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Macroeconomic & Geopolitical

Europe's Most Endangered Species

17 September 2021 - 3 min read

As fiscal "hawks" fade from the scene, the continent's economic policy is transforming in ways that will boost growth long after the pandemic ends.

The Arctic fox, the Mediterranean monk seal, and the North Atlantic right whale are among Europe’s most endangered species. But if the economic debate continues even roughly in the current direction, they may soon be joined by something called the “Northern fiscal hawk.” Even investors concerned with protecting biodiversity should cheer these developments as opening a new phase of European growth. They should also keep a close eye on Germany’s September 26 elections to gauge how quickly real change might come.

Drawing lessons from the last financial crisis, Europe’s central strategy has been to put lots of money in people’s pockets, flood financial markets with liquidity, and keep doing both until the recovery is fully entrenched. In 2011, the European Central Bank raised rates prematurely and is now desperate to avoid repeating the same mistake. Governments have suspended fiscal limits through next year, eager to sidestep the toxic debate over “growth” and “austerity” that very nearly scuppered the whole European project.

But what will come next year if COVID variants look contained and the recovery shows durable momentum? What principles should guide the decisions? Spending and borrowing decisions are central in any country’s economic debate and, lest we need any reminder, the European Union encompasses 27 separate countries (even without the United Kingdom). Of these, 19 have agreed to share a currency, requiring much closer trust and integration. 

Currently, all EU countries operate within the parameters of the Stability and Growth Pact (SGP), which under normal circumstances limits deficits to less than 3% of GDP and government debt at 60%. Naturally, every club needs rules, but European politicians and economists are discovering that the SGP is based on bad economics—or at least outdated concepts

Over the last four decades, global growth, inflation, and interest rates have drifted ever lower. Globalization has undercut wage growth as millions of new workers joined the world’s labor pool. Technology has transformed business and data processes to drive costs down. And demographic trends have richer countries aging and slowing. Europe’s share of the global population will likely fall to 4% by the end of the century, from 7% today, while the proportion of Europeans over age 80 will double to 11% of the continent’s population by 2050. 

These stiff structural headwinds will likely keep rates low for decades and make it possible for governments to borrow much more than seemed reasonable when Europeans were setting ground rules for integration 30 years ago. They also make it even more important for governments to spend more to underpin aggregate demand and for monetary policy to let the recovery run hot. The ECB calls it a “symmetric 2% inflation target.”   

This makes the current fiscal rules a problem. The pandemic response has driven European debt levels as a whole well above 100%. Greece, Italy, Portugal, France, and Spain are all above 115%, while even Germany clocked in at 71%. Any effort to get back to 60% will undercut growth and drain resources Europeans have committed for climate mitigation and digital modernization.
 

Public Debt (%GDP)

Source: International Monetary Fund, World Economic Report. As of September 17, 2021.
 

Deficit/GDP (%)

Source: International Monetary Fund, World Economic Report. As of September 17, 2021.


Europe’s own fiscal watchdog has called the debt limits into question, while EU finance ministers last week proposed a fresh debate on greater fiscal flexibility. This quickly drew a rebuke from eight countries, including the Netherlands, Austria, Finland, and Denmark, which argued against loosening the current framework. What was surprising, however, was that even these “northern hawks” acknowledged that the debate was open and that some reform was inevitable.  

Even more surprising is that the most prominent hawk of all, Germany, did not sign the letter. Polls going into the German election suggest many possible outcomes in a likely coalition government, but rapid budget consolidation looks unlikely. The Social Democrats, who are currently leading in the polls, and Angela Merkel’s own Christian Democrats both argue for preserving the country’s constitutionally mandated “debt brake,” but they also both speak of more public investment that would not include current spending. While the pro-business Free Democrats favor rapidly paying down the debt, the far more popular Green Party wants to reform the debt law.

Investors who bought any of last week’s EU seven-year bond issue will be paying close attention to any reforms that might affect how they are paid back. But the large order book suggests that markets are comfortable with a policy direction that supports more investment and growth.

As with any endangered species under duress, the hawks could still rally and derail the debate on more flexible rules. But, barring a surprise that triggers lasting gridlock in German coalition negotiations, the continent seems to be learning how to set economic policy for the conditions at hand.

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