Edvard Munch: Evening on Karl Johan Street.
Dear Chappies,
A letter on what’s going on in the European economy. I will aim to do these each time the European Central Bank lays down its judgements. Next one in October.
Beyond the ECB decision, I will also analyse some other economic happenings. In this case, Germany’s struggles and the recent Draghi Report.
[1] ECB Decision: Rates down. No rush.
The European Central Bank (ECB) has trimmed interest rates by 0.25%. A slight reduction that balances persistent inflation and sad economic growth.
Headline inflation remains high, but in line with prior forecasts. A relief to see energy prices continuing to fall from the peaks of 2022. However, core inflation, which strips out volatile items like food and energy, is somehow even higher. The ECB expects core inflation to hit 2.9% this year, before easing next year.
The ECB has not yet reached its goal of 2% inflation in the medium term. So, why then cut rates at all?
The main aim is to reduce inflation, and these rates continue to do so. However, the ECB has its eye on the sad state of economic growth in Europe:
‘The economy grew by 0.2 per cent in the second quarter, after 0.3 per cent in the first quarter, falling short of the latest staff projections. Growth stemmed mainly from net exports and government spending. Private domestic demand weakened, as households consumed less, firms cut down business investment and housing investment dropped. While services supported growth, industry and construction contributed negatively. According to survey indicators, the recovery is continuing to face some headwinds.”
Christine Lagarde, President of the ECB. 12 September 2024.
So while the trim signals some optimism, it preserves a restrictive policy that aims to reduce inflation. But as economic growth continues to flounder in Europe, they know that reducing interest rates, even by a little bit, they might “support consumption and investment.”
Polite Reminder:
Headline inflation compares prices of a bucket of goods and services from one period to the next.
Core inflation inflation is the same but excludes more volatile products (e.g. energy and food).
[2] The Draghi Report
“We're going to be a society that basically shrinks,” sighed the former head of the European Central bank, Mario Draghi. As part of a report for the European Commission, he spoke some more sad realities: Europe’s economy is in relative decline.
Here are some quick shots from the report:
Economic decline: European living standards are slipping compared to the United States. The average EU per capita income is now about one-third lower than that in the US, a gap driven largely by stagnant productivity growth across Europe.
Political consequence: “If Europe cannot become more productive, we will be forced to choose. We will not be able to become, at once, a leader in new technologies, a beacon of climate responsibility and an independent player on the world stage. We will not be able to finance our social model. We will have to scale back some, if not all, of our ambitions.” Scary.
Some of the proposed solutions:
Closing innovation gap with China and US, with record annual investments of €750-800bn.
Lower energy prices and seize opportunities of decarbonisation;
Forming one European trade policy; and
Uniting defence industries.
I’m always a little sceptical of an organisation commissioning a report for itself to just say “more money please!” But if you have time, the report is worth a read. There’s a lot of great analysis. You can always check out the Draghi’s gloomy foreword or examine this summary by Adam Tooze.
[3] The German diagnosis
In the second quarter of 2024, Germany economy contracted by 0.1. The gloom has led some like the Financial Times’ Martin Wolf to revive an old, overused cliche: “Is Germany the ‘sick man’ of Europe once again?”
Germany’s unique economic position in Europe is in part due to a solid manufacturing base. This is the Mittelstand. A large cluster of small and medium-sized businesses that produce really high-quality manufacturing goods.
When China joined the World Trade Organization in 2001 it needed all these German goodies: investment goods, machinery, vehicles. The outcome was not bad at all. From 2001 to 2022, German exports as a share of its GDP increased from around 30% to 50%.
This did not just bring growth to Germany, but also to hungry Europe. But now trade is slowing. For Germany, it's like slowly losing your best customer at a garage sale. They used to buy all the weird stuff, but now you’re stuck with a growing pile of dolls.
Already, demand for goods has been falling across the world with the weight of higher inflation and increased interest rates. In May, exports to China dropped 14 per cent when compared to last year. Trade is volatile, sure, but at this point, exports to China have been falling for two years in a row.
At the same time, China has easily overtaken Germany with the making of electric cars. These days, the automotive industry accounts in Germany for some 5% of GDP and over 800,000 jobs. If Germany fails to adapt, the consequences might be dire. For now, they might just get EU tariffs on Chinese EVs to protect them.
Of course, there was the revving up of energy costs after the Ukraine Invasion in 2022. It was the expected result of Germany’s long-standing dependence on Russian energy and growing geopolitical tensions. Germany’s energy-sensitive industries suffered the most.
This is not yet mentioning the structural problems. Its working population is shrinking. There was a clear motive behind Germany’s open immigration policies. More people is important to economic growth. Otherwise, it’s a lot harder to produce more goods and services. And as even the left-wing government begins to sour on immigration, Germany must look for productivity. This unfortunately, is no more inspiring:
Graph: Productivity in Germany, measuring how efficiently inputs like labor and capital are used to produce output, 2017-2024. SA 2021=100. Source: Trading economics, Deutsche Bundesbank
The modest economic decline in Germany last quarter stops short of a recession—at least for now. Another quarter of negative growth would push Europe’s largest economy into a downturn.
Many of the anxieties that Mario Draghi expressed in his report are illustrated in Germany. Trade dependency, high energy costs, and low productivity. Maybe, as he suggests, massive investment is necessary. In Wolf’s diagnosis, he observed a similar issue: the lack of public investment in Germany, while pointing to the huge surplus of private savings.
In other News
Germany’s left-wing government comes down on immigration in attempt to survive. (Politico)
Two sentenced for claiming the President’s wife, Brigitte Macron, was a transgender man. (Le Monde Fr)
UK Gov gives India’s Tata £500mn to save country’s largest steelworks. (BBC)
Italian bank vying for Germany’s Commerzbank. An insight into how to veil threats with corporate jargon. Their press release here.
US republicans threatening shutdown (Vox).