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1. Are bad governments a threat to sovereign defaults? The effects of political risk on debt sustainability

Author:
Samantha Ajovalasit, Andrea Consiglio, Giovanni Pagliardi, and Stavros Zenios
Publication Date:
01-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
Political risk is a significant determinant of bond yields and economic growth in both developed and emerging markets and we develop a debt sustainability analysis model with both channels using a country ratings proxy of political risk. Political risk also affects a sovereign’s willingness to pay and it can render debt unsustainable, triggered by changes in the rating level, volatility or both. Conversely, sustainability can be restored through reforms that can be as effective as large-scale quantitative easing programmes. The political effects on debt are especially large for high-debt countries during periods of high interest rates, and have an impact on debt management through the choice of optimal financing maturities.
Topic:
Governance, European Union, Macroeconomics, Sustainability, Public Debt, and Sovereign Debt
Political Geography:
Europe

2. Gender diversity and economic growth

Author:
Jonathan Ostry
Publication Date:
02-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
Most macroeconomic and growth accounting models assume that male and female workers are perfectly substitutable in the aggregate production function. Whether this assumption is valid is an empirical question that this paper aims to answer by estimating the elasticity of substitution between female and male labour. We apply linear and non-linear techniques to firm-level data, cross-country sectoral data and cross-country aggregate data. We find that women and men are far from being perfect substitutes in production, a result that is consistent with much microeconomic evidence, but has not permeated to macroeconomics. The failure to account for imperfect gender substitutability has far-reaching implications. In particular, standard growth accounting exercises are likely to attribute to technological progress gains that are more properly attributable to the impact of greater gender inclusiveness in the labour force over time. Put differently, the gains from gender inclusiveness are likely to be much larger than standard economic models estimate.
Topic:
Governance, Women, Employment, Inequality, Economic Growth, and Macroeconomics
Political Geography:
Global Focus

3. Dilemmas for the EU in deficit-financing of defence expenditure and maintenance of fiscal discipline

Author:
Lucio Pench
Publication Date:
03-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
The European Union is grappling with the challenge of increasing defence expenditure while maintaining fiscal discipline under the Stability and Growth Pact (SGP). The European Commission has proposed activating the national escape clause available under the SGP to accommodate defence spending without triggering the excessive deficit procedure (EDP). However, the scope and enforcement of this measure remain uncertain. A proposed 1.5 percent of GDP cap on extra fiscal flexibility is legally questionable and unlikely to be enforced. While low-debt countries do not require the clause due to existing flexibility, highly indebted nations may find it insufficient in the face of rising debt costs. The escape clause may also serve as a backdoor for European Central Bank interventions under the Transmission Protection Instrument, which requires compliance with EU fiscal rules. The Commission has also proposed the Security Action for Europe (SAFE) funding mechanism, a €150 billion loan programme to finance national defence investments. SAFE relies on national borrowing and follows the model of the SURE (Support to mitigate Unemployment Risks in an Emergency) facility, put in place during the COVID-19 pandemic. However, SAFE’s limited scale and dependence on national fiscal capacities mean it falls short of the collective security funding approach advocated by economists. Meanwhile, Germany’s decision to reform its constitutional debt brake marks a major departure from its traditional fiscal policies. The reform establishes a permanent ‘defence golden rule’, exempting military spending from borrowing limits, alongside a €10 trillion infrastructure fund. Although this move does not endanger Germany’s fiscal sustainability, it undermines EU-wide fiscal coordination and conflicts with the SGP. This could weaken the European Central Bank’s position in future market interventions. Given these challenges, discussions on a new EU fiscal framework are necessary to ensure fiscal flexibility while maintaining debt sustainability.
Topic:
Security, Budget, European Union, Fiscal Policy, and Defense Spending
Political Geography:
Europe

4. The quickly fading memory of why and when bank capital is important

Author:
Jesper Berg, Nicolas Boivin, and Hans Geeroms
Publication Date:
04-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
Less than fifteen years after the global financial crisis of 2007-2008, banks and policymakers are calling for deregulation and lower capital requirements in the financial sector. They dispute that the Basel framework, the global standards for regulating large international banks, should be implemented fully in the European Union. One concern is that stricter capital regulation will affect the competitiveness of European banks compared to those in the United States and will restrict loan provision in the EU, despite Europe’s significant investment gap. However, deregulation should not be confused with reducing capital requirements for banks. On balance, there is only limited empirical evidence that respecting the capital requirements necessary to support financial stability hampers credit to the economy, investment or economic growth in the long term. Only well-capitalised banks can continue financing the economy during economic setbacks, and weakening the implementation of the Basel standards increases the risks of a new financial crisis. Bank lending and access to financing surveys also show there is no credit crunch in the euro area at present and that capital requirements are not the primary constraint on credit provision. A detailed look at current banking regulation does not support the conclusion that European banks are more strictly regulated overall than US banks. A direct comparison suggests rather the opposite. However, the compliance cost incurred by EU banks from current banking regulation can be reduced by simplifying EU rules.
Topic:
Markets, Financial Crisis, European Union, Regulation, Capital, and Banking
Political Geography:
Europe

