Navigating fragmentation: Europe’s response to economic and security challenges

The global economic and security landscape is becoming increasingly fragmented, presenting Europe with a unique set of challenges. In the face of low growth, tight fiscal space, and mounting geopolitical tensions, the European Union (EU) finds itself at a crossroads.

Decades of efficiency-driven integration through initiatives like the European Single Market and global frameworks such as the World Trade Organization (WTO) are now being tested by shifting global dynamics. Russia’s war in Ukraine, ongoing trade rivalries, and a global push for industrial self-sufficiency have further heightened concerns over supply chain resilience and economic security.

These challenges coincide with long-standing issues within Europe, including weak productivity growth, an aging population, and skill mismatches, which collectively dampen economic prospects. As European nations work to rebuild fiscal buffers in compliance with new EU fiscal rules, they are increasingly turning to industrial policies as a tool to drive growth, enhance competitiveness, and secure supply chains. However, balancing these national strategies with broader European and global economic objectives requires careful coordination to avoid adverse spillovers and inefficiencies.

Global disruptions amplify Europe’s economic challenges

Europe’s economic hurdles have been exacerbated by external forces. Russia’s invasion of Ukraine disrupted global energy supplies, leading to volatility in prices and supply chains. This crisis has intensified the push for energy independence and accelerated the need for clean and secure energy sources.

Simultaneously, longstanding state support for industries in China, coupled with significant fiscal interventions in the United States, such as the Inflation Reduction Act and the CHIPS Act, have amplified global competition. These measures aim to bolster domestic manufacturing and technological leadership, leaving Europe to contend with the ripple effects on trade and investment flows.

Europe’s internal challenges, including declining productivity growth, skill mismatches, and the fiscal pressures of an aging population, have further complicated the situation. These domestic issues limit the EU’s ability to respond flexibly to external shocks and to invest in long-term economic resilience.

The rise of industrial policy in Europe

Industrial policy has re-emerged as a central tool for European governments to address these challenges. Data on state aid shows a steady rise in industrial policy spending over the past decade, with a significant spike during the COVID-19 pandemic and subsequent energy crisis. By 2022, industrial policy spending in the EU accounted for approximately 1.5% of GDP, compared to 0.5% a decade earlier.

Current industrial policies are predominantly focused on environmental protection and energy efficiency, reflecting Europe’s commitment to the green transition. Key EU-level initiatives, such as the European Green Deal, the European CHIPS Act, and the Digital Europe Program, underscore this shift. These policies aim to correct market failures, enhance production efficiency, and ensure the continent remains competitive in the global economy.

However, industrial policies must be carefully designed. “Good” industrial policies, which address market failures and leverage economies of scale, can enhance productivity and drive growth. Conversely, poorly targeted policies risk resource misallocation, fiscal waste, and the unintended distortion of competitive markets.

Balancing national and regional objectives

While industrial policies can boost domestic growth, they also have the potential to create winners and losers within Europe. Structural modeling highlights that unilateral industrial policies, even when aimed at correcting domestic market failures, can negatively impact trading partners within the EU.

For example, policies that expand production in high-productivity industries with scale externalities can lead to a “production relocation” effect. This phenomenon, described in economic literature, occurs when subsidized industries in one country outcompete similar industries in trading partner countries, disrupting comparative advantages and reducing overall regional productivity.

Furthermore, unilateral industrial policies can adversely affect the welfare of the implementing country itself. Subsidizing specific industries often requires reallocating labor and capital from other sectors, which can distort export prices and reduce economic welfare, especially in smaller, trade-dependent countries.

The case for coordinated industrial policy

To mitigate these risks, Europe must pursue coordinated industrial policy at both regional and international levels. Coordinated efforts can align industrial strategies across member states, avoiding counterproductive competition and maximizing the benefits of scale and specialization.

The European Union’s state aid rules provide a framework for such coordination. These rules enable member states to monitor and evaluate each other’s policies, ensuring they are well-targeted and do not cause significant spillovers. Transparent and collaborative approaches also enhance cost-effectiveness and reduce governance failures, making policies more sustainable in the long run.

A successful example of coordinated industrial policy is the Airbus initiative. By pooling resources and expertise across multiple European countries, the Airbus project created a globally competitive aerospace industry with a high-quality supply chain. Such examples underscore the potential of collective action to achieve strategic economic objectives.

Strengthening EU-level integration

In addition to policy coordination, deeper economic integration within the EU can amplify the benefits of industrial policy. Full internal mobility of firms and labor across member states allows resources to flow more efficiently, enhancing the overall impact of targeted interventions. Harmonizing regulations and streamlining approval processes can further reduce barriers to implementation and ensure consistency across the bloc.

To achieve this, Europe may require a singular decision-making body to oversee and streamline industrial policy initiatives. Consolidating the array of existing programs and instruments under a unified framework could simplify coordination and enhance strategic focus. Utilizing common EU funds to finance industrial policies would also help address fiscal disparities among member states, enabling the implementation of collectively optimal policies.

Global implications and multilateral coordination

The fragmentation of the global economy calls for multilateral efforts to align industrial policies beyond Europe. International coordination through institutions such as the WTO can mitigate the risks of trade distortions and ensure a level playing field. Transparent agreements on the design and implementation of industrial policies can reduce tensions and foster global economic stability.

Structural modeling suggests that global cooperation on industrial policy can enhance gains from specialization and mitigate adverse terms-of-trade effects. Europe’s leadership in promoting multilateral agreements on industrial policy could set a precedent for other regions, fostering a more integrated and resilient global economy.

Charting a path forward

The rising fragmentation in the global economic and security landscape presents Europe with significant challenges but also opportunities. By embracing well-targeted and coordinated industrial policies, the EU can enhance its resilience, boost productivity, and secure its position in the global economy. Achieving this requires a delicate balance between national interests and regional objectives, supported by deeper integration and transparent multilateral cooperation. Through strategic and collaborative action, Europe can navigate its current challenges while laying the foundation for sustainable and inclusive growth in the years to come.