Epitaph
Those who advocate more and more government regulation have been experimenting for 40 years, trying to create an economic system in which everyone can somehow be made more prosperous by the toil of someone else ― Ronald Reagan
The Peace of Westphalia signed in 1648, marks a pivotal moment in European history with far-reaching significance. This series of treaties, including the Treaty of Osnabrück and the Treaty of Münster, ended the brutal Thirty Years' War, which had devastated Central Europe. Beyond its immediate impact on the conflict, the Peace of Westphalia laid the groundwork for modern international relations and profoundly shaped the political landscape of Europe.
One of the most significant aspects of the Peace of Westphalia was establishing the principle of state sovereignty. The treaties recognized the independence and autonomy of individual states within the Holy Roman Empire and the sovereignty of European nations more broadly. This marked a departure from the medieval notion of universal authority under the Catholic Church and heralded the rise of the nation-state system, where states enjoyed supreme authority within their borders.
In addition to redefining political sovereignty, the Peace of Westphalia introduced the concept of religious tolerance and freedom in Europe. The treaties officially recognized Protestantism within the Holy Roman Empire, acknowledging the legitimacy of Catholicism and Lutheranism. This recognition of religious pluralism set a precedent for coexistence and religious diversity, establishing a framework for peaceful relations among different faiths.
Furthermore, the Peace of Westphalia contributed to the stabilization of Europe by establishing a balance of power among major states. The treaties sought to prevent any single power from dominating the continent, promoting a system of equilibrium that aimed to maintain peace and prevent future conflicts. This concept of balance of power became a cornerstone of European diplomacy for centuries, influencing alliances and strategic considerations.
Economically, the Peace of Westphalia facilitated the reconstruction and recovery of war-torn European regions. The treaties aimed to restore trade and commerce by lifting trade restrictions and promoting economic cooperation among states. This economic revival contributed to the growth of cities and trade networks, laying the groundwork for the emergence of modern capitalism and economic integration across Europe.
Moreover, the Peace of Westphalia set new diplomacy and conflict resolution norms. The treaties emphasized using diplomatic negotiations and treaties to settle disputes rather than resorting to prolonged warfare. This shift towards diplomatic solutions and international law represented a fundamental change in European politics, promoting stability and predictability in interstate relations.
Culturally, the Peace of Westphalia fostered intellectual and artistic developments across Europe. The end of the war allowed for a renewed focus on education, literature, and the arts, leading to the flourishing of the Enlightenment period in the following centuries. The peace also facilitated cultural exchanges and intellectual collaboration among European nations, contributing to advancing science, philosophy, and the arts.
In summary, the Peace of Westphalia was a transformative event with profound and lasting consequences in Europe. It reshaped Europe's political, religious, economic, and cultural landscape, establishing principles of state sovereignty, religious tolerance, and diplomatic relations that continue to influence international affairs today. The treaties laid the foundation for the modern nation-state system and set precedents for resolving conflicts through diplomacy and negotiation, marking a significant step towards a more peaceful and stable Europe.
Today, it is increasingly apparent that the European economic success story might be coming to an end, as European politicians display what Friedrich August von Hayek called "a pretense of knowledge" in making economic policy. This phenomenon is not unique to Europe, but the continent seems one step ahead of other parts of the world, particularly compared to the United States.
Regarding monetary policy, central planning has a long tradition in both currency areas, with financial macro-management stemming from the actions of the European Central Bank (ECB) and the Federal Reserve. Consequently, every decision on interest rates and the subsequent press conference has become a significant spectacle, especially since the onset of financialization in the 1980s.
Last week, the ECB governing council held its April meeting, again deciding to maintain interest rates at current levels but hinting at an upcoming reduction. The markets widely expected these announcements, resulting in subdued price swings.
Christine Lagarde's press statement hardly differed from previous conferences. She said that although the economy performed weakly in the first quarter, inflation is moving in the right direction, although some sectors continue to show high inflation levels and financial conditions remain tight, leading to reduced loan demand. This echoed her previous remarks.
As usual, the more interesting moments came after the prepared statement when the press was allowed to ask President Lagarde questions. However, one could sense that reporters were treating it like an FOMC press conference.
