The big problem with the way European fiscal deficit targets act in practice is that they often end up killing public-sector investment. The one laudable aspect of the Next Generation EU programme is that it provides a pot of money for investment. For Germany, the fund is a macroeconomic irrelevance. It is there where we see the full impact of the reversion to fiscal targets in the 2024 budget. As Spiegel reports, the German government is now massively cutting the budget for digitalisation. This has been one of the coalition's flagship projects - to make up for lost investments over the last 20 years. This year the government is spending €377m on the digitalisation of the public sector. Next year, this budget has been cut to €3m. This is millions, not billions. What happened is that Christian Lindner has been scrambling for savings to meet the balanced-budget goal of the German constitution.

The FDP's hypocrisy on this issue is mind-boggling. Hardly a day passes by without Marco Buschmann, the justice minister, complaining about bureaucracy. Along with Lindner, he is the most visible face of the FDP in the German government. How can you cut bureaucracy without digitalisation? Faster fax machines? 

The government claims that it still has money left over from previous years for digitalisation investment. This may be true, but the cuts will reduce federal co-investments into the digitalisation projects of the states where most of antediluvian bureaucracy resides. It will also cut the funds available for federal-level investment in future years. We have to remember that Germany's legendary lack of digitalisation is not an oversight, but the consequences of a political choice made by SPD, FDP and CDU/CSU in their support for the constitutional debt brake. 

Poland is heading for elections on October 15. The ruling Law and Justice party is leading the polls and is using all tricks in the books to cash in on anti-EU and anti-German sentiments. Stirring up anti-German sentiment ahead of Polish elections is nothing new, but the frequency and intensity of the anti-German rhetoric increased since last autumn and goes beyond the usual World War II references. Polish politicians now regularly accuse Germany of instrumentalising Donald Tusk to interfere in Polish affairs. Tusk, a former Polish prime minister and president of the European Council, is leader of Civic Platform, the main adversary for PiS.

As part of its electioneering the PiS plans to hold a referendum on the EU’s migration pact proposal at the same time as parliamentary elections. The referendum itself has not been called yet. Parliament still has to consider the issue later this month. But the PiS is moving ahead anyway and published a video featuring its chairman Jaroslaw Kaczynski unveiling the first of four questions in the referendum which is completely unrelated to the migration pact. One question the PiS wants to ask is: Do you support the sale of state-owned enterprises?

In the video Kaczynski said it would be up to ordinary Poles to decide what happens, not German politicians, who were trying to instal opposition leader Donald Tusk in power and to sell all of Poland's property to Germans. It is the old narrative of Poland being ransacked by Germany. The Polish government has actually sold state assets to foreign companies. A few months ago they sold a 30% state in the Polish refinery to a Saudi Arabia’s Aramco and MOL from Hungary without even a tender, according to Notes from Poland.

The PiS is ahead in the polls with 36%, even if they stand to loose compared to the 43.6% in the last elections. Their lead over a coalition led by Tusk's Civic Platform is 6pp, according to Politico’s poll of the polls.

Exiting from the EU or the euro area used to be a top priority of far right parties in Europe. Not anymore. Today, hardly any of those far-right parties campaign for an explicit exit from the EU, using immigration instead as their main project fear. Some dropped their references quietly or relegated it at the back of their pamphlets amongst some other lofty long term goals. Others, like Giorgia Meloni, did a U-turn in full sight once in power as Italy’s prime minister. Marine Le Pen dropped the ball even before Meloni, finding it much easier to talk about immigration and cost of living instead.

This agenda U-turn has various reasons. Voters were less keen on a formal exit from the euro or the EU than its politicians. Then the parties hardly had thought about the practical implications and those who did, concluded it was not worth the effort. Brexit did not help. Brexit was first heralded as a role model for exiting from the EU. But it soon emerged that independence is no good if politicians have no clue what they want to do with it. Far right parties in Europe have no concrete ideas of how to exit a currency union, what national sovereignty can give them and how to redefine relations with the EU after that. Brexit also showed us how slow and painful the disentanglement can be. The costs are high and the benefits not clear.

Most far right parties prefer to focus on defining what they are against. This can be done even better inside the EU. Rebelling against Brussels or the EU’s reach into national politics can get the public attention in the public discourse. They can emerge as the defender of national sovereignty and, if played skilfully, become a source a continuous vote winners.

