Europe’s way forward in a post-industrial world

Change has come to Europe’s developed economies. The combination of China Shock 2.0 and a reduced American security umbrella is creating the conditions that if seized could move Europe toward a more perfect union.

Indeed, Germany recently approved a combined $1.08 trillion in outlays on infrastructure and defense. That should bolster German gross domestic product by close to 0.5% this year.

The German spending is one element of a new framework in Europe that is likely to include the joint issuance of debt by the European Union, the use of Keynesian fiscal stimulus and the development of a continental debt market to support the euro and provide for Europe’s common defense and economic well-being.

That shift is shaking Europe out of the long torpor that followed the financial crisis and will result in a reallocation of resources toward defense and the modernization of Europe’s infrastructure.

Under this approach, a fiscal union will be unavoidable. But for now, the need to find another outlet to use the overcapacity inside Germany’s manufacturing sector to support the reconstitution of Europe’s defense industry should take precedent.

Modernizing the German and European infrastructure—especially the roads, bridges, ports, and technological and environmental remediation in the east—all cannot be ignored as the global financial, technological and security framework radically changes.

Undertaking this change will be difficult, but failure is not an option.

The events prompting this rethinking of Europe’s fiscal and defense policies have taken place with stunning speed. To begin with, Europe rapidly became uncompetitive compared to China and suffered an energy shock from the war in Ukraine. In addition, political change in the United States has forced Europe to tap its underdeveloped debt markets to meet the Keynesian moment and pay for its defense.

Europe can no longer rely on the world to buy its manufactured goods. It can no longer rely on Russia for its cheap energy. And now it can no longer assume that the United States will be a backstop for its defense.

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While it is not certain that NATO and the United States will part ways—there has been too much defeatism in our estimation—the relationship is in flux and that uncertainty now requires Europe spend more on defense commensurate with its economic capabilities.

It used to be said that the purpose of NATO was to keep the U.S. in, the Germans down and the Russians out.

That would still appear to be the case. But that will now require a rebalancing of the responsibilities of providing for the common defense.

To borrow from Ernest Hemingway, it is the end of something. But we would argue that each crisis presents itself with an opportunity.

In this crisis, the European Union has a chance to move from a common market to a unified political, economic and financial entity, But it will take time and it will take money.

Winds of change

The winds of change are evident in the quick move by Germany to suspend its constitutional limit on deficit spending and in actions being taken by other European states.

In the first week of March, Britain took steps to create a “coalition of the willing” to support Ukraine and rearm Europe after decades of underinvestment.

British Prime Minister Keir Starmer announced new spending on defense, including roughly $2 billion in air defense missile purchases for Ukraine, to be manufactured in Belfast.

In Germany, the incoming Chancellor Friedrich Merz announced plans for spending nearly $1 trillion on defense and infrastructure, labeled one of the most significant economic and security announcements in Europe in a decade.

His announcement came amid a new willingness of the German political establishment to lift the constitutionally imposed debt brake, something that not long ago was hard to imagine.

France’s President Emmanuel Macron then called for a national effort to reinforce France’s and Europe’s defense and to promote its reindustrialization.

Defense and infrastructure spending is simply a transfer payment from debt holders to the defense and construction industries in the private sector, all to the eventual enrichment of their employees and shareholders.

Administered correctly, defense and infrastructure spending results in increased domestic growth, higher employment and rising household incomes.

We would argue that Europe and Germany in particular have spare capacity and the means to overhaul their infrastructure and to grow their economies.

In this cycle, a Europe-wide Keynesian fiscal shock starts with increased defense spending at the national level.

The rebuilding of Europe’s economy and its military posture would eventually require the joint issuance of debt and a unified European bond market. That would attract funds seeking investment alternatives to U.S. bond markets.

It’s time to end policy decisions based solely on not financing the deficiencies of the smallest of nations in the EU. And it’s time to abandon the fragmented national markets and over-reliance on bank lending.

For regions of the developed economies, and for Germany in particular, the loss of comparative advantages in manufacturing during the recovery from the financial crisis has had a significant impact.

The loss of market share to Asia has led to steep job losses, particularly in eastern Germany, where the unemployment rate among men has increased once more to 8%.

