Brexit continues to dominate headlines in the UK, but the European Union faces other long-term challenges, from the rise of Euroscepticism in Italy to the stalled progress of euro zone reform.

Wearing a sharply tailored suit and a twinkling smile, France’s new president Emmanuel Macron strides across a calm blue ocean. Behind him, UK prime minister Theresa May’s leopard-print shoes float listlessly on the water – a symbol of the doomed Brexit project. But Macron presses on, eyes fixed on the limitless horizon.

The Economist’s cover image of June 2017 neatly encapsulated Europe’s grand hopes for the Macron presidency. Having created a new party from scratch and trounced his far-right rival in the French election, Macron – liberal, centrist, staunchly pro-European – was hailed as the man who would revive France, see off the threat of populism and save the euro zone. 

The EU faces a vacuum of political leadership during a daunting period

Fast forward 18 months and Macron is not so much walking on water as frantically trying to keep his head above the surface. His approval ratings have dropped amid mass street protests, ostensibly a revolt against new fuel and pensions taxes. Nationalist parties are on the rise in the south and east of the European Union, complicating Macron’s hopes for EU reform. To make matters worse, his close ally Angela Merkel will soon step down as German chancellor. 

With Macron and Merkel losing authority, the EU faces a vacuum of political leadership during a daunting period.

Brexit could yet cause market disruption and Eurosceptic parties look set to make gains at the European Parliament elections in May. Italy remains economically vulnerable. Over the medium term, the euro zone’s half-finished institutions are ill-equipped to handle another debt crisis, while divisions over migration could cause deeper rifts.

“Europe is at a turning point,” says Stewart Robertson, senior economist for the UK and Europe at Aviva Investors. “The EU has much to celebrate, not least healthy democracies, affluent economies and the world’s most liveable cities. But if the EU is to prosper into the future, it will need to fix some pressing problems, notably the political and economic fault-lines in the euro zone.”

Europe in 2019

Start with the immediate challenges. At the time of writing, the UK was set to leave the EU on March 29, 2019, although the details of its departure remained unclear. If the UK prospers independently, other EU member states could be encouraged to follow its example; an economically damaging Brexit, on the other hand, would prove a cautionary tale.

Neither side would benefit from traffic-clogged motorways or grounded aircraft – the risks of a ‘no deal’ scenario – but the euro zone economy looks better positioned than Britain’s to absorb any shock. Euro zone GDP growth stood at a solid if unspectacular 1.5 per cent in 2018, lower than in 2017, but a sustainable level within the long-term capacity of the bloc.

Escalating global trade tensions remain a threat to growth, but the European Central Bank (ECB) has left some room for manoeuvre when it comes to normalising policy. 

The European Parliament elections in late May will provide a gauge of post-Brexit political sentiment across the EU. Though the body will reduce in size following the UK’s departure, the vote is still a massive undertaking: 705 MEPs will be elected from across 27 member states, representing nearly 500 million people. The European Parliament is the only institution in the EU whose members are directly elected; most MEPs sit in loose alliances that work together to pass legislation. 

“The European Parliament elections will be important,” says Chris Bickerton, Cambridge University academic and author of The European Union: A Citizen’s Guide. “They are the first test of Macron really, and it is quite likely that he does rather badly. Who picks up his votes will be interesting – in France, possibly the Front National or the centre-right.”

The European Parliament elections will provide a gauge of post-Brexit political sentiment across the EU

Having advocated closer integration of the euro zone and mounted a vociferous defence of liberal values, the French president has become a lightning rod for Eurosceptic discontent across the continent. At home, the Gilets Jaunes protestors continue to crowd the streets of Paris in their high-vis vests, despite the government’s attempts to placate them by boosting the minimum wage and scrapping proposed new fuel taxes.

“Macron’s attempt to force a common consensus [in Europe] is going to be affected by domestic developments,” says Professor Jean Pisani-Ferry, an academic at the Hertie School of Governance and formerly Director for Programme and Ideas on Macron’s presidential campaign. “Macron is weakening as a consequence of the Gilets Jaunes. What we’re seeing in France is a specifically French manifestation of a much broader phenomenon: the economic, social and political frustration of the middle and lower middle classes, which we saw in the Brexit vote and in the election of Donald Trump.”

Analysts believe the European Parliament elections are unlikely to result in a clear winner for any of the existing parliamentary groupings, with the socialist parties aligned with the Progressive Alliance of Socialists and Democrats expected to lose seats. This means MEPs may need to create a grand coalition to pass legislation over the next five years – not an outcome likely to assuage complaints that the Parliament is ill-equipped to respond to Europe’s most pressing issues.

