A recent European Central Bank (ECB) survey has put into numbers something that should already be obvious to anyone watching Europe’s economic trajectory: European investment is stagnating not because capital is scarce, but because demand is weak. The ECB writes that it is mainly ‘a weak demand outlook’, followed closely by ‘low profitability’ that constrains business investment in the euro area.

This has important implications that EU policymakers often miss. What happens, for example, if – as Christine Lagarde and others have hoped – global investors begin to shift out of US assets and start acquiring more EU debt, so that the euro becomes more of a global rival to the dollar? The answer you are most likely to hear in policy circles in Brussels or Frankfurt is that these inflows would be good for Europe. They lower interest rates, boost investment, and make more capital available to struggling firms.

But if, as the ECB itself concedes, the constraint on business investment isn’t access to capital but a lack of demand, these inflows will do no such thing. Why would a firm ramp up capacity if domestic demand is tepid? In a world in which China is determined to expand its domination of global manufacturing, and the US is determined to revive its manufacturing sector, an increase in the value of the euro and a rise in net capital inflows will weaken both domestic and foreign demand for European goods and accommodate a rise in the US-China share of global manufacturing through a reduction in the EU share. The risk is that, rather than stimulate investment, net capital inflows actually reduce business incentives to invest. This, after all, is what the American economy has faced, and what US policymakers are now trying to reverse, especially because of the long-term contraction in the American share of global manufacturing.

The balance of payments must always balance. If the eurozone receives higher net capital inflows without a corresponding rise in investment, it will be forced to adjust by reducing its own savings. This is where things get uncomfortable.

One way in which EU economies might adjust is through rising unemployment. This would happen if European manufacturers, struggling under a stronger euro and declining competitiveness, cut back production and lay off workers.

Alternatively, it could come in the form of rising debt. The ECB might counter employment pressures by inflating domestic debt to replace the demand that leaked abroad through the trade deficit. It can cut interest rates, encouraging household borrowing to replace demand lost to imports. This reduces household saving by increasing consumer debt. Similarly, EU governments can replace demand lost to imports by expanding fiscal deficits. In that case, government saving drops.

Europe has already witnessed how these adjustment mechanisms operate in practice. In 2002, Germany’s  labour reforms gave rise to an economic model based on wage compression and weaker labour protections. This boosted export competitiveness and generated large current account surpluses. These surpluses, however, came at the cost of weak domestic demand creating excess savings that spilled over into capital inflows toward the rest of the euro area. This forced other countries in the eurozone – deprived of the exchange rate tool – to adjust in alternative ways. Spain, for example, adjusted at first in the form of a debt-fuelled property boom, only to face a brutal correction after 2008, with collapsing demand and unemployment soaring above 25 per cent. Italy, meanwhile, relied less on wage restraint or mass layoffs and more on persistent fiscal deficits and ECB support, effectively shifting the burden of adjustment onto rising public debt rather than unemployment.

Crucially, neither Spain nor Italy deliberately chose these paths: both were compelled to adjust in order to absorb the surpluses generated by Germany’s industrial policies within the common currency framework.

As in the case of Spain and Italy, the EU will be forced to adapt to the increase of capital inflows. In both scenarios, we will see an overall decline in EU saving – either from a rise in unemployment or a rise in debt – and a shift in the structure of the EU economy away from manufacturing. In the case of ‘adjustment by unemployment’, total production would decline along with the fall in manufacturing, as happened in Spain after 2008. In the case of ‘adjustment by debt’, total production would be maintained, but with a structural shift toward services, as in Italy, where public debt and ECB support sustained demand and prevented mass unemployment – at the cost of weakening industrial capacity and leaving growth increasingly dependent on services and public spending.

This shift would occur whether or not the EU – or individual European governments – wanted to encourage it. That’s because China’s economic growth model depends heavily on increasing China’s share of global manufacturing – currently at 31 per cent for an economy that comprises 18 per cent of global GDP. At the same time, a new bipartisan consensus in Washington demands that the US reverse its accommodation of global imbalances by reviving its share of global manufacturing – currently 18 per cent for an economy that comprises 24 per cent of global GDP.

