Who is the true sick man of Europe?
Why Britain can only dream of having Germany's problems/ And why the Houthis are not the only long-term threat to global shipping
Suddenly everybody agrees on one thing. Well, almost everyone. Christian Lindner, the German finance minister, last week rejected the notion that Germany is the sick man of Europe. Instead, he insisted it is the “tired man of Europe”, in need of a strong cup of coffee to wake it up. The focus on Germany has let Britain off the hook given that until a few months ago, beset by stagflation, strikes and the kind of political and financial volatility usually associated with emerging markets, it topped most people’s list of sick economies. But one big GDP revision and a dodged recession later, the title that no one wants has shifted to the only major European country whose economy contracted last year, with GDP shrinking by 0.3 per cent in 2023.
But is the new consensus right? Is Germany really in worse shape than Britain? True, the German economy faces serious headwinds. And the latest forecasts do not look good. The European Commission expects Germany to grow by just 0.8 per cent this year and 1.2 per cent in 2025, the weakest of any European Union member. But Britain faces headwinds too and the Office for Budget Responsibility is forecasting very similar levels of growth of just 0.7 per cent this year and 1.5 per cent in 2025. In any case the sickness of an economy shouldn’t be judged on the basis of a few quarters. Whose problems are the more intractable? And which is best placed to tackle them?
Common Peoples
The two countries have much in common. Both are led by weak and deeply unpopular governments: in Germany’s case, an unwieldy coalition assailed from the outside by the far right, in Britain’s case, a government with a large majority assailed from the inside by the hard right. Both are paying the price for past poor fiscal policy choices, which has resulted in crumbling infrastructure and dire public services. In Germany’s case the error was a zero deficit budget rule that made it impossible to borrow to fund investment in line with what most economists have long urged. In Britain, the mistake has been a fixation with keeping taxes low, which has led to years of damaging austerity while the extra income was squandered on consumption and imports rather than saved and invested. Meanwhile both are suffering from severe worker shortages which are holding back growth and contributing to inflationary pressures.
In fact, the similarities go further. Germany is in the spotlight not just because of past domestic policy choices but poor foreign policy choices too. Its two big bets on Russia, as its main supplier of energy following former chancellor Angela Merkel’s decision to abandon nuclear power, and China as a leading export market have backfired, raising fears that its entire economic model is at risk. The loss of cheap Russian energy has hit Germany’s large manufacturing sector hard, removing one of its key competitive advantages. At the same time, Germany’s Chinese exports have declined amid escalating geopolitical tensions and growing competition from Chinese companies, particularly in the automotive sector.
Indeed, there are growing fears for the future of Germany’s most important industry, which depending on how you measure it, accounts for five per cent of German jobs, 16 per cent of exports and 4 per cent of GDP, and which is struggling with the transition to electric vehicles. German brands used to account for 25 per cent of the Chinese car market, but they account for just four per cent of electric vehicle sales which now accounts for 35 per cent of new cars sold in China. In a complete turning of the tables, Berlin is demanding that Brussels take action to prevent cheap Chinese EVs from flooding the European market. One measure of the depth of the malaise is that shares in VW are currently trading at just four times next year’s expected earnings.
Yet here too, there are parallels with Britain. Just this week, the bosses of Britain’s biggest banks went to see Jeremy Hunt, the chancellor, to discuss their worryingly low valuations. All are trading at a fraction of the book value of their assets. This comes amid growing alarm about the London stock market, which is not just suffering a dearth of new listings but has seen an exodus of big names to America. The UK is now only the 18th biggest IPO market in the world and “risks being reduced to the ranks of the junior varsity league”, according to former senior banker Craig Coben. And as transactions dwindle, an entire ecosystem of bankers, brokers, analysts, lawyers, consultants and public relations advisers is starting to unravel.
As with German manufacturing, the remarkable success of the UK financial services sector was also fuelled by two big geopolitical bets. The first was the embrace of European integration which saw London suck in jobs and capital from across the continent. The second was to ride the tiger of globalisation by opening itself up to the world’s newly minted wealth without asking too many questions about its origins. Yet now both engines are in reverse, the first as a result of Brexit and the second as a result of deglobalisation and the post-Ukraine war clamp down on oligarchic capitalism and the London laundromat. Britain’s most important industry is suffering the long-dreaded “slow puncture” as jobs and capital drift abroad.
Strong Medicine
But if both countries face serious challenges to their economic model, who is best placed to rise to them? Germany needs to do what it did the last time it was labelled the sick man of Europe in the late Nineties, when its economic fortunes were being sapped by high unemployment and lost competitiveness. Then it responded with a package of labour market reforms that ushered in two decades of robust growth. This time what is needed are reforms to boost labour supply, reduce bureaucracy and better infrastructure - the strong cup of coffee that Lindner identified. The government clearly gets this: it has just overhauled immigration rules to help fill the 1.8 million vacancies that is estimated to be costing Germany two per cent of GDP a year and it is cutting red tape to speed up investment in infrastructure.
Perhaps biggest risk is political. There appears to be no chance that the current government will scrap the country’s ill-judged zero deficit rule which in a fit of fiscal bravado was baked into the constitution in 2009 and would in any case require a two thirds majority to repeal. Lindner’s Free Democratic Party for one is opposed. But a constitutional court ruling last year outlawed the off-balance sheet borrowing ruses that governments had been using to circumvent the rules, blowing a €60 billion hole in this year’s budget. That has forced the government to make spending cuts, sparking large scale protests by farmers, angered by cuts to fuel subsidies and has boosted support for the far right AfD party. The danger is that deepening political polarisation will derail much-needed reforms and infrastructure investment.