The effect on asset prices is clear. Germany’s interest rates are far below those in the United States, which weakens the euro and makes European financial assets even less attractive for investors.

But this not a case where nothing can be done. The developed European economies have accumulated enough wealth to take care of displaced persons and industries. Increased wealth implies increased education and innovative skills needed to move the economy from basic industries to a technologically based productive sector augmenting the service sector and financial sectors.

Analysis and reports by the former Italian Prime Ministers Enrico Letta and Mario Draghi have laid out the roadmap for Europe’s economic revival, to which we would add the need for Europe to adapt a unified fiscal policy.

That includes the rebuilding of Europe’s infrastructure, the promotion of nascent industries and increased aid to facilitate labor mobility.

Lastly, there is no way the Euro area can get past the question of joint European debt issuance.

The latest shocks and the responses from Britain, Germany and France appear to be the start of shedding the economic orthodoxy of the past generation in favor of government expenditures to help the private sector get back on its feet.

Identifying the problem

Deindustrialization is unavoidable. Overcapacity in industrial production must be turned from a problem into a solution. Germany can use this Keynesian moment to mitigate the pain of the transition and keep employment relatively stable through a number of strategies:

• Reconstitution of its industrial defense base.
• Rebuilding of its public infrastructure.
• Promotion of an innovation-based economy.
• Creation of a unified euro-bond market.

It is time to recognize the limitations of austerity and a fragmented financial system. Giving the EU the means to take on a Keynesian stimulus package is perhaps the most important step in the maturation of the single market.

While people and goods can move freely around the European Union, Erik Jones of the European University Institute and Matthias Matthijs of Johns Hopkins University argue that money cannot move as freely.

Instead, much of Europe’s savings either sits idle in domestic banks or chases higher returns in the deeper, more liquid capital markets in the United States.

The authors point to Letta’s and Draghi’s reports, finding that Europe’s relative economic decline constitutes an existential threat to the single market. The prime ministers stress the importance of strengthening research, fostering innovation and making sustained investments in new technologies to reverse that decline.

This means a reinvigoration of the private sector and a smaller role for the state.

The reports find that the only way the EU will achieve these goals is by making it easier for Europeans to invest their savings within the EU, rather than burrowing them in savings accounts or investing them abroad.

Draghi sees competitiveness as an existential challenge for the EU and estimates that Europeans will need to invest an additional 800 billion euros a year (about $820 billion) to restore the continent’s industrial prowess.

Building on that framework, we suggest the following steps:

• Eliminate Germany’s debt brake. This is what killed public investment over the past two decades. On March 6, the ECB cut its policy rate to 2.65%. But monetary policy alone cannot solve what has become a fiscal policy shortfall. An economy that exists on low interest rates is by definition either self-contained (see Switzerland) or incapable of growing (see Japan until recently). The euro zone is neither but has had to overcome a trade shock, an energy shock and, now, a national security shortfall. This calls for a fiscal policy boost—and this is what German lawmakers did on March 21 with the aggressive new spending plan that effectively lifts the debt brake.
• Adopt joint European government debt issuance. There is no way to get past the question of a European Treasury and the ability to invest in government guaranteed European bonds.
• Promote defense spending. This can prime the investment pump, promote innovation, promote employment and help ensure Europe’s safety.
• Promote scientific research and new technologies. This would ensure further economic growth and increase productivity.
• Create a European corporate bond market. Business lending in Europe has traditionally been done through the banks. In theory, lending decisions of a liquid bond market should be superior to a closed banking system. In practice, you can judge Europe’s banks against the depth and efficiency of the U.S. corporate bond market.

Why is Europe so important?

The European Union is the world’s second-largest economic entity, behind only the United States. Germany by itself is the world’s third-largest economy.

Within the euro area subset, the three biggest economies (Germany, France and Italy) produce 63% of the area’s gross domestic product, with Spain a distant fourth.

Britain is the world’s sixth-largest economy and is, for all practical and historical reasons, a full partner with the EU.

Measuring Europe’s distress

Average growth in the G-7 advanced economies should be less than emerging economies, which are starting from much lower base.

Growth among the advanced economies last year was just 1.7%, which is close to what would be expected as the normal level of potential growth for established nations with high levels of income.

