EU: defence, debts and deficits

The European Union is planning new controls over borrowing and debt, with some flexibility for more spending on weapons and the green transition.

| 9 min read

Much of the European Union (EU) has been flirting with recession in 2023. The EU’s own forecasts were for GDP for the whole area to advance just 0.6% last year, with growth edging up 1.3% this year. Germany, once the main economic driver of the area, is widely expected to remain sluggish in 2024. The International Monetary Fund thinks Germany will stagger to just 0.5% growth. The southern states have – for once – been doing a bit better as people return to holiday destinations after Covid lockdowns.

The German economy is suffering from an erratic German energy policy and from the impact of net zero requirements on its traditional industries. Former Chancellor Angela Merkel scrapped nuclear power in a panic about safety following the Fukushima disaster in Jaspan. Some Greens argued strongly against it as a source, worried by what to do with the waste.

Relying ever more heavily on German imported gas, Germany suffered another energy blow with the invasion of Ukraine. The country needed to switch in a hurry away from reliance on Russian imports, which were coming through recently constructed pipes under the sea. It switched to dependence on imported liquified natural gas from the US and Qatar.

In office, Donald Trump tried to stop Germany completing the Nord Stream 2 pipeline. It is now not being used. This left German industry with more expensive energy bills and with fears of winter shortages. The government is keen to press on with decarbonisation, favouring wind and solar power on a much larger scale. This still poses issues over how to store it in times of abundance to provide power when the sun does not shine and the wind does not blow.

Germany’s car makers and ‘net zero’

The EU’s long road to net zero is cheered on by the current German governing coalition, with the Greens as one of the three partners. This leaves Germany’s main industry – making vehicles – more exposed.

The German manufacturers have been slow to adopt battery technology to offer competitive electric cars. They have watched as Tesla has created much of the up-market interest and captured substantial sales at their expense. Germany is now spending a lot to try to catch up with the need for battery production facilities. It is including a wide range of new designs incorporating batteries into the well-known vehicle brands like BMW, Mercedes, Audi and VW.

China has been more successful at gaining access to the minerals and metals the battery factories need, to putting in the battery making capacity, and mass producing working electric vehicles. It is going to take time for the German car makers to win back lost market share.

Meanwhile, Germany – like the EU itself – remains unsure of what the final technology will be. Some think developing synthetic fuels for existing fossil-fuel cars would be a better idea. Some favour the roll out of hydrogen as the new ‘net zero’ fuel, so long as it is made using renewable electricity. The EU requires member states to put in hydrogen fuelling stations on main roads.

Other industries also suffer

German chemical producers have found it difficult to cope with much higher energy costs. Chemicals producer BASF is closing substantial parts of its Ludwigshafen plant, the world’s largest integrated chemical complex. Other smaller companies are reducing capacity, and orders have been weak.

The German steel industry needs to switch activity from fossil-fuel fired blast furnaces to more electric arc recycling production., The German government has recently announced a €2.6bn grant to assist with these closures. The electricity industry is considering transitional investment in gas fired stations to replace coal ones, with the option of switching these to hydrogen from sustainable sources in due course.

The European Central Bank (ECB) is widely expected to make an earlier move than the US Federal Reserve to get rates down. This is based on the weak performance of the EU economy, and the evidence of inflation falling this year.

The ECB has paused its rate rises at a bit lower level than the Fed – and has not faced the same giant fiscal stimulus as an offset for the money severity in the way the US has undertaken. The ECB will not want undue harshness as it is conscious of the need to allow the weaker and more heavily borrowed economies to expand to ease the financial tensions. The ECB is also well plugged into EU policy, which favours more investment in green transition to provide a boost to the economies. The central bank is led by a European politician – Christine Lagarde – who will want a more favourable background for the summer European election.

Tiptoeing back to old controls

The EU has resolved its arguments over how to exert budgetary control on member states. The EU’s Treaty lays down through Article 121 and the Protocol on borrowing that states should keep their annual deficits below 3% and their stock of debt below 60%. Most are way over on stock of debt – and some are likely to be over the 3% target. Targets were suspended during the Covid-19 pandemic and the outbreak of the Russian war.

From next year the EU will go to an adaptation of the Treaty system. Each member state will have to draw up a medium-term fiscal plan. This needs to include investment, reform and debt control. The main item for EU control will be net primary expenditure by the state.

The state proposals are considered and the EU Commission approves a trajectory to get debt down over a four-to-seven year period. It can take the longer time of this range where the member state wants to borrow to invest in EU-approved matters such as the green transition. The EU has also added defence spending to the approved list as it puzzles over how the EU will make more of its own provision for defence.

When he was President, Donald Trump forced rises in some European countries defence spending to get closer to the NATO minimum level. Candidate Trump is threatening more of the same.

The new system must fit into the European Semester annual programme for controlling debts and deficits. If a state fails to comply by not getting approval for a budget trajectory or by breaking the plan it has agreed, the EU can still trigger the excessive deficits procedure against it. This can lead to forcing a member state to make deposits of money with the EU for no interest, or the imposition of fines.

The green imperative drives policy

The EU has set out the need to cut emissions of carbon dioxide by 55% on the 1990 base by 2030 and by 90% by 2040. These are tough intermediate targets which will take some hitting. The EU is urging more production of batteries, EVs, heat pumps and solar panels. It leaves open use of carbon capture and storage to help get to target – and has pledged to roll out hydrogen as a fuel.

It is difficult to see where all the planned investment in new sources of energy and in electrification is going to come from to hit these targets. Germany importing large quantities of LNG is adding to the world output of carbon dioxide. Its promise to end all coal power stations by 2030 means closing stations that have kept Germany going over the last two winters.

The EU’s economic model will deliver slower growth than the US.

Germany has just approved a budget after the decision of the Constitutional Court found the initial proposals broke the debt rule. The government has opted for another year of suspending the rule. It is also putting in a new ammunition factory, conscious that the EU is falling short of its promised supply of ammunition to Ukraine. The German car industry is still producing and selling well below 2019 levels, and German domestic purchases of electric cars are low.

The EU’s economic model will deliver slower growth than the US, based as it is on the green transition more than on the digital revolution which powers much of America’s success. Europe still has some good individual global companies with popular brands or with innovative patents as with some pharmaceutical businesses.

The new EU compromises over debts and deficits allow some scope to expand and invest but do not guarantee well-judged and productive investment. In its chosen area of green leadership, the EU will go further than the rest of the world. It faces a big competitive challenge from China, which has developed much of the technology and capacity needed to power the green revolution. The EU will “go green” by importing some needs from China given the strength of China’s position in batteries, turbines, solar panels and electric vehicles.

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EU: defence, debts and deficits

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