The Eurozone: Under Pressure (Again)

Darkening skies

Back in April, the IMF thought that the eurozone would grow by 2.8 percent this year and by 2.3 percent next – down from its previous estimates. Then the European Commission stated that the EU economy was “particularly vulnerable” to surging energy prices − even before Russia effectively reduced the flow of gas in the Nord Stream 1 pipeline by 80 percent this week.

Inflation in the eurozone as a whole is expected to come in at 7.6 percent this year, before falling to a forecast four percent next year – but these estimates were announced before the latest developments in Russia’s energy war with the west. The IMF’s forecasts now look optimistic. The eurozone Purchasing Managers’ Index (PMI) fell to 49.4 this month, down from 52 in June. Any PMI score of less than 50 suggests that private-sector activity is shrinking. The manufacturing-only PMI fell to 46.1. The European Central Bank (ECB) raised rates by 50 basis points last week, casting further gloom.

On Tuesday (26 July), 26 EU states voluntarily agreed to reduce their gas consumption by 15 percent by next March. European Commission president Ursula von der Leyen announced the agreement in front of a giant banner which read – in English – “Save gas for a safe winter”. Hungary, which enjoys cosy relations with Russia, demurred. So, the prospect of widescale energy rationing across Europe this winter looks probable.

As recently as 30 May, Europe was receiving about 227 million cubic metres of gas per day from Russia, according to the Oxford Institute for Energy Studies. By 18 July, that had fallen to 82 million. Now, supplies are running at possibly as low as 60 million.

Russia and Iran – a country with which Russia seems to have formed a de facto alliance – together account for about one third of total natural-gas production. Vladimir Putin was in Tehran just last week, glad-handing the ayatollahs. Both countries are subject to swingeing western sanctions and determined to undermine the ascendancy of the democratic west in the current world order. Other countries which support Russia in its war against Ukraine include North Korea, Belarus, Eritrea and Syria. This alliance gives Putin further confidence that he can bring Europe to heel by cutting off its gas. Further, he could facilitate Iran’s long-held ambition of becoming a nuclear power.

Even if many Europeans – especially the Germans – would prefer to stay neutral in Russia’s war on Ukraine, Putin aims to hurt not just the west in general but the EU in particular. In a keynote address at the International Economic Forum, held in St. Petersburg in late June, Putin said that the sanctions regime against Russia was a “double edged sword” that would lead to a systemic decline in the European economy for years to come. Put simply, one of Russia’s war aims was and is to stoke inflation in Europe. In his own words:

“This will aggravate the deep-seated problems of European societies. There will be further growth of inequality which will split their societies still more. Such a disconnect from reality will inevitably lead to a surge in populism and extremist and radical movements”.

Russia’s economic war on Europe has been underway since last autumn when Moscow started to manipulate gas flows westwards. The most recent inflection point was when the EU decided to stop all flows of Russian seaborne crude oil by the end of the year. Goldman Sachs estimates that the EU economy would contract by 2.7 percent next year if the Russians were to cut off the gas taps altogether, but by even more in Italy and Germany.

Despite the sanctions regime, Russia is awash with fossil-fuel revenues, given the spike in the price of oil and gas. The Russians are selling less but charging more. As a result, the rouble, which sank in the first month of the war, is resurgent. True, Russia has technically defaulted on its outstanding debt-service payments – but not through insolvency. Rather, it has been unable to meet interest payments because much of its banking system is frozen.

Russia’s war in Ukraine could prove to be protracted and could get even more bitter. Neither side is offering the prospect of any kind of settlement. If Volodymyr Zelensky were to concede territory to Russia, everyone knows that that would just be a hiatus in the conflict. Russia’s stated aim is to wipe Ukraine off the map – and the Ukrainians will fight to the last.

The war could yet escalate into something existentially dangerous. The incipient Ukrainian counteroffensive to take back Kherson could force Putin’s hand. What Putin wants is to ratchet up the pain threshold in the hope and expectation that European solidarity will falter, and that some states will relax the sanctions regime against Russia. He calculates that the first EU state to crumble will be the richest one − Germany.

Germany: confusion and decline

The Germans have a reputation for no-nonsense efficiency. They combine brilliant engineering skills with outstanding design. They have an extraordinary culture rooted in a fascinatingly rich language. Germany was Europe’s economic model – once. But no longer.

Something extraordinarily significant happened last weekend. The gung-ho, reforming boss of giant car-maker Volkswagen, Herbert Diess, was removed. He was the man who was going to drag the vaunted German automotive industry into the fourth decade of the 21^st century, championing electrification, AI-aided design and – oh yes – redundancies. Diess came a cropper when the Porsche and Piëch families, plus the state of Lower Saxony, who are still significant shareholders, lost confidence in his reforming zeal. He had become a radical in an economic ecosystem that favours traditionalism and gradualism – even though those tendencies have dug Germany into an ever-deeper hole.

