9 July 2019

Has the impetus behind European reform,  so evident following French President Macron’s victory last year, now stalled? The recent Italian election result illustrates that the appeal of populist remedies to Europe’s ills has not receded, and Euro-scepticism remains widespread. The challenge remains for Europe’s mainstream national leaders, along with the EU institutions themselves, to demonstrate they can produce prosperity and  jobs (especially among young people) that are widely shared by the electorate.

The recent EU summit had a full agenda of vital topics: Brexit, reforming the Euro’s FX architecture, responding to America’s protectionist threats, and dealing with the potential consequences of the Italian elections. However, in an effort to help German Chancellor Merkel cope with domestic political challenges, only immigration received any real attention.  And, while enough probably was achieved to buy the Chancellor some time, even that issue remains far from resolved.  Addressing difficult policy issues is best accomplished when times are good, despite the instinct to adopt an “if it ain’t broke, don’t fix it” attitude. And, while economic conditions in Europe remain healthy, the recent slowdown (Chart 1 shows this year’s slump in the PMI index ) reminds us that the good times will not last forever.

The case for an out-performance of European equities (which has not materialised during the past 6 to 12 months) relies on European leaders making considerable progress on economic reform, especially boosting European productivity and competitiveness and addressing the deficiencies in the Euro’s FX architecture that contributed to the Single Currency’s recent crisis.  However, as Brexit will assuredly dominate the October EU summit, material progress on these vital issues appears unlikely  before the December meeting.  The next 6 months will be crucial.

Immigration: Moving Beyond Crisis to Strategy

To be sure, the genesis of the concerns about immigration are easy to identify. During the volatile past decade, the recession emanating from the Global Financial Crisis followed by the Euro Crisis has led to persistently high levels of  unemployment in most countries, especially among young people.  In addition, the huge inflow of asylum seekers during the 2015/16 crisis, strained public services and finances at a time when local residents were enduring stringent fiscal austerity.

Fortunately, the worst of the asylum crisis now appears over.  Indeed, after accepting 1.3 million asylum applications in both 2015 and 2016, such requests are projected to decline to about 400,000 in 2018.  Nevertheless, even the lower level of 2018 applications remains above the historical norm of 200-300,000 annually.  Also, in several front-line nations, e.g. Cyprus, Malta, and Greece, requests are still rising.  Applications are also still rising France and Spain, although  from comparatively low levels (when measure in comparison to the size of the local population).

It is also worth noting how countries differed in their response to the crisis.  The Chart above illustrates the number of refugees arriving compared to the size of the local population.  Germany’s contribution (over 1.2 million requests in 2015/16) is well known, but Austria, Sweden, and Hungary (before it closed its border in 2016) coped with even larger inflows. To be sure, Angela Merkel is paying a political price for her decision to open Germany’s border, as the German public was understandably shocked by  the nearly overnight increase in their population of almost 2%. Nevertheless, German generosity in coping with the influx has been commendable.  On the other hand, the United Kingdom, Spain, and France (and the USA) made comparatively small contributions.  Italy provided safe harbour for 123,000 refugees in 2017, but their overall effort has been only roughly in line with the EU average.

The Chart above, moreover, illustrates that all of the reduction in asylum applications has come from Syria, Iraq, and Afghanistan (although all three remain above long-term averages) and the western Balkan nations, after the EU placed them on their list of “safe countries”.  Meanwhile, applications from Africa, the Indian sub-continent, and the rest of the world remain at persistently high levels: revealing a strong underlying demand to enter Europe. The following Chart illustrates the ongoing demographic explosion in Africa where 45-50% of the population is below 15 years old (compared to 15% in the EU). In addition, the population of many African nations continues to grow 3% annually.  Unless opportunities emerge on that continent, Europe should prepare for continued immigration pressures in the future.

With the crisis abating, Europe must begin to define an immigration strategy that both meets its economic needs and is consistent with its values.  To be sure, the region will need to improve its ability to control its external border, and the recent plan to establish vetting stations in North Africa and elsewhere is unworkable.  And, as long as European unemployment remains high,  resistance to immigration will remain widespread.  However, immigration has the potential to remedy one of the most potent impediments to Europe’s long-term growth performance:  the aging — and in many cases declining — regional population.