The war in Ukraine was another turning point for the far-right. All of the sudden there was agency in the EU as a global actor and as an insurer against the land grab from Russia. A new raison d-être for the EU as seen from the far right, as the lesser of the two evils. Jussi Halla-aho, the Finn’s party’s freshly nominated presidential candidate who in 2019 wrote his party’s Fixit strategy, told Reuters ahead of his nomination that European unity a priority for now, though Fixit will remain a long term goal of his party. This view seems to be widely shared across the party.

So no Fixit, Frexit, Nexit or Italexit. At least for now.

This is our last briefing before our summer holiday. We will be back on Monday, August 14.

Our main story today is a sceptical note following Christine Lagarde's press conference yesterday. What became clear to us is that the ECB is still reliant on its forecasting model to determine whether it is on a trajectory to reach the 2% inflation target. This is not a technical issue, but rather it is critical for the assessment of what to expect. Since this model is biassed in favour of forecasting the target, we conclude that the potential for a policy error is growing. 

The big problem with data dependence is that it does not tell you what you need to know. You may know that inflation is coming down, but you don't know whether or not it is coming down to 2%. Lagarde told us yesterday that the ECB was using the forecast, or projection as they call it these days, to make that determination. That alone tells us that the ECB will from now on tread more cautiously, because the forecast is hard-wired to predict outcomes in the vicinity of the inflation-target. In particular, it makes the assumption that the sheer announcement of an inflation target anchors people's expectations. We know this is not true, but it forms an essential element without which the framework would not work.

We reported the other day on an informal data policy rule, advocated by a highly placed central banker, that says that the ECB should pause if core inflation falls for three consecutive periods. Core inflation was up again in June, so the earliest period for a stop would be October, if core rates came down in July, August and September respectively. That would suggest one more 25bp rate rise in September, and that's it. Even we expect inflation to fall over the next six months. The problem with this policy rule is that it would give you the same answer regardless of whether your target is 2% or 3%. 

Whether you are model-dependent or data-dependent, you somehow need to include the target into the model. This is the reason why the Taylor Rule had such a long and successful run. It split the difference between the deviation from actual to potential output, and the gap between existing and targeted inflation. If you plugged actual numbers into this model, as opposed to perennially optimistic expectations, the level of interest rates would be closer to 6% rather than 4%. There are problems with the Taylor rule, as we gladly acknowledge, but not nearly as many problems as with a biassed forecasting model. 

It is interesting that central banks have never subjected their forecast performance to outside evaluation. The ECB's model has been giving wrong forecasts for the last ten years. It is not the forecast error that is the problem, but the forecast bias. The model is biased in favour of the actual target. It does not tell you what you need to know. It tells what you want to hear. If your benchmark is biased in favour of the target, then it is biased in favour of a lower interest rate. The reason we are focused so heavily on discussions of the model here at Eurointelligence is because it is the main source of policy errors.

If this happened in finance or in political polling, these models would have been kicked out a long time ago, along with the staff that produce them. That is not happening in central banks, whose economists are attached to what they like to call their workhorse models.

Going forward we see a range of tilted outcomes, ranging from the scenario where the ECB is lucky and gets it just right to one where inflation gets stuck at 4%. That would put 3% in the mid-range. 

In its update of its World Economic Outlook, the IMF also warned about the asymmetry of inflation. So did several economists like Olivier Blanchard, Kenneth Rogoff. Some of them may be open to the idea of a higher inflation target.

The argument is that it will become very costly to push inflation down to 2%. We don't want to spin out this scenario any further, but we would remind readers that a permanent inflation overshoot would have asymmetric economic effects. 

We conclude therefore that the risk of a permanent inflation overshoot at the ECB is high. We are not investors ourselves. But we would not be surprised to see people starting to place strategic bets on the ECB missing its inflation target. This is not a forecast of what will happen. What it is, however, is a shift in the bias of our expectations, which reflects the bias of the method.  

Spain’s quarterly employment data are out, and what they show is a continued tight labour market, with unemployment hitting 11.6% in Q2 2023, a post-financial crisis low. Overall employment grew as well, reaching a record level based on social security affiliations. Whilst Q2 is normally a strong quarter for Spanish employment, since it coincides with hiring picking up as the summer tourist season begins, this is relatively robust even for this time of year.

