Viewpoints: 2026

Weak growth and divided governments complicate fiscal repair and the investment needed to improve productivity.

Europe is caught in a difficult circle. Weak growth is undermining confidence in governments, while political fragmentation makes it harder to agree on the reforms and budgets that might restore it. Higher debt-servicing costs leave less room to reconcile competing demands. Economic disappointment and political division risk reinforcing one another, limiting the ability to strengthen growth.

There is no painless way out. Spending cuts can depress activity and alienate voters, while further borrowing may add to the debt without improving the capacity to service it. Higher productivity offers a more promising escape: AI could raise incomes and tax revenues enough to ease the burden. But the investment needed to secure those gains competes for capital and energy, potentially raising Europe’s costs well before it raises European incomes.

That delay matters for monetary policy. Further ECB tightening might restrain inflation, yet also weaken investment and demand in economies struggling to grow. Europe must therefore improve its capacity to invest and govern while managing the immediate pressures on household incomes and public finances.

The difficulty of governing France illustrates the problem. Its minority government is struggling to secure support for a budget intended to curb the deficit. In Spain, a parliamentary defeat over measures to ease the housing crisis has prompted a snap election. In Germany, regional gains by the far-right AfD are putting the governing coalition under pressure. Different economic circumstances have produced a common difficulty: assembling durable support for difficult choices.

Those choices are becoming more expensive. Voters want better services and relief from living costs, while defence and energy security require greater spending. At the same time, governments must refinance debt issued when interest rates were much lower. Rising interest bills leave less room to satisfy these demands, making political agreement harder just as the cost of failing to reach it increases.

Weak growth weakens consent The roots of this difficulty extend well beyond the latest political disputes. The World Bank’s political-stability measure shows a broad deterioration across advanced economies over the past decade. Germany has suffered a particularly marked decline, whereas Greece and Italy have improved or held their ground after earlier periods of upheaval.

Korea is emerging from the extraordinary political turmoil of 2024–25, triggered by former President Yoon Suk Yeol’s declaration of martial law in December 2024 and subsequent impeachment. The Lee government has since consolidated its political position, winning 12 of 16 major mayoral and provincial contests in June.

Political upheaval was not the only challenge. Last year was difficult for Korean exporters too, and external headwinds remain. Korean goods continue to face 15% US import duties, with tariffs on certain products rising by a further 10–12.5% in July 2026 under measures related to forced-labour policies.

Yet Korea—and its exporters in particular—has bounced back. Riding the global semiconductor upcycle and successfully diversifying export markets, exporters have seen both volumes and pricing power rebound sharply. In August, export volumes rose at a double-digit rate for the ninth consecutive month, climbing 26% YoY, while export prices surged 40.7%.

Artificial intelligence can lift productivity and sustain business investment. The scale and durability of the gains will depend on labour, energy, materials, finance and the policy response.

Introduction and summary messages The surge in artificial-intelligence investment is being driven by the technology's potential to raise productivity and corporate profitability. It is unfolding, however, in a world economy increasingly constrained by scarce labour, power, materials and capital. Those constraints make labour-saving technology more valuable, but they also limit how quickly the infrastructure supporting it can expand.

The initial macroeconomic effects can be favourable. If productivity rises faster than wages, unit labour costs fall. Firms can expand output without increasing employment at the same rate, supporting margins while containing underlying inflation. Stronger supply can therefore coexist with resilient demand and give monetary policy more room to accommodate growth.

The central risk comes later. Capacity and scarcity determine whether that favourable chain continues or reverses. Productivity gains can be diluted if electricity, grids, equipment, industrial materials or skilled labour become binding constraints. Inflation may then rise even before demand has weakened, leaving central banks to balance price stability against the investment needed to expand supply.

Backdrop Companies are buying computing power, software and equipment because they expect to produce more with fewer workers. Scarcity adds urgency to that calculation. Labour is expensive, trade is more fragmented and capital is no longer free. Governments are also investing in energy security, defence and domestic supply chains. Climate disruption and tighter immigration policies in some economies are adding to the pressure on energy systems, transport, construction and skilled labour.

Energy is where the tension is sharpest. Digital capital can be installed quickly; power stations, transmission lines and mines cannot. The most important price in the AI boom may therefore be the price of electricity rather than the price of a semiconductor.

