Since the start of the corona crisis in 2020, incumbent governments have been removed from office in 75% of the elections in Western democracies. In France, Germany, Japan, Canada and South Korea, governments and/or leaders have fallen. These states are all – probably not coincidentally – among the group of countries that have benefited the most from globalisation and the postwar Pax Americana. Each of these nations faces great trials as holes start to appear in the US military, diplomatic and economic umbrella, while voters are becoming uncertain, angry and/or fearful, and political systems are starting to creak.
Europe seems very vulnerable. Besides the fundamental financial and economic factors that account for the European underperformance and the euro’s weakness, the political picture also adds a hefty dose of pessimism. The most pressing issues facing Europe are:
The Ukraine war
The war between Ukraine and Russia could take three directions this year:
Scenario 1: a prolonged war
A continuation of the war is still a likely scenario. This also entails continued (and more intense) sanctions against Russia, a persistent risk of disruption of energy supplies and pressure on Europe to keep ramping up defense spending. This scenario will also increase the likelihood of further political polarisation and ongoing economic uncertainty in Europe.
Scenario 2: a peace agreement
The presidency of Donald Trump – who has long been boasting that he will quickly strike a deal – and the gradual shift in opinion in European capitals and in Ukraine that territorial concessions to Russia are necessary after all, mean that a truce or even a peace agreement may be more likely. It may help that the Russian economy is showing signs it is beginning to suffer under the strain of the war. A successful peace agreement could provide the European economy with a minor boost.
Scenario 3: escalation
Further escalation remains an option. Ukraine was given permission to deploy American and British long-range missiles on Russian territory, and Putin responded by deploying a type of missile that had never before in history been deployed on the battlefield and by updating the nuclear weapons doctrine.
In addition, the deployment of North Korean troops on the Russian side is obviously extraordinary, to say the least. Such steps may lead to ever further steps up the escalation ladder. Further escalation could also result from more willingness on the part of Kyiv to make concessions, in the sense that Putin may smell blood. This is the point made by hardliners on the Western side.
Economic dependence on China
The European Union (EU) relies heavily on China for imports of critical commodities and technologies. This dependence makes Europe vulnerable to geopolitical tensions and economic shocks. Calls to reinforce the so-called European strategic autonomy and reduce dependence on external suppliers have therefore grown ever louder. But progress is slow and European dependence on China and other authoritarian countries will remain immense in the coming years.
Transatlantic relations
EU-US relations remain crucial to Europe’s economy and to European security. European states have substantially increased their defense budgets in recent years. However, the availability of troops and equipment remains a problematic issue. And the promises and intentions to step up collaboration in the military field have been heard for decades, but a European army is still a long way off, and it very much remains to be seen whether it will ever materialise.
Moreover, America has been wanting to shift its strategic focus from Europe to Asia for several decades. This shift may accelerate and intensify under Trump 2.0. However, it would be very unwise of the US to give Russia more leeway in Europe to be better able to hold its own against China. You cannot be a Russia dove and a China hawk at the same time.
The rise of nationalism and populism
The recent European elections and political developments point to a significant growth of populist and nationalist movements in countries such as Italy, Romania, the Czech Republic, Slovakia, Croatia and Hungary, and even in traditionally stable democracies such as Germany, the Netherlands and Sweden.
These movements are characterised by a strong emphasis on national sovereignty, criticism of EU institutions, rejection of supranational decision-making, resistance to migration and generally a pro-Russian stance. However, the challenges facing Europe – such as the climate crisis, energy security and geopolitical tensions (eg Russia’s war on Ukraine) – require more co-operation.
Monetary policy
The European Central Bank (ECB) continues to grapple with the balance between inflation control and propping up economic growth. German consumers and businesses, for example, are gloomy, European industry continues to shrink according to PMI figures, a number of European countries need to tighten fiscally, and Trump could drive inflation higher through a trade war, among other factors, and who will slow European exports.
The outlook for the capital and banking union
If Europe wants to be really competitive, it will have to significantly step up efforts to optimise the common market. A common capital market and a banking union are basically indispensable here. European capital markets are still highly fragmented; they still operate largely along national lines. This fragmentation hinders the efficient allocation of capital and reduces the competitiveness of European companies. However, the outlook is not very encouraging, given Europe’s deep divisions on the issue and because policymakers have many other more pressing matters on their minds.
The EU is at risk of falling behind technologically compared to the US and China. The best researchers in the field of AI are based mainly in the US and China. European companies also play a minor role in the digital sector. Space is another sector where Europe is lagging behind. A final example concerns electric vehicles. European carmakers, such as Volkswagen, lag behind Chinese competitors in the development and production of electric vehicles.
However, we must not create the impression that Europe is on life support and that its heartbeat could stop at any moment. Seven European countries (including five EU member states) still ranked among the world’s ten most innovative countries last year. Yet, Europe struggles to translate this innovation into higher productivity growth and economic growth.
Climate change and energy transition
Adaptation to the impact of climate change is becoming increasingly important for the European (and global) economy. Floods, droughts and heat waves cause significant economic damage. Europe seemed well on track to lead the way in the global energy transition. However, the brakes have occasionally been hit hard at the European level and in many countries, eg due to funding shortfalls and the electoral success of the populist right.
A pitiful people?
Clearly, Europe is facing a tumultuous period bringing together geopolitical tensions, internal economic headwinds and political polarisation as well as the need for sustainable transition, among other factors. The EU has undeniably made significant strides in setting up policies for strategic autonomy, the circular economy and monetary stability. However, the challenges remain immense. And it all seemed so great at the turn of the millennium; as Simon Kuper wrote in the Financial Times:
“Think back to 2000. Britain’s economy that year was about the size of India’s and China’s combined. Russia was an economic basket-case with a new pro-Western president, Vladimir Putin, who flirted with joining Nato. Even Europe’s terrorists seemed to be fading into retirement.” But now, “The outsiders see Europeans as backward peoples who stopped having children and who possess only a few cute ancient assets worth stripping: our châteaux, universities, handbags and football clubs.”
Implications for the economy and markets
The aforementioned political forces will likely have the following implications for the European economy and markets:
Mounting pressure on the ECB to stimulate the economy with a looser monetary policy.
Tensions will likely increase further, as the political situation may prompt governments to do less or make fewer concessions to help other EU countries.
Rising tensions – in the form of higher sovereign spreads – could be enough to give EU countries the political motivation to implement the plans that are already in place, which could greatly improve the outlook for the European economy.
An example of a positive development is the fact that European citizens’ confidence in the EU has reached its highest level in 17 years, which provides Brussels with slightly more legitimacy to implement reforms at the European level. However, it should be noted that only 51% of Europeans tend to trust the EU. That said, over six in ten Euro-citizens are optimistic about the future of the EU and only 17% have a negative view of the EU. What is also hopeful in light of the geopolitical competition with authoritarian regimes is the fact that 71% of Europeans still support economic sanctions against Russia.
A great deal of pessimism about Europe is priced in, judging by, for example, the performance of European shares against US shares and the euro’s exchange rate. A correction to this is quite possible once the French political turmoil has subsided somewhat and once, in all likelihood, Friedrich Merz of the CDU/CSU takes office as chancellor, with the latter showing slightly more flexibility with regard to the infamous Schuldenbremse (‘debt brake’).