More positive employment data will come as a relief to Pedro Sanchez and the Spanish government. If the economic situation remains strong, that will improve their negotiating position ahead of any government formation talks. Whilst we do not think the statistics themselves will necessarily do much to influence voter sentiment, more people being able to find work clearly improves the government’s electoral position, albeit only up to a point.

Falling unemployment is especially helpful to both the Socialists and Sumar because they can point to it as evidence that one of the big initiatives of their time in office, 2021’s labour reform package, is working. The extent to which this is about the package specifically, and not a reflection of wider pan-European trends, is of course debatable, though the proportion of temporary contracts has dropped a lot since the reforms. But in politics, you take credit for things out of your control, just as you bear the blame for calamities you’re not responsible for too.

Looking more closely at the data provides more evidence that Spain’s economy is following broader European trends in other respects too. Job growth is especially buoyant in services. Hospitality has, unsurprisingly, grown a lot quarterly, whilst the biggest year-on-year increase has been in professional, scientific, and technical services.

Manufacturing, on the other hand, has seen job losses both on a quarterly and annual basis. This chimes with a broader European, and global picture. Inasmuch as economic growth has occurred, it has been driven by services, whilst manufacturing has contracted. Spain is also benefitting from a strong year for tourism in Europe. In the first five months of the year, the country received 28% more tourists than in 2022, and total spending was up 32% year-on-year.

Economic growth may be sluggish, or even technically in recession, but the employment data are not yet reflecting this. Entrepreneurship also seems to buck this trend. This, at least, seems to be the case in France.

The latest Insee data on the creation of new enterprises suggest that the French economy is doing rather well despite a stagnant economy. The number of newly created enterprises this quarter is only slightly below that of last year, and it is still rising on an annual basis. This also comes after two years of an explosion in new enterprise formations, with 1m created last year alone. Most notable is the rise in micro-entrepreneurship, with a strong rebound of 5.3%, particularly pronounced in the wellbeing sector, business services, and cleaning. This is partly due to the fact that it is nowadays so much easier to set up a micro-business in France.

The coming months will tell us more about whether this is a trend or a temporary feature. After the end of the whatever-it-takes fiscal support, the number of business failures are back to the level where they have been before the pandemic. It seems, however, that the businesses created during or after the lockdowns have held up rather well, at only a couple of thousand. Despite being created under adverse conditions, they have survived and are performing well thanks to solid financing and good preparations, writes Les Echos. This wave of company creation also created three new jobs on average and reoriented the economy. They are geographically anchored, thus contributing to the reorientation of the French economy. This is despite considerable administrative obstacles that remain to creating a business in France compared to for example the UK. The rise in interest rates only weighs on those requiring several tens of thousands in startup capital, but many of these new businesses only need a couple of thousands and are thus defying the trend.

Entrepreneurship is also becoming a key plank for inner-city politics. After the youth riots in cities throughout France, there is a fresh political impetus to encourage people living in those banlieues through entrepreneurship and local projects. This sense of independence, risk taking and responsibility that comes with entrepreneurship, all good ingredients for a healthy society where young people may not have to take out their destructive mood onto the streets. But for this to work, markets will have yet to be created. The difficulty will also be to avoid the trap for many of those delivery drivers: independent, yes, but low paid and stuck. Emmanuel Macron announced that there will be a subsidy to encourage entrepreneurship in the suburbs, a promise that will have to be further defined in the autumn. But as with all seed funding, eventually those businesses will have to learn to walk on their own. That will be the crucial test further down the line, and will determine whether the creation was not only political but also an economic success.

Italy’s recovery fund is not going well. Only 20% of the grants available had actually been disbursed as of 2022, and the government has found itself getting stuck as the time has come to fulfil concrete objectives. This is a problem that the government has acknowledged, and, after months of foreshadowing, they have come up with their own recovery rescue plan.

The shifts the government wants to make are pretty sizeable. Their big idea is to move €19bn worth of funding into the new RePowerEU chapter of the plan, which is worth approximately 10% of the combined grants and loans they have taken. This comes ahead of the European Commission’s deadline for member states to submit their RePowerEU chapters next month.

