 
Source: European Commission calculations. 

59 

-0.4-0.20.00.20.40.60.81.01.21.426272829303132333435%a) Real GDP, %Scenario rangeCORE 3.5 % (SF25)EXTRA 1.5%0.01.02.03.04.05.06.07.08.026272829303132333435Pps.b) Debt to GDP, ppScenario rangeCORE 3.5 % (SF25)EXTRA 1.5% 
   
 
(Continued on the next page) 

60 

Box 4.2: Simulation results of the extra 1.5% of GDP componentThis box summarises the simulation results for the “extra 1.5%” component, covering broader defence- and security-related spending.(1) Table 3 compares the modelling assumptions used in the analyses on the two components. The “extra 1.5%” of GDP spending is projected to raise EU real GDP only moderately, by about 0.5% above the no-policy-change baseline by 2035. At the same time, the debt to GDP ratio remains broadly unchanged, reflecting upfront budget-neutral financing and limited primary balance effects ex-post.  The relatively moderate increase in GDP associated with the “extra 1.5%” reflects assumptions on financing and spending profile.(2) It is assumed that the spending will gradually increase over time, reaching 1.5% of GDP after 10 years. Moreover, cutting other public investment and transfers to finance spending upfront can reduce the impact on growth compared to debt financing. The model shows that when social transfers are reduced, households with tight budgets have less income, which decreases demand.  Backloading spending and higher interest rates reduce private demand because households and firms anticipate future tax and interest rates increases, reducing their consumption and investment. Inflation remains also contained because fiscal spending is only gradually implemented and financed upfront, which, combined with the central bank’s response, restrains demand and price increases. If Member States boost their defence spending more rapidly, the effect on GDP could be greater, according to the model. This sensitivity also arises because, in the model, households’ and firms’ expectations about the future can already influence today’s outcomes.(3) The economic impact of the “extra 1.5” for broader defence and security may also be smaller, as part of spending may already be planned. The possibly limited increase in effective spending can also be seen as implicit in the financing assumptions outlined above, where additional spending is partly offset by reallocating funds from similar budget areas. In general, lower “additionality" would proportionally reduce the overall impact in the model.  On the upside, channelling additional defence and security-related spending towards more productive investments can yield long-term benefits. Such supply-side gains have a greater impact on economic output beyond 2035, ultimately bringing GDP to a 1.1% above baseline in the long run.  Additional scenarios illustrate how the GDP and fiscal impacts depend on the composition of spending and how it is financed. Two alternative scenarios for the “extra 1.5%” defence- and security-related spending illustrate the main channels involved (Graphs A1, A2). In a “Lower productivity” scenario the impact on GDP is minimal. When a smaller share of spending is allocated to productive investment, there is a much smaller impact on  (1) The SF25 analysis examined the other, core defence component, including sensitivity scenarios. See European Commission, (2025h) (2) In the QUEST model, fiscal multipliers are not fixed parameters but vary according to the fiscal instruments employed and factors such as the economic environment and timing of the measures. For the EU aggregate, short-term government consumption in QUEST, typically, yields multipliers of 0.7-0.8, which aligns with the literature. For example, see Coenen et al. (2012). Productive government investment can have larger (cumulative) multipliers by enhancing productivity of private sector. By contrast, a longer spending program, as considered here, raises the need for future financing, which dampens the growth effects, in addition to import leakages. (3) For additional comparisons across modelling tools, see Bokan et al. (2025).   
 
 
 
   
 
Box (continued) 

(1)  There are differences between the way NATO defines and calculates defence spending, and the way Eurostat does it. The Eurostat 
figures on defence are based on the international classification of the functions of government (COFOG), and are consistent with the 
several  concepts  used  in  the  context  of  the  Stability  and  Growth  Pact  (like  government  deficit  or  net  expenditure).  For  specific 
purposes  –  like  the  monitoring  of  NATO  targets,  or  the  implementation  of  the  national  escape  clause  (NEC)  of  the  Stability  and 
Growth Pact, it is important that the right concepts are used, though in most cases the differences between the two definitions are 
not  very  large.  This  note  does  not  discuss  or  otherwise  elaborate  on  the  differences  between  those  concepts;  for  many 
macroeconomic analyses, one concept is a relatively good proxy of the other. 

(2)  Germany  (6.8%)  and  France  (5.3%)  were  the  next  largest  arms  suppliers  to  Europe.  For  more  information  refer  to  SIPRI  Arms 

Transfers Database | SIPRI. 

