Foreword
Europe’s resilience has been tested repeatedly over the past two decades, but today's challenges are of a different nature. A shifting global order, fragmentation in global trade, persistent geopolitical tensions, bouts of financial-market volatility, and energy disruptions are placing increasing strain on the euro area. Many European countries face high public debt alongside rising structural spending needs. With buffers thinning and shocks occurring more frequently, awareness and preparedness are the first lines of defence. With this in mind, the European Stability Mechanism (ESM) has launched the Euro Area Stability Watch as part of its crisis prevention role.
The first edition of this new annual publication examines risks to the euro area economy through one central question: can the euro area's resilience be sustained as external risks intensify and fiscal buffers erode? Our answer is clear: the euro area has repeatedly demonstrated its resilience, but resilience cannot be taken for granted. Sustaining it will require difficult policy choices as weaker growth and demand for more public support challenge debt sustainability. Many member states will need to adjust their public finances more decisively to preserve the credibility of the European fiscal framework. Financial markets may otherwise increasingly limit countries' fiscal space, generating uncertainty and instability, as past crises have shown.
The report presents an adverse scenario to assess the macroeconomic and fiscal outlook of euro area member states under difficult external pressures. This edition's adverse scenario envisions two highly relevant risks materialising simultaneously: (i) prolonged geopolitical tensions and a re-escalation in the Middle East, pushing up energy prices and keeping uncertainty high, and (ii) a sharp repricing of United States financial assets, tightening global financial conditions and transmitting losses to European investors. Each shock on its own would be challenging, but together they could push the euro area into recession, drive annual inflation close to 5%, and put most countries on upward-trending public debt paths. Three insights from the analysis stand out:
- First, a prolonged and severe geopolitical shock causes disproportionately larger economic damage than a more contained one. Furthermore, persistently sluggish investment leads to permanent economic damage.
- Second, fiscal pressures under the adverse scenario are distributed differently across countries than during the sovereign debt crisis of the early 2010s. Differences in exposures to external shocks such as energy dependency or trade openness – rather than initial fiscal positions – determine the impact across countries. Sovereign vulnerabilities thus reflect the nature of the shock.
- Third, defence expenditure can either finance imports of weapons from abroad or become an investment in European innovation and growth potential. If used productively and backed by efficient European supply chains, defence expenditure can support long-term growth while debt sustainability risks remain contained.
What does this imply for fiscal policy? To paraphrase the late politician and statesman Willy Brandt, credibility is not everything, but without it, everything is nothing. Fiscal frameworks buy time and flexibility, but only as long as markets trust that governments are willing and able to use them wisely. The required fiscal adjustments go beyond what many countries have achieved in the past and are compounded by spending pressures from defence requirements and population ageing. When room to manoeuvre is that limited, the quality of policy choices becomes critical, particularly in a context where political fragmentation may complicate implementation.
Beyond scenario analysis, the ESM has deepened its market monitoring and debt sustainability frameworks to detect turning points in real time. This report reflects that effort: it brings together macroeconomic and financial analysis with proprietary market intelligence – including a new survey of euro area sovereign bond market participants – to assess how global risks transmit to sovereign balance sheets and financing conditions. In doing so, it complements the stability assessments of peer institutions such as the European Commission, the European Central Bank, and the European Systemic Risk Board. The ESM contributes its distinctive sovereign perspective on these risks: how shocks shape governments' capacity to finance themselves, and what this implies for the resilience of the euro area as a whole.