Britain has one big advantage over Germany: its economy is far more geared to services, which is less exposed to cyclical swings in demand than manufacturing. But Britain also starts from a far less propitious position. As the Resolution Foundation noted in Ending Stagnation, a report published last month real wages in Britain have flatlined since 2007; inequality is higher than in any other large European country; a third of young people not in education by age 18, compared to a fifth in Germany and France; investment by British firms 20 per cent below those in the US, Germany of France. And having already close to losing the confidence of markets during the disastrous Liz Truss premiership, Britain has limited fiscal room for manoeuvre.
What’s more, unlike in Germany, there is no chance of history repeating itself. When Britain was last dubbed the sick man of Europe, in the 1970s, the solution was clear. More than the Thatcher tax cuts and privatisations, it was Britain’s entry into the European Economic Community and the subsequent creation of the European single market that transformed its fortunes, turning it into a magnet for foreign investment and providing barrier free entry to a vast new market. But thanks to Brexit, the single most powerful lever that Britain could pull to restore its economic fortunes today - rejoining the EU customs union and single market - is out of reach. For all the talk of an incoming Labour government seeking a closer relationship with the EU, there is nothing it could negotiate that could mitigate a fraction of the damage of Brexit.
The British Disease
Instead, the danger is that a British political class out of good options will reach for bad ones. Indeed, it is already doing so. Rather than encouraging immigration to fill worker shortages, it is putting up new barriers. Rather than investing in broken public services and creaking infrastructure, a desperate Conservative party is doubling down on reckless tax cuts which Labour, despite its huge poll lead, is too terrified of the right-wing media to oppose. Meanwhile vested interests are demanding special treatment to help shield their sectors from the consequences of Brexit. Faced with a slow puncture, the City is lobbying hard for the sweeping away of investor protections and new ruses to coerce savers into buying British shares.
This is the kind of protectionism and economic nationalism that in the 1970s proved a recipe for crony capitalism and financial scandals. No wonder the FTSE 100 was the worst performing major stock market in the world again last year, rising by just four per cent, compared to double digit rises in the rest of Europe and America, including a 20 per cent rally in Germany’s Dax index. The UK stock market has been trading at a persistent discount to other major markets for years. It is as if the financial markets have long made up their minds who they think is the true sick man of Europe.
The Other Shipping Crisis
Houthi attacks on Red Sea shipping have focused attention on the risks to trade from rising geopolitical tensions. Despite disruptions to this vital trade route during the pandemic and when the Ever Given ran aground in the Suez Canal in 2021, the world has tended to take freedom of navigation for granted. Now that ships are having to be divert around Africa, adding seven days and billions of dollars of costs to cargoes, we are getting another reminder of how quickly the benefits of globalisation can turn into liabilities. The disruption threatens to feed through into empty shelves and higher prices. With another key maritime choke point, the Straits of Hormuz, also vulnerable to escalating Middle East hostilities, there is a risk of an even bigger shock.
But the disruption in the Red Sea should also serve as a warning to take seriously another growing threat to shipping. This threat comes as a result of climate change and, as the Atlantic Council, a US think-tank, has warned, it is already causing havoc around the world. For example, a severe drought in 2022 caused water levels in the Yangtze River, down which 3 billion tonnes of cargo sails every year, to fall by more than 50 per cent, stopping shipping in the middle and lower sections of the river. Likewise the fall in water levels in the Mississippi during a 2022 drought led to $20 billion in losses. In 2021 and 2022, water levels in the River Rhine fell so low that ships had to sail with half their usual cargo. Meanwhile a severe drought last year led to a sharp reduction in the capacity of the Panama Canal which transports 40 per cent of US container traffic and five per cent of global trade.
As Sydney Sherry, the report’s author, notes;
“With climate change expected to make extreme weather more frequent, a big rethink of how goods move around the globe is necessary. Adaptation strategies, including refitting ships for shallower water or dredging and reengineering rivers, are costly and fail to solve the larger problem. A future with reliable transportation of goods will require rebuilding the global shipping map, from its hubs to its methods of transport, along with new technologies to navigate the world’s rapidly changing waterways.”
One country above all appears to have understood this. Many in the West scoffed at China’s Belt and Road Initiative as a sinister plot for world domination through building and taking control of vital infrastructure on key trade routes using aggressive debt diplomacy. But suddenly it is starting to look extremely smart as the world scrambles to find new trade routes to avoid potential choke points, notes Parag Khanna, the founder and chief executive of Climate Alpha, in Foreign Policy. “The BRI represents what all countries should do in their own national interest: build as many pathways as possible for supply to meet demand, both as a hedge against unforeseen disruptions but also to boost one’s connectivity and influence.” Not for the first time, it is the West that has been caught napping and needs to catch up.
Simon I enjoyed your article. One wonders if the incoming labour government might be keeping their powder dry and in their first term introduce the idea of joining the customs union like Norway. This must be one option to seriously consider to reverse the decline? Your comment on climate change impacting trade is interesting. One does wonder why it is Britain and the US spending a fortune firing rockets into Yemen, but the Chinese seem to be completely absent? Surely a lot of the goods travelling through this area come from China? Is it not in their interest to keep shipping safe? Why are they not there? Are they smarter than us by not getting trapped into a futile scrap with the Houthis in Yemen? How many sites do the Houthis have and how long can they keep causing disruption? according to Jeremy Bowan every missile we fire into Yemen costs 1 million pounds? Can we not find a better way to spend a million quid?
Brilliant analysis!