EU: a steady erosion of growth potential.

The European Union remains one of the world’s largest economic blocs. At market exchange rates, the EU ranks second globally in terms of overall GDP, behind only the United States. However, the relative size of the European economy has declined over time. In the early 1990s, the EU economy was slightly larger than that of the US, whereas today it is only around two-thirds as large. Reversing this long-term relative decline has become one of the central strategic challenges facing Europe. In terms of living standards, the EU ranks only eighth among G20 economies in GDP per capita at purchasing power parity (PPP), reflecting both uneven productivity growth and slower economic dynamism compared with some competitors.

Demographics are likely to remain a major constraint on future growth. United Nations projections point to a substantial decline in the working-age population over the next 25 years. This ageing trend is expected to reduce labour force growth and place greater pressure on public finances through pensions and healthcare spending. As a result, the key economic question for Europe is whether stronger productivity growth and innovation can compensate for weaker demographic momentum. The investment spending needs to achieve this, identified in the Draghi Report, are substantial.

The 3Ds of Draghi

Inflation remains an important near-term concern. Eurozone annual inflation rose to 3.0% in April 2026, up from 1.7% in January. However, core inflation excluding food and energy has continued to ease, falling to around 2.1%. This suggests that underlying domestic inflation pressures are moderating, even as energy prices remain a major risk. If oil prices were to remain near $100 per barrel for a sustained period, inflation could easily rise above 4%, placing renewed pressure on households and policymakers.

Economic growth remains subdued. Full-year GDP growth in 2025 was 1.4%, while the IMF’s April 2026 reference forecast projects growth slowing to 1.1% in 2026, assuming a relatively quick resolution to tensions in the Middle East. Europe remains highly vulnerable to energy price shocks because of its dependence on imported energy. If oil prices remain elevated, growth could be reduced by a further 0.5 percentage points or more, leaving the euro area perilously close to stagnation. Early signs of this weakness are already visible, with first-quarter 2026 growth only marginally positive.

Europe performs relatively well on carbon emissions compared with many advanced economies. Emissions per capita are low by international standards, reflecting strong environmental regulation and widespread adoption of renewable energy. Nevertheless, current trends suggest the EU is still not fully on track to achieve net zero emissions by 2050.

Fiscal conditions are more stable than in several other major economies, although debt levels remain elevated. Government debt is projected to rise only modestly, from around 88% of GDP in 2025 to 90% by 2031, suggesting that public finances are only marginally unsustainable under current assumptions.

The EU’s external position remains a significant strength. The current account surplus is expected to continue over the coming years, supported by a strong net external asset position. Although US trade measures continue to create pressure on exports, recent trade agreements — including closer ties with India — may help offset some of these headwinds.

Monetary conditions have eased gradually. Broad money growth remains weak, consistent with Europe’s low-growth, low-inflation environment. Following the European Central Bank’s June rate cut to 2%, policy rates now appear broadly neutral. Governance standards across the EU remain comparatively strong, with generally low levels of corruption. However, Europe still faces a major competitiveness challenge. Improving innovation and productivity growth will be essential if the region is to restore stronger long-term economic performance.