COVID-19: What is the future of the EU economy?

The EU economy is about to rebound this year and next, as vaccination rollout progresses rapidly (ECDC 2021) and restrictions are increasingly lifted. The European Commission Summer 2021 Economic Forecast projects that the EU economy will expand by 4.8% in 2021 and by 4.5% in 2022, reaching its pre-pandemic level of output in the last quarter of 2021 (European Commission 2021e). The economy in the first quarter of this year proved more resilient than expected, and upbeat survey results among consumers and businesses as well as data tracking mobility suggest that activity in the EU shifted up a gear in the second quarter (Figure 1). The growth momentum should pick up in the third quarter, on the back of continued easing of containment measures and strong resumption of social activities, including tourism.

Figure 1 Stringency of restrictions and mobility in the EU

The recovery path projected in the Commission Summer 2021 forecast is considerably stronger than in the aftermath of the Global Financial Crisis (GFC) and subsequent sovereign debt crisis (Figure 2). An extension until 2025 of the GDP growth path suggests that long-lasting pandemic-related effects on potential output could be contained. However, such extrapolation could prove too optimistic if long-term damage to potential growth was to emerge when the emergency policy support measures are finally lifted.

Figure 2 The trajectory of EU27 real GDP during the GFC and COVID-19

Note: Real GDP (on a seasonally adjusted basis) in Summer 2021 Forecast (index, 2019Q4 = 100). Recession 2008 - 2009 (index, 2008Q1 = 100).
Source: European Commission (2021e)

Unlike the GFC, which was characterised by a persistent decline in investment, the COVID-19 contraction in GDP was largely driven by private consumption, with public policies mitigating the negative supply-side effects. This is likely to limit the long-term damage to the EU economies as compared to the previous crisis.

Nevertheless, a number of factors could have a negative impact on future potential output. Evidence based on ORBIS micro data shows that the COVID-19 shock has increased the financial vulnerability of the corporate sector in the EU (European Commission 2021a), especially in the sectors most hit by the restrictions. While the number of firms filing for bankruptcy fell sharply at the outset of the pandemic crisis, data on the number of bankruptcies at the end of 2020 suggest some noteworthy increases in Spain and to a lesser extent in Italy (Figure 3). As the emergency policy support measures for firms are lifted, this could lead to an increase in corporate distress across the EU, in turn raising financing constraints. In addition, increased risk aversion following the pandemic experience and corporate debts accumulated during the crisis may act as drags on investment.

Figure 3 Number of bankruptcies in selected member states

The labour market is expected to remain cushioned against pandemic effects over the forecast horizon (Figure 4). The widespread use of short-time working schemes and various support schemes for firms have prevented a sharp increase in unemployment. However, with labour market indicators largely determined by policy responses, ‘labour scarring’ cannot be excluded if employment losses become more persistent, leading to losses of human capital and lower productivity. This could, if unaddressed, damage valuable firm- and job-specific knowledge, while technological disruption or new business models lead to skill gaps or mismatches.

Figure 4 Unemployment rate, long-term unemployment rate, and very long-term unemployment rate in the EU27

The COVID-19 crisis could also lead to increased inequality and affect social cohesion. Low-skilled workers and young people have experienced the largest negative falls in employment (Figure 5). Evidence from the Commission’s Business and Consumer surveys suggest that the young (from 16 to 29 years old) and those in the lowest quartile of the income distribution have been hit harder by the crisis. However, support policies put in place by national governments to protect jobs and incomes have played a crucial role in mitigating the impact of the pandemic on household incomes. Eurostat’s newly released advanced estimates on income inequality and poverty indicators broadly confirm this picture. Household incomes and poverty indicators remained broadly stable at the EU level in 2020, as losses in earnings have been alleviated to a large extent by new and already existing social policies. Still, there is large heterogeneity across countries and different segments of the population. Flash estimates for half of the countries show a moderate increase in the at-risk-of-poverty rate for the working age population (aged 18–64), including in Portugal, Greece, Spain, and Italy. Younger workers (aged 16–34) suffered higher employment income losses.

