Industrial production has been falling in most European
countries, driven by sluggish internal demand, high energy
costs and competition from the United States and China.
The Wall Street Journal wrote in January that Europe's growth
engine is broken. Eurostat data released last
month shows that industrial production fell by 2.2% in the
eurozone and 1.7% in the European Union over the prior
year. Germany, France, Italy and
Spain, Europe's four largest economies, all recorded a year
on year drop in the production of capital goods and consumer
durables. It's not all bad though.
Some of the smaller economies like Denmark, Greece and Finland
saw significant growth. Denmark had the fastest
industrial growth in Europe, up almost 20% over the 12 month
period, driven by its booming Pharmaceutical industry which
has produced popular weight loss drugs and an mpox vaccine.
The former president of the ECB, Mario Draghi, wrote in a report
last month that the European Union today faces an ecstasy
substantial challenge, and if it doesn't change, it will be
condemned to a slow agony. He wrote that real disposable
income per capita has grown almost twice as much in the
United States as in Europe since 2000.
And as things stand, there's no reason for this downward slide
to stop. Germany, which has been a
powerhouse of manufacturing in Europe for decades, has seen its
output trend downward since 2017.
And Bloomberg writes that it's days as an industrial superpower
might be coming to an end. Since its peak, German
industrial production has contracted by 14%, and it's now
back to a level last seen in 2006, if we exclude the sharp
decline seen globally during the pandemic.
This manufacturing downshift can be seen when factories are
shattered or firms reduce headcount, but it also shows up
more subtly when firms scale back their expansion and
investment plans or decide to grow their operation in other
parts of the world. Last week, Volkswagen, which is
Germany's biggest employer, announced plans to close at
least three factories, eliminate thousands of jobs and slash
wages for 10s of thousands of German workers.
This would be the first time in the company's history that
they've closed a factory in their home country and the
planned salary cuts could affect as many as 140,000 German
workers. It could be argued that
Volkswagen can be seen as a symbol of Europe's battle for
industrial relevance as it struggles to compete with
foreign rivals, balance the demands of shareholders, unions
and government, deals with high energy costs and grapples with
an expensive transition to greener technology that it's end
customers are not necessarily demanding.
From the launch of the euro in 1999 through to the start of the
pandemic, euro area exporters and German firms in particular
benefited from strong growth in China, which fueled demand for
European capital goods. Over the same period, Europe
switched from being self-sufficient in energy
production to becoming the largest importer of natural gas
in the world. Russia was the cheapest supplier
and the EU relied on it for 41% of its natural gas needs, the
Economist wrote when discussing Germanys problems.
A national business model built in part on cheap energy from 1
autocracy and abundant demand from another autocracy faces a
severe test. Since the credit crunch, U.S.
stock prices have hugely outperformed British and
European stocks. And some of this is because
European stocks are a lot cheaper on a price to earnings
ratio basis. But that's no excuse.
U.S. companies have seen earnings per share grow 290%
since 2010, when European earnings only grew 60% over the
same period. So is industry destined to die
in Europe? And should Europe just pivot to
tourism and settle on becoming the world's museum as some have
suggested? According to Mario Draghi's
report, which is one of the best pieces I could find on the
problems facing Europe, high energy prices are a real
headwind for European manufacturing.
Natural gas prices are three to five times higher in Europe than
they are in the United States, and electricity prices,
specifically those for industrial sectors, are
currently two to three times those in the United United
States and China. Now, European energy prices have
always been higher, but this issue has worsened over time.
In 2020, renewables overtook fossil fuels to become the
leading source of power in Europe for the first time ever.
But wind and solar power are incapable of generating enough
power to account for 100% of demand year round, even in the
most favourable climate conditions, according to Draghi.
The phase out of nuclear power in countries like Spain and
Germany, who have set national targets for winding down their
existing nuclear fleets, increases the gap between
consumer demand and the electricity supply that can be
generated by renewable sources. The way power is priced in
Europe is complex. They use a marginal model, which
means that if a mix of sources are used, the price paid is set
at the price of the most expensive fuel required to meet
projected demand. So even if solar power is cheap,
but some of the energy needed is natural gas, which is expensive
in Europe, all suppliers end up getting paid the price of
natural gas. The model is set up this way,
they say, to allow utilities to recover investments they made by
installing new sources of energy on the grid.
In situations where all of the demand can be met with wind,
solar and nuclear, which have low generation costs, the price
of power can be very low or even negative, as happened in spring
2020, when electricity demand was low and renewable energy
production was high. Countries like Spain, who
generate most of their power from renewables, have complained
about the way this pricing system works to the European
Commission. They might be getting 95% of
their power from solar, but if the remaining 5% was natural
gas, they have to pay up as if the entire fuel supply had been
natural gas. The European Commission have
rejected their appeal, saying that other systems like a pay as
bid approach have been analyzed and actually lead to higher
energy prices in places where they've been implemented.
