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27 March 2024

Europe's next financial crisis

Today's Eurointelligence briefing is outside the paywall. Our main stories this morning are the next European financial crisis, and the now likely collapse of the European Commission flagship Green legislation - a sign of what is to come. We also have stories on the politics behind the two state solution; on why the oil price cap did not work; and below on how to avoid the complacency-panic cycle when thinking about geopolitical disruption.

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Today's free story

Europe's next financial crisis

In our last briefing before the Easter break, we would like to alert our readers to a theme that has been preoccupying us for a while - the possibility of another financial crisis in Europe. We have generally been restrained in our warning of financial crises. The main exception was the global financial crisis and its cousin, the euro area's sovereign debt crisis. Fifteen or so years later, we see another financial crisis ahead here in Europe: a crisis of the European social and political model with deep consequences for fiscal and financial stability.

The canary in the coal0mine is the overshooting budget deficits in France and Italy, at over 7% and over 5% for 2024 respectively. These numbers are a symptom, not a cause. Behind them lies a lack of economic growth needed to sustain Europe's social model. Germany's fiscal policy could not be more different than that of France or Italy, and yet Germany is afflicted by the exact same problem. The collapse of Nicolae Ceaucescu's repressive but debt-free regime in Romania should serve as a lesson that it is not the volume of debt that determines sustainability. It is, in the broadest sense, about a state's ability to provide welfare and contentment whilst remaining solvent. Politics is the art of keeping those three balls in the air permanently. 

The European model was powered by oligopolistic industrial companies, which were heavily supported by the state through regulation that tilted the level-playing field in their favour. The German car industry is a classic example, but everybody did this. The services sector existed mostly to service industry: state-owned banks that give preferential loans to industrial companies; repair shops for industrial products, like car services. These industries enjoyed large profits margins because of the monopolistic or oligopolistic markets in which they operated, together with high barriers of entry. This system powered the entire social policy structure - in the form of fiscal transfers and labour market policies to make sure that the spoils of the model would trickle down in an even manner.

A remarkable feature of that system was its long-termism. The EU, governments, industry and universities organised research that fed this model. 

After the end of the Cold War two further factors sustained the model: a large decline in defence spending, in some case by several percentage points of GDP, and the rise in globalisation.

What is killing this model now is a shift in technology and geopolitical fragmentation. Of the two, we would argue the first is the more important. More and more functions in our lives that were previously the realm of purely mechanical processes are nowadays wholly or partially digitalised. Barriers of entry have collapsed. China went from zero to the world leader in electric cars.

European companies no longer generate sufficient profits to fuel the social model - and to fund long-term research. The heavy bias in Europe's research towards existing companies is taking its toll. It is not about the public versus the private sector. Government intervention played a huge role in the development of the digital industry. Picking winners is still possible, for as long as you pick the winners. In Germany, for example, if research is not done by the car or the big chemical companies, it is not happening. It is no surprise that Europe has only very few tech companies.

In short, Europe's oligopolistic old-tech model no longer works in a digital world. We have been reporting on the attempts by the EU to stem against technological developments through regulation. But this is a way of addressing symptoms, not causes.

After the multiple global shocks of this decade, the consequences of Europe's technological decline translate into lower potential growth rates. Italy came first. Its productivity growth has been near zero since it joined the euro. The UK's productivity growth slumped after the global financial crisis, and never recovered since. Germany's productivity growth is unlikely to recover, even if the economic cycle does. The German Council of Economic Experts see a potential growth of around 0.5% until the end of the decade. With productivity growth that low, Europe's model has become financially unsustainable. It is unsurprising that the political system is fragmenting everywhere. The argument for sustained deficits, in France for example, is that you need them to keep Marine Le Pen out of power. This means they will persist.

We have a fiscal crisis ahead, caused by a combination of falling productivity growth and political gridlock. Technology is the main cause of the decline. Geopolitics is what accelerated it. The solutions we have been advocating over the years - a joint fiscal capacity, a capital markets union, joint defence procurement to neutralise the rise in defence spending - are further away than ever. Unless one of these parameters change, a financial crisis is a very plausible scenario. 

