Policymakers’ discussions of Europe’s “investment gap” are often reminiscent of a dysfunctional couple debating how to repair a leaking roof: everyone agrees something must be done, but no one has any practical ideas about how to fix it.

But what is this investment gap, exactly? Why is it so frustratingly difficult to close? And what are the prospects that Europe could significant boost investment over the coming years?

This explainer will aim to answer all of these questions. We’ll show you that:

• Europe’s investment needs are enormous – in the region of trillions of euros.
• EU policymakers’ overwhelming focus on boosting private investment is likely mistaken.
• There is very little prospect that Europe will plug its investment gap anytime soon.

Why is everyone talking about it?

There are several reasons, but the main one is that Europe’s economy isn’t doing very well – or, at least, it is in many respects faring significantly worse than China and the United States.

According to the International Monetary Fund (IMF), the European Union’s total output grew by just 1.1% last year: less than half as much as the US and just over a fifth as much as China.

The EU is also facing numerous structural headwinds that suggest it will remain an economic laggard for the foreseeable future. These include high energy prices, weak domestic and external demand, cheap Chinese exports, and, of course, a tariff-loving US president.

Compounding these economic woes is the increasing urgency of combating climate change, the need to avoid being left behind in cutting-edge research areas such as artificial intelligence, and security concerns exacerbated by Russia’s ongoing war in Ukraine.

“The European Union needs to move forward with the green transformation, the digitalisation of the economy, and the strengthening of its military defence,” economists at the European Central Bank wrote last year. “This requires a lot more investment than in the past.”

How much money are we talking about?

There is no precise, generally agreed figure. But everyone admits that it’s a lot of money.

ECB economists estimate that Europe should spend an additional €5.4 trillion from 2025 to 2031 – which works out at around €771 billion per year.

Mario Draghi, an esteemed Italian technocrat and a former ECB chief, similarly suggested last year that Europe must increase green, digital, defence, and research investments by at least €750-800 billion per year.

However, Draghi himself noted that this amount – equivalent to 4.4-4.7% of the EU’s annual GDP – is almost certainly a “conservative estimate”, insofar as it doesn’t include funds for climate adaptation, re-skilling Europe’s workforce, or strengthening the bloc’s economic security.

Indeed, other independent studies indicate that climate adaptation and mitigation alone could cost as much as €1,600 billion per year.

All in all, it seems that Europe’s investment needs could be closer to €1-2 trillion, rather than €750-800 billion – and might even be substantially higher.

Is this private or public money?

Again, there is no general agreement for how this investment burden should be divided up between the private sector and public sector. It is likely, however, the lion’s share of Europe’s investment needs will have to be borne by private firms.

Historically, 80% of countries’ core investment needs have been met by the private sector, while 20% have come from the public sector.

However, and as Draghi himself has noted, simulations by the IMF and the European Commission suggest the current cost of private capital in Europe is around 250 basis points (or 2.5 percentage points) too high for this “80-20” split to be feasible.

This means that, in Europe’s case, the investment split might be closer to 50-50, with 50% of the money each coming from the private and public sectors.

In other words, EU governments might need to cough up (at least) an extra €400 billion per year: comfortably more than the combined annual GDP of Lithuania, Latvia, Estonia, Malta, Cyprus, and Luxembourg.

EU government officials hope that the public sector’s financial burden won’t be quite this large. Indeed, with the ECB currently lowering interest rates and the integration of Europe’s long-stalled Capital Markets Union (CMU) gathering steam, one might think this wish is at least partially grounded in reality.

Analysts, however, remain sceptical that these factors will reduce the cost of private capital by a sufficient amount to maintain the traditional 80-20 split.

As Maria Demertzis, a senior analyst at The Conference Board, a think-tank, bluntly put it: “It’s not going to happen.”

What is the Commission’s strategy for boosting investment?

Despite Draghi’s repeated exhortations about the importance of public funding, the Commission’s overwhelming focus in recent months has been on plugging the investment gap via the private sector.

