Europe’s economy is at a crossroads. Will it take the right path?

The European economy stands at a crossroads. The Competitiveness Compass adopted in late January by the European Commission is supposed to chart a new strategy for the next five years. Will this ambitious plan succeed?

After a robust post-COVID recovery, supported by a stimulus package based on an unprecedented common debt issuance, the European economy was struck by a second black swan, the Russian invasion of Ukraine. While this event reshaped geopolitics globally, its economic impact was especially severe in Europe due to soaring energy prices and the end of the illusion of cheap Russian gas. Still, Europe avoided a recession, and also managed to avoid an energy supply crisis and to bring down inflation.

Worst case scenarios did not materialize, but Europeans enter 2025 in a rather pessimistic mood. Economic growth is a very slow 1% per year, and much of that is because of Spain’s strong economy. The German economy is shrinking. Donald Trump’s victory in the U.S. presidential election was not Europe’s preferred outcome.

However, the main source of European woes lies not in the near-term economic outlook nor in the risk that President Trump will launch a trade war. The core problem is the European lack of competitiveness well described by the recent reports of two former Italian Prime Ministers, Mario Draghi and Enrico Letta. Addressing this is exactly what the Commission’s Competitiveness Compass is about. Europe does now have a plan. The European Union promises to prioritize innovation and support of businesses “squeezed by high energy prices and a high regulatory burden.”

The plan addresses four main challenges, largely following Draghi’s imperatives.

First, closing the innovation and tech gap. Europe has talent, a strong education system, high-quality research, and global patents. Europe also has money, due to the very high level of household savings. What it lacks is a bridge between research and commercialization and entrepreneurs’ access to risk capital. The main reason is the fragmentation of European capital markets.

Second, combining decarbonization and industrial policy. The embrace of the Made in Europe initiative—an industrial policy aimed at strengthening and modernizing European manufacturing—is a game changer. But Europe still needs to find a balance between industrial policy and the decarbonization imperative. This will not require abandoning the green transition strategy but does require making it more flexible and adaptable to industry challenges.

Third, strengthening economic security. This is the follow up of a strategy adopted after the Russian invasion of Ukraine: “Not decoupling but derisking” is the motto for a global player interested in making supply chains more secure while keeping the door open to global trade. The energy and defense industries will be the main focus of this effort for economic security.

Fourth, reducing the bureaucratic burden. The European Commission has committed to an unprecedented simplification effort aiming to reduce at least 25% of the reporting burden. The first step will concentrate on reducing green and energy reporting requirements.

Having a plan is a good starting point. The Commission has displayed awareness and ambition. And it crafted legislative acts to implement the plan. But success is not guaranteed. There are the headwinds of political fragility in several E.U. countries, the ongoing war in Ukraine, and the new tensions in global trade.

The biggest challenge to the Commission’s hopes: Will the Commission be able to win the support of the main European economies? Three obstacles stand out.

One, resistance to reducing the fragmentation of capital markets. Every year, 300 billion euros of European savings flow to foreign markets—and at the same time, foreigners are buying E.U. companies, much to the consternation of European citizens. But progress towards reducing intra-European barriers to capital flows requires the cooperation of member governments, beginning with France and Germany. Cooperation will also be needed for the European defense industry, where common procurement and “buy European” remain wishful thinking. And if unanimity will prove to be out of reach, will the E.U. be ready to move with “enhanced cooperation” among 15 or 20 of the 27 member countries as it did when it introduced the euro or abolished restrictions to travel across borders?

Two, reducing bureaucracy is easier said than done. Red tape is public enemy number one among decision makers and stakeholders, and rightly so. But simplification within the kingdom of regulation—the E.U.—could prove to be quite a vaste programme. Even internally, where the excellent Brussels officials may fear becoming like “turkeys preparing Christmas dinner,” top-down determination will be essential, and proponents need to explain that simplification is different from deregulation—and that it could actually add value to services provided by the Commission.

Three, where is the money? Here is the obvious and more challenging obstacle. The easy answer is, of course, private investments. And the entire plan is conceived to incentivize them. But substantial amounts of public money raised at the European level are also needed. The E.U., as a whole, has the lowest level of public debt among its global peers. Although the resistance to public spending is shifting slightly in Germany, will this be enough to prod all E.U. members to spend more?

Europe has a good strategy to address its weaknesses. But headwinds and obstacles will not be easy to overcome. The problem with medium-term plans is also the risk of disruptive events: a bad conclusion of the Russian war in Ukraine or a trade conflict with the U.S. My view is that a full-scale trade war between the E.U. and U.S. can be avoided. Yet pursuing competitiveness priorities in a deteriorating geopolitical and trade environment could become very challenging.