27 March 2024

Farmers vs Nature restoration law?

The EU and its member states have gone to lengths to show that it is pro-active to respond to farmers protests. It decided to soften some of the red tape under the Common Agricultural Policy. And it shelved the Nature restoration law, the flagship bill of the green agenda, after it emerged that more and more member states turned against it.

The Nature restoration law has been in the making for the past two years as a way to make nature part of the solution to achieve climate change goals. The objective is to restore 20% of natural habitat and biodiversity on land and waterways, gradually starting 2030 until 2050 with goals for specific areas such as peat land, forests or coral reefs. The law, in an already watered down version from the original proposal by the European Commission, had been adopted by the European Parliament despite the opposition from the EPP, it was backed by the EU member states and the Commission. Under the Belgian EU presidency, this law was supposed to be rubber stamped by EU ambassadors last week as a mere formality, but it all turned into a political fiasco after eight member states decided to oppose the law and thus deprive the vote the qualified majority it needs to pass. Hungary was critical for passing that threshold. The final count had just 1% between those in favour and those who object or abstain. The vote had to be postponed.

Even if the Belgian EU presidency reassures that it would to work on a compromise it is unlikely to pass before the European elections. Any substantial change means that the legislation has to go back for a second reading to the European parliament, which holds its last session end of April.

The tragedy is that farmers protests are not fundamentally one against nature but to ensure their income. It is the classic dilemma for all common goods, whose benefits are shared but whose costs are carried by only a few. EU member states will have to go back to the drawing board and find a solution that can square the equation in a fairer way.

But there are political hurdles for that to happen. The next European Parliament is expected to shift to the right with a big push expected for eurosceptic groups. It will be even less inclined to talk about the environment than the current one. The past five years have been the high noon for a green agenda movement, every party endorsed its own version of environmental policies. That movement is on its way out. The Green party stands to loose significantly in the elections, while conservative and far-right parties hooked on to farmers as their new voter contingent. A solution is not impossible, but it needs to engage farmers with natural restoration, otherwise this will only be a contest between two sides where none of them has an interest to move.

27 March 2024

Diplomatic tango with Israel

A UN resolution calling for a cease fire in Gaza in return for Hamas’s hostage release finally passed without a US veto. Another act of political drama is unfolding as Benjamin Netanyahu cancelled his visit to the US, while his defence minister was received with open arms, with his list of arms requests in tow. Iran, meanwhile, celebrated the UN vote as a triumph for Hamas, while Israeli security forces warn that Iran plans to supply weapons to Gaza. The more Iran potentially gets implicated in this war, the more pressure there would be on the US to respond on the side of Israel. So far, neither Iran nor the US have signalled any interest in escalating the war.

Expect a lot of hot air ahead of the US elections, where Democrats are increasingly split and uncomfortable over Gaza. Netanyahu can capitalise from this split, and use his swipes against Joe Biden to mobilise Israelis behind him. Perhaps he is betting on Donald Trump to return to power after this November's elections. After all, it was Trump’s peace proposal that granted Israel the right to confiscate an additional 30% of the occupied West Bank, and folded Palestine into a vision of a Greater Israel.

For Biden, the aim had been to get Israel to commit to a two state solution as a long-term goal. With Trump as an opponent on the campaign trail, this question has also a domestic dimension. The US administration has been holding talks behind close doors with Israel and Arab leaders. The question is how hard the White House is prepared to push Israel to accept it, with only seven months left before the elections. Diplomats are keen to avoid the errors of the Oslo agreement, namely letting Israel get away without fully committing to a Palestinian state as a long term goal, and leaving it up to the Israelis and the Palestinians to sort out their differences. How far can a US president, who is in election campaign mode, go to get a recognition of Palestinian statehood? Biden has his reputation and legacy to hold up, but may not be able to do much before the elections. If re-elected, he would be able to put much more pressure on Netanyahu's government.