This move is designed to do two things. One is lengthening the time period they’ll have to actually disburse the funds. The other is funnelling the money away from local governments, and a variety of small projects, towards large, partly state-owned big energy firms like Eni and Enel. Doing that will potentially speed up the disbursement process, since these firms are used to managing larger volumes of money, and bigger projects.

There are a few outstanding questions, however. One is what the Commission will think of this. We doubt there will be any serious issues here. The money is basically going from one EU programme with conditions attached, laddering into the Commission’s big-picture objectives, to another. If it’s a tangible opportunity to rescue the politically important recovery plan, that will also help. What may cause more disquiet is the government’s proposals to water down some of the objectives, such as by delaying the target for reducing courts backlogs.

Another, more serious issue for the government is the political fallout it will experience because of the reallocation. The local governments that were supposed to receive these funds are obviously going to be unhappy that they aren’t getting what was promised to them at the beginning. Redirecting funds away from local administrative control also reduces the incentive for these administrations to implement the structural reforms that form a very important component of the plan.

Finally, another question is whether the reallocation will be big enough to get the plan back to where it needs to be. The gap the government needs to make up has gotten quite large, and it finds itself in a difficult place. A dramatic shift would be disruptive, whilst a smaller one risks being less effective.

At the African summit in St Petersburg, Vladimir Putin has promised six African countries to send 25,000 to 50,000 tonnes of grains to replace the Ukrainian delivery. Putin insisted that there will be no return to the grain deal despite African delegations advocating it. Where does this leave the grains in Ukraine? Both Russia and Ukraine are set to have another bumper harvest this year. 

The European Commission made the bold assertion that the EU can take all the grains and other products Ukraine needs to export. But this is a tall order. It hinges on transport via the land route, since neither the Black Sea nor the river Danube are safe after Russia’s bombardments at the ports. Every complexity adds costs, and thus makes Ukrainian grains less competitive on world markets. The EU's agriculture ministers have not yet found a common way forward yet, postponing a decision to September, when the current EU restrictions run out. Poland threatens to impose an unilateral ban if the EU does not extending the restrictions. But an extension of the EU ban was rejected by Germany, France, Denmark, the Netherlands, Luxembourg and Estonia at the EU Council's agriculture meeting this week.

Thus other solutions need to be found to get grains out of Ukraine through the EU to the world markets. Lithuania proposed passing the grains through Poland to its Baltic port of Klaipeda and four other ports in Estonia and Latvia. Together, the five ports are capable of handling 25m metric tons of grain a year. Ukraine is in favour of this, but wants to add other ports such as Hamburg and Rostock in Germany, Rotterdam in the Netherlands, Rijeka in Croatia, Trieste in Italy, and the Slovenian port of Koper.

The magnitude of this undertaking is staggering: Between May 2022 and June 2023, 41m tons of Ukraine’s grain exports came into the EU via the solidarity lanes, while 32m tons were exported via the now-defunct Black Sea deal. Thus the EU will have to find a way of how to accommodate 73m tons of grains if only to transport it further into the world markets.

This means more investment in infrastructure in ports and on the roads, more traffic and more checkpoints. Poland, Hungary and Romania have agreed in principle to the Lithuanian proposal, but do not want to shoulder the bill. There are thus pressures on the EU to finance exports from Ukraine and keep their grains competitive on the world market despite increased costs for logistics.

This episode is a foretaste of what EU countries are about to experience when Ukraine is to become a member of the EU, writes l’Opinion. This is one of the underestimated problems of a future Ukrainian EU membership. Vast subsidies from the CAP funds would go to Ukraine if there are no changes to the system, much to the detriment of farmers particularly, in France, Germany, Spain, Italy, and Poland.

If the problem with Germany is the irrational attachment to industry, the problem with the UK is an unresolved Brexit trauma. The Nigel Farage/NatWest summer story is symptomatic of a wound that is not healing. But it is also symptomatic of an issue that is not resolved: the UK got Brexit but not a model to make it work.  

Business models do not arrive by accident. The Thatcher government gave the UK a distinct business model inside the EU: it positioned the UK as the EU's financial centre, and as a low-regulation, low tax location for inward industrial investment. That model persisted for around 30 years until the global financial crisis in 2007. After that the UK has suffered a persistent decline in productivity growth and falling real incomes for large sections of the population, including, critically, the median voter. This led us to conclude, long before Brexit, that the model is broken. It would have needed fixing, Brexit or no Brexit.