(3)  The geographical location of the production activities of the main defence actors active in the EU is examined, using firm-level data 
obtained  through  an  innovative  AI-assisted  approach,  relying  on  a  large  language  model  that  has  been  specifically  enabled  to 
process sensitive yet non-classified Commission data. 

(4)  This approach identifies 103 major defence-related parent companies, of which 60 are headquartered in the EU. These companies 
have a total of 560 locations, of which 459 are within the EU and distributed across 36 NUTS3 regions in 11 Member States. The EU 
plants and subsidiaries are spread across 118 NUTS3 regions in 15 Member States. 

(5)  To identify the military-specific sectors, a selection based on key words relevant for defence (e.g. military, weapons) is used, while 
the  identification of  dual-use  industries  is based on AI  (prompting  Co-Pilot  with  the  question  “sectors at  Rev.  2.1  three-digit  level 
highly relevant for defence”). Military-specific sectors include manufacture of weapons and ammunition (254) and manufacture of 
military fighting vehicles (304). In addition, AI classifies also manufacture of instruments and appliances for measuring, testing, and 
navigation  (256),  manufacture  of  air  and  spacecraft  and  related  machinery  (303),  architectural  and  engineering  activities  and 
related technical consultancy (711), research and experimental development on natural sciences and engineering (721), and security 
systems  and  service  activities  (802)  as  highly  relevant  for  defence.  Note,  however,  that  while  defence  may  depend  on  the 
technologies  developed  in  these  dual-use  industries,  it  is  difficult  to  understand  to  what  extent  these  technologies  would  not  be 
developed without the demand from the defence sectors. Moreover, it is likely that these defence-related activities represent only a 
very small proportion of the overall activities in the sector. 

(6)  For example, see Reuter (2025). 
(7) 

Indeed reports that some corporate/project functions, such as project managers, supply chain and logistics managers and technical 
sales, have also been in high demand. 

(8)  To  avoid  penalising  Member  States’  applying  for  the  national  escape  clause  that  have  already  increased  defence  spending  since 

2021, a general flexibility is granted for the increase in defence spending occurred between 2021 and 2024. 

61 

productivity. By contrast, more growth-friendly financing (“Fin: Gov consumption”) leads to better outcomes. Cutting “unproductive” government consumption instead of reducing productive public investment fosters productivity gains and lifts real GDP by around 0.7% by 2035, and improves the primary balance compared to the main scenario.  Graph 1: Extra 1.5%, QUEST Simulation results, EU27, different scenarios      Note: a) This figure reports the level of EU real GDP in percent deviation from a no-policy change baseline; b) This figure reports EU government’s debt-to-GDP deviation from a no-policy change baseline. Source: European Commission  -0.4-0.20.00.20.40.60.81.01.21.420262030203520402045%a) Real GDPMainLower productivityFin: Labour taxFin: Gov consumption-5.0-4.0-3.0-2.0-1.00.01.02.03.020262030203520402045Pps.b) Debt to GDPMainLower productivityFin: Labour taxFin: Gov consumption 
 
 
 
 
   
 
 
(9)  The fiscal adjustment covers a period of four years, or—if extended—up to an additional three years, supported by a commitment to 

implement relevant reforms and investments.  

(10)  On  the  impact  on  productivity  of  governmnet  demand  from  defence  industry,  see  also  Ilzetzki,  E.  (2024),  ‘Learning  by  Necessity: 

Government Demand, Capacity Constraints, and Productivity Growth,’ American Economic Review, 114-8, p. 2436. 

(11)  For public expenditure response in the QUEST model, see Motyovszki G., Pfeiffer, P., & in ‘t Veld, J. (2024), “The Implications of Public 

Investment for Debt Sustainability”, European Economy Discussion Paper 204. 

(12)  The 2025 Spring Forecast assessed the impact of raising core defence spending by up to 1.5% of GDP over 2025–28 to advance the 
3.5% core target. The results of the main scenario showed that real GDP would rise by 0.5% above the baseline by 2028, while the 
EU government debt-to-GDP ratio would be 2 pps. above the baseline by 2028. 

62 

 
 
ANNEXES 

 
 
 
 
ANNEX 1: THE EUROPEAN UNION AND EURO AREA IN THE WORLD 

Map A1.1:  Key indicators 

64 

 
 
 
 
 
 
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