Last year, the U.S. grew at a surprising 2.8% annual rate, while Germany and Japan were the worst-performing among the developed economies, each declining at a 0.2% yearly rate.

The enduring costs of the trade war

History suggests that nothing gets done without a shock becoming the catalyst for change.

We can argue that China’s final ascendancy was a byproduct of the shock of the 2018-20 U.S. trade war and the global manufacturing recession that it set off.

The upheaval of the 2018 trade war coincides with the stripping of Germany’s hold on exports. German real (volume) exports that had grown by 15.5% from 2013 to 2017 went in reverse, declining by 11.6% from 2017 to 2024.

During the same period, U.S. exports in real terms grew by 11.3% from 2013 to 2017 and then increased modestly by 3.5% from the end of 2017 to 2024.

It seems evident that once traditional ties were broken by the recession, it was in everyone’s best interest to find the cheapest source of goods; which was China.

But it is difficult for individuals and policymakers to simply move on. Economists call this hysteresis; or hanging on to what once worked long after it stopped working.

Lost market share

The hard data tells a stark story in Germany: Its manufacturing orders fell during the 2018-20 trade war, plummeted during the pandemic, recovered and then went into decline. Both domestic and foreign orders are lower than in 2015.

And the soft data tells a similar story: A survey of German manufacturers conducted by the Munich-based Institute for Economic Research indicates a plunge in foreign orders for motor vehicles as well as a decline in orders across capital and intermediate goods since 2022.

This decline points to competition from China, with China now capable of producing goods that until recently were available only as imports. This suggests a long-term problem of lost market share for Europe’s manufacturing sector.

The political fallout

When economies evolve, whether it’s from agriculture to manufacturing, or from manufacturing to services, political consequences follow as workers are displaced and struggle to adapt.

The number of manufacturing employees in Germany peaked in 2019 and has since dropped in absolute terms and as a percent of the labor force. Without government assistance, displaced workers struggle to find new employment, which places a drag on the economy.

Helping workers, and an economy, make a transition is not a lost cause, though. We could point to the postwar success of the U.S. rebuilding Europe and Japan. But when the U.S. tried to extend this approach to Russia and China, the policy was a failure. The peaceful resolution of the Cold War devolved into crony capitalism in Russia and its outright aggression into Ukraine. The hopes that bringing China into the World Trade Organization would encourage it to embrace democratic norms only backfired as it now takes an aggressive posture toward Taiwan.

Measuring Germany’s losses

Germany’s decline is unmistakable. Consider these four areas:

• GDP: Germany’s real GDP has been in decline, decelerating to a 1.4% yearly growth rate in 2022 before outright contractions of 0.3% in 2023 and 0.2% last year. In the fourth quarter, manufacturing declined by 0.6%, its seventh consecutive quarterly drop as reported by Statistisches Bundesamt. Service branches, though, recorded a slight increase in the quarter.
• Bankruptcies: German bankruptcies have been increasing since the start of 2022, reaching their highest level since the financial crisis. In the fourth quarter last year, the 4,215 company insolvencies affected almost 38,000 jobs, as reported by Reuters.
• Unemployment: Germany’s unemployment rate has risen over the past three years, signaling the end of the post-financial crisis recovery.
• Productivity: Germany’s labor force productivity per hour has been declining since 2019, which speaks to a loss of competitiveness.

What is the way forward?

We would argue that much like the U.S., Germany is evolving from being a postwar manufacturing giant and needs to rely more on its intellectual roots. Germany has a history as a center of scientific achievement, particularly in particle physics and engineering. But as the 2024 report by Mario Drahgi stresses, too often now intellectual pursuits have moved offshore where it has been easier to flourish.

It is our position that Germany has been held back by its self-imposed fiscal constraints and by its tradition of the banking sector taking precedence over market-based financial decision making.

To be sure, not every manufacturing entity is suffering in Germany. While low-technology manufacturing is slightly lower than it was in 2015, high-technology manufacturing has increased by more than 5.2% per year on average.

And the European Commission ranks Germany third in terms of the percentage of employees in high-technology manufacturing sectors and knowledge-intensive service sectors. In 2023, 9.5% of the German labor workforce was employed in high-tech occupations, the highest share of larger economies.

But with China Shock 2.0 and the reordering of the global economy, Europe will have to adjust. There is a base on which to expand. But doing nothing to support the productive sector is not the most prudent choice.