5. Lessons for the European Central Bank from the 2021-2023 inflationary episode

Author:
Pablo Hernández de Cos
Publication Date:
05-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
Since mid-2021, the euro-area economy has gone through several shocks, leading to the highest inflation since the creation of the European Monetary Union. A forceful and persistent response from the European Central Bank, grounded in the monetary policy framework it agreed in 2021 ahead of the inflationary episode, has succeeded in bringing inflation down and delivering on the central bank’s price-stability mandate. The framework will be reviewed in 2025 and it might conclude that there is no need for a drastic change. Nevertheless, this assessment should be compatible with identifying some areas for improvement. In particular, the 2021 review was primarily focused on the effective lower bound. The recent inflationary episode, together with high ongoing uncertainty, indicate that the articulation of monetary policy strategy frameworks should be robust to very different scenarios. Likely persistence of high levels of uncertainty over the next few years will also require an emphasis on flexibility to adapt to the magnitude, origin and persistence of shocks. Unconditional forward guidance should be avoided. In addition, there might be a need to more clearly distinguish in the future, when possible, between quantitative easing for market functioning versus monetary stimulus, which could incentivise a careful assessment of the amount, duration and structure of any asset purchase programme. Communication also needs to be improved in relation to the level of uncertainty and its consequences for monetary policy making with, for instance, greater use of scenarios and sensitivity analyses as appropriate. Improving forecasting/modelling tools, in particular when dealing with large supply shocks, and understanding the roles of different measures of inflation expectations should also be priorities.
Topic:
Monetary Policy, Governance, European Union, Central Bank, and Macroeconomics
Political Geography:
Europe

6. Sovereigns on thinning ice: debt sustainability, climate impacts and adaptation

Author:
Matteo Calcaterra, Andrea Consiglio, Vincenzo Martorana, Massimo Tavoni, and Stavros Zenios
Publication Date:
05-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
A fundamental problem for sovereigns enacting climate policies is whether they can manage increasing debts as their economies suffer from adverse climate impacts. We develop stochastic debt sustainability analysis integrating a coupled climate-economy model with debt financing scenario optimisation, and stress test sovereign debt for representative countries globally under the Intergovernmental Panel on Climate Change marker narrative scenarios of climate change. The stress test combines socioeconomic and climate pathways with calibrated aleatory scenario trees of economic, fiscal and financial variables to generate forward-looking debt projections over the century. These projections incorporate climate-induced damages to economic growth, spanning the broad spectrum of impact functions from the literature. Our findings reveal significant risks to sovereign debt sustainability, particularly under high climate damages, that are large from mid-century. Expected costs increase by up to 3 percent of GDP under high climate impact in a world of regional rivalries, or 0.25 percent under low impact in a middle-of-the-road narrative, with considerable variation between countries. The long-run debts of highly impacted countries are unsustainable. We assess whether adaptation investments or fiscal consolidation can mitigate potential climate-debt crises. Public financing of reactive adaptation is a justified expenditure that breaks even but does not fully restore the debt sustainability of highly impacted high-debt countries. Maintaining public spending while ensuring debt sustainability appears infeasible under climate impacts.
Topic:
Climate Change, Governance, Macroeconomics, Fiscal Policy, Public Debt, and Decarbonization
Political Geography:
Global Focus

7. Radical novelties in critical technologies and spillovers: how do China, the US and the EU fare?

Author:
Alicia Garcia-Herrero, Michal Krystyanczuk, and Robin Schindowski
Publication Date:
05-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
Critical technologies including artificial intelligence, semiconductors and quantum computing are attracting attention because of their indispensable nature and their role in national security strategies. We compare China, the United States and the European Union in these technologies and their subfields. We use large language models (LLMs) to identify which patents in these technologies can be considered most groundbreaking (not patented before) and worth replicating. These are ‘radical novelties.’ We find that the US clearly dominates quantum. Chinese and EU progress is similar. The US does slightly better than China in AI with clear dominance in generative AI, but China stands out in some important subfields, such as aerial vehicle technology. China dominates in a larger number of semiconductor fields but not in the highest value added, which is related to design. In a second step we assess how quickly radical novelties in these three technologies are transferred from one economic area to another and within each economic area. We find that the fastest transmission overall is for AI. The EU is by far the slowest in replicating radical novelties from the US and China, while the US and China tend to replicate European novel patents relatively quickly. Radical novelties are also replicated quickly between China and the US which is surprising given US controls on exports of critical technologies to China. Our findings are concerning for Europe because it does not produce enough critical patents in these technologies and because it is slower in replicating patents from the US and China.
Topic:
Science and Technology, Economy, Trade, and Artificial Intelligence
Political Geography:
China, Asia, and United States of America

