Germany and the European Union should brace for difficult structural reforms
Twenty-five years after the launch of the euro, the European Union faces a serious predicament, with the two largest economies — Germany and France — struggling to improve their competitiveness with coalition governments are under pressure. This is happening at a time of mounting security challenges amid uncertainty about President Trump’s stance on the trans-Atlantic alliance, Ukraine and tariffs.
Germany’s problems are particularly daunting, with the economy predicted to be flat for a third consecutive year. This is the longest period of stagnation since World War II, according to the Ifo Institute.
Friedrich Merz, the leader of the conservative CDU-CSU alliance, won the federal elections at the beginning of this week. He is expected to oversee a grand coalition with the Social Democrats, who suffered their worst result since World War II.
Merz has vowed to move quickly to tackle Germany’s pressing problems, and he pledged to exclude the far-right Alternative for Germany, which doubled its support to become the second-strongest party. However, the two extreme parties — AfD on the right and the former East German communist Die Linke on the left — could make it difficult to enact economic reforms, including relaxing Germany’s balanced budget amendment, commonly known as the “debt brake.”
Merz rolled out his “Agenda 2030” plan that pledges to restore annual growth of at least 2 percent at a conference of CDU leaders last month. The plan calls for lower taxes for companies and households, dismantling bureaucracy and fostering investment in research and development. It also includes repealing green regulations and cutting welfare benefits introduced by the previous coalition government, as well as curtailing immigration.
The plan has met a lukewarm reception, mainly because there are no easy fixes for many of Germany’s problems.
German living standards plummeted following Russia’s invasion of Ukraine three years ago. Gas flows from new LNG terminals have not fully offset the closure of Russia’s Nord Stream 1 project. The manufacturing sector has been hit hard, with industrial production and auto production near their lows since the COVID-19 pandemic struck, as German auto producers face increased competition from Chinese EVs.
Meanwhile, Germany’s transport, energy and communications infrastructure is suffering from years of under-investment, partly in response to the country’s strict public deficit rules.
Long before the invasion of Ukraine, it was apparent that Germany and the EU as a whole needed to tackle structural problems. The Financial Times points out that since the 2008 Global Financial Crisis, there has been a substantial widening in the productivity gap between the U.S. and Europe in which productivity has grown three times faster in the U.S. than in the Eurozone.
So, what will it take to make the EU more competitive?
Mario Draghi, former Prime Minister of Italy, addressed this issue in a recent Financial Times commentary. His assessment is that two major factors have led Europe to a predicament whereby the EU is barely growing.
The first is its inability to tackle supply constraints, especially high internal barriers and regulatory hurdles. Draghi contends they are more damaging than any tariffs the U.S. might impose, and he cites an IMF finding that the level of trade across EU countries is less than half of that across U.S. states.
The second factor holding Europe back is its tolerance for weak domestic demand. Since 2008, the U.S. government has injected more than five times as much fiscal stimulus to bolster the U.S. economy than the EU has.
The current situation is more complex than in 2012 when a crisis in Greece and other highly indebted countries in the EU periphery created uncertainty about the viability of the euro. Draghi was the head of the European Central Bank at the time, and he ended these doubts when he declared that the ECB would so “whatever it takes” to ensure the euro’s viability. Although this pledge potentially had high costs at stake, the promise alone proved sufficient to quell market speculation.
The main issue this time is whether there is political will in Europe to follow through with necessary structural reforms. Unlike 2012 Draghi recommends very high levels of EU spending, both public and private, which may not be attainable. The funding requirements would also entail substantial policy changes pertaining to capital markets and banking integration that have languished for more than a decade.
Absent structural changes, it is difficult to foresee what could make global investors turn more optimistic about Europe’s prospects.
The Economist recently noted that the cumulative return of the S&P 500 from March 2009 to November 2024 was three times greater than the Euro Stoxx 600 return. It asked whether, in the face of this, investors shouldn't just give up on stocks outside America. The conclusion was that investors should not abandon Europe, but it is getting harder for many to keep the faith.
The case for bottom-fishing in European equities is that their valuations based on one-year forward price-earnings multiples are the cheapest they have been in 20 years relative to U.S. stocks. To some extent, this reflects the higher multiples that tech stocks command and their greater weight in U.S. stock indices. Tech represents nearly one-third of the weight in the S&P 500 index versus 7 percent for the MSCI Europe index.
Another consideration is that while inflation has come down significantly in both the U.S. and Europe, there is greater scope for the European Central Bank to ease monetary policy than the Fed because European economies are weaker than the U.S. This has contributed to European equities outperforming U.S. stocks since the start of this year.
Nonetheless, it is difficult to make a case for adding long-term exposure to European equities at this time. Indeed, the path of least resistance for making Europe more competitive is to allow the euro to weaken further.
Nicholas Sargen, Ph.D., is an economic consultant with Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including Global Shocks: An Investment Guide for Turbulent Markets.
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