Europe's search for security and growth
Geopolitical tensions are leading to greater protectionism, a development that is especially threatening for export-dependent member states of the EU.
Europe is gearing up for rearmament. Two major announcements last week are likely to open the door to higher defence spending.
On Tuesday Germany’s chancellor-to-be, Friedrich Merz, announced sweeping reforms to the rules that limit government borrowing. The new arrangement would create a €500bn debt-financed infrastructure fund outside the current rules. More significantly, defence spending in excess of 1.0% of GDP would be exempt from the rules. The changes, if enacted, would represent a historic shift to expansionary fiscal policy and rearmament.
In an echo of the language used by European Central Bank (ECB) president Mario Draghi during the euro crisis, Merz promised to do “whatever it takes” to “fend off threats to freedom and peace”.
German bund yields, or interest rates on government debt, saw the largest one-day increase in 28 years on the news as financial markets priced in higher government borrowing. An increase in borrowing and spending on the scale proposed by Mr Merz could boost German growth significantly – Goldman Sachs estimates the measures could lift German GDP growth in 2026 from 1.0% to 2.0%.
The EU also launched its own rearmament plan last week. Meeting in Brussels last Thursday, EU leaders approved the European Commission’s $860bn “ReArm Europe Plan,” which will be funded by EU bonds and a relaxation of the rules on borrowing and spending.
Last week’s announcements were in response to abrupt changes in US foreign and defence policy in recent weeks. They present yet another challenge – on top of lacklustre growth, a loss of competitiveness and the rise of populist parties – to the European economic and social model.
President Trump’s recent actions have brought them into sharper focus, but the problems facing the EU are not new. Indeed, last September, the EU laid out its blueprint to improve growth and security. In a landmark report, Mario Draghi, former ECB president and Italian prime minister, identified three major threats to Europe: geopolitical change, the innovation gap and the energy transition.
The Draghi report, published two months before last year’s US elections, was adamant that Europe needs to raise defence spending and focus on innovation and disruptive military technologies. This requires spending on a vast scale. The Economist believes that military spending will need to rise from an EU average of 1.8% of GDP to between 4%-5%. Last week’s announcements from Germany and EU leaders suggest that much of this spending will be financed with debt.
Geopolitical tensions are leading to greater protectionism, a development that is especially threatening for the export-dependent member states of the EU. Trade accounts for 55% of euro area GDP. Comparable figures for China are 37% and for the US 25%.
Draghi says the EU should be willing to tackle unfair competition with tariffs and other trade measures and by supporting domestic industries, as the US has, through subsidies and tax breaks. The report recommends that the EU implement the Critical Raw Materials Act rapidly, with the aim of diversifying supply chains, increasing domestic investment in critical technologies such as semiconductors and creating a platform for joint procurement and strategic stockpiling.
Innovation is the report’s second focus, with Europe falling behind the US and China, particularly in technologies in fast-growing sectors like AI and clean tech. This failure is central, Draghi argues, to Europe’s poor productivity growth. European industrial structure is too static, with “few new companies rising up to disrupt existing industries or develop new growth engines.” It is remarkable that no EU company with a market capitalisation over €100bn has been set up in the last 50 years while all six US companies with a valuation above €1tn have been created in this period.
Draghi argues that regulatory burdens and internal barriers to trade are stifling European tech firms and preventing them from growing. GDPR, for example, is estimated to have reduced the profits of small European tech firms by up to 12%.
Europe’s single market was supposed to sweep away barriers to trade between countries, but many remain. The IMF estimates that such barriers are equivalent to a tariff of 45% for manufacturing and 110% for services. Unsurprisingly, trade between EU countries is less than half the levels between US states. One of the reasons that Europe lacks US-sized businesses is that it lacks a US-sized internal market.
Energy is the third challenge identified in the Draghi report. European firms face natural gas prices that are 4–5 times US levels and electricity prices that are 2–3 times US levels. The EU relies on imported fossil fuels while the US is a net exporter of oil and gas. The differential between European and US energy prices widened as Europe replaced cheap Russian pipeline gas with more expensive liquified natural gas in the wake of the invasion of Ukraine. Draghi also notes the high level of energy taxation in Europe compared to the US, which acts as an additional charge on consumers. High energy costs have led some businesses in energy-intensive sectors including steel, aluminium, fertilisers and chemicals to shift production from Europe to the US.
Draghi argues that the EU should exploit its bargaining power as the largest global gas importer to lower costs and reduce exposure to volatile spot prices through longer contracts. To support the energy transition he argues for swifter approvals for green investment and greater investment in grids and interconnectors.
It's hard to disagree with Draghi’s focus on regulation, investment and an incomplete single market. But, even with last week’s easing of the constraints on public borrowing by Germany and the EU, it’s hard, if not impossible, to see where all the money will come from. Draghi doesn’t specify how much of the funding would come from public sources, but the sheer scale of the investment needed to address the problems of digitisation, decarbonisation and defence appears unviable.
Draghi’s solution to the problems of coordination and fragmentation is in greater cooperation between member states. The growing challenge from more nationalist political parties, such as Germany’s AfD or France’s National Rally, makes such cooperation difficult. And on some of the most important issues, including the development of an EU fiscal policy, agreement seems unlikely. Shortly after the Draghi report was published the German finance minister, Christian Lindner, said that Berlin would not agree to issuing shared EU debt as the pooling of "risks and liability creates democratic and fiscal problems”.
Achieving the sort of transformation envisaged in the Draghi report is an epic undertaking. Yet in a crisis Europe can move quickly and very effectively. In 2012–13, the EU managed to head off a breakup of the euro area. In 2020–21, it launched a vast programme to bolster the economies of the EU in the face of the pandemic. Europe will need to summon – and sustain – the same urgency to meet today’s threats.
A personal view from Ian Stewart, Deloitte's Chief Economist in the UK. Subscribe and/or view previous editions of Deloitte Monday Briefing here.