Many questions revolved around the US inflation numbers released a day earlier, which drove up global long-term interest rates, and whether the hot US inflation data influences the ECB's policy assessment. Lagarde appeared somewhat surprised by this line of questioning but emphasized that the ECB must focus on its data and is not dependent on the actions of the Fed.
This aligns with my previous view, suggesting that the ECB will likely cut interest rates before the Federal Reserve does. After all, the economies in both currency areas are performing quite differently. The US economy continues to show solid growth, while the Eurozone economy has returned to stagnation.
France, Italy, and Spain were among the best-performing economies in the euro area in 2023. However, the IMF projects that per capita output growth in these countries will decline in 2024 and 2025. While these countries managed to reduce their debt-to-GDP ratios since 2020, the pace of debt reduction nearly stalled during Q1 and Q3 in 2023. The current century has seen a pattern of debt-to-GDP ratios: two steps forward, one step back.
In December last year, EU finance ministers agreed on a new framework to reduce overall government debt. While this is commendable, the main problem persists: most governments are not really adhering to these guidelines. The French and Italian governments missed their deficit targets for 2023 again, raising doubts about their commitment to deficit reduction this time.
The economic slowdown in the euro area suggests that the ECB is once again behind the curve. Just as it was overly confident that inflation was transitory in 2021, it now appears too optimistic that the economy can withstand the current level of interest rates. Evidence suggests that low demand due to high rates is a primary driver of weak productivity.
Although the latest industrial production numbers in the euro area suggest a potential rebound, the recent Bank Lending Survey indicates that there is still less appetite for loans due to tight credit standards. It's important to note that European businesses rely much more on bank credit than their US counterparts, who often borrow from capital markets.
Market participants widely expect the ECB to cut rates in June, followed by two more. While Christine Lagarde emphasizes that the ECB will act based on incoming data, signs point in that direction. However, the question remains whether this will be sufficient to support the economy.
Yet, if one argues that the ECB, contrary to Lagarde's statement, is monitoring the Fed to gauge its policy path, the assumption of three rate cuts appears exaggerated. While I believe this scenario is unlikely, it's worth recalling what ECB's Gabriel Makhlouf told CNBC this week:
But I think meeting by meeting is the way to do it. There’s too much uncertainty. And certainly in the inflation numbers today, we were still seeing enough in services inflation, to make us cautious about predictions, so I would not predict how many cuts there may be at all.
Furthermore, when Isabel Schnabel presented the new operational framework for the Eurosystem, she mentioned that the spread between the Main Refinancing Operation Announcement Rate and the Deposit Facility Rate will be narrowed by 15 basis points. One could argue that, under this perspective, assuming three rate cuts would be overly optimistic. However, it could hold if the US economy continues its widely expected soft landing path, although I continue to question this view.
Moreover, it's not that the Eurozone suffers from ultra-high interest rates compared to other parts of the world. A problem that rate cuts do not address is the economic environment of regulations and centralization. The saying that the US innovates, China replicates, and the EU regulates contains a lot of truth, especially considering that EU commissioner Thierry Breton recently celebrated the EU as the first economic area with AI laws, yet lacks any noteworthy AI companies.
Under current law, EU businesses must complete extensive sustainability reports, which tie up resources and increase operational costs. This weighs on productivity and decreases competitiveness against businesses from other parts of the world. It seems as if nothing will stop this trend.
Germany continues to be a prime example of this. Although the problems started years ago under the Merkel government, the situation worsened when the Ample coalition took office and doubled down on the economic policies Merkel implemented. After the invasion of Ukraine, the German government not only decided to gradually halt imports of natural gas from its biggest former supplier, Russia but also chose to phase out its nuclear power plants. According to Bild, economist Manuel Fondel estimates that shutting down nuclear power plants resulted in a loss of prosperity in the billions.
In 2023, Germany became a net energy importer for the first time since 2002, with higher energy prices than most of its European peers and a more carbon-intensive energy mix compared to countries with nuclear power plants, like France. Although green politicians continue to claim that more renewables lead to falling energy prices, it is expected that energy prices will not fall but rise until 2040.
