Executive summary

The euro area is facing a more volatile global environment, in which simultaneous shocks interact and amplify one another. This report examines two key external risks to the euro area: prolonged geopolitical tensions, including a possible re-escalation in the Middle East, and an abrupt correction in United States (US) asset prices. Combined, they could have significant implications for the euro area economy, its sovereign markets, and fiscal trajectories. 

The euro area faces this new era having demonstrated remarkable resilience to recent shocks, but with a smaller margin to absorb new ones. Employment is at record highs, sovereign spreads remain contained, banks are well capitalised, and common backstops are stronger than in the past. However, such resilience is conditional, as these strengths coexist with important vulnerabilities. First, fiscal space is eroding, in part driven by increased defence spending needs. Second, the region remains structurally exposed to energy price shocks stemming from geopolitical tensions. Such shocks raise prices and uncertainty, weigh on competitiveness and investment, and risk lasting damage to productivity. Finally, close financial linkages with the US expose European investors to any potential repricing of US Treasuries and equities. Rising political uncertainty, longer-run fiscal sustainability concerns, and stretched equity valuations built on artificial intelligence-related earnings expectations create the potential for a sudden asset price correction emanating from the US. Meanwhile, euro area sovereign markets are becoming more reliant on price-sensitive investors, many from abroad, increasing the risk that a deterioration in sentiment translates into material sovereign bond spread moves. 

Chapter 1 illustrates that under the adverse scenario considered in this report, the euro area could enter a recession and inflation could approach 5%. These estimates do not consider any monetary policy or discretionary fiscal policy response. Investment would be hit hard, exports would weaken, and output losses would persist, with real gross domestic product (GDP) remaining around 2% below the baseline in the long term. Deficit and debt ratios would rise only moderately in the first two years, cushioned partly by higher inflation. The longer-run picture is more sobering: the average euro area public debt-to-GDP ratio would increase by about 20 percentage points compared to baseline projections, with almost all member states on upward debt trajectories. The resulting large fiscal adjustment needs would have to be managed under the European Union's new fiscal framework, which does provide flexibility and time. But the aggregate consolidation requirement goes well beyond what many countries have achieved in the past. Maintaining market trust is crucial for a successful gradual adjustment, requiring tough policy decisions on spending priorities and a clear focus on growth-supporting reforms. 

Fiscal resilience ahead is thus conditional on credibility. Well-designed fiscal frameworks are essential to preserve resilience in a fragile macro-financial environment. Without institutional guardrails, countries would be at the mercy of market volatility driven by sentiment shifts, an important cause of past crises. Policy design and communication matter as well, as illustrated by the experience of the 2022 energy crisis: broad-based support measures proved harder to unwind where electoral pressure and political fragmentation were greater. Such a dynamic could prove more costly in a future shock as fiscal space is narrower. This strengthens the case for temporary, targeted, and tailored measures to cushion external shocks. Rebuilding buffers, spending efficiently, and advancing reforms are as essential as ever. As a backstop, the euro area safety net can prevent liquidity strains from turning into solvency fears, including through credible insurance mechanisms such as European Stability Mechanism precautionary arrangements.  

Europe’s defence build‑up is a policy priority with fiscal implications, but fiscal costs can be contained if expenditure is designed to nurture growth. As Chapter 2 shows, defence investment can generate productivity spillovers through domestic supply chains that, in the long term, offset more than half of its fiscal cost. The defence sector must become a source of innovation, not just a recipient of public demand. Productivity spillovers and fiscal payback from economic growth are most likely to occur when research and development is prioritised, sourced broadly within Europe, its procurement is innovation-intensive, and is bound by the guardrails of a credible fiscal framework. Anchoring defence spending within a sound national fiscal design and effective European coordination can reinforce one another, reducing the fiscal cost of higher defence expenditure requirements.