Two big shocks in quick succession – how can Europe avoid another decade of growth disappointment?

The war in Ukraine and the economic impact of the COVID-19 pandemic have triggered two major shocks in quick succession – echoing memories of the European Union (EU)’s anemic growth after the global financial crisis (GFC) and the European debt crisis.

Is the EU, once again, headed toward a decade of tepid growth? The simple answer is – not necessarily! The European Union and the world learned from the policy mistakes that followed the GFC meeting. So, when the pandemic broke out, governments stepped in with resolute and unprecedented political support to protect income despite the prolonged shutdowns. This gave way to a quick recovery, with the EU recovering to pre-pandemic levels by 2021.

However, the war in Ukraine halted this short-lived recovery, as its repercussions continued to have a devastating effect on economies. Rising inflation and consequent monetary policy tightening have squeezed fiscal space in the wake of pandemic support measures, disruptions to trade and financial flows, and a high degree of uncertainty portending weak growth. In addition, EU countries have committed to green and digital transformations, while also facing structural headwinds from aging populations, increasing inequality, and hampering institutional progress.

Despite all these limitations, the EU is well positioned to avoid a repeat of a decade of low growth after the global financial crisis. What will this take?

We explore this question for four EU member states – Bulgaria, Croatia, Poland and Romania – in the EU’s latest Regular Economic Report: Rising to Potential in the Wake of Adverse Shocks. In short, the answer is that it will take deliberate reforms to boost the workforce, strengthen inclusion, increase investments, improve institutions, and increase spending on research and development.

In these four countries, we estimate the impact of major reforms on potential growth and convergence prospects over the next decade. These reforms are related to combating the impact of a shrinking workforce, promoting inclusion, improving institutions, increasing investment, and promoting digital and green transformations. More specifically, the reforms evaluated in each category include the following:

  • Countering a shrinking workforce entails raising the retirement age which could expand the workforce from 10 to 40 percent of the inactive population aged 55-64 in the four countries, and integrating immigrants.
  • Promoting inclusion as an increase in the number of years of education to close learning gaps (as of 2020) has been combined with the EU average, especially for the less affluent, where these gaps are typically lower and wider.
  • Institutional improvement and investment promotion includes (i) improving the rate of absorption of EU funds to a level that is best performing in the EU; and (ii) increase the standard error of the Institutional Quality Composite Index from 2020 levels to capture improvements in government effectiveness, rule of law, and anti-corruption.
  • Advancing digital and green transformations entails increased spending on research and development as a share of GDP for stated national goals, along with increased spending on energy and decarbonization.

The combined effect of these reforms and the convergence process is staggering (see figure below). If these reforms are implemented, potential growth over the next decade is expected to double from the baseline in Bulgaria (up to 4.6 percent annually) and Croatia (up to 3.2 percent annually) and to the pace seen during accession to the European Union in Poland ( 4 percent) and Romania (5.2 percent). This means a boost to potential growth that ranges from more than 1 percentage point in Poland (which has nothing to do with per capita income in the EU) to more than 2 percentage points in Bulgaria (which has the most catch-up of the four countries). Importantly, these reforms are estimated to reduce the time needed to reach average EU per capita income levels (in purchasing power parity terms) to nearly half of what is required in the base scenario for Bulgaria and Croatia and 30 percent less for Poland and Romania .

Figure 1. Impact of reform scenarios on potential growth in Bulgaria, Croatia, Poland and Romania

Sources: Oxford Economic Model; global bank. Note: above The figures show the impact of the reforms as described above and in Chapter 4 of the report. The full reform scenario includes the implications of legislative changes to the retirement age, closing the education gap with the EU, closing half the institutional quality gap with the EU, raising the uptake of EU funds to the best performer, and increasing green investment from NGEU (which is also integrated into the line basis), and to reach nationally set targets for investment in research and development. For details, see Sections 4.1-4.5.

The findings highlight the meaningful impact that such reforms can have to help counter the impact of structural headwinds, accelerate convergence, and advance green and digital transformations. These reforms are within the reach of these countries and will bring significant gains. Now, it is up to policy makers to capitalize on the immediate effects of multiple crises and carry out much needed reforms. The four countries can seize the unique opportunity presented by the EU’s large financing package to ensure a resilient, inclusive and sustainable recovery – most of all given downside risks and the growing uncertainty surrounding the outlook.

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