Now, I haven't seen any analysis of this, but it does seem quite
surprising. One issue mentioned in Mario
Draghi's report is that marginal price setters are often fossil
fuel sources who are charged a carbon tax which is embedded in
the price that they charge. This higher price then boosts
what's paid to the renewable energy producers in the mix.
According to the report, carbon costs accounted for around 10%
of the EU industrial retail electricity price in 2023.
An economist piece on renewables and the European energy market
makes the point that at times European energy is very cheap.
They argued that firms and regulators are simply not making
the most of this and that there are three ways a more efficient
market could be established. One, sending energy to areas
where there's no surplus. 2, shifting demand to hours when
energy is plentiful. And three, storing energy as
electricity, fuel, or heat. The problem with those solutions
is that sending electricity to places where it's needed
involves expensive grid upgrades.
Storage involves expensive battery packs or building out
hydrogen storage systems, or systems where excess solar
energy is used to pump water up a hill, and that water can be
used later for hydropower when there's not enough solar energy.
But once again, all of this is expensive and all of these
solutions can be held up for years in planning.
It's slightly disingenuous, I feel, to claim that renewables
are cheap if they only provide reliable power after a bunch of
really expensive upgrades are made.
I by no means claim to be an expert on this topic, but I do
find it really interesting and I've read up quite a bit on it.
I can find lots of articles telling me how cheap renewable
energy is. But despite all of this cheap
energy, power is so expensive in Europe that factories are
shutting down. I don't really see an Enron type
middleman getting rich in Europe either by ripping everyone off.
But the money must be going somewhere.
And it mostly appears that a lot of new sources have been tacked
on to the existing electrical grid and they don't really work
that well together yet. And the solutions that will get
everything working will be both expensive and take time to
implement. I do aim to learn more about
this, as it seems to me that energy is a big problem that
will need to be solved in the coming years.
The Economist's other solution of shifting demand to hours when
energy is plentiful and cheap using things like smart meters,
may work for certain types of user.
Your electric car, for example, could be set up to charge itself
in the middle of the day while solar energy is cheap and you're
at work. But that still doesn't work for
a factory that needs to be running 24 hours a day.
Energy is obviously a very complex problem, more
complicated than Will Smith's marriage, but finding a solution
does need to be prioritized. In Europe.
The chief economist at Berenberg, a private bank, told
The Economist last year that with energy prices likely to
stay high for a while, 2 to 3% of Germany's industrial
companies that use energy intensive processes will likely
relocate abroad. I made a video about a year ago
on how China overtook Japan to become the largest car exporter
in the world. China's exports have been
stepping up as its economy has slowed as its leader solution to
a drop in domestic demand has been to manufacture the same
amount of goods as when the economy was booming and export
the surplus. As a result, the European
Commission imposed new tariffs of up to 35% on Chinese EVs on
top of the existing 10% duty. The automotive sector employs 13
million people in Europe and makes up 7% of total employment
in the region, so it's no surprise to see the EU pushing
back against massive subsidized imports.
The export driven growth model is an economic strategy
pioneered by Germany and Japan in the post war period that aim
to grow productive capacity by focusing on foreign rather than
domestic markets. It rose to prominence in the
late 1970s, largely driven by its success in Japan, and became
part of the new consensus among economists about the benefits of
economic openness. One of the problems today is
that every economy around the world seems to plan on growth
through exports, with no one planning on running a trade
deficit. And that simply can't work.
If everyone's exporting, someone has to be importing.
The economist Thomas Parley argues that there are reasons to
believe that the export LED growth model stopped working
after the 2008 financial crisis because of changed conditions in
both developing and developed economies.
High debt in the United States, fiscal austerity in Europe and
supply side stimulus in emerging markets led to a global demand
shortage. He argues that going forward
there needs to be a shift in most economies towards domestic
demand LED growth while only aiming to export enough to pay
for imported goods that are not produced domestically.
Essentially a move towards more balanced trade.
No matter who wins in the upcoming US election, trade can
be expected to be a huge political issue going forward in
the United States. And while the Democrats and
Republicans may offer slightly different solutions,
protectionism, tariffs and subsidies do appear to be on the
cards. While American productivity
appears to have grown during the pandemic, the same thing did not
happen in Europe, the FT reported this week.