Italian exit?

Of these problems, Italy’s Eurosceptic turn is arguably the biggest threat facing the European project. The ruling coalition government, an unusual alliance between the far-right Northern League and the anarchic, broad-church Five Star Movement, has threatened to flout the euro zone’s fiscal rules, although it reached a belated agreement on spending with the European Commission in December 2018. The new budget will see Italy’s deficit rise to just over two per cent, higher than a previously mandated limit but below the 2.4 per cent projected in the original proposal.

There are still weaknesses in the Italian financial sector, and political tensions could flare up again

The end of the ECB’s quantitative easing programme in December may have been a factor in the Italian government’s climb-down. Policymakers were especially worried about widening yield spreads between Italian and German bonds as the continent’s biggest buyer of government bonds reduced its purchases. Italy’s public debt stands at more than 130 per cent of GDP, a debt burden that could quickly prove unsustainable if yields spiked.

“The agreement between the European Commission and the Italian government should calm the situation,” says Robertson. “Italy’s public finances were at risk of heading down explosive and hugely unsustainable paths. But there are still weaknesses in the Italian financial sector, and political tensions could flare up again. Italy is not out of the woods yet.”

Italy’s combustible mixture of Eurosceptic populism, high debt and anaemic growth has led some to fear it could eventually follow the UK out of the EU. Given Italy is part of the single currency, the consequences would be far more damaging than Brexit – redenominated into lira, Italy’s wealth stock would plunge and its euro-denominated debts would become unpayable, potentially sending shockwaves across the euro zone and wider financial markets.

Carlo Bastasin is a senior fellow in the Foreign Policy programme at the Brookings Institution in Washington D.C. and author of Saving Europe, an in-depth study of the euro zone crisis. He points out Italy is still an affluent country, with high levels of per-capita wealth. According to Bank of Italy figures, Italian households are sitting on a collective €10.5 trillion of private wealth, of which €4.2 trillion is held in financial assets. When push comes to shove, Italian citizens would be unlikely to put this wealth at risk.

“In a way, Italians have used patrimony and wealth as a self-defence against an inefficient state,” says Bastasin. “A recognition that the fiscal situation is wobbly, and that one day the government may not be able to repay its debts and meet its pensions commitments, has led Italians to accumulate real estate and savings. Paradoxically, the low level of economic growth in Italy makes it more important to defend the wealth levels vis-à-vis income levels.”

All of which means a change in the Italian government – perhaps prompted by a worsening of the country’s economic fortunes – is more likely than an EU exit in the medium term, according to Bastasin. “Italy’s fiscal situation is not consistent with the government’s economic policies. Either the fiscal position proves unsustainable or we have a change in government, and the latter is easier to bring about. Even if you had only one populist party in the coalition government, rather than two, the fiscal situation and the agenda of the government would become more consistent.”

The north-south divide

The stand-off between Italy and the European Commission points to a deeper fissure between north and south in the euro zone. Like Italy, other southern European nations – including Greece, Spain and Portugal – are still suffering the economic consequences of the sovereign debt crisis that followed hot on the heels of the global financial meltdown in 2009.

Bound to the single currency, these weaker economies were unable to take the conventional route out of hardship – slashing interest rates to devalue their currencies and make their exports more competitive. Instead, they had to push down wages and prices to achieve the same result. Austerity and widespread unemployment left economic scars that persist to this day – ‘hysteresis effects’, in economic parlance – and contributed to populism in these nations. Meanwhile, northern European states have recovered much more quickly.

In his book EuroTragedy: A Drama in Nine Acts, economist Ashoka Mody likens the accelerating gap between the euro zone’s north and south to the ‘great divergence’ that occurred following the Industrial Revolution in the late 18th century, during which growth in some European countries sped up while other regions such as Latin America and Africa entered a long decline. In his view, endemic and interrelated problems such as poor institutional quality, rapidly ageing populations and low productivity will continue to weigh on southern European economies and test the integrity of the euro zone.

Map of Europe

At the same time, Europe’s northern countries will continue to perform robustly, accumulating large surpluses that contribute to imbalances across the bloc. Germany ran an estimated current account surplus of US$300 billion (7.8 per cent of GDP) in 2018, according to the Munich-based Ifo Institute for Economic Research – the largest in the world for the third year running.

“Europe needs a rebalancing of the German economy, but it’s politically difficult for Germany to give up its hard-earned current account surplus,” says Ed Kevis, European equities fund manager at Aviva Investors. “Germany has benefited from an artificially weak currency; even as other countries have suffered. Ideally, the German government would invest in infrastructure both at home and in wider Europe to redistribute some of that money.”

