Rolf Strauch, chief economist of the European Stability Mechanism, sounded the alarm on widening economic disparities in the eurozone on Friday 18 October 2024, warning that rising fiscal imbalances, climate threats and infrastructure weaknesses are pushing the region towards economic instability unless decisive action is taken at both the European Union and national levels.
Strauch stressed in a blog post that effectively addressing this divergence is essential to preventing long-term economic fragmentation and ensuring the euro area’s stability and prosperity. The key challenge lies in developing a coordinated policy approach that balances national reforms with EU-level provision of critical public goods.
Policy divergence
Strauch reasoned that the euro area is at risk of widening economic disparities due to varying levels of “fiscal space” among member states. Countries with higher debt, for instance, face stricter fiscal adjustments under the EU’s new fiscal framework, which could lead to fiscal fatigue. This risk becomes even more pronounced if these adjustments are not carefully calibrated, potentially weakening public finances and undermining long-term productive investment.
In previous rounds of fiscal consolidation, some euro area members experienced negative impacts on investment, particularly those with less innovative economies. According to Strauch, similar outcomes could arise from the EU’s reformed economic governance framework if countries fail to design consolidation measures that protect growth-promoting investment. Additionally, the planned end of the Next Generation EU recovery fund in 2026 will eliminate a key mechanism that has helped reduce disparities in productive capital across the euro area.
Strauch highlighted that these dynamics place countries at different starting positions for addressing long-term challenges, exacerbating the risk of economic fragmentation within the eurozone.
Public finances
Strauch also mentioned that long-term budgetary pressures vary significantly across the euro area, driven by differences in demographics, exposure to climate risks, and security concerns. For example, Mediterranean countries are more vulnerable to extreme weather events, necessitating costly adaptation measures, while northern European countries may focus on sustainability initiatives in their more temperate climates. Similarly, countries bordering conflict zones face different geopolitical challenges, leading to diverse defence spending needs.
Differences in infrastructure and energy resources also contribute to varying investment needs across the euro area, with some nations lagging in renewable energy adoption and energy efficiency improvements. Strauch noted that this divergence could worsen as financial markets focus more on fiscal pressures and weaker economic performance, which may result in higher financing costs for certain countries.
Centralised provisioning
Addressing these multifaceted risks, Strauch advocated for a more efficient division of responsibilities between EU and national levels, particularly in the provision of public goods. While member states must undertake reforms to ensure their economies are prepared for future challenges, Strauch argued that certain policy areas would benefit from EU-level centralisation. Historically, the EU has provided public goods primarily through regulation, such as in the single market and external trade, which has been crucial for growth and competitiveness. However, Strauch stressed that the current geopolitical and economic environment requires more direct EU investment in critical areas.
Strauch highlighted three key areas for potential EU centralisation: research and development, network externalities and macroeconomic stabilisation. Centralised research and development could generate significant knowledge spillovers, boosting innovation and growth across member states. Investment in common digital infrastructure and cross-border green energy projects could produce network effects, while joint purchasing of critical raw materials and security supplies would enhance resilience and reduce costs. Additionally, Strauch reasoned that having an EU-level macroeconomic stabilisation mechanism would help mitigate the financial risks posed by large, externally induced economic shocks.
Future policy priorities
Strauch concluded that the EU must prioritise long-term reforms to strengthen its institutional infrastructure, which has historically evolved in response to crises. The current challenge, however, stems from slow-burning issues such as declining competitiveness, geoeconomic fragmentation and the impact of climate change. Strauch emphasised that failure to address these challenges would lead to weaker growth, reduced resilience and deeper fragmentation within the euro area.
Looking ahead, Strauch remarked that the EU’s financial infrastructure can be more cost-effective than individual national measures in addressing these long-term issues. He pointed to the upcoming discussions on the EU’s 2028–2034 budget as an opportunity to reassess the allocation of EU resources. The Draghi report, which called for refocusing EU financial resources on strategic projects, supports this view. Strauch suggested that EU funds should complement private investments, with an enlarged pool of EU resources helping to reduce costs and prevent the need for permanent transfer schemes.
Finally, Strauch highlighted the role of the ESM in addressing future financial stability challenges. The ratification of the ESM treaty and discussions on adjusting the ESM’s toolkit are important steps in reducing the risk of divergence due to economic shocks. Strauch stressed that only through concerted action by both EU and national policymakers can the euro area avoid further economic divergence and ensure a unified response to future challenges.
Based in Kirchberg, the ESM acts as a financial backstop to euro zone countries facing, or potentially facing, financing difficulties.