Biden’s administration has already put forward various proposals to Israel, include recognising a nascent Palestinian state, a Palestinian state with some conditions to be met, or merely affirming an incontestable Palestinian right to a state, according to the Atlantic. What matters at this point is that Israel commits to the principle before they get to the details. So far, Netanyahu’s government won’t have any of this. On the contrary they continue to commission more confiscations of land in the West Bank.

The Europeans are not really players in these negotiations, but they add their tones to the music. The UK, France and Spain have signalled that they are considering unilateral recognition of a Palestinian state.

The two-state solution is key for Israel’s own security. Hamas’s 7 October terrorist attack shook Israel’s sense of security to its core. Israel’s disproportionate response caused the death of more that 32,000 Palestinian civilians dead and famine in Gaza, likely to rise once they enter Rafah. What is necessary is the prospect of a long-term solution that ensures Israelis and Palestinians both have their place, which would take out the fuel for extremism. Political courage is essential to embrace this path.

One of Biden’s objectives in the region before Hamas's attacks was to get Israel and Saudi Arabia to normalise their relations with agreements on nuclear and defence matters. Since the war in Gaza, Riyadh has increased its price, demanding Palestinian statehood as a condition for normalisation. Its government concluded that their security is also not guaranteed unless there is a solution for Palestine. That is probably true for other Arab nations as well.

Israel’s war not only devastated Gaza. It also strengthened Iran’s role in the region. This is why Iran’s regime cautions its militias not to drag the region into a conflict, which the Houthis seem not to have listened to. Iran and Saudi Arabia are the big players amongst Muslim and Arab nations. It is for the West to choose where and how much of their efforts go towards convincing Israel that the two-state solution is in their best interest too.

27 March 2024

Price cap cakeism

One of the many lessons from Clausewitz’s On War that remain relevant to modern times is that warfare is, as much as anything else, a contest of wills. The capabilities anyone can muster matter little if they either do not want to fight, or are not mentally prepared for the consequences of doing so. Pain thresholds are easy to ignore, because they are difficult to quantify. But they matter hugely.

This is something we risk learning, to our detriment, in our own economic struggle against Russia after its invasion of Ukraine. Our sanctions against Russia, both on finance and energy, have been designed to maximise the impact on the Kremlin, but only insofar as the negative short-term consequences do not rebound on us. This is, we think, an approach that has run out of road, especially as Ukraine fatigue on weapons deliveries sets in.

Another example of how this has a real-life impact comes to us from the Dallas Fed. It recently published an interesting working paper on the different effects the two main oil sanctions the west used against Russia had on Russian oil prices. One of these was the embargo which western countries, namely European ones, enforced against Russian oil. The other is the now better-known G7 oil price cap.

What the paper found is that the embargo did have a material effect on oil prices. But inasmuch as the price cap itself had an effect, this was limited to the opportunity cost Russia bore when it has to assemble its so-called shadow fleet of tankers to circumvent the cap. The most obvious example of the cap’s failure is how benchmark prices for Russian oil have frequently exceeded the $60-per-barrel cap limit since the summer of 2023.

Instead, the fluctuations in Russian oil discounts seem to have more to do with global oil prices. When there was a glut, and oil prices were relatively weak in early 2023, it was worse for Russia. As oil prices rose again, Russia’s situation improved.

This is relevant to the wider issue of how far we are prepared to go for Ukraine because of the purpose the oil price cap was supposed to serve. The idea was that, instead of a total ban on tankers carrying Russian oil using western-provided maritime services, like insurance, you’d have the cap. Russia’s oil revenues would be limited, but without disruption to Russian oil supplies, and therefore the global market.

There is always an argument to be made for trying to design a policy optimally, to raise the benefits and limit the costs. But this is just a foreign policy equivalent of having your cake and eating it. It is a sign of what is becoming more evident now. Vladimir Putin’s big advantage over us is how much he is prepared to put his own country, and the world, through for the sake of victory in Ukraine compared to us.