Deindustrialization and the financial markets

The deindustrialization of Europe’s economy has hurt euro area financial assets, from interest rates to stock prices to its currency.

We begin with the response of the monetary authorities to the slowing economic growth and its effect on the value of the exchange rate and euro area interest rates.

The foreign exchange market

A currency’s value is set within an international marketplace reacting to a nation’s monetary and fiscal policies, both of which have an effect on economic growth and the demand for the nation’s currency.

In the case of the euro, the European Central Bank was compelled to keep short-term interest rates at zero from 2016 to 2022 during its long recovery,

After raising interest rates during the inflation shock, euro-area rates were pushed lower than those in the U.S., where growth has been higher than in Europe for most of the modern era.

A combination of low interest rates and an austere fiscal policy is normally negative for a currency. This seems particularly true for the euro until just recently, when the uncertainty surrounding U.S. policies has shaken the underpinnings of the dollar’s strength.

The euro had an increasing role in global commerce until this latest episode of deindustrialization. The euro’s share of international transactions has been in decline since 2021, with a precipitous drop in 2023.

Fixed income markets

In terms of the attractiveness of euro-denominated securities, the European Central Bank’s monetary policy has had the unintended consequences of keeping euro-denominated fixed-income securities at a disadvantage.
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At the short end of the yield curve, and most attuned to the relative monetary policy stances of the European Central Bank and the Federal Reserve, euro-denominated money-market securities as of the middle of March were 180 to 190 basis points lower than U.S. short-term rates, which are used to park cash receipts for exporters or to fund carry trades.

Recently, the short-term interest-rate differential has had a profound effect on the attractiveness of the dollar compared with the euro.

At the long-end of the curve, U.S. 10-year Treasury notes are yielding 200 basis points higher than a German bund, a substantial difference that would cushion the blow of potential dollar weakness.

Equities

There has been an outsized demand for the returns of the U.S. stock market. The Nasdaq index returned 15% per year on average since the 2009 recovery from the financial crisis, while the S&P 500 index has returned 11.7% per year. The returns of the more traditional Dow Jones Industrials index returned 9.9% per year.

Germany’s major stock index, the DAX, returned 9.2%, with a performance profile similar to the Dow. There are, of course, high-performing tech stocks in Germany. But Nasdaq’s Germany index has managed only modest returns since 2012.

This speaks to Draghi’s contention in his report that even though Europe is as technologically advanced as the United States, tech startups in Europe are relocating elsewhere as fast as they can.

That suggests that the pull of the U.S. tech sector is positive for the dollar’s value. Add to that the currency returns for investments in dollar-denominated assets, and the result was a U.S. equity market that was much more attractive for international investors.

Currency devaluation is not a good idea

There will inevitably be those who argue for manipulation in the foreign exchange market, devaluing the euro to make Europe’s products more competitive in the global market. But currency manipulation in a world of market-based economies is as unrealistic as trying to set the value of the DAX.

Arguing for devaluation shows a lack of understanding of the international finance that powers nearly every market-based economy.

Market-based valuations have replaced artificial valuations based on the amount of gold in storage or some other artifact. And for 35 years, the flow of international capital in an efficient market has resulted in stability and growth.

The takeaway

Germany’s prosperity can be attributed in large part to the production of automobiles, bulk chemicals and machine tools. Those products were in demand by the world and especially by China as it modernized.

But now, with the global economy rapidly changing, Europe has to adjust. While deindustrialization is unavoidable, Germany and the other industrial nations can mitigate dislocations, keeping employment relatively stable through the reconstitution of an industrial defense base and the rebuilding of infrastructure.

The economic and geopolitical crises have come to a head in Europe. Britain is committed to supplying Ukraine with arms, France expressed its commitment to increase defense spending, and the incoming German administration is modifying limits on its budget deficit that killed public investment over the past two decades.

It is time to abandon austerity in favor of a Keynesian stimulus program to rebuild Europe. This includes the joint issuance of debt and a common fiscal approach.

But the path will not be easy: Hungary has threatened a veto that would stymie a unified EU response.

Still, a coalition of the willing could well be the next phase of postwar efforts to defend Europe and to get past the economic damage done by the emergence of China.