If the Chinese and US shares of global manufacturing rise, to the extent that the EU accommodates foreign imbalances, it will be forced to weaken its industrial base and increasingly finance growth through debt-driven expansion of the service sector. In short, if half of the world – the US and China – expands its share of global manufacturing, the other half – Europe and the rest, including India and parts of the BRICS – will inevitably see its share shrink.

If we assume that developing countries will continue to dominate lower-value added manufacturing – as will almost certainly be the case – the EU will find itself contending for a shrinking share of high-value manufacturing, under intense competition from powerhouses like Japan, South Korea, Taiwan and other economies that can manage their exchange rates and external balances far more actively than Brussels.

None of these scenarios will have benign outcomes. None imply a healthier EU economy or a more productive capital stock. They are, instead, compensating imbalances – adjustments forced by foreign capital that Europe doesn’t need but whose purpose is to allow surplus countries to externalise the cost of their domestic policies.

While many EU officials see the US retreat from its role in accommodating global capital imbalances as a chance to partially replace the US, it is important to understand the implications of this. If European businesses aren’t constrained by the lack of capital but by demand, as confirmed by the ECB, encouraging capital inflows will not benefit European manufacturers or producers. It will instead benefit its banking system and strengthen its global role in monetary affairs but, as happened in the US, at the cost of surging debt and a structural shift in the economy away from manufacturing and towards services.

This could have important social and political consequences for the EU. Manufacturing has always been a key driver of productivity growth. Unlike most services, it can be traded across borders, which makes it crucial for exports and competitiveness. Services, on the other hand, are mostly local – think of healthcare or personal care – and even the tradable ones, like finance, IT, or consulting, are much smaller in scale compared to the global demand for goods. This means services alone can’t make up for the loss of manufacturing: they don’t generate enough exports or the kind of productivity growth that lifts wages. The result is a structural imbalance, with too much consumption fuelled by debt, persistent trade deficits, and growing political frustration boosted by deepening inequalities.

In the end, a country’s internal imbalances must mirror its external ones. The more it surrenders control over its external balance, the more its domestic economy is forced to adjust to the industrial policies of its main trading partners. This is the paradox that Europe needs to confront urgently if it is to preserve its integration and maintain global relevance.

So what are the options? We can identify four potential scenarios, each marked by an inverse relationship between their plausibility and their potential impact.

Scenario 1: One possible scenario involves China rebalancing toward domestic consumption and working with the US and EU to reset global trade. In theory, Beijing could follow the Japanese path of the 1980s, shifting from an export-driven model toward domestic consumption and thereby easing the external distortions that weigh on the US and EU. This would be the optimal outcome, as stronger household demand within China would naturally ease global trade tensions and could even create the basis for a Bretton Woods 2.0 – an agreement aimed at revitalising global trade by preventing countries from exporting their domestic distortions, much as Keynes had advocated back in 1944.

This scenario is highly implausible. Household consumption in China remains below 40 per cent of GDP – by far the lowest in the world – and raising it meaningfully would require a massive transfer of income away from local governments, whose constituencies benefit the most from the growing distorted supplies, and towards households. Such a redistribution, equivalent to 10-20 per cent of GDP, would not just be an economic adjustment, but a fundamental political one, undermining the power of the state sector that has been the main beneficiary of the current model.

For this reason, while the arithmetic of rebalancing is straightforward, the political costs make it an extremely unlikely path for Beijing. What is more, it cannot happen quickly. Japan – whose imbalances were much smaller at their peak than China’s today – took nearly two decades to rebalance, and paid a steep price: its share of global GDP fell from almost one fifth in the early 1990s to around three to four per cent today.

Scenario 2: A more plausible path is that Beijing does not correct its growth model and continues to rely on external demand to sustain industrial expansion, while the US continues to absorb most of the global excesses. This is essentially the world we live in today: China shows no real signs of shifting decisively toward domestic consumption, and its growth remains tied to exporting its surplus production and capital abroad. The United States, meanwhile, has not solved the problem with tariffs, which merely redirect trade flows without reducing the underlying deficit, while Europe remains largely unprotected. Together, the US and EU continue to absorb China’s surplus output and financial imbalances, with the very consequences already described: weaker manufacturing, rising debt or unemployment, and growing political strains.

This scenario is ultimately quite unlikely, because – unlike in Europe – there is now a bipartisan consensus in Washington on the need to defend the US economy from such distortions: the question is no longer whether the US will rebalance, but how it will choose to do so.