The German business executives are now warning that high levels
of sick leave are damaging their competitiveness and compounding
the country's economic woes. A study found that were it not
for the country's above average number of sick days, the German
economy would have grown by half of a percent last year, rather
than shrinking 0 .3%. Lower European productivity is,
however, not just explained by extra sick days.
According to Mario Draghi, the productivity gap between the EU
and the United States over the last 25 years is largely
explained by the tech sector. Europe mostly missed out on the
digital revolution and the productivity gains that it
brought. He says that the problem is not
that Europe lacks ideas or ambition, but innovation is
blocked at the next stage, it's not translated into
commercialization, and innovative firms that want to
scale up are hindered by inconsistent and restrictive
regulations. Many European entrepreneurs, he
says, prefer to seek financing from American venture
capitalists and scale up in the American market.
There are large sections in his report on computing and AI and
semiconductors, but unfortunately these topics all
circle back to the the high European energy costs which
represent a disadvantage for EU based providers.
According to Mario Draghi, the European economy has fallen
behind the United States and China is rapidly catching up.
Real disposable income per capita has grown almost twice as
much in the United States as in Europe since 2000, and he says
that as things stand, there's no reason for this downward slide
to stop. He says that due to the ageing
European workforce, by 2040 the population will start to lose 2
million working people per year, which will mask the effects of
lower growth. But without growth, Europe will
not be able to finance its social model and will have to
scale back some, if not all, of its ambitions.
An IMF blog post from earlier this year asked if Germany, the
manufacturing centre of Europe, was irreparably broken.
They highlight that critics say that the strong growth in
previous decades was based on importing cheap Russian gas,
which powered Germany's export industries.
With this cheap gas no longer available, the German
manufacturing model stopped working.
They point out that after a big spike in 2022, wholesale gas
prices fell back to 2018 levels. They say that it was not the
loss of Russian gas, but that the post pandemic rebalancing of
global demand from manufactured goods, which Germany specializes
in, towards services was unfavorable for Germany's
economy. They argue that concerns for the
longer term future of German industry are exaggerated.
While energy intensive industries like chemicals,
metals and paper manufacturing have contracted, they only make
up 4% of the German economy. Automobile production on the
other hand, rose 11% last year. They highlight that
manufacturing value added remained steady even as
industrial production fell because manufacturers adapt to
the energy crisis and supply chain disruptions by shifting
into higher value added products that use fewer intermediate
inputs. They say that the biggest
problems for Germany are a projected decline in Germany's
working age population, which this chart shows is much worse
than is expected in Japan, the rest of the EU and the UK.
They argue that German productivity has been dragged
down by inadequate investment in public infrastructure.
Where Germany is near the bottom of advanced economies in terms
of public investment, this is mostly driven by the German
aversion to debt. While borrowing for the sake of
borrowing makes no sense, borrowing to pay for necessary
infrastructure that will boost the nation's productivity does
make sense. Productivity could also be
enhanced by cutting red tape, they say.
Apparently, the German economy is bogged down with excess
regulation. They give the example that it
takes 120 days to obtain a business license in Germany,
which is more than double the OECD average.
While news of Volkswagen's factory closures led to
headlines of European industrial decline, the problems at
Volkswagen can be explained as much by its own corporate
governance issues and a botched transition to EV manufacturing
than the fact that it's a European firm.
Volkswagen's emissions cheating scandal in 2015 tarnished its
reputation with customers, regulators and investors.
It's focus on manufacturing expensive SUV's and exporting to
China has not worked out. I would argue that almost every
problem with Volkswagen is summed up with its new electric
bus. Now look, I'm no Chip Foose and
I'm really no graphic designer either.
I don't think many graphic designers use PowerPoint, but I
think I could fix a few of the problems with the Volkswagen ID
bus. Firstly, they got the front
wrong. It needs to look like the
original one. We need a bigger logo next.
Then they got the top all wrong. We need all of those windows
back. We need to get the wheels right.
Next, and this doesn't make a ton of sense if you're taking
family trips, it should probably be a hybrid.
And of course, this is the worst part, $70,000.
It's a minibus, It's not an S class.
If anyone at Volkswagen is watching, I'm happy to help out.
This is turning into a bit of a budget version of Mighty Car
Mods. And please don't criticize the
panel gaps either. I did this in PowerPoint, like I
said, and there are people out there buying cyber trucks, so
this looks just fine. And we can put an iPad on the
dashboard because people seem to love that sort of thing.
Anyhow, this isn't a car design channel.
I'm just trying to help out a little bit.
Nicole Pelesh at Oxford Economics argues that the
decline in European industrial output in recent years is more
of an industrial recession than deindustrialization.