8. Which companies are ahead in frontier innovation on critical technologies? Comparing China, the European Union and the United States

Author:
Alicia Garcia-Herrero, Michal Krystyanczuk, and Robin Schindowski
Publication Date:
05-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
Competition in critical technologies is attracting increasing attention not only because of the foundational nature of these technologies for other types of innovation, but also because of their role in the United States national security strategy. In this paper, we look into which entities in China, the European Union and the US innovate at the technology frontier in the three most important critical technologies – artificial intelligence, quantum computing and semiconductors – based on identification of the most radical novel patents in these technologies and their subsectors. Working with these pathbreaking patents, we look into the origin of the companies that file the largest numbers of them. US innovators dominate the innovation frontier for quantum computing and, to a lesser extent, AI, with Chinese innovators doing better in semiconductors. European innovators lag in all, but perform relatively better in quantum computing, in which they rank similarly to Chinese innovators. Furthermore, the innovation ecosystem is quite different across geographies. In the US, tech companies top the rankings of critical novelties and are highly concentrated: as many as three companies are in the top rankings of all of the three critical technologies. Frontier innovators in the field in which the EU competes most equally – quantum – are mostly research centres and not companies. China lies somewhat in between in all three domains.
Topic:
Science and Technology, European Union, Innovation, Artificial Intelligence, Semiconductors, and Quantum Computing
Political Geography:
China, Europe, Asia, and United States of America

9. India-China rapprochement: what are the long-term prospects?

Author:
Nayanima Basu and Alicia Garcia-Herrero
Publication Date:
05-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
China-India relations, which have long been fraught, were further complicated by the 2020 military standoff on the Himalayan border. The political disruption had a significant impact on Chinese companies’ presence in India. And yet, India’s dependence on Chinese imports has increased since. The Indian economy is decelerating at a challenging time for Prime Minister Modi, who governs in a coalition. China could offer a partial solution to India’s economic woes by providing manufacturing FDI and creating jobs. The Modi-Xi ‘rapprochement’ after their encounter at the October 2024 BRICS summit signals that relations could improve. India may be willing to accept targeted investment from China, but relations are unlikely to fully normalise, particularly since the 2025 India-Pakistan military stand-off. There are three main reasons for this. First, the Indian army remains cautious about the situation at the border and security risks relating to China. Second, the United States under President Trump will exert pressure on Modi not to depend further on China. This is even more relevant in the context of Trump’s threat to impose tariffs on India. Third, Indian public opinion on China and the Belt and Road Initiative remains negative. India is predicted to experience greater growth than China in the coming decades, meaning China could lose its upper hand in economic relations between the two countries. This, however, will depend on how dependent India might have become on China for imports or for jobs through FDI and other channels. The militarised border, India’s asymmetric economic dependence on China and China’s leadership in the Global South will still shape the relationship even if the Indian economy grows to a similar size to China’s. India-China ‘rapprochement’ is possible but will remain fragile and unlikely to be maintained in the long run.
Topic:
Bilateral Relations, Governance, Economy, Economic Growth, Investment, and Trade
Political Geography:
China, India, and Asia

10. Intra-Western Balkans dynamics: stocktaking and ways ahead

Author:
Armin Steinbach, Nina Vujanović, and Anna Fiore
Publication Date:
05-2025
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
In the context of the push by the European Union for regional integration in the Western Balkans, this paper explores the barriers to, and prospects for, deeper intra-Western Balkan economic relationships. First, it addresses the pronounced bilateral economic relationships between Western Balkan countries associated with historical path-dependencies. Second, by comparing the Central European Free Trade Agreement with Stabilisation and Association Agreements that the EU has with Western Balkan countries, it identifies areas of less economic integration under the former. Third, it focuses on intra-Western Balkan trade barriers and how the associated costs influence regional integration. Finally, the paper describes the structures of Western Balkan economies and how much they contribute to regional exports through domestic value added. The paper emphasises the importance of regulatory alignment for reducing trade barriers and the role of funds under the EU Growth Plan for the Western Balkans for investment in transport infrastructure within the region. It finds that the Central European Free Trade Agreement and Common Regional Market should focus on untapped potential, especially in the liberalisation of capital, services and movement for employment. Infrastructure issues, trade logistics and the tackling of technical barriers to trade should feature prominently on the policy agenda.
Topic:
Governance, Macroeconomics, Trade, and Trade Policy
Political Geography:
Europe and Western Balkans