Germany is Europe’s sick man, but others are coughing

By Lionel Laurent

Germany, the sick man of Europe, is about to end a quarter it would rather forget. The first three months of 2024 probably marked its second straight quarter of economic contraction, and for the full year it’s expected to deliver little to no growth. Its industrial powerhouse has become a liability, with demand still subdued, and a deglobalizing world has robbed it of levers like Chinese exports, cheap Russian gas and a dependable US security guarantee.

The new worry is the coughing sound coming from elsewhere in the euro zone. Economies like trade-dependent Netherlands and Ireland have been big drivers of European growth in recent years (maybe deceptively so in Ireland’s case), but now they’re stalling. France, whose demand-led economy usually zigs when Germany zags, is eking out meager growth despite a swelling budget deficit as higher interest rates bite. Optimism that a recession can be avoided is being tempered by anemic investment and productivity growth.

Which leaves the last big bellwether left standing — Italy, where Giorgia Meloni’s officials are defying the gloom by expecting gross domestic product to expand around 1 per cent this year. That would be better than Germany, France, the Netherlands and the euro average, and would be in keeping with Italy’s outperformance since 2019 despite a history of low growth, high debt and volatile politics. Alongside the likes of Spain and Portugal, which after years of crises are enjoying higher competitiveness and export growth, according to ING research, Italy’s recovery has been a boost for Europe.

The problem is there are also signs of ill health, or what Italian Finance Minister Giancarlo Giorgetti recently called a “stomach ache.” He was referring to the Superbonus, a tax credit for eco-friendly home renovations worth 110 per cent of their cost, which brought a big sugar rush for residential investment and played a significant fillip in Italy after the pandemic. Financiere de la Cite economist Nicolas Goetzmann estimates the superbonus — worth a staggering €107 billion ($116 billion) in eligible investment — added about 15 times more to euro-area GDP as Italian construction fixed investments than the entire German economy since end-2019.

What’s given Giorgetti indigestion is not so much the growth but the hit to public finances — it’s a tax credit, after all — which is why the superbonus is being pared back after contributing to a budget deficit of 7.2 per cent last year. And without it, Bloomberg Economics expects growth momentum to keep losing steam, as the above chart shows. “The economic benefits are in the past, while the fiscal cost is in the future,” says HSBC Holdings Plc economist Fabio Balboni.

It’s not all doom and gloom: There are signs of better consumer confidence and stronger wages, and financial markets aren’t yet putting pressure on Italian debt. The expectation that interest rates have peaked, combined with the retreat of inflation, is seeing recession bets fall.

But the bottom line is that Italy is still more likely to slow than outperform this year, adding to European officials’ alarm over the long-term gap opening between Europe and the US economy, which is due to grow 2 per cent this year. Enrico Letta, a former Italian prime minister who’s been drafted by Brussels to write a report on the future of the European single market, last week sounded the alarm on this issue. Investor talk of a soft landing will mean little in a higher-debt, higher-inflation Europe that can’t deliver greater growth.

What might a better road to recovery look like? One is for Italy — and Europe — to make a success of pandemic recovery funds designed to heal the scars of Covid and invest in the future. Rome has spent €45.7 billion, or less than half, of the funding it’s received, which isn’t good enough. Europe has huge investment needs — including €620 billion annually for the climate transition — and a more successful implementation of pandemic funds means a better chance that other necessary spending initiatives will be launched, such as for defense. It would also more than offset the rollback of the superbonus, adding potentially 2.5 percentage points to Italian GDP growth by 2026.

And while Letta’s upcoming report will have plenty of ideas on how to knock down structural barriers to growth, perhaps by uniting Europe’s disparate financial markets and tax rules, Europe should also take a leaf out of America’s book by adopting more demand-led policies to boost consumption. The poor implementation of the superbonus shouldn’t blind us to Europe’s current misguided mix of tight monetary policy and lack of fiscal support, with new EU fiscal rules likely to lead to cuts in public investment — not ideal given Europe’s need to become more geopolitically self-reliant.

“There’s always talk about Germany being a sick man … I’m more worried that Europe is getting sick,” Bundesbank boss Joachim Nagel said last week. He has a point. Better get the medicine ready.