State of the European Union, Part 3: The Economy

14 February 2024

3. Economy

For most of its history, economic issues have dominated the politics of the European Union at both the national level and the European level. Unfortunately, those two debates–national and European–often seemed to take place in different universes. In Brussels and Frankfurt, among technocrats, the discussion often sounded like a bloodless seminar in economics, while political leaders enthused about the anticipated benefits of the positive-sum outcome that would result from freer trade, more open borders, and rule-based cooperation. More raucous and contentious exchanges about the distributional consequences of the single market and common currency were relegated to the hustings in member-state elections, where the words “neoliberal” and “globalist” were wielded as weapons against the alleged self-dealing of supposedly contemptuous and out-of-touch elites.

Now that more emotionally fraught issues such as war, immigration, and the environment have risen to prominence, however, economic debate has, in relative terms at least, receded from view. In the absence of any current economic crisis (other than inflation and farmer protests), this may seem unremarkable, but deep concerns remain just beneath the surface.

For one thing, the European economy is facing major challenges. It has fallen behind in key technologies, including electrical vehicle and battery manufacturing, artificial intelligence, and semiconductors. It is vulnerable to the slowdown of Chinese imports. Following the substantial rise in interest rates of the past few years, highly indebted states must contend with the increased cost of servicing their debt. The retirement of the Baby Boom generation has dramatically increased dependency ratios as well as demand for workers to service the elderly. Inflation has constrained the purchasing power of many lower-income workers.

Second, Germany, which has long been the engine of the European economy, has been ailing of late. Its automobile and machine tool industries, which found a steady customer in China, have suffered from the recent sluggishness of the Chinese economy. U.S. restrictions on the export of certain technologies to China have adversely affected European firms. The E.U.’s laudable efforts to encourage reduced CO2 production have led it to subsidize the consumption of electric vehicles, while the Chinese government is simultaneously subsidizing their production, with the unsurprising consequence that Europe is now a net importer of electric vehicles produced in China. Finally, the German constitutional court ruled that money allocated to certain off-budget special funds for purposes such as Covid relief cannot be repurposed without falling under the restrictions imposed by the Schuldenbremse, or debt brake, written into the German constitution to limit deficit spending. This ruling will require the German government to cut expenditures by at least €30 billion, or 0.75 percent of GDP.

A negative shock of that magnitude to the German economy should nevertheless be manageable, but its knock-on effects may well be compounded by external factors. The German contraction will be felt first and foremost by Germany’s European trading partners, especially France and Italy. In addition, the German court decision has emboldened deficit hawks in Germany, most notably finance minister Christian Lindner. Lindner’s Free Democratic Party is the weakest member of the Ampel coalition, and recent polls show its support dwindling to below the 5 percent level needed to qualify as a full-fledged parliamentary group in the Bundestag. With the party’s very existence at stake, Lindner has grown increasingly zealous about stamping out deficit spending. Among other things, he is pressing the European Commission to heighten its vigilance over states with persistent budget deficits, such as France and Italy, which may face sanctions under the E.U.’s excess deficit procedure. In December, S&P renewed its AA- rating on French government debt but maintained its negative outlook. And no relief from high interest rates is in sight from the European Central Bank, which has thus far been less successful than the U.S. Federal Reserve in managing the inflation that followed the waning of the Covid threat. Taken together, these factors may deliver a substantial negative shock to the broader EU economy.

Meanwhile, firms that extensively offshored production prior to 2020 have had to rethink their globalization strategy in the wake of the Covid shock. The vulnerability of extended supply chains to totally unforeseen circumstances was demonstrated in myriad ways during the pandemic. More recently, the Houthi attacks on shipping and the consequent rise in freight rates has had a similar effect. How to “insure” against such risks without entirely forgoing the benefits of comparative advantage? The answer to this question is far from clear and will no doubt vary from industry to industry.

In recent weeks farmer protests have erupted across Europe, most notably in Italy, France, Belgium and Germany, where tractors have been employed to block roads and dramatize the plight of their drivers, mostly smaller farmer who find themselves squeezed by a variety of market and regulatory forces: a glut of grain flowing out of Ukraine, whose normal export markets have been affected by the war; monopsony power of large hypermarket chains and food processors; EU regulations on the use of pesticides; rising fuel prices; etc. These protests have drawn substantial public support, even though it is unclear what governments can do about them, since those who support the farmers also want lower food prices and environmental protections.

For now, however, the industrial sector remains quiet, and but for the recent strike of German locomotive engineers, even the often obstreperous transport sector has been relatively calm. The most disruptive social conflicts have involved a turn to more aggressive tactics in some quarters of the environmental movement, as well as militant protests against Israeli tactics in Gaza. These issues have different partisan valences in different member states.

As for inflation, the onus has fallen largely on the European Central Bank, which has dutifully kept interest rates high. Despite this, the price level has been slower to stabilize than in the US, notwithstanding the Biden administration’s willingness to stimulate the economy with the so-called Inflation Reduction Act. Europe has nevertheless weathered the shock to energy prices occasioned by the war in Ukraine better than most observers anticipated.

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