Why Europe can’t cope
Credit: Milos Bicanski / Getty   

The European Union is ill-equipped to deal with big political questions. Its default modus operandi pushes back against serious problems by rigidly asserting its own internal doctrines and hierarchies, and by expressing its commitment to a rules-based international order. This approach is peculiarly unsuited to the troubles at hand.

Right now, the EU confronts an awkward trilemma. It must decide whether to risk the economic shock of Brexit without a transition, and it must do so while the spectre of recession hangs over the Eurozone’s three largest economies, and as the French and German governments seek to maintain a united front with Britain to combat US sanctions on Iran.

In all probability, the EU cannot preserve every detail of its Brexit stance, minimise the risk of a Eurozone recession, and maintain the British Government’s commitment to side with the EU over the United States on Iran. Meanwhile, the EU has no guarantee that concessions made to the British Government over the Irish backstop will be sufficient to allow the Withdrawal Agreement and the Political Declaration to pass through the British Parliament and eliminate the economic risk of a no-deal Brexit.

The economic side of this trilemma arises in part from the Eurozone’s structural dysfunctionalities. The Eurozone crisis never went away, it only abated in immediate ferocity. Now Italy’s woes have visibly resurfaced. In the fourth quarter of last year, the Italian economy returned to recession for the third time in a decade (it only avoided a fourth recession in late 2013 going into 2014 because the economy grew by 0.1 per cent in the first quarter of 2014).

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After the European Commission rejected the first budget submitted by the Lega–5 Star coalition government last October, Italian bond yields reached their highest level since 2014. Bond rates fell again after Italy agreed a compromise budget with the Commission in December. But when non-Italian European banks have more than €400B worth of exposure to Italian debt, more than half of which is French, other Eurozone states need Italy to retain investors’ confidence as much as Italy does.

The need to rollover Italy’s gargantuan debt will require its government to sell around €400 billion of debt this year without the support of the European Central Bank, which has wound down its Quantitative Easing programme. Italy has got off to a good start with large demand for a new 30-year bond issue this month. But sentiment in the bond markets moves rapidly, sometimes for no obvious reason. As credit analyst Matt King at Citi commented last October: “The market is schizophrenic about ‘Italy matters, Italy doesn’t matter. Italy matters, Italy doesn’t matter’.”

Under these frenzied market conditions, it would not take much to push Italy to the point where rising borrowing costs cause the Italian government to demand the resumption of ECB asset purchases, a position that is unlikely to be greeted with any enthusiasm in Berlin or a number of other European capitals. There is already a reasonable likelihood that the Eurozone will begin the next recession, when it comes, with zero interest rates. If the Eurozone enters that recession with the ECB also deploying Quantitative Easing, it will be in near mind-bogglingly unprecedented territory.

The economic risks originating in Italy are magnified by the recessionary pressure emanating from Germany. Since the autumn, the German economy has struggled. Having chalked up falling output in the third quarter of last year, Germany has seen a set of poor economic data at the beginning of this year, including falling industrial production for what is now four months in a row.

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Significantly, this weakness does not spring from within the Eurozone itself. Factory orders from other Eurozone economies rose in December 2018 by 3.2%, but foreign orders plunged by 5.5%. Germany’s economy has become acutely dependent on China both in terms of exports and supply chains in several German industries, and China’s economy is slowing down under the weight of the US-China trade war as well as China’s monetary and credit tightening in the first half of last year.

To make matters worse, China’s ongoing economic rise is acting as significant disruptive force on the German economy. Chinese companies are increasingly in direct competition with German industrial producers, including the automotive sector, as they move higher up the economic value chain as part of Xi Jinping’s Made in China 2025 strategy. German car companies are also caught by the tit-for-tat tariffs between the US and China, since BMW, Volkswagen and Mercedes Benz in part export to China from their American factories.

This ‘China shock’ to the German manufacturing economy will not be shared with other Eurozone economies, since Germany exports much more to China than other European countries, and other economies compete much less in the top-end manufacturing markets China hopes to capture. Consequently, while Italy’s burdens could be lightened by the ECB’s monetary stance, Germany’s predicaments cannot be. This creates little incentive for the German government to acquiesce to more QE, and leaves Germany with a problem to address for which the US-China relationship is more consequential than what happens to its Eurozone partners.