If another crisis hits, a more direct fiscal transfer from north to south might be required to rescue the indebted economies. But bailouts are a politically sensitive issue in Germany and other northern nations such as Denmark, Finland, Ireland, Sweden, the Netherlands and the Baltic states; a group dubbed the New Hanseatic League after a confederation of guilds that dominated trade in medieval Europe.

Robertson contrasts the euro zone with the US, which responds very differently to internal economic pressures. The US savings and loan crisis of the 1980s and 1990s, for example, resulted in the bankruptcy of more than 1,000 small banks, mostly in the American south. A US$50 billion federal government bailout in 1989 amounted to a fiscal transfer from affluent US states on the east and west coast to these economically weaker areas. But unlike the recent euro zone bailouts, this provoked scarcely a murmur of political opposition.

“In stark contrast to the euro zone’s foot-dragging over the Greek bailout deal in 2015, the rescue effort during the savings and loan event was uncontroversial, even though the proportional cost to richer US states was far greater than the hit to Europe’s rich nations during the euro crisis,” says Robertson. “Until the euro zone is run like the US, with an internal transfer union, you will keep seeing these sorts of problems.”

Open versus closed

The EU’s divisions are not simply economic. While Europe’s mainstream parties are much alike, every populist party is populist in its own way. Where insurgents in southern Europe have set out their stall against the fiscal austerity imposed by northern countries, right-wing leaders in the east, such as Hungary’s Victor Orban and Poland’s Andrzej Duda, tend to be more opposed to social liberalism and immigration, challenging the values by which Europe has sought to define itself.

Support for freedom of movement within the EU remains strong, but opposition to non-EU migrants is growing – and not just in the east. Angela Merkel’s refusal to turn away two million refugees from the German border in 2015, many of them displaced by the war in Syria, was greeted as symbolic of Europe’s social liberalism by her admirers across the West. But it created an opportunity for the far-right Alternative für Deutschland (AfD) party to grow as an electoral force by stirring resentment against immigration. 

Pisani-Ferry says Europe’s main political divide is no longer left versus right; the key debates are now between those who would advocate ‘open’ versus ‘closed’ social and economic models. “On the one hand you have people who would put more emphasis on closing borders to migrants, but also perhaps to goods and services. On the other hand, you have those who are more internationalist. That is becoming a significant divide across Europe.” 

New alliances are forming along this ‘open-closed’ political line. Both Orban and Matteo Salvini, the far-right Italian interior minister, are pushing for a new compact between anti-immigration parties to challenge the liberal consensus within the EU’s institutions.1 On the ‘open’ side of the equation, Belgian MEP Guy Verhofstadt has called for the EU to go further in sanctioning member states that breach Europe’s liberal values by eroding democratic norms and attacking the free press.2

Germany's reliance on Russian energy supplies complicates the picture

Part of the problem is that the EU has little power to tackle the root causes of global instability that contribute to far-right politics. Even Germany, Europe’s largest economy, spends only 1.2 per cent of GDP on defence, well below the NATO guideline of two per cent. This means it must reckon with the consequences of global catastrophes – such as the Syrian refugee crisis – without being able to contribute to their resolution.

In an era of rising ‘great power’ tensions, this could become an ever-more damaging weakness, especially as climate change is expected to lead to greater competition for natural resources and fuel mass migration over the longer term. Germany’s continuing reliance on Russian energy supplies via the Nord Stream pipeline further complicates the picture. 

“The protectionist threat from Trump; the issue of Nord Stream; the domestic political legacy of the migrant/refugee crisis; the growing influence of Austria within the EU and its ability to make alliances with states like Italy – all these are difficulties that German governments haven’t had to deal with in a long time and are not set up to deal with,” says Helen Thompson, professor of political economy at the University of Cambridge. 

The EU stands to lose its biggest army after Brexit, albeit with agreements about future cooperation between the UK and European forces. As it stands, the EU has been reluctant to summon joint forces to pursue global objectives under its Common Security and Defence Policy. Its only recent combat mission was in the Central African Republic, where it sent 750 troops. (Casualties were more or less non-existent; one French corporal died – but that was from malaria.3) Whether the rest of Europe would be willing to sign up to Macron’s plan to create an EU army to take on a more assertive geopolitical role remains to be seen, although France and Germany have agreed to ramp up their military cooperation under a new treaty signed on January 22.4 

Future scenarios

Given the deepening political and economic fault-lines across the EU, shrewd statecraft will be needed to ensure the European project survives. And the continent’s leaders have shown they are aware of the need for reform. 

