We want to become less dependent on China, help Ukraine fight Russia, reindustrialise, invest in climate policy and cope with demographic shocks. We have not done the maths.
Events in Germany right now should serve as a warning for what happens when you try to do too much at once. It is the first western European country to hit a hard budget constraint. This is because Germany has tighter fiscal rules than others. A ruling by the German constitutional court in November enforced those rules in the strictest possible manner. Elsewhere, the EU’s own fiscal rules are also kicking back in this year, following their suspension during the Covid crisis. So far, governments have not taken them very seriously. But that is about to change.
The French government ran a fiscal deficit of 4.9 per cent in 2023, with no consolidation in sight. France could be a couple of government-debt downgrades away from triggering another sovereign debt crisis in the eurozone. In Giorgia Meloni, Italy has a prime minister who has so far avoided attracting the attention of the bond-market vigilantes. But her government is also not addressing the fundamental problem of the Italian economy – its lack of productivity growth. Austerity now beckons everywhere.
Some of our fiscal problems are imposed by outside events. Germany spends 0.5 per cent of its gross domestic product on aid for Ukraine. The UK spends 0.4 per cent. France and Italy spend less than 0.1 per cent – comparatively, almost nothing. This is what happens when you hit the budget constraint. You can wrap yourself in
a Ukrainian flag. But you cannot help.
On top of that, there is a consensus among the European Nato members that they need to spend more on defence. Germany has been struggling to meet the Nato defence-spending target of 2 per cent of GDP – prompting Donald Trump to threaten that he would not protect Europe from an attack by Russia. During the early phase of the Cold War, between 1954 and 1969, Germany spent 4.7 per cent on defence. Defence spending in most advanced economies fell in the 1970s and 1980s to 3 to 4 per cent. By the last decade, it was down to below 2 per cent on average. In view of present and future geopolitical conflicts, defence spending will have to rise again – possibly back to where it was during the Cold War.
Because central banks are finding it harder to gobble up government debt without creating inflation, it will be up to states to set spending priorities. The big choice of Joe Biden’s administration has been the Inflation Reduction Act, probably the single most successful example of an industrial policy in history. After decades of stagnation, industrial investment in the US has exploded. But it has come at Europe’s expense. China is also flooding the world’s markets with subsidised exports. The result is deindustrialisation in Europe.
On top of this comes another shock: the retirement of the baby boomers, and the rising costs to subsidise pensions and to pay for old-age care. Everyone saw that coming, but few governments have made the necessary fiscal provisions. The British economist Charles Goodhart views this as a driver for another financial crisis.
The West is confronted with more or less foreseeable fiscal shocks: defence spending, ageing populations, global trade and climate change; defence spending correlates strongly with perceived threats. The cost of ageing populations is also, to a large extent, a fixed cost. You cannot deny healthcare to those who need it. Something has to give. What will it be?
In Germany, we can already see where this is going. Olaf Scholz’s government is starting to reduce climate spending and public sector investments. The British Labour Party’s decision to roll back its climate spending plan is not as isolated as it may appear. Whenever countries implement austerity, it is investment that goes first.
Green policies are an important part of investment. Germany’s opposition, the CDU/CSU, has already started breaking away from the green policy consensus in
the EU by opposing key planks of Brussels’s and Berlin’s green policy agenda, including the EU’s Nature Restoration Law and Germany’s Domestic Heating Bill.
Until a few years ago, Germany basked in the delusion that it would become a global leader in green technologies. We now know that it won’t. China is the champion of the car battery and of solar technology. The US Inflation Reduction Act is also luring green producers away from Europe.
Germany has even started to push back against the new value-based foreign policy, which its government had until recently advocated. The government has also withheld support for one of the most important EU regulations under the current European Commission: a European supply chain law forcing companies to ensure that none of their suppliers violate labour standards – on slave or child labour, for example. Germany already operates a much milder variant of that law and has discovered that even this version exerts a high compliance cost on companies.
Germany is an indicator of the danger ahead – the country where the various fiscal collisions happened early. But Germany is not unique. European countries may choose different responses. Some may try to raise taxes. Some may try to get away with less defence spending than others. Most will reduce green investments. One way or the other, austerity is coming.
[See also: Brexit is not as secure as it appears]
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