IMF Urges EU to Tackle Market Fragmentation to Unlock Growth and Productivity Gains

A powerful new IMF working paper authored by researchers from the Fund’s European Department, Nathaniel Arnold, Allan Dizioli, Alexandra Fotiou, Jan Frie, Burcu Hacibedel, Tara Iyer, Huidan Lin, Malhar Nabar, Hui Tong, and Frederik Toscani, presents a compelling argument for why the European Union must urgently dismantle long-standing structural barriers in its Single Market. Drawing on research from institutions such as the European Commission, European Central Bank, European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA), the paper diagnoses the continent’s lagging productivity and proposes a roadmap to reignite innovation and growth. At the heart of the paper lies a critical insight: Europe is not suffering from a lack of technology or ideas, but from its inability to allow dynamic firms to scale and thrive across borders. The proposed reforms are designed to address four deeply entrenched constraints: fragmented regulation, financial inefficiency, labor immobility, and energy market disintegration. According to the IMF’s simulations, even modest progress in these areas could lift EU GDP by 3 percent over the next decade.

A Single Market Still Divided

The EU's Single Market, often hailed as a triumph of integration, remains riddled with inconsistencies that limit its effectiveness. Regulations vary widely between member states, creating a bureaucratic maze for firms that wish to expand. About 60 percent of EU exporters report having to comply with different consumer protection and certification rules in different countries, discouraging cross-border investment. Fragmentation is particularly acute in the services sector, where tariff-equivalent barriers remain as high as 110 percent. The legal landscape is further complicated by “gold-plating,” where member states over-implement EU directives. This not only undermines legal uniformity but disproportionately burdens small firms, especially those driving innovation. The authors advocate for the creation of a voluntary “28th regime”, a harmonized set of rules for company formation, accounting, and insolvency that would operate alongside national laws. Such a framework would offer firms the option to operate across the EU under one legal standard, cutting red tape and lowering compliance costs.

The Capital Problem: Too Much Cash, Not Enough Risk

Europe’s financial ecosystem suffers from a chronic inability to channel household savings into productive investments. While the EU boasts high overall savings, a disproportionate share remains locked in low-yield deposits. EU households hold about one-third of their financial assets in cash or bank accounts, three times the level in the United States. Moreover, EU pension and insurance funds allocate just 0.02 percent of their portfolios to venture capital (VC), compared to 0.12 percent in the U.S. This makes it exceedingly difficult for start-ups to secure growth capital within Europe. The result is a “brain and capital drain” as high-potential firms seek IPOs and investment in more mature markets like the U.S. The IMF’s plan includes expanding long-term capital pools through automatic enrollment in pension schemes, improving financial literacy, and reforming retail investment products like the Pan-European Personal Pension Product (PEPP). By tripling VC investment to catch up with EU leaders like Denmark and Sweden, Europe could unlock a wave of firm creation and innovation.

Locked Talent and the Price of Immobility

Labor mobility within the EU is alarmingly low. Fewer than 4 percent of working-age citizens live in another EU country, and the distribution is highly uneven, from under 1 percent in Poland and Romania to 40 percent in Luxembourg. Barriers include language differences, complicated recognition of professional qualifications, non-portable pensions, and soaring housing costs in economically vibrant regions. According to EIB surveys, around half of European firms cite skill shortages as a major obstacle to investment. The IMF proposes a suite of reforms to improve labor mobility: modernizing and digitizing qualification recognition, harmonizing pension rights, expanding affordable housing, and investing in public language programs. The authors argue that these reforms would not only unlock talent across borders but also address skill mismatches that dampen firm productivity. Better labor matching would also encourage educational attainment and skill acquisition, creating a virtuous cycle of human capital development.

Energy Fragmentation: A Barrier to Investment

Europe’s fragmented energy market continues to be a drag on business confidence and investment. The shock from Russia’s invasion of Ukraine and the subsequent energy crisis exposed severe weaknesses in the EU's energy architecture, chief among them being an overreliance on imported fossil fuels and a lack of grid integration. Electricity prices remain volatile and uneven across the continent. In 2023–24, the median wholesale electricity price doubled relative to pre-pandemic levels, and price volatility tripled. This unpredictability hinders capital investment, especially in manufacturing and R&D-heavy sectors. The IMF recommends developing a comprehensive, data-driven EU-wide energy strategy, investing in cross-border infrastructure, and streamlining permitting for renewable projects. A more integrated and resilient energy system would not only reduce costs but also boost competitiveness and attract long-term investment. The report even suggests the creation of an EU grid interconnector operator to manage cross-border energy flows.