27 March 2024

Trying to make sense of the US Congress

The US Congress is inching towards a Ukraine aid bill, but the obstacles and risks remain formidable. The Atlantic did a good job of trying to disentangle the legislative choices ahead, which are so hard to comprehend for Europeans not versed in the intricacies of US legislative procedures. 

The US Congress is currently on holiday, as is most of the western political world. In the US, this is called recess. Behind the scenes, Mike Johnson, the Republican Speaker of the House, will be negotiating both with Republicans and Democrats to allow him to bring forward the bill. As the Atlantic writes, he has four choices, each with different implications for Ukraine.

The first would be to introduce the bill already approved by the Senate after the recess. Secondly, he could draft his own competing legislative package that would include various contentious Republican demands, again after the recess. Choices three and four are so-called discharge petitions, legislation the House can approve during a recess. Here, too, the same options apply: a Democrat-led version based on the Senate draft, or a Republican-led version. In the US, recess legislation requires a two-thirds majority.

Johnson's problem is that his once slim majority has eroded and that he is facing a leadership challenge from the far-right of his own party. In his public comments, previously he said the only version of a Ukraine bill that could pass would be on discharge. 

He may opt for amendments, for example, a loan-only military aid programme, a problem that could end on the plate of the Europeans who will probably end up as the ultimate guarantors of all Ukrainian debt. 

There is a scenario where Johnson colludes with the Democrats if they protect him from a no-confidence vote. But that would end his political career beyond the current term. There are still also scenarios of gridlock where the only legislation Republicans could approve would carry so many sticks that Democrats would vote against it. The big risk is that Johnson brings forward legislation so contentious that it faces defeat.

Another factor is timing. The advantage of passing an unamended Senate bill is speed. It could move straight to the president for signature. If the House passed a different bill, it would go into what is known as a conference committee, made up of members of both houses. After that it goes back to a vote in both the Senate and the House. This is how legislation dies.

We know that Donald Trump is personally opposed to aid for Ukraine, as are some Republicans. But this is not the main reason why this package is stuck. It is stuck because the issue is not sufficiently important to a sufficient number of legislators to override the domestic issues they care about more. 

Whether or not this package succeeds is ultimately less important than what happens in November. If Trump wins the presidential election, all bets are off. There is some movement in the opinion polls in some critical swing states towards Biden. Just as we should not dismiss Trump - as Europeans habitually did until not to long ago - we should also not take his victory as given. 

27 March 2024

How to think about disruption

When something bad in our world happens, the natural response is often to shift wildly from complacency to panic. Either we all overreact at the beginning, and then calm down a bit later, or we don’t take a problem seriously enough until it is too late. But, in a more disruptive world, the best thing we can try and do is see through things towards the longer-term, and interconnected, implications.

Yesterday’s Baltimore bridge collapse is a case in point. At first, aside from the human tragedy, the economic implications seem scary: Baltimore is a major port on the US east coast. Then, in context, it’s less dramatic when you consider Baltimore is responsible for only about 3% of US shipping on the east coast and Gulf of Mexico.

But the impact of a prolonged port closure would hit specific sectors harder. It is the most important port in the US for car trade, with more than 750,000 passing through it in the past year. It is also not necessarily a one-off, since much of the US’s infrastructure is in a bad state. The bridge collapsing is not the sort of thing that matters on its own. It’s when other things happen at the same time, maybe to the car industry, that it has an impact.

Another example is the impact of Houthi attacks in the Red Sea. The impact of diversions on global container shipping has been absorbed by over-capacity in the market. Maersk, one of the world’s largest shipping firms, gave a downbeat assessment of its profits for 2024 last month. But the root cause was the oversupply issue, even if the Red Sea also has an impact.

Instead, where this should be more concerning is how it fits into a pattern globally. Along with recent Ukrainian attacks on Russian oil refineries, what the Red Sea disruption shows is how easy it has become for someone in the right place at the right time to do this kind of thing. Lower-cost drone technology, plus US foreign policy’s recent indecisiveness and European ineffectuality, have played a role in both. The real concern should be things like this happening more often as US hegemony recedes, and the world becomes a more multipolar, and possibly chaotic, place.