Diess identified Tesla, as well as rising powers such as China’s BYD, as VW’s key competitors rather than Renault, Ford and Toyota. Reportedly, Elon Musk once offered him a top job. True, the markets were not impressed by his efforts: VW’s share price has fallen by around 28 percent year-to-date – but that may reflect investor scepticism around the automotive sector in general.

Germany is the last country to conclude business deals by fax. Most big German companies are run by conservative, risk-averse senior management. The German digital-technology sector is small compared with that of France, where Emmanuel Macron has incentivised start-ups, or the UK. The Germans favour safe pairs of hands over nimble ones. But German manufacturing success has been founded on abundant cheap energy. With energy prices soaring and exports flagging, the country recorded its first trade deficit for 30 years last month.

The German political elite does not want Ukraine to become an EU member, let alone a member of NATO, and thus anchored in the west. If Ukraine were ever to join the EU, it would be its fifth-largest member by population − and one of the poorest. Ukraine would account for about nine percent of the EU’s combined population. That would put a huge strain on EU finances. Countries such as Portugal and the Czech Republic would have to become net contributors to EU coffers. Ukraine plus neighbouring Poland, whose languages are cognate, would have a larger population than Germany (even though five million Ukrainians have fled and possibly 60,000 are now dead). In tandem, they could outvote France-Germany.

The Germans are also keen to avoid provoking Russian ire: apart from a few howitzers, Berlin has only provided Kyiv with helmets. Germany is still blocking the release of EU financial aid to Ukraine because it objects to the principle of “joint debt issuance”. Although Ukraine was officially invited to become a candidate member of the bloc last month, the Germans have signalled that Ukraine’s accession would require treaty changes, with national vetoes abolished.

Meanwhile, chancellor Olaf Scholz’s much-trumpeted hike in defence spending, by terms of which Germany’s military capacity might have overtaken France’s, has run into the sand. Germany’s armed forces are to be cut back even further next year.

Germany has significant gas reserves which are stored in huge underground freezers. But unless usage is cut drastically in the immediate future, even these are expected to be depleted by January. The average household fuel bill in Germany is already set to rise by €2,000 per annum and there are plans afoot to provide emergency accommodation in town halls for those who are unable to heat their homes. Some landlords are already turning down the thermostat in blocks of flats, and some local authorities are turning off streetlights. Disused coal-powered power stations are to be recommissioned. So much for Germany’s green credentials – its target of getting to net-zero carbon by 2045 now looks risible.

Even Germany’s normally docile press has begun to question how the country’s political elite could have brought to country to such a state of energy insecurity. The once-sainted Angela Merkel is now seen as the principal culprit. She presided over the closure of nuclear-power plants and built the Nord Stream pipelines which made Germany beholden to Russia. Germany’s red-amber-green “traffic light” coalition, put together so painfully last December, may yet implode. It has failed to articulate a vision of where it wants the country to go and seems only to react to external events.

Italy: in search of a government

Further to Mario Draghi’s resignation as prime minister on 21 July after 17 months in the job, he remains as caretaker leader (just like Boris Johnson in the UK) until a general election − which could come as soon as September. Draghi resigned almost 10 years to the day after, as ECB chairman, he pledged to do “whatever it takes” to save the euro. Like Johnson, he is a lame-duck prime minister who can do nothing to avert the impending crisis. The populist Brothers of Italy party is poised to gain support come the election.

When Draghi was installed as Italian prime minister in February last year he was seen as the brilliant technocrat who would finally put the economy on an even keel. The beneficent EU provided Italy with €220bn from its €800bn Covid Recovery Fund – more than to any other EU member. But all his plans for spending initiatives and structural reform were blown out of the water by the explosion in oil and gas prices. Italy is almost as dependent on Russian gas as Germany. Inflation is rampant, growth has taken a nosedive and Italian government-bond yields are soaring again relative to their German equivalents.

Rising interest rates in the eurozone, as determined by the ECB, will entail that the cost of servicing Italy’s debt burden will rise. Italy today has a higher debt-to-GDP ratio than it had during the European sovereign-debt crisis of 2011-12: 150 percent now as compared to 125 percent then.

There is some possibility that Italy might be able to bolster gas supplies by buying from Algeria, but that may take time.