In 2017, the European Commission published a white paper on the future of the EU, which set out various possible scenarios.5 These options included “nothing but the single market”, a plan that effectively gives up on closer integration on security and defence issues and re-centres the European project on maintaining an efficient trading bloc. The paper also outlined a so-called “two-speed” EU in which core states, including economies in the euro zone, step up political and economic integration while those on the periphery retain greater independence. The final scenario sees all EU states do “much more together”, with improved coordination on fiscal, social and defence matters within euro zone and non-euro zone states. 

In 2018, Macron and Merkel made tentative progress on a model for new reforms. At a conference in the German town of Meterberg in June, they agreed the euro zone should create a budget to respond to financial crises, albeit one administered by the EU’s existing institutions. A joint Franco-German statement issued to EU finance ministries did not specify the size of the putative budget and stipulated it would be financed through joint contributions from euro zone states, via instruments such as a financial transaction tax (which doesn’t yet exist, despite originally being proposed in 2011). 

Given the Macron-Merkel proposal forms part of the EU’s financial infrastructure, it would need all the EU’s member states to accede to it, which is far from certain. Merkel herself is due to step down as German chancellor before 2021, having already been succeeded as leader of the Christian Democratic Union (CDU) party by her one-time protégé Annegret Kramp-Karrenbauer. It is unclear whether Kramp-Karrenbauer would be willing to push through the Merkel plan in the face of domestic opposition should she become chancellor as expected. The Dutch-led Hanseatic group, which is resistant to financial risk sharing, is also likely to prove a stumbling block. 

Ever closer union, or decentralisation?

Where does this leave the European project? Claus Offe, a German sociologist, argues Europe has become “entrapped” by competing imperatives.6 Political considerations mean it cannot move forward to closer integration without great difficulty, but neither can it easily shed members or split into northern or southern currency blocs. The only economy likely to be strong enough to survive the disruption caused by a redenomination of its currency is Germany. 

Bastasin argues greater integration might yet happen as a result of external factors. In an ever-more fraught geopolitical environment, Europe might be compelled to come together to strengthen its digital and military defences, forming the groundwork for closer economic cooperation. In this scenario, the desire for peace and stability – the original motivations behind the creation of the European Coal and Steel Community in 1951 – would spur the necessary completion of the economic framework. In the meantime, progress on financial integration within the Customs Union could improve the resilience of the euro zone’s institutions from the bottom up.

Pictograph of the Euro-zone countries

Another possibility is that Europe becomes more decentralised without fracturing wholesale – a version of the ‘nothing but the single market’ scenario put forward by the European Commission. In Ashoka Mody’s view, such an outcome could revitalise the EU. By giving up aspirations to fiscal integration and handing national governments more autonomy via a new debt-restructuring mechanism, Europe could open the way for a “vibrant competitive decentralisation” that spurs innovation and educational standards.

True harmony?

For all that populism grabs the headlines, the European project retains the support of vast swathes of the continent’s population. The European Commission’s latest Eurobarometer survey, conducted in May 2018, showed support for the EU was at its strongest level for 35 years. Two thirds of Europeans polled said their country had benefited from EU membership, while 60 per cent considered EU membership a good thing. The European Union is still seen as a guarantor of peace and economic prosperity by many. 

Whether Europe’s leaders back decentralisation or push for closer union, they will need to balance the competing demands of national sovereignty and collective stability to keep Europe’s citizens onside. But then, it was ever thus. In an 1833 essay, the German historian Leopold von Ranke described the development of great power relations on the continent and envisaged a future based on equilibrium. His words still resonate today: “[With states and nations] the union of all depends on the independence of each ... A decisive positive dominance of one over the other would lead to the others’ ruin. A merging of them all would destroy the essence of each. Out of separate and independent development will emerge true harmony”.

Investment implications: A tale of two markets

The political future of the European Union will have an enormous impact on markets across the continent. As of early 2019, investors are monitoring events in Germany and Italy particularly closely. The received view is one of German strength and Italian weakness, and while this broadly holds true, a closer analysis reveals some nuances.

Germany is in the grip of great change. In the wake of costly defeats in regional elections in 2018, Angela Merkel was replaced as leader of the Christian Democratic Union (CDU) by Annegret Kramp-Karrenbauer, who may also succeed Merkel as chancellor. Economic issues may partly explain why voters turned against Merkel: GDP growth has started to slow and looks increasingly unbalanced by the dominance of large export companies