Europe’s population has grown only 2% during the past decade.  And, the Chart above illustrates that the local-born population is declining or stagnant throughout much of the continent.  Immigration has the potential to offset these patterns.  In Germany, for example, gains in immigrants have offset the declining local population since 2010.  In Scandinavia, the Low countries, Austria, and elsewhere immigration gains have outpaced the meagre gains in local births.  At the other extreme, the population in much of  Eastern Europe and the Iberian peninsula is declining, as immigration has not been sufficient to offset shrinking local populations. The Chart is flattering to Italy, but headcount also has been declining since 2015.  Only France and the UK have healthy local birth rates; but, even in the UK, gains in foreign-born residents have outpaced the advance in the local population since 2010.

Individual countries will take advantage of immigration’s potential differently.  The Chart provides two metrics for measuring the role of immigration in individual countries (scaled to the size of the local population).  Scandinavia, Switzerland, the Low countries, and Germany appear best positioned: liberal approach to immigration reflected in high foreign-born populations.  The UK and Austria share these qualities, but both may change direction in the years ahead.  Terrorist episodes in France have curbed the nation’s historical openness to immigration (Foreign residents make up an above-average share in the population).  Iberia, Eastern Europe, and even Italy will need to shift gears in order to exploit the advantages offered by immigration.

Single Currency: Future Still Not Secured

Since the Euro-crisis much progress has been made in improving Europe’s  fiscal and competitive position, which were at the heart of the turmoil. The Chart above illustrates the reduction in each country’s budget deficit (excluding interest payments) since 2010.  Likewise, the following Chart indicates that these efforts have begun to stem the sharp, unsustainable rise in government debt.

However, the job is not done. The recent acceleration in European GDP growth and low-level of interest rates have contributed significantly to the recent stabilisation of debt levels. What happens as interest rates normalise, and economic growth decelerates, or even tips into recession (which will happen at some stage in the next few years)?  Even without making extreme assumptions, the Chart shows my projections of a return to an unsustainable path for government debt levels.

There are only two solutions: additional austerity or an improvement in Europe’s long-term growth trend. As mentioned earlier, immigration can play a role in boosting growth.  However, curing Europe’s poor productivity track record is the surest way.  While slowing labor efficiency gains is a world-wide problem, the following Chart illustrates that Europe has lagged behind the USA for decades, and productivity is actually declining in both  Italy and Greece!

Without improvements in productivity, European leaders will not be able to deliver the rising living standards craved by their electorates, and populist solutions will remain appealing.  Likewise, in the absence of stronger long-term GDP growth, a return to  unpopular fiscal austerity will be required to stabilise debt, and to secure the future of the Single Currency!

To be sure, many of the necessary decisions must be taken at the national level.  However, many issues must also be resolved at the EU supra-national level: e.g. strengthening the Growth and Stability Pact, establishing a regime of automatic fiscal transfers, debt mutualisation, programs to boost regional investment, etc.  Deep divisions exist between Germany and France on many of these topics.  They must be addressed prior to the December EU summit.  Little progress is discernible so far!

Strategic Implications

• Europe must make hay while the sun shines, the good times will not last forever!
• As the asylum crisis is abating, Europe must devise an immigration regime consistent with its economic needs and ethical values. Immigration pressures will persist, especially as Africa’s population expands rapidly. Controlled inflows of people/workers could offset Europe’s aging, shrinking population, and contribute to stronger long-term economic growth.
• Only sustained improvements in European productivity will deliver the rising living standards and jobs craved by the electorate.  Until that occurs, the appeal of populist, anti-immigrant movements will persist.
• The Euro’s future is not yet secured.  Policy decisions are needed by December, as Brexit will dominate the October gathering.
• The case for over-weighting European equities rests in large part on progress on economic reform.  If policymakers fail, I will reconsider this position.