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 coalmine 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 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 favor. The German car industry is a classic example, but everybody did this.
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 digitalized. 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. 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 defense procurement to neutralize the rise in defense spending – are further away than ever. Unless one of these parameters change, a financial crisis is a very plausible scenario.