However, transferring powers to Brussels and increasing the centralization of policymaking will probably not lead to higher competitiveness. The US Inflation Reduction Act, coupled with high energy prices and regulations, has prompted a reshoring of production away from the European continent.
One must acknowledge that the EU, under Ursula von der Leyen, has recognized the need to act. Yet, once again, it becomes evident that when politicians determine that action is needed, they often arrive at the wrong conclusions.
Ursula von der Leyen turned to Mario Draghi, widely seen as the savior of the euro during the sovereign debt crisis, to devise a plan for maintaining Europe's competitiveness. Draghi recently spoke at the High-level Conference on the European Pillar of Social Rights in this context, addressing the problem. At least he addressed it, although his conclusions seem rather bizarre.
First of all, Draghi claimed that "Europe" (referring to the EU as "Europe") had focused on the wrong priorities:
The approach we took to competitiveness in Europe after the sovereign debt crisis seemed to prove his point. We pursued a deliberate strategy of trying to lower wage costs relative to each other – and, combine this with a procyclical fiscal policy, the net effect was only to weaken our own domestic demand and undermine our social model.
I would argue that is exactly what did not happen. When Italy adopted the euro, the issue was that it couldn't lower wages without everyone noticing, as it had done in the past through the devaluation of the lira. Therefore, even if one argues that competitiveness was affected by insufficient wage growth, the reason for Italy's stagnation was that wages weren't low enough.
Draghi fails to recognize the significant increase in regulation within the European Union since 2000. On the other hand, he is correct in arguing that the policies implemented during that time primarily resulted in a shift of investments from one part of Europe to another. Germany benefited from the monetary union because the reluctance of countries with low productivity to lower wages to an equilibrium level led to a weak euro that favored countries where the domestic currency would have typically appreciated.
However, the German people did not benefit from these policies, as their purchasing power eroded faster than before. The real beneficiaries were exporting businesses that could boost their exports due to the euro's depreciation. German industrial production greatly benefited from a consistent decline in the euro exchange rate following the Global Financial Crisis.
Being the Keynesian that he is, Draghi's solution essentially boils down to the argument that European countries need to invest more and emulate the US Inflation Reduction Act to implement an "Industrial Deal." In this sense, he aligns with those who claim that European governments aren't spending enough, although the debt levels indicate otherwise.
However, the most striking part of his speech was the following (emphasis added):
We are lacking a strategy for how to keep pace in an increasing cutthroat race for leadership in new technologies. Today we invest less in digital and advanced technologies than the US and China, including for defence, and we only have four global European tech players among the top 50 worldwide.
We are lacking a strategy for how to shield our traditional industries from an unlevel global playing field caused by asymmetries in regulations, subsidies and trade policies.
Energy-intensive industries are a case in point.
In other regions, these industries not only face lower energy costs, but they also face a lower regulatory burden and, in some cases, they are receiving massive subsidies which directly threat the ability of European firms to compete.
Without strategically designed and coordinated policy actions, it is logical that some of our industries will shut down capacity or relocate outside the EU.
Once again, Draghi acknowledges some real challenges, such as high energy costs and extensive regulations, without addressing the elephant in the room itself. Furthermore, he later argues that the green transition is the right path, so he clearly doesn't question whether some of these challenges are genuinely justified.
It's apparent why Ursula von der Leyen chose him to devise a strategy. The main takeaway is that Draghi advocates for more centralization of power and decision-making. While he acknowledges this, he doesn't view regulations as the problem; quite the contrary. He calls for actions to "shield" European industries from producers in other parts of the world with fewer regulations.
In fact, it sounds as though he urges the EU to implement tariffs, akin to what Trump did during his presidency, although the apparent solution would be to eliminate unnecessary regulations. If anything, Draghi's proposals would weaken the European Union rather than strengthen it. It's a form of Neo-Mercantilism, suggesting that if the EU collapsed one day, its epitaph might read: "Even tariffs weren't enough.
They came in chariots to come and carry us,
They came to save ourselves from what we've done,
They sent the messengers to come deliver us,
They came to save ourselves from what we have become,
They came to contemplate our ways (there's no escape)
And all the winds of change (won't save us)Make Them Suffer – Epitaph
Have a great weekend!
Fabian Wintersberger
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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.
Thanks for the nice read.