Scenario 3: The US and EU could both take steps to defend themselves while China tries to stay its course. In this scenario, China would maintain its existing growth model, which requires that its share of global manufacturing continues to rise faster than its share of global consumption and therefore force Beijing to retain a very large trade surplus to balance the domestic demand gap.

In this case, however, we assume that both the US and the EU would move aggressively to regain control of their external accounts and to protect their domestic economies from being restructured by the needs of their trade partners. This, in turn, is likely to create an impasse: if the external imbalances required by the structure of the Chinese economy are not absorbed by the US and the EU, either they must be absorbed by other large, advanced economies or by the developing world, or they must be eliminated.

The former is unlikely to happen. In this scenario, countries like Japan, the UK, Australia, Canada and South Korea would almost certainly move aggressively to defend their own economies. The latter is also unlikely. The developing world cannot realistically absorb the resulting Chinese surpluses through massive trade deficits given existing debt burdens and limited access to capital.

It is far more likely that China would be forced into a rapid restructuring of its domestic economy. In theory, it would be possible to rebalance the economy with a surge in consumption. But China would need a 10-15 percentage point increase in the household income share of GDP in order to become a ‘normal’ developing country. For China to rebalance to this extent while the country continues to grow by four to five per cent requires that consumption grow by up to eight per cent for over a decade. While this is possible in theory, it would require such large transfers from business and governments to households (the opposite of what happened for most of the past three decades) that it is hard to imagine how China could manage the transfers while still maintaining high GDP growth rates. The transfers themselves would probably be highly disruptive.

The only other way to rebalance the economy, of course, would be in the form of a sharp slowdown in GDP growth, or even a contraction. While the former is possible in theory, historical precedents only show cases in which the latter occurs. This is an outcome Beijing would presumably do all it can to avoid.

Scenario 4: There is another potential future, however, in which China stays the course, the US defends itself, and the EU fails to respond. This is probably the worst outcome for the EU. In this scenario, China could continue expanding its share of global manufacturing while continuing to restrain the growth of its share of global demand. The US does the opposite of what it has been doing so far, and takes steps to regain control of its domestic economy and revive its share of global manufacturing. By reducing its role as the world’s ‘automatic absorber’ of excess savings, Washington could ease the pressure on its manufacturing base, help reduce household debt, and contain social polarisation.

As the US share of global production rises relative to its share of global consumption – to mirror what was already occurring in China  –  the bulk of the global adjustment is forced onto the EU. Europe will be forced to absorb this excess of global capital and production through either higher unemployment or higher debt. Given the severe social and political costs of a sharp rise in unemployment, the EU may instead seek to absorb this excess capital by allowing debt to rise. And as rising EU debt fuels greater consumption, the EU’s share of global consumption will rise, even as its share of global manufacturing declines and its economy shifts from manufacturing to tourism and other services.

The first scenario is obviously the best from the point of view of the global economy, but, at least for now, it seems politically the least likely. The fourth scenario, however, represents the most plausible path forward, in large part because of the risk that Europe fails to recognise the historical magnitude of this challenge.

If Europe wants to stop being the default absorber of other countries’ imbalances, 27 separate fixes won’t do. It needs a single EU-level framework that regains control of the external account, prevents other countries’ industrial policies from bleeding into European costs and wages, and lifts household incomes so demand can grow without piling up debt.

Concretely, this means five linked planks. First, a single external-economic policy that aligns trade defence, investment screening, procurement reciprocity, and standards policy so that Europe’s import-mix and capital inflows do not systematically erode its tradable sector. Second, reform state-aid and competition rules so the EU can offer EU-scale, time-limited support to truly tradable, productivity-raising sectors – and enforce strict surplus discipline inside the single market, so that one country’s wage restraint or fiscal stance can’t shift the adjustment costs onto others (i.e. Germany 2002). Third, a modest but permanent euro-area fiscal capacity that stabilises demand symmetrically, countering the old pattern in which deficits and unemployment cluster in the same places while surpluses persist elsewhere. Fourth, a wage-and-incomes compact, especially in surplus economies, to raise household income shares and domestic absorption, reducing the bloc’s dependence on external demand. Finally, a clear doctrine on third-country overcapacity: where price gaps reflect subsidised factor costs or currency management, Europe should use calibrated tariffs, quotas, and standards – not to pick winners, but to neutralise the distortion and preserve space for efficient European producers to invest.