The investment response is already visible. Orders for capital goods across the United States, Germany and Japan have risen for seventeen consecutive months, while Asian semiconductor exports tell the same story from the production side. Inflation-adjusted orders remain below their 2021 average, suggesting that the cycle is still relatively young.

The increase in investment is only the starting point. Its economic significance will depend on whether it produces measurable gains in output and productivity, how those gains are divided between labour and capital, and whether the expansion runs into physical or financial constraints. The framework below traces that transmission before the subsequent section considers what the available evidence suggests about how far it has progressed.

Since the introduction of ChatGPT in November of 2023, investments in artificial intelligence (AI) have surged. Economists await indisputable evidence of a positive return on those investments manifested in faster trend growth of productivity. Meanwhile, a popular – albeit “partial” - narrative is that without the AI buildout the economy would have been considerably softer over the past three years than observed.

We can agree that, in an accounting sense, the contribution to recent growth of GDP made by AI investments - defined here as fixed investment in computers & peripheral equipment, in software and in R&D, as well as construction of data centers - has become quite significant. My first chart shows the recent decomposition of 4-quarter growth in real GDP (not compounded). Since early 2024, the contribution to growth of AI investments has (roughly) quadrupled and now accounts for roughly 40% of total GDP growth. Yet during that span GDP growth itself has not moved noticeably higher.

Brent crude traded near $70 a barrel when the Strait of Hormuz closed at the end of February. It reached $138 in April and has since retraced part of that move while remaining well above its pre-disruption level. The macroeconomic response has so far been modest. Consensus forecasts for world output in 2026 have been revised down, but only very modestly.

The natural interpretation is that the structural sensitivity of output to energy prices has fallen, through lower energy intensity, more flexible product and labour markets, and better-anchored inflation expectations. There is something in each of these. But the evidence points to a more contingent explanation. The adjustment has been accommodated principally on the inventory margin rather than through quantity rationing or demand destruction, and the capacity to continue accommodating it that way is close to exhausted.

Implied global stock changes, derived from the EIA's world supply-demand balance, show a cumulative six-month drawdown roughly half as large again as the previous maximum in 2007. The initial condition matters here. Stocks were being accumulated rapidly through late 2025, so the disruption arrived with storage unusually full; the buffer was the incidental product of a preceding surplus rather than the result of deliberate precautionary accumulation. Commercial cover across the OECD has since fallen to around twenty-one days, and non-OECD buyers have begun to draw down the precautionary holdings built in the spring.

State labor markets were somewhat improved in August. Four states reported a statistically significant increase in jobs—California gained 39,400 and New Mexico Eight states saw statistically significant drops in their unemployment rate, though none was larger than .2 percentage points. The highest unemployment rates were in DC (5.7%), Connecticut (5.1%), Oregon (5.1%), California (5.1%), and Michigan (5.0%). Nebraska, New Hampshire, Hawaii, Vermont, North Dakota, and South Dakota had unemployment rates under 3.0%, while South Dakota’s 2.0% was the lowest in the nation.

Puerto Rico’s unemployment rate increased to 6.1%, reflecting a .7% increase in the island’s labor force (July saw a .8% rise), while the island’s job count was up 1,000.

10-year Treasury yields averaged 4.2% in the 12 months ending February 2026. They now hover near 5%, a significant increase. Besides higher oil prices, several explanations are plausible. Real rates have risen associated with the sustained healthy economic growth and higher expected rates of return on investment, particularly reflecting the booming AI buildout that is involving more debt financing. Inflationary expectations have remained generally well-anchored, but market-based measures have risen a few tenths of a percent. And the persistence of budget deficits and projections of ever-rising government debt-to-GDP may be exerting pressure on yields.

This note focuses on oil prices and yields. As a temporary negative supply shock to the economy, the higher oil prices are supposed to hurt economic activity which may be associated with lower real rates and are not supposed to impact intermediate and longer-run inflationary expectations. But Chart 1 shows convincingly that short-run movements in WTI oil spot prices (measured in 21-day changes in dollar-per barrel) and 10-year Treasuries (21-day percentage point changes) have been very closely correlated since end of February 2026 when the bombing in Iran commenced. Chart 2 shows that the levels of the Treasury yields and oil prices.

WTI rose dramatically from $65/barrel end-of February to the high-$90s end-of-March, bounced around and rose to $108 in May and plummeted to $70 in early July during the temporary ceasefire and then ratcheted up during the summer to its current above $102. Treasury bond yields rose and fell and rose again with these fluctuations.