Trade and Politics Start To Take a Toll

By Thomas Cooley, Charlie Nusbaum, and Peter Rupert

European Politics

During the first quarter of 2018, the EU has been marred by both political and economic uncertainty. Increasing tensions between the U.S. and its European allies have resulted in the looming threat and subsequent imposition of trade tariffs. Moreover, Germany and Italy, the largest and fourth largest economies in the EU, respectively, were struck by the emergence of the populist, Eurosceptic wave washing over Europe. Indeed, the Social Democratic Party polled its lowest during the German election since World War II whereas the Alternative for Germany party, the nationalist insurgency, gained entry into the Bundestag for the first time with the third largest number of votes. Angela Merkel’s Christian Democratic Union party lost a total of 55 parliamentary seats. Despite the conclusion of the German elections in late September of last year, a formal coalition was not formed until March.

In Italy, a similar story played out during 2018Q1. In late December, President Sergio Mattarella dissolved the parliament and called for new elections to be held in early March. In the run-up to the election the Five Star Movement, a right wing populist party which has supported abandoning the Euro and leaving the EU at various times, surpassed the consistently pro-Europe Democratic Party to take the top spot in opinion polling while Lega, the more fervent anti-Europe party, maintained its fourth position in such polls. The results of the election showed the Five Star Movement winning the popular vote and Lega placing third.

Uncertainty surrounding Brexit, however, lessened as the deadlock in the first round of negotiations broke. In fact, the United Kingdom entered 2018Q1 having just reached an interim agreement surrounding three key issue: free movement across borders, the rights of UK citizens abroad and EU citizens in the UK, and a financial settlement to be paid to the EU. While preliminary, it served as an important step in resolving some of the uncertainty surrounding the crucial transition period of the Brexit process.

The resolution surrounding Brexit was rewarded by the markets with all four major stock indices in the EU seeing gains towards the end of the year. These gains were quickly lost, however, when it became clear that the uncertainty surrounding tariffs, Italian elections, and the formation of a coalition among Germany’s major political parties were a potential threat to Europe. In fact, all four indices showed largely horizontal movement throughout 2018Q1. These trends beg the question: Is the European economy robust enough to withstand such bouts of uncertainty?

Economic Growth

Overall, the EU28 and EA19 both saw a minor slowdown in growth during 2018Q1, ticking down from 2.71% and 2.83% during 2017Q4 to 2.43% and 2.54%, respectively. Moreover, both were outperformed by the U.S., which saw a year-on-year growth rate of 2.78% according to the BEA’s second estimate. The Eastern European countries by and large outperformed the rest of the EU, while Cyprus continued to break from its Greek neighbors and boasted year-on-year growth above 3.5% for 6 straight quarters. This is quite a turnaround for the small European island given that just four years ago it struggled to pull itself out of a two year contraction. On the other hand, the four largest economies in the EU underperformed.

Indeed, France, Germany, Italy, and the United Kingdom all saw a decrease in growth during 2018Q1. For the United Kingdom, this continues a long term trend that began in 2015Q1 and was restarted during 2017 following the Brexit vote. For France, Germany, and Italy, however, this marks one of the first signs of weakening in this regard over the past year and a half.

Europe lagged behind the United States slightly in terms of investment growth with real fixed capital formation growing by 4.19% and 3.59% in the EU28 and EA19, respectively, compared to 4.45% in the U.S. Here again, the Eastern European countries fared best while Cyprus saw a severe contraction in investment. Going forward, this trend may inhibit Cypriot growth and break its impressive streak of exceptional growth.

The Unemployment rate in most European countries remained low during 2018Q1. Indeed, only Spain and Greece maintained unemployment rates above 10%, with values of 16.2% and 20.5%, respectively. Across the EU28, the unemployment rate decreased slightly to 7.2%. The European labor market remains behind the United States, which boasted an unemployment rate of only 4.1%, in this regard.

Still, the European labor market is heading in the right direction despite the uncertainty revolving around the European political status quo. Those countries whose labor market struggled the most continued their long run trends of declining unemployment. While Finland, France, and Italy have seen the least dramatic movement in unemployment, a slight downward trend still presents itself. Not pictured below are the first and second largest EU economies: Germany and the United Kingdom. Germany and the United Kingdom both display a similar downward trend, though they boast unemployment numbers of 3.5% and 4.2%, respectively. Both of which are on par with the United States.

As a whole, the EU labor market has shown persistent improvement. Indeed, the EU28 Beveridge curve continues to indicate ever increasing market tightness as is evident by the simultaneous decrease in unemployment and increase in the job vacancy rate.

A key comparative static of Beveridge curves are whether they display an outward or inward shift as they complete their loop. Here, it is clear that the Beveridge curve has seen a drastic outward shift between 2013Q2 and 2018Q1 as compared to the 2006Q1 to 2008Q1 period. This implies that the labor market requires a higher number of unfilled jobs in 2018Q1 than 2008Q1 in order to sustain the same level of unemployment.

An Uncertain Future

In spite of the political uncertainty throughout the continent, the EU largely maintained its positive growth. There are, however, some early signs that the perceived threats to the European experiment are beginning to have a real impact.

It is far too early to sound an alarm, but we take the recent data to be an early symptom that should be watched carefully. Trade policy between the U.S. and the EU is becoming increasingly strained as each side ratchets up tariffs, tension has emerged within the German coalition over legislative priorities and the refugee crisis, and a populist coalition between the Five Start Movement and Lega that many fear will place increased strain on Italy’s finances has taken power. Moreover, the United Kingdom and the rest of the EU must come to a final Brexit agreement in the coming months before the mid-October EU summit. While the EU has shown resilience to the early political events of 2018, increasing uncertainty and an escalating trade war will be a true test of the European economies.

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