Europe moves on from economic 'peak pessimism'

Business Times

04-06-2025

JANUARY'S 2025 World Economic Forum in Davos is sometimes seen as the moment that 'peak pessimism' reigned about Europe's future economic and political performance. Yet, fast forward to today and expectations for the region's prospects have improved significantly since.
To be sure, Europe continues to have many challenges. However, the mood music has flipped, at a minimum, from 'glass half empty' to 'glass half full'.
On Thursday (June 5), for instance, the European Central Bank (ECB) is widely expected by economists to cut interest rates for what would be the eighth time in a little more than a year. This would see the ECB diverge further from the recent path of the US Federal Reserve, which has had rates on hold in 2025.
Other central banks in the region have also cut rates too. This includes the Bank of England which has made four cuts of a full percentage point since a peak last year of 5.25 per cent.
Yet, it is not just this stimulus from monetary policy that has helped change perceptions of the economic and political outlook for the region. In Europe's largest economy, the new German government has surprised on the upside, despite its erstwhile shaky start in office, with reform of the so-called constitutional balanced budget amendment or debt brake. This could see over one trillion euros of additional spending in the next decade. Moreover, wider supply side reforms could lift the economy further in the next four years of Friedrich Merz's chancellorship.
Further, there has also been a resurgence in the European trade liberalisation agenda. Last December, the EU agreed on a big deal with the Mercosur bloc, and it is chasing down agreements with a wide range of other nations. Moreover, the United Kingdom has recently delivered a big trade agreement with India.
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All in all, it is perhaps no big surprise that several big firms have changed their stance on Europe. Research by KKR, for instance, has highlighted an 'investment renaissance' in the region in 2025.
This is even before the possibility of potential progress on the competitiveness agenda of former ECB chief (and ex-Italian prime minister) Mario Draghi. This is a political super priority for European Commission president Ursula von der Leyen amid a blizzard of economic initiatives, including a new EU Clean Industrial Deal launched in February which may become the signature issue of her second term of office.
This shift in perceptions of Europe in 2025 highlights how sentiment about powers can change, sometimes significantly, in a relatively short space of time. What has underpinned this change is political developments not only economic ones, emanating both from Europe and the United States.
In Europe, markets have perceived newfound political resolve following multiple key elections in 2024 and the first half of 2025, including in the United Kingdom and Germany. There is a perception that this may provide a much needed political 'window of opportunity' for reform, including scope for a very significant defence build-up.
Yet, the increased positivity of sentiment towards Europe also reflects downgrades in perceptions of the US growth outlook under the second Trump administration. Views of US financial exceptionalism have been badly dented in the last few months, not least because of the chaos of Trump's trade tariff policy.
One of the many ironies about the re-election of Donald Trump as US president last year is that this key event might actually strengthen rather than weaken Europe, despite concerns to the contrary. Trump's presidency has, so far at least, been a driver for the region's economic reform and strengthening of security and defence.
Yet, we should not get carried away with this positivity. While there is still more potential for Europe to surprise on the upside, the fact that the region is at a possibly big economic and political pivot point means there are less rosy scenarios that may still materialise.
What makes Europe's future economic and political pathway hard to forecast is that the regional landscape is characterised by intense volatility, uncertainty, complexity and ambiguity (Vuca). So it is full of both risk and opportunity, with the balance between the two waxing and waning from time to time.
At present, there is an upswing in positive perceptions about Europe's prospects, despite the region's ongoing challenges. Yet, several plausible developments could, collectively, help sour sentiment again.
One example is the Ukraine war, which shows little, if any, sign of being resolved anytime soon. Indeed, there is a growing possibility that the conflict could continue into 2026, despite Trump's campaign pledge to resolve it within a day of taking office.
Perhaps the central challenge facing the region, however, is enhancing its competitiveness, particularly in the EU's largest economies: Germany, France, and Italy. All three still face significant economic problems whereas some southern European powers such as Spain, Greece and Portugal, plus much of Eastern Europe, have outperformed the EU growth average in recent years, a trend likely to continue in the medium term.
Failure to reform, economically, will intensify the political challenges facing Europe. Right-wing populism has not lost its appeal, as was shown in last Sunday's Polish presidential election result, which saw conservative historian Karol Nawrocki elected. A fan of Trump, Nawrocki flew to Washington during the election campaign for a brief meeting and a thumbs-up photo of himself with the US president in the Oval Office.
Indeed, the rise of right-wing populism may yet help make for an existential crisis for the EU. No less a figure than Draghi highlighted this possibility last September in his European competitiveness report.
Moving from domestic to international politics, the geopolitical context facing Europe is also likely to continue to be very difficult in the second half of the 2020s, whether or not Trump can deliver a sustainable deal to end the Ukraine war. This would primarily be because of continuing security problems posed by Russia.
Beyond Moscow, there are wider challenges, including the possibility of significant migration flows from the region's southern borders, plus ongoing tensions in the Middle East. So, while the 1920s became known as the prosperous 'Roaring 20s', a century later there is a significant risk that the 2020s will be seen as a much more difficult 'Warring 20s' that help pivot Europe's future in a negative direction.
Taken together, this showcases the potential tipping point that Europe may still be at. The first half of 2025 has been, overall, more positive than many expected, but big challenges still lie ahead, which could change the picture again in a significantly more negative direction.
The writer is an associate at LSE IDEAS at the London School of Economics