Figure 5 Changes in employment (persons) since 2019 Q4 in the EU27, by type of worker

The COVID-19 crisis also revived the geographical divergence within the EU, not least due to country-specific economic structures, including the importance of contact-intensive sectors. The risk of persistent divergences within the EU is real. The fact that the pandemic has led to a broad deterioration of the fiscal situation in the EU adds to this. The general government deficit jumped to around 7% of GDP in 2020 and is set to increase further to 7.5% of GDP in 2021, and the debt-to-GDP ratio reached around 92% in the EU (and 100% in the euro area) in 2020. This will limit future fiscal space, notably in countries that had already relatively high levels of debt before the crisis.

At the same time, the COVID-19 crisis led to an acceleration in a number of structural trends that could bring long-lasting positive effects, including the digital and green transitions. For example, the strong boost in digital technology fostered by the COVID-19 crisis could, in the long term, increase productivity, though not all sectors would benefit and the effect could take time to materialise. Some estimates show that the pandemic has brought forward the digital transition in Europe by seven years (McKinsey 2020) and that 20% of work hours will move permanently from office to home (Barrero et al. 2020), leading to new demand patterns emerging in the future. Business survey evidence from a subset of advanced economies suggests that there is potential for annual productivity growth to increase by about one percentage point up to 2024 (McKinsey 2021). However, significant digital skill gaps across EU member states, if not properly addressed by appropriate policies and investments, risk exacerbating further divergences and labour market challenges.

To limit the long-term damage to the economy, continued policy support is needed. The nature of this support, however, should change from life support to support for structural change. The implementation of the Recovery and Resilience Facility (RRF) as part of the NextGenerationEU programme will serve this purpose. The timely and effective implementation of the National Recovery and Resilience Plans (RRPs) provides the opportunity to address the structural challenges for the EU and its member states head on.

Through the RRF, the EU provides large-scale financial support to investments and reforms that contribute a greener, more digital and resilient economy. Since last summer, member states, in close collaboration with the Commission, have worked intensively on the preparation of their National Recovery and Resilience Plans. Over the past three weeks, the Commission has presented its assessment of 14 of these plans. The overall picture that emerges from these assessments gives reason for optimism. Member states have presented coherent packages of investments and reforms that will – if effectively implemented – give a significant boost to the greening and digitalisation of the EU economy. In addition, the plans contain important steps to increase the ease of doing business and to reduce barriers to investment. Where most needed, the plans include ambitious reforms to the judicial system and public administration, addressing some of the key bottlenecks to sustainable growth.

In addition to support fixed investment, the RRPs will also fund investment in human capital to reduce the extent of long-lasting negative impacts on the labour market. In line with the Commission Recommendation on Effective Active Support to Employment following the COVID-19 crisis (EASE), plans include reforms and investments to modernise public employment services and improve the quality, coverage, targeting, and effectiveness of active labour market policies. They also contain measures to upgrade vocational training, strengthen apprenticeship schemes and enhance the research performance of universities as well as the quality of university education.

Reforms and investment will be needed to support total factor productivity growth throughout the recovery. The RRPs aim to promote the digitalisation across public and private sectors (especially SMEs), support business R&D in key green and digital technologies, and stimulate the uptake of new digital technologies by firms.

Finally, some RRPs set out to mitigate negative distributional effects of the crisis through a variety of measures covering education, health, social inclusion, affordable housing, and equality. Youth, and in particular young people from disadvantaged backgrounds, are one of the six priorities of the RRF along with the green transition, digital transformation, smart, sustainable and inclusive growth and jobs, social and territorial cohesion, and health and resilience. Plans also include measures to mitigate the negative impact of school closures on youth and to upgrade school infrastructure.

Overall, the total direct impact of the RRPs over the forecast horizon until the end of next year is expected to be approximately 1.2% of the EU’s 2019 real GDP (see European Commission 2021b). For several member states this direct impact exceeds 3% of GDP, without taking into account the expected positive impacts of reforms which take time to materialise and are more difficult to quantify. With the programme continuing after the horizon of the Summer 2021 Forecast, this estimate represents only a small fraction of the total growth effect of the RRPs. Moreover, as outlined above, it is not the sheer size of the direct growth impact that matters, but how the composition of output is affected and thus the quality of growth that is raised. NextGenerationEU and the Recovery and Resilience Facility have the potential to play a key role in steering the EU economy from the COVID-19 crisis to stronger and more sustainable growth in many years to come.

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