We therefore encourage readers to try and think about the bigger picture when looking at any of these news stories. One will often find that there’s no reason to panic. But there can be one to be concerned.  

26 March 2024

It's the housing, stupid!

Simon Harris, Ireland’s 37 year old education minister, was elected to take over from Leo Varadkar as Fine Gael party leader. He will take over also as prime minister once parliament is back from its Easter break. Harris was the only candidate coming forward in this leadership contest. He now has less than a year to establish himself as leader of a party that is trailing behind Sinn Féin in the polls. If Sinn Fein were to win next year’s elections in March with the 28% predicted in the polls, it would need a coalition partner. Both Fine Gael and Fianna Fail, which are at 20 and 18% in the latest poll, have excluded a deal with Sinn Féin, though Fianna Fail is perhaps less adamant about it.

In his first speech as party leader Harris took several swipes at Sinn Féin and moved the goal posts for the centrist party a smidge further to the right. He inherits a thriving economy with full employment and no budget worries, unlike other European countries. But the lack of affordable housing is the number one hot topic, and one where Sinn Féin scores particularly well. The country also has seen the largest influx of immigration over the past years, which is exacerbating the housing crisis. Anti-immigrant protests started popping up since last year, driven by fringe groups or locals who oppose the housing of asylum seekers in their communities. The lack of access to education, healthcare and mental health services is also linked increasingly to the lack of affordable housing.

It is not clear what Harris can do about this housing crisis in less than a year. But by taking a tougher stance on immigration, he may tap into the anti-immigration mood in the country and attract those falling out with Sinn Fein over its open door policy.

Blaming the housing problem on immigration is a sign of desperation in a country known for its hospitality. Compared with other EU countries, Ireland has no significant far-right political party, but lots of micro parties, including the Irish Freedom party, Ireland First and the Nationalist party. One of the reasons for this exception in Europe lies in Ireland’s history and its armed conflict, the Troubles, from which a strongly nationalist Sinn Féin emerged. Being nationalist on the left made any emergence on the far-right unnecessary. But if immigration is now becoming an issue in Ireland, the mix could become toxic. It already served as the impetus for a bunch of conspiracy theorists to block access to parliament and to organise riots last winter.

Varadkar may indeed have chosen the right time to retire before it gets nasty. We ourselves observed that the coverage in newspapers like the Irish Times has become gloomier over the past years. This is despite a thriving economy and plenty of good things to say about Ireland, as we grew so used to reading. Paul Lynch, an award-winning novelist, imagined a far-right party in power in his book Prophet Song. Is this the end of the Irish exception? We hope not.

25 March 2024

Tanks for that, everyone

After years of arguing, it now looks like France and Germany are ready to start building a tank together. The idea of building a next-generation tank together, known formally as the Main Ground Combat System, first came about in 2017. Since then, the two countries have got stuck. But last week, the two defence ministers announced that they agreed on the details necessary to begin the development process properly. The earliest start date will be 2035.

What’s interesting is not so much that it’s going on, but why the negotiations got stuck, and the solution the parties found. The main difficulty on the new tank was how work would be divided between the two firms responsible, the German Krauss-Maffei Wegmann (KMW) and the French Nexter. They formed a joint venture, KNDS, in 2015 to work on projects together, including the tank.

Cooperating through KNDS allows the two firms to sidestep the other country’s export restrictions more effectively. But it does not get rid of haggling over who does what. This is an inevitable feature of still nationally concentrated defence industries. When governments make announcements that they are going to spend billions of euros on a new tank, or plane, or whatever, they need to have some economic benefits to show for it. How you distribute those benefits is one of the most politically sensitive parts of any negotiation like this.