Underscoring this point, the EU executive’s much-vaunted “Competitiveness Compass”, released last month, focuses heavily on generating additional private investment by “cutting red tape” and integrating the bloc’s CMU.

However, the plan – described as by Ursula von der Leyen as the “North Star” of the new Commission – contains virtually no details about how Europe should boost public investment.

“It emphasises that both public and private money is needed – but most of the part on financing just discusses [how] we should bring in private money,” said Zsolt Darvas, a senior research fellow at Bruegel, a Brussels-based think-tank.

Darvas also warned that Brussels’ focus on leveraging private money constitutes a serious flaw in the Commission’s overall funding plan.

“From this strategy, I see a little hope that is a sizeable portion of the investment gap could be closed,” he said.

Demertzis also warned that the impact of deregulation and CMU integration will take many years to have an impact – while Europe’s investment needs are urgent.

“All the agenda of reform, including CMU and the like, are welcome – but you cannot do it immediately,” she said. “It’s not for now.”

What’s the problem with public money?

There are several reasons for the Commission’s reluctance to produce detailed plans for additional public investment, but the main one is frugality.

As officials from countries like the Netherlands and Germany have repeatedly argued, many EU member states are already running high budget deficits – and are, ipso facto, contravening the bloc’s stringent new fiscal rules.

Eight countries, including major economies like France and Italy, are currently subject to an “excessive deficit procedure”, or formal reprimand, from the Commission for breaching the EU’s budget threshold of 3% of annual GDP.

Analysts, however, pour cold water on the notion that EU member states are so indebted that they lack the fiscal capacity to plug Europe’s investment needs.

“Fiscally, it should be sustainable,” said Darvas, adding that academic studies show that the required boosts in public investment will not “result in skyrocketing of interest rates”.

“Unfortunately, the new fiscal rules are not really investment-friendly,” he said.

Another, related reason for the Commission’s focus on private money is that their major source of public funds, namely the EU’s €800 billion “NextGenerationEU” COVID-19 pandemic recovery fund, is set to expire in 2026. Frugal member states are also heavily opposed to its renewal.

The scheme, which is financed through debt jointly underwritten by member states, aims to stimulate member states’ post-pandemic economies by financing crucial green and digital investments in exchange for targeted reforms.

Exacerbating the fiscal squeeze, member states will have to fork out around €30 billion per year to pay back the accrued debt from 2028 – an amount equivalent to roughly a fifth of the EU’s regular budget.

Many analysts, including Draghi himself, argue that a renewal of NextGenerationEU is essential for Europe to plug its investment gap.

“Some common debt may be unavoidable but it is controversial, even if it is only used for productivity-increasing investments in EU public goods such as breakthrough innovations, defence and cross-border energy infrastructure,” analysts at the Centre for European Reform wrote in a recent report.

What are the other options?

One possibility is an “opt-in” defence fund, underwritten by joint debt that non-EU countries could sign up to.

Darvas noted that such a scheme is “quite likely” but that it wouldn’t be as effective as NextGenerationEU, which aims to boost investment in a broader range of areas.

Another potential option is “new own resources”, or additional revenue streams for the EU budget, generated through schemes like a new carbon tax.

Darvas also dismissed this as insufficient. While such resources might “marginally help” going forward, they ultimately won’t make a big difference unless the EU’s seven-year regular budget – which accounts for only 1% of the bloc’s annual GDP – is expanded.

“Most of these new own resources would change how countries contribute to the new budget, but wouldn’t really change the overall revenue amount unless the EU budget spending ceiling is increased,” he explained.

Demertzis, however, noted that one way in which Europe could meet its investment needs in the near-term is by leveraging the power of the European Investment Bank.

She added that the EIB – the world’s largest multilateral lender – would be especially capable of helping if it was allowed to make riskier investments that “crowd in” private money.

“If they finance the riskier tranches of interesting projects, then private money may be interested because the private money doesn’t want to take the risks,” she said.

[OM]