France: the return of state planning

Macron’s reaction to the European energy crisis was to try to impose price controls and to renationalise France’s monolithic power company, EDF. Before the presidential election in April, Macron capped the price of electricity and gas, thus forcing the big energy companies − EDF and Gaz de France – to supply power at a loss. Then he announced that the French state would buy back the 16 percent of EDF in private hands at a cost of up to €10bn – whereupon the company’s shares surged.

Macron came to power in 2017 as a reformer who was going to restore fiscal discipline in a country which has been in breach of the EU’s Stability and Growth Pact for 11 years. His proposal to raise the retirement age at which French citizens receive a state pension from 62 to 65 is still far from realisation – and will probably have to be abandoned now that he does not command a majority in the Assemblée Nationale. Notoriously, France is the nation that taxes and spends the most, yet works the least. Government spending amounted to 57 percent of GDP last year.

Macron has made it slightly easier to hire and fire staff in France than before; but the French labour market is still much more rigid than the UK’s or the Nordic states’ labour markets. He has decentralised wage bargaining in a country with a highly unionised workforce. He has abolished wealth taxes, so beloved of French socialists. But the plan to cut the public payroll by 100,000 has been shelved.

Perhaps surprisingly, France had a lower debt-to-GDP ratio than Germany until the financial crisis of 2008. In 2007 it was 64 percent ( Germany’s was 65). This year France’s debt-to-GDP ratio will reach 113 percent while Germany’s will hit 71 percent, according to IMF data. France’s fiscal deficit (tax revenues minus total state spending) will still be above three percent of GDP in 2024 even as Germany’s will be zero. This makes France all the more vulnerable to rising interest rates in the eurozone.

Yesterday, the yield on 10-year German bunds was 0.96 percent while the yield on the French instrument of equivalent maturity was 1.538 percent – a spread of nearly 58 basis points. That is about double what it was at the beginning of the year. That is partly because the ECB flagged an end to government-bond purchases earlier this year. A eurozone with rising interest rates and no more quantitative easing will probably exacerbate that trend.

The French power grid is already under strain because several nuclear reactors are out of service pending essential maintenance work. As a result, contrary to what we would expect, the France-England interconnector has been conducting electricity from the UK to France of late. On Thursday afternoon about six percent of total UK electricity production was being sent to France, according to the National Grid Status Monitor. So much for Macron’s threats to cut the cable during the Brexit negotiations.

Habits are hard to break. In France, the prevailing ideology of étatisme – the notion that the state knows best – is deep-seated. We can expect more of the same.

Europe: the future in question

Living in the EU is largely an extremely congenial experience. In most member states people enjoy a high standard of living, eat well and generally live well. But the bloc is now beset by major challenges. Mass migration is now compounded by endemic inflation and low growth. The Franco-German mercantilist export model is defunct in an age of more expensive energy.

Most seriously, the fundamental imbalances that beset the currency union are now back in play. As I have outlined here before, the currency union entailed a monetary union without a corresponding fiscal union. The French have long since aspired to a European ministry of finance which would at least coordinate the tax regimes of all eurozone member states, if not set some Europe-wide taxes directly. But the Germans have resisted this – and still do – because they know that Germany will end up as the ultimate ‘Bank of Mum and Dad’ for the entire continent. The eurozone has still not had its ‘Hamilton’ moment where member states cede fiscal responsibility to a federal authority. As I have written here before, a currency union between unequal economies was always going to benefit the rich countries and immiserate the poorer, deficit-ridden ones.

There is a parallel in security policy. Macron – the man who said that NATO is “brain dead” two years ago – wants Europe to have a “defence identity”. But since Sweden and Finland joined NATO, Ireland and Austria remain the only “neutral” EU states. French plans for a European army now look unrealistic.

What the markets make of it

European equity markets are now facing their worst year since the financial crisis. Goldman Sachs expects the pan-European Stoxx-600 Index to end the year 20 percent below where it started. It is already down about 12 percent.

Personally, I think that is optimistic. Inflation is still accelerating, and interest rates are only just beginning to enter positive territory. Italy and others are politically unstable. My best guess is that Putin, having teased Scholz to distraction, will turn off the gas entirely just as winter sets in. There will be recrimination. The US is now in recession. Europe is likely to follow soon. But at least the US enjoys a high degree of energy security.

This coming winter will be painful in the UK too. Both Europe and the UK have made huge strategic errors in their energy policies which are now apparent, compounded by the delusion of net-zero carbon. The political elites on both sides of the Channel are unequal to the challenges they face.

The historian, Robert Tombs, likens the EU to the late Austro-Hungarian empire – “divided, weak, and unreformable”. I suspect that Putin would agree.

Listed companies cited in this article which merit analysis:

• Volkswagen AG (ETR:VOW)
• EDF (EPA:EDF)