He says that Europe shrinking share of global industrial
output is more driven by increased output from Asia than
by decreased competitiveness in Europe.
He points out that the industrial share of GDP only
declined slightly in 2022. And 2023, indicating that the
current industrial troubles should be seen within the
context of a broadly weak economy.
And this is not the industrialization.
He says that some industries can be expected to decline, but this
decline will be offset by the rise of other industries.
He points out that Europe's strengths lie in highly complex,
specialized areas of manufacturing, and these areas
require a highly educated workforce, which Europe has.
They benefit from network effects, institutional knowledge
and the cumulative impact of decades of investment in
intellectual property, patents and physical capital.
There are further barriers to entry too in the form of
research costs and building trust amongst potential our
customers. Mechanical engineering,
electronics and pharmaceuticals are examples of such sectors
where Europe competes strongly. Companies like ASML, who make
the machines needed to produce semiconductors, Novo Nordisk,
who makes the blockbuster drug Ozempic that we mentioned
earlier, and Airbus, the airplane manufacturer, are the
types of high scale, high specialization businesses that
are thriving in Europe. These sectors are still growing
as a share of total industry and economic activity.
Europe's ageing workforce, according to Payless, puts in
place an incentive for greater factory automation, which he
points out. Germany is a leader in certain
industries he says are at risk, like textiles and clothing,
paper manufacturing, refining, plastics, metals and chemicals.
The green push in Europe, combined with high energy
prices, means that energy intensive industries like
reducing iron ore to make steel, heating limestone to produce
cement, and using steam to crack hydrocarbons into their
component molecules will be a struggle.
On top of that, the chemical processes themselves give off
lots of additional CO2. Cutting all of those emissions
appears to be prohibitively expensive given today's
technology. The problem is that shutting
down these industries in Europe and importing steel, cement and
Petro chemicals just means that the pollution occurs in other
parts of the world, where these processes are often done in a
dirtier manner than they're done in Europe.
It makes neither environmental nor economic sense.
The chemicals industry faces the biggest challenge as it's
extremely reliant on hydrocarbons, both for energy
and because thousands of necessary products are derived
from crude oil. 142 gallon barrel of crude oil creates just
under 20 gallons of gasoline and the rest, more than half, is
used to make everything from ink to antihistamines to fabrics,
detergents, paints, the list goes on.
Part of the case made to European voters who were
skeptical of the need for a green transition was that going
green would do more than just fend off climate change.
It would make Europe less dependent on Russian gas and
create lots of new green tech jobs.
Critics today argue that meeting the new environmental targets
which shiploads of Chinese solar panels, which were produced
using cheap Chinese coal, has only served to move pollution to
to the other side of the world and change the autocratic regime
Europeans have to depend on while crushing employment.
Labour unions in the UK are arguing that green policies are
hollowing out working class communities and that the
government needs to stop decarbonization through
deindustrialization. Going back to Mario Draghi's
report, which I've linked to in the video description, he
highlights that European companies face electricity
prices that are two to three times higher than those in
America, and natural gas prices that are four to five times
higher. He says that Europe's energy
market has to be quickly reformed so that end users can
see the benefits of clean energy in their bills.
Industrial energy prices in the EU are impacted by tax, taxes,
levies, carbon fees and other charges which when combined,
account for a substantial portion of the final energy cost
which is substantially higher than in other global regions.
I mostly agree with Oxford Economics that Europe is not
deindustrializing. Some industries are suffering,
in particular the most energy intensive ones, but others are
growing. For all of the talk of German
deindustrialization, manufacturing there still makes
U almost 20% of the economy, which is about twice the level
in the United States. With China stimulating its
economy and pumping out more exports than ever before while
importing next to nothing, and with the US moving in a
protectionist direction, the export driven growth model may
have reached the end of the road and economies may need to
restructure towards domestic demand LED growth, aiming to
balance imports and exports such that enough is exported to pay
for goods that are not produced domestically.
This change might impact emerging markets much more than
it impacts Europe, as they may not be able to rely on the
United States to absorb their excess production in the way
that they could in the past. There are lots of challenges
ahead for Europe, as there are for the rest of the world too,
but Europe has a highly educated workforce capable of high tech
production and innovation. Unlike some of the critics, I
don't expect the continent to turn into the world's museum or
become some sort of green energy version of Easter Island where
they keep buying solar panels from China until the whole
economy grinds to a halt. If you disagree, do let me know
in the comments section. Thanks for tuning into this
week's podcast. I'd love it if you could tell
your friends about it to help the podcast grow as unlike
YouTube, there is no podcast algorithm.
Have a great day and talk to you again soon.
Bye.