The impediments to this set of policies are less technical than political. The single market houses incompatible growth models: creditor economies that rely on external demand and wage restraint, and debtor economies that must offset the demand leakage with public debt or unemployment. In the absence of a common external stance, these models collide inside the euro and turn foreign imbalances into intra-EU rifts. That clash shows up first in how the Union decides and then in how it delivers.

Decision-making first stalls at the top. On key external-economic files – including sanctions, trade instruments with geopolitical bite, and parts of foreign policy – formal unanimity (and frequent de-facto unanimity even where qualified-majority voting exists) lets any single capital veto, slow-roll, or extract carve-outs. The result is lowest-common-denominator compromises that arrive late, are narrower in scope, and riddled with exemptions just as the window for leverage closes.

Execution then breaks down. Even when Brussels sets the rules, 27 national authorities and multiple EU bodies – customs, competition and state-aid units, FDI and export-control offices, regulators and courts – apply them with very different capacity and caution. Companies and third countries exploit these differences by routing activity through the most lenient jurisdictions and by litigating, so enforcement becomes uneven, slow, and full of loopholes. Put together, this results in gridlock at the centre and patchy enforcement on the ground.

The consequence is a default to the path of least resistance: tolerate capital inflows, celebrate a strong euro, and socialise the costs through debt, services-sector expansion, or job losses. Fear of retaliation – especially in sectors heavily exposed to Chinese markets and inputs – then locks the system into a collective-action trap: no member state wants to move first, and the Commission’s mandate remains narrower than the problem.

In short, the EU is structurally set up to arbitrate competition cases inside the market, not to manage balance-of-payments politics at its borders. Until that gap closes, Europe will keep importing other countries’ industrial strategies and exporting its own adjustment through inequality, deindustrialisation, and political fracturing.

What is at stake is not Europe’s ‘competitiveness’ in the narrow sense but the architecture of its social model and its capacity to act as a geopolitical pole. If the EU continues to absorb net capital it does not need while tolerating overcapacity imports it cannot match, it will finance consumption with debt, shift employment into non-tradeables (i.e. services), and watch the tradable base that anchors productivity, wages, and cohesion decline.

In the end, the EU’s lack of political unity means that it cannot respond unilaterally in a world in which its major trading partners (China, Japan, India and, increasingly, the US) are determined to control their external accounts and are able unilaterally to do so. A country’s ability to control its external accounts affects the extent to which it can control its internal imbalances while externalising their costs, along with the structure of its economy and its mix of manufacturing and services.

The EU is often criticised for its heavy regulation of business and its extensive welfare state, but these are not necessarily weaknesses and they are not necessarily bad for the global economy. Anything that boosts household income, for example, is good for global business because it boosts global demand. But in a global trading system in which the ‘winners’ are those economies that repress wages the most relative to productivity – including lower welfare support and fewer regulations that protect workers and households – we are locked into a kind of ‘Kalecki paradox’: a single country can implement policies that make its exports more competitive, and so increase its growth through trade. But if many countries adopt these policies, they reduce global demand and collectively suffer, leading to slower global growth.

The EU suffers in this case not because it necessarily has bad domestic policies, but because many of its policies, while collectively good for the EU, good for the world, and good for global growth, undermine its competitiveness relative to countries that don’t follow the same set of rules and that are willing to sacrifice domestic needs in order to maximise the global competitiveness of their industries.

The alternative is not an autarkic Europe, but a Europe that sets the macro ground rules under which openness is sustainable: symmetric stabilisation inside the euro; surplus discipline that raises household income shares; an external-economic policy that filters foreign imbalances rather than internalising them; and EU-level industrial tools that boost productivity instead of propping up entrenched interests; and, underwriting all of them, a trade policy that protects the EU from being forced to compete in a global race to the bottom.

The choice is binary in its logic, if not in its politics. Either Europe governs the terms on which it trades with surplus economies and with the United States’ evolving stance – or it will continue to trade away the very conditions that make European integration economically viable and politically legitimate. The window for that choice is closing, not because of ideology, but because balance-of-payments arithmetic, left unmanaged, becomes politics by other means.