These economic blows are also political shocks to the EU. Each episode of the Eurozone crisis has exposed the gulf between the idea that the European Union is a rules-based order and the realities of its hierarchies. Some states do get to break the rules. The Italian government might have backed down in December about the size of its budget deficit but so too did the Commission, which is now accepting a deficit which rises next year instead of falling, and is far above Italy’s previous commitments. The Dutch Prime Minister, Mark Rutte, complained in an interview at this year’s Davos that the Commission’s indulgence of Italy’s rule-breaking causes citizens in other member-states to mistrust the EU’s authority.

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For its part, the Italian government did not hide its anger when the Commission accepted that the French budget deficit for 2019 would rise over the 3% limit because of the concessions made by President Macron to try to end the gilet jaunes protests. France will have managed to keep within the 3% rule now only twice in ten years, but it is Italy’s willingness to stick to the fiscal rules on which the New Hanseatic League of north European and Baltic states will concentrate in their demands for fiscal discipline.

In part, this distinction between member-states’ rule breaking reflects the fact that Italy’s debt burden is significantly higher than France’s and investors are much warier of the risks. But it also arises because the European Union works through an internal hierarchy in which – as Jean-Claude Junker blurted out in 2016 when explaining why France was being given yet more leeway over its budget deficit – France is France.

Nonetheless, whatever French fiscal privileges persist, the Eurozone crisis is disrupting that hierarchy. The New Hanseatic League states acted vigorously in opposing Macron’s plans for a substantial Eurozone budget and a Eurozone finance minister. Bruno Le Maire, the French Finance Minister, became so angry after dinner with his Dutch opposite number, that he accused the New Hanseatic League of acting as a ‘closed club’ to divide the EU.

The Eurosceptic government in Rome is itself a product of the Eurozone crisis and, in particular, the fallout in Italy from Berlusconi’s exit from power at the behest of the ECB, Angela Merkel and Nicolas Sarkozy. Now Matteo Salvini, the most powerful man in the Lega-5-Star coalition, is openly contemptuous towards Macron and appears to revel in the French President’s difficulties with the gilet jaunes.

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Salvini last month travelled to Warsaw and promised to ‘counter the Franco-German axis with the Italo-Polish axis’.  The Italian government has also shown, in its vetoing EU recognition of Juan Guaido as Venezuelan President, that even acting alone it has disruptive power.

Rather like the Roman Catholic church, the European Union has long worked by fiercely defending the authority of the centre of the Union. Any number of hypocrisies and outright sins are tolerated there while agitation in the periphery is quickly rendered heresy. This structural hierarchy is what always doomed David Cameron’s attempt to renegotiate the terms of Britain’s EU membership, and it is why in the event of a ‘no-deal’ Brexit, Ireland is likely to have to accept the EU’s rules on a border with Northern Ireland.

Nonetheless, the Franco-German relationship that has underpinned this hierarchy is insecure. For Macron, getting the French budget deficit below 3% was the primary means to repair the damage to the Franco-German relationship done during François Hollande’s Presidency and to force concessions from Germany on the Eurozone. When he did, the German government still rejected his reform plans. Now, in his concessions to the gilet jaunes, Macron has palpably sacrificed what remained of his European ambitions to his domestic problems.

Germany’s interests are, in part, now well served by the willingness of other north European states to resist France on Eurozone matters. By contrast, Germany’s China problems belong to it and it alone, and the China-driven difficulties for the auto sector, in particular, ensure that the German government simply cannot be cavalier about the prospect of a no-deal Brexit. Of course, Merkel may choose to privilege maintaining the EU’s authority over the economic and geopolitical costs of a no-transition Brexit, but the economic and geopolitical differences between France and Germany are now politically inescapable.

This divergence is not in itself new territory for the EU. Indeed, if Germany had not experienced the singular economic and political shock of reunification in 1990, the Eurozone would quite probably have been a rather different kind of beast. A less-fiscally constrained Germany would have been in a position to insist on strict compliance to the Maastricht convergence criteria in deciding who could participate in the Euro. But EU rules are irrelevant to the unique economic difficulties for Germany that arise from China’s ongoing disruption of the international order. In the face of such a problem, the European Union’s inability to directly confront political questions will be more exposed than ever.