Europe - the search for security and growth

Europe - the search for security and growth

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, Mr 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.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 1.5% at 8,679, its worst week this year, amid global uncertainty from US trade policy announcements.

Economics

• The US initially imposed 25% tariffs on imports from Canada and Mexico, as well as additional tariffs on China. Donald Trump subsequently granted a one-month extension from import duties for goods from Canada and Mexico that met the rules of the 2020 free trade agreement
• China, Canada and Mexico announced tariffs and other measures against US imports in response to the tariffs
• US equities continued to fall this week, led by the tech sector, amid fears that tariffs will hit US growth
• The US added 151,000 jobs in February, below expectations and adding to a run of weaker than expected US data
• The Economist said that the turbulence from Mr Trump’s tariffs “is worse than anyone imagined” and that, “the worst-case scenarios [for tariff increases] are looking all too plausible”
• In a historic decision, Germany’s incoming chancellor Friedrich Merz, announced the government’s plan to ease Germany’s debt brake, which limits deficit-financed spending, to allow significant increases in spending on defence and infrastructure
• In response to the news, German government’s borrowing costs surged to 2.9%, the biggest one-day increase since 1997. Borrowing costs of other European nations, including France, Spain and Italy, also rose
• European Commission president Ursula von der Leyen announced the ReArm Europe plan, worth up to €800bn, which includes €150bn in loan provisions and allows member states to increase budget deficits to boost defence spending 
• The European Central Bank cut interest rates by 0.25 percentage points to 2.5%, in line with expectations. The ECB said, “the disinflation process is well on track”
• Euro area inflation fell in the year to February to 2.4%, from 2.5% in January, according to initial estimates
• UK chancellor Rachel Reeves submitted government spending plans to the Office for Budget Responsibility which included public spending cuts, the FT reports, as higher borrowing costs and lower than expected UK growth have reduced the fiscal headroom from last October’s budget
• The proportion of small UK businesses accessing finance declined in 2024 compared with the previous year, as investors cited risk aversion and the high costs of credit for the lack of investment, according to the British Business Bank
• UK house prices fell 0.1% between January and February this year, according to Halifax, as strong demand ahead of stamp duty increases in April softened slightly
• The Chinese government announced its 2025 growth target of “around 5%”, in line with the previous two years’ growth targets
• Oil prices fell following the announcement that Opec+ countries would gradually increase oil production from April as planned

Business

• Dividend payouts reached a record high of $1.75tn in 2024, according to the Janus Henderson Global Dividend Index
• The UK’s Financial Ombudsman Service received a record number of complaints about car loans in the final quarter of last year, amid an ongoing legal case regarding car finance mis-selling
• The UK’s Competition and Markets Authority approved the acquisition of business travel provider CWT by Amex Global Business Travel following a previous investigation regarding concerns of reduced competition
• The UK’s Payment Systems Regulator announced plans to tackle a lack of competition in the card payments market
• Healthcare insurance company Bupa announced a 10m increase in customers globally to 60.5m in 2024, leading to a 16% rise in revenues
• Energy company BP cancelled plans to build a green hydrogen plant in the UK as it shifts away from renewable energy
• Europe’s largest battery storage project, located in Blackhillock, Scotland, went into operation last week, with an eventual capacity to supply power to 3.1m homes
• Siemens Energy and Rolls-Royce agreed a partnership to manufacture, install and commission small modular nuclear reactors
• French technology company Eutelsat said it was discussing with European governments the possibility of providing satellite connectivity in Ukraine following reports that the US has threatened to cut access to Starlink, although owner Elon Musk has disputed this
• Denmark’s state-run postal service announced it will stop delivering letters by 2025 amid a decline in letter volumes and an increasing focus on parcel delivery 
• The UK government announced amendments to the Employment Rights Bill that will expand the eligibility of statutory sick pay and make payments available from day one of illness 
• The FT reports that a record number of senior lawyers have moved jobs in London so far this year in a sign of the buoyancy of the market for legal services

Global and political developments

• The US suspended military aid to Ukraine and stopped sharing intelligence
• Russian and North Korean forces advanced in Kursk, threatening Ukraine’s position in the region
• Ukraine and the US are expected to start negotiation talks this week to discuss ending the war in Ukraine. European and Commonwealth leaders held talks last week to form a “coalition of the willing” that would support Ukraine following a peace deal
• The Wall Street Journal reported that the Trump administration plans to strip security clearances, government contracts and federal-building access from a law firm with Democratic ties, Perkins Coie. Mr Trump told Fox News, “We have a lot of law firms that we’re going to be going after because they were very dishonest people”
• European nations are discussing options for using €200bn of frozen Russian assets, including seizing the funds if Russia breached a future ceasefire deal, the FT reports

And finally… a Flamin’ Hot Cheeto – a type of crunchy snack – shaped like a Pokémon character was sold at auction for almost $90,000 last week. The 3-inch spicy Cheeto was discovered and preserved by a sports memorabilia company sometime between 2018 and 2022 – hot commodity