Macroeconomic & Geopolitical

Europe's Political Strength Will Buffer the Coming Downturn

November 2022 – 2 min read

The recession will be painful, but the “old continent” is proving surprisingly adept at facing new challenges

The bumper sticker summary of today’s global economy runs something like this: “America's slowing, China's stabilizing and Europe's heading for disaster.” But an equally succinct summary of the world’s political trends would highlight that America’s parties are gridlocked, China’s reforms are flagging and Europe has made some of the bravest decisions since the launch of its common currency.

If the “old continent” looks headed for a nasty recession looming ahead, it has also demonstrated a surprising political coherence and vision as it faces some of its most pressing challenges. This may be small consolation as inflationary shocks and rising interest rates trigger rising unemployment and popular discontent. But it may leave the European Union in much better shape to manage its recovery when the cycle turns.

Roughly a decade after a financial crisis nearly shattered its common currency, and barely six years since its second largest economy voted for Brexit, consider this record for 2022:

  • European governments have backed eight separate packages of sanctions against Russia, their fifth largest trading partner. From afar, it’s easy to suggest that Moscow’s invasion left Europe’s politicians little choice. But when Russian tanks were heading for Kyiv in February, there were few who would have predicted that the EU’s 27 governments would essentially end their dependence on most oil and gas coming from the East. Still fewer would have suggested European leaders would secure enough alternative supply to avoid rationing this winter.
  • Amid these wrenching shocks, Europe chose to raise its already ambitious commitments to reduce carbon emissions. Ending Russian energy imports has led a temporary rise in coal consumption, but the E.U. will be completing legislation this year that will more than meet its goals under the Paris Climate Accord to reduce emissions by 55% before 2030. At this week’s COP27 in Egypt, E.U. officials promised to come to next year’s climate gathering with even more sweeping goals.
  • Brussels has continued to press a vigorous free trade agenda even as the key commercial partners turn inward. With war on their borders, European leaders have taken their most important military ally to task for narrow protectionism. Specifically, they have lodged complaints over President Biden’s signature Inflation Reduction Act, which they argue will discriminate against imports of electric vehicles. Closer to home, the E.U. continues to insist the United Kingdom live up to its trade commitments around the flow of goods through Northern Ireland.

Both voters and investors seem impressed by this streak of political fortitude. The E.U.’s popularity has risen notably over the last few years, with some 72% of respondents in a recent Pew Research poll viewing it favorably. This includes 78% in Germany, 89% in Poland and even 68% in the United Kingdom. Meanwhile, bond spreads show few signs that markets fear a fresh bout of fragmentation for the euro area amid the current stress. Nor do bond yields suggest many doubts that the European Central Bank will bring inflation to heel.

None of this, of course, will soften the immediate economic shock from high energy prices and rising interest rates. The European Commission itself slashed the 2023 growth forecast to 0.3%, which will mark a sharp deceleration from a surprisingly strong 3.3% this year. Our central forecast is for a more serious recession near -1%, although the actual outcome may depend heavily on winter temperatures and whether current gas supplies will be sufficient to avoid further spikes in energy prices.

But Europe will also benefit from a more sophisticated consensus on fiscal and monetary policy than the rigid interpretations of rules that hamstrung growth and nearly shattered the common currency in the wake of the Greek debt crisis. More flexibility on budget deficits and more tools to stabilize financial markets represent significant progress.

The downturn ahead raises obvious risks for Europe’s political coherence in the face of the crisis. Far right populist parties have posted notable gains in recent elections, even if some have softened their criticism of the European project. Support for anti-European parties has flagged in Germany, but the end of cheap Russian energy presents a massive disruption to the country’s economic model, with uncertain political consequences.

Through it all, Europe’s unwieldy and lumbering institutions remain an easy target for critics who find them remote, bureaucratic and, indeed, silly when official documents must be translated into 24 official languages (including Maltese!). But that is what makes its recent unity and coherence on difficult issues like sanctions, climate change and trade so notable. Fresh commitments to allow more flexible rules on fiscal targets also represent significant coming of age.

Further crises surely lie ahead on emotive questions around immigration, burden-sharing and security. But today’s European Union will emerge from the next cyclical downturn with stronger institutions and better growth prospects than the last time.

Christopher Smart, PhD, CFA

Chief Global Strategist & Head of the Barings Investment Institute

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