The UK's exit from the EU reduces the policy choices dramatically, but not to zero. The now abandoned sunset clause for all EU legislation was not a constructive answer. The UK now needs to define what it wants. Brexit was about what people didn't want. 

Our suggestions would have been for the UK to exploit niche positions in a number of 21st century new technologies, such as artificial intelligence, crypto-currencies, medical research and fintech, and use the regulatory freedoms specifically to that effect. The reason why the EU is in such a mess over the US inflation reduction act is that US subsidies actually get paid, whereas subsidies in countries like Germany are mostly phantom money, stuck in bureaucracy. Germany's struggles, on which we reported yesterday, could have been seized on as the UK's opportunity. Germany is friendly terrain for mid-sized widget makers, but a hostile environment for new high-tech entrepreneurs. Germany is still stuck in 20th century technologies, and its regulatory system reflects that specialisation. The UK could have chosen to fill Germany's tech vacuum.

We noted in our coverage on Germany yesterday that there is not a single party in Germany that questions the old industrial model and the obsession with current account surpluses. Likewise in the UK, there is no political party with a clear definition of a post-Brexit economic model. The UK's economic discourse still follows the ideological dividing lines of the 1980s. The issue for the UK today is not about free trade and free markets, but about the right regulatory environment for 21st century industries. A return to Thatcherism or Blairism will not solve the problem. Something new is needed. But neither Rishi Sunak nor Sir Keir Starmer have an answer. 

If this question remains unanswered, the case for a Brexit reversal will become louder. It will not come from the old Remainers. As their reactions to the Farage affair this week have shown, they are too angry to think clearly. The case will be made by a new generation, unencumbered by the Brexit wars of the late 2010s. They will ask the simple question: what benefits did Brexit bring? In the absence of a new business model, the answer is: not much, if anything. The benefit of belonging to a larger trading and geopolitical zone will outweigh the unexplored regulatory freedoms of Brexit.  

Africa is Russia’s new strategic priority. What this means concretely will be the subject of the African summit in St Petersburg over the next two coming days. It is the second of its kind after the first in Sochi in 2019. The number of leaders coming to St Petersburg may be fewer, only 21 compared with 43 who came to Sochi, but 49 out of 54 African countries sent delegations, at least according to the official record.

The Kremlin’s refusal to extend the Black Sea deal for Ukrainian grains has to be understood in this context. Forget Ukraine, we are your friends, seems to be the marketing message ahead of the summit. Russia offers to deliver Russian grains instead of Ukrainian grains free of charge to those countries most in need. Promoting peace and humanitarian aid is a message that ticks all the boxes in Moscow to demonstrate that Russia is not isolated in this world. But African leaders may not be reassured by this offer, as world food prices would continue to go up, and would add more pressure on them, rather than alleviating it. How far will the Kremlin go to reassure its African interlocutors? Could Vladimir Putin return to the deal to meet their concerns?

Several African countries have been keen to demonstrate their independence from the west, and did so by not backing the western sanctions against Russia. They are also ready to travel to Russia to talk business when the west is trying to exit. But how far can this go in forging concrete alliances? There is still a dependency on western countries, be it as markets or for financial aid. Russia has, so far, only a tiny presence in Africa compared to China or Europe. To enter this continent, they need to offer them something in return.

The narrative building is one of vindictive victimhood. The Kremlin has been orchestrating a victim story: Russia had asked the west for equal treatment to allow export of its own grains and other food products similar to Ukraine’s. For this to happen, sanctions would have to be suspended on banks, insurers and intermediaries that are key to delivering Russian products onto the international market. The EU refused the request and thus a narrative was born for Russia being the victim of western demands, a theme that resonates well in Africa.

Beyond narrative, it comes down to balancing interests. Would countries like Egypt cross the Rubicon and risk forgoing IMF support? South Africa convinced Vladimir Putin not to come in person to the Brics summit in Pretoria, as it would have obliged them to arrest Putin in order to comply with an international arrest warrant from the International Criminal Court. What the summit will produce other than words is thus more a question of what Russia is ready offer, and what price African countries are willing to pay for it.