In the end, the agreement between the two seemed to tie together three projects. One was the tank, which KMW will take the lead on. The other is a mostly Franco-German project to develop a new fighter jet. France’s Dassault will apparently be the senior partner in that project. Finally, the two defence ministers announced that KNDS will also set up a new facility in Ukraine, to help make replacement parts for both countries’ materiel there.

What should worry anyone who’s interested in seeing more defence-industrial integration in Europe is that it took this long to reach a fairly logical conclusion. It makes total sense to think of the tank and plane projects together. Since KNDS exists in the first place, cooperating on replacement parts for Ukrainian equipment is also not surprising. But this has taken years to get off the ground. We would suggest that the future of European defence integration will look like the past without some fairly radical changes to how it is funded.

22 March 2024

Adieu

De-industrialisation has many faces. A more subtle aspect is a decline in industrial nationalism. In the UK, the Royal Family drives Audis. We are not at the point where the German chancellor drives a Tesla. But a symbolic shift did happen yesterday when the German national football team dropped Adidas as their sponsor after 70 years, and is switching to Nike. The US company is said to have offered €100m in sponsorship, from 2027 to 2034. 

It is quite something for the DFB, the German football association, to be criticised by a Green economics minister for lacking patriotism. Robert Habeck said he cannot imagine the German team without the three stripes. 

In the commercial world of sports, €100m does not appear to be a lot of money. But it is a lot of money for the DFB. It is a not-for-profit organisation that sponsors amateur football - aside from running the national football teams. Adidas is believed to have offered only half as much. They needed the money.

It is a tale of how patriotic industry-based models end. People just cannot afford this any more. High profit margins are what used to feed the model. De-industrialisation does not begin with off-shoring, but with a squeeze on margins. This is what is happening in the car industry, for example. The profit margins for electric cars are much lower. That in turn has a whole number of consequences. There is less money for activities with doubtful commercial returns - like trade fairs, corporate junkets, or the sponsorship of unsuccessful football teams. Maybe we should look at this story in a different way. Adidas, too, has other priorities now.

21 March 2024

Varadkar's moment to quit

Leo Varadkar chose his moment to step down as Ireland’s prime minister. The surprise announcement yesterday had its shockwave effect and prompted the question why now? Varadkar himself said that he wants to give his successor sufficient time to establish themselves before accompanying candidates in local and European elections, and a year ahead of national elections. He also wants time for himself to reflect on what to do next. How to quit a job well depends on spotting when chances are about to turn. It is a matter that defines one’s own reputation and lays down the path for the successor.

Varadkar’s resignation speech was reminiscent of Jacinda Arden, former prime minister of New Zealand, with her frank acknowledgement that does she no longer has enough juice in the tank to do this job well. The mood and the tone of Varadkar’s less than 10 minute speech was similar. With some emotion, Varadkar said that after some soul-searching, he decided to leave for private and political reasons.

This resignation also reminds us of Stefan Löfven, who resigned as Sweden’s prime minister two years ago to give his successor enough time on the job before heading towards elections. It did not work out for Magdalena Andersson, his chosen successor, after the elections. But as a handover, this is as good as it gets in politics.

The other parallel with Löfven’s resignation is that it came on the heels of some proper defeats. In Löfven’s case, his government lost a no-confidence vote over rent controls when he lost the parliamentary support of the Left party. Varadkar’s leadership has come under pressure from inside his own party. There are already 11 MPs elected in 2020 who left the party over disagreements with the leadership. Behind closed doors, Varadkar was also held responsible for this month’s sound rejection of the government’s proposed changes to the constitution in the family and care referendum that should have sailed through given the backing of most opposition parties, writes the Irish Times. None of those rifts will be discussed in public, so as to avoid losing further votes to Sinn Féin. Upcoming local elections also are set to deliver a defeat for Fine Gael, and would have made his resignation a much more embarrassing event. So it may turn out to be the best moment for Varadkar to leave before things turn ugly.

The succession race already began in the media. Simon Harris, the education minister, has emerged as the immediate frontrunner. But Paschal Donohoe or Heather Humphreys are also strong contenders, should they choose to run.