What ails Europe and why a cure is possible
Strip away comforting illusions, and the hard truth is that prosperity demands productivity, not politics.
In a nutshell
- Boosting productivity and output can offset energy-caused income losses
- Diversified energy, nuclear and chip production reduce import dependency
- Business-friendly reforms turn trade tensions into investment opportunities
- For comprehensive insights, tune into our AI-powered podcast here
The economic legacy of the past few years is mixed. The annual global gross domestic product (GDP) growth rate may hold steady at about 3 percent, yet the United States’ economy is slowing, the European Union is all but stagnating and the Chinese economy shows significant cracks. Additionally, inflation is not going away.
The public finance situation in several key economies has deteriorated, deregulation has remained a mirage and central bankers have kept playing with monetary policy to please heavily indebted households and governments while hoping to keep price inflation at tolerable levels. Moreover, globalization has amplified the consequences of geopolitical tensions. Abrupt, one-sided moves – the U.S. tariff war and the Hormuz crisis are the most recent examples – introduce new elements of uncertainty and threaten vital supply chains.
However, there is also some good news. First, despite significant global interconnections, large economic blocs have developed substantial, diversified internal trade flows and are well positioned to absorb external shocks with relative ease.
Second, the so-called shale revolution, the race for energy security, and global competition have generated impressive improvements in the exploitation of energy. This phenomenon is likely to continue and will soften the impact of energy crises.
Although public opinion often vilifies capitalism and private initiative, people’s ambitions to improve their well-being still offer plenty of opportunities.
Third, despite government interference, technological progress rolls on at formidable speed. Artificial intelligence is making headlines, and while its consequences are still hard to predict, its improvements will be seen in machinery, farming and industrial organization.
Although public opinion often vilifies capitalism and private initiative, people’s ambitions to improve their well-being still offer plenty of opportunities. The key question is to what extent these opportunities are being missed.
Fresh openings are round the corner, created by new scientific knowledge (which then translates into technological progress), higher productivity and more effective protection of property rights, which drive entrepreneurship toward useful, welfare-enhancing initiatives. However, poor domestic policymaking often thwarts entrepreneurial efforts by providing distorted incentives, and fails to protect private property and ensure freedom of contract. Distortions include redistribution through inflationary monetary policy and public expenditure, while failures include taxation and regulation.
European baseline perspectives
Self-inflicted damage, especially in the EU, is evident. There are no signs of impending deregulation or significantly lower taxation. Average educational standards are dropping further − especially in areas that have recently seen an influx of low-skilled immigrants. On balance, the continent’s economic growth will stay close to zero.
Moreover, government spending is a deadweight burden that cannot be ignored. On average, EU government spending is near 50 percent of GDP; most of it finances the bloated welfare state and discourages work. The ratio is much higher when one considers only what is produced by the private sector. No significant efforts to curb public expenditure are in sight and although taxation is high, it is insufficient to balance the budget. Thus, debt-to-GDP ratios across the bloc are rising, which means increased economic fragility, greater risks for creditors and higher interest rates.
The picture will not change much in the next few years. Governments’ major concerns will be persuading or forcing investors to refinance existing debt and finance new debt. If they fail, the authorities will necessarily tap the ultimate creditor – the European Central Bank. It has happened in the past and will happen again in the future. This will be followed by price inflation. All the rest is window dressing, and external shocks will be exploited to hide or justify domestic failures.
Regarding interaction with the rest of the world, Europe will face three kinds of shocks. One concerns Covid-style emergencies, but more relevant are those to trade flows (sanctions and protectionism) and supply chains and access to selected raw materials.
Protectionism on the continent
Europe lacks leaders of quality and is therefore unable to take the initiative or respond swiftly and effectively to external events. For example, although it is far too early to assess the results of the recent Mercosur-EU free trade deal, it took some 25 years of negotiations to achieve and it is still contested within Europe.
In general, the continent has maintained a low-profile, protectionist approach consisting of a mix of tariff and non-tariff barriers. Europe’s strategic weakness ensures that it will not pursue an aggressive trade policy and that it remains exposed to new waves of protectionism originating from the rest of the world (the U.S., China and possibly India). Under such circumstances, Brussels will likely stay put: Politicians will rely on bureaucrats, while large companies will react by asking for subsidies, possibly seeking to find new buyers in Asia and Latin America, expanding their production facilities in protected markets and adjusting their supply chains accordingly.
Of course, adjustment involves substantial costs. The size of such costs depends on the extent to which European producers currently rely on key markets, on their flexibility and how EU trade attitudes are perceived in non-critical parts of the world. One fears that taxpayers will ultimately pay for the dream of low-cost, painless adjustment.
Global supply shocks
Geopolitical tensions provoke supply shocks. Energy and microchips are currently the areas most likely to produce such shocks. Solving energy crises requires reliance on nuclear power, diversified suppliers and credible naval protection of key shipping lanes. Nuclear energy now accounts for less than 13 percent of the EU’s energy consumption, with significant regional variations. For example, it is high in France (37 percent) and zero in Germany. Although most countries are now reconsidering their views on nuclear power, it will take decades to remedy past mistakes.
For the time being, therefore, the EU must live with a 57 percent energy dependency ratio on suppliers outside the bloc and with the reluctance to use military power to ensure safe transportation. Combined, this leaves the EU vulnerable.
Microchips suffer from the same problem: Despite the presence of a key Dutch producer (ASML), the EU currently imports about 90 percent of its requirements from abroad (mainly from China). The good news is that European semiconductor production capacity can be developed faster than nuclear power. But it will take years, not months, and requires a friendly business environment.
A coming period of transition
Trade disruptions would certainly harm the European bloc, but not catastrophically, especially if companies are allowed to reshape their supply chains without excessive bureaucratic interference.
Read more by economist Enrico Colombatto
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In fact, global tensions could even bring investment and innovation to the bloc, which is one of the planet’s largest markets for affluent buyers. By contrast, energy and high-tech materials look set to remain problematic, at least for a few years, and any resulting damage will be aggravated by populist policymaking.
Scenarios
Most likely: Market adaptation with policy-driven costs
A supply shock generally provokes changes in the structure of prices. When an adverse energy shock strikes, net importers of energy are necessarily worse off. One cannot change the reality that energy has become scarcer, but one can respond by being more productive. In other words, it will become inevitable that importing nations increase the volume of what they produce and sell if they want to recover at least part of their purchasing power.
Somewhat likely: Consumption rationing
Rather than making the effort to shape legislation and find consensus to make life easier for producers and innovators, policymakers may take the path of least resistance and move in another direction: rationing consumption. In the case of energy, rationing petrol is a common practice, although passenger cars account for less than 20 percent of total final energy consumption. Nor does limiting consumption change the overall picture since energy still remains scarce, but governments hope to garner praise for taking action and for ensuring that scarcity makes everybody equally worse off (the social fairness mantra), while ensuring there are no incentives to overcome the crisis.
Less likely: Debt-financed subsidies and financial fragility
Another scenario involves handing out debt-financed subsidies to alleviate the consequences of shortages. This is populism once again. Money printing, redistribution and debt financing do not eliminate scarcity, nor do they enhance productivity or work efforts. Yet, despite initial societal numbing, such steps would push some countries to the brink of financial disaster, not to mention the consequences of monetary inflation.
Both rationing and public spending would ensure that shocks are used as an excuse to further sclerotize productive structures. Thus, geopolitical tensions will become the perfect culprit for public-finance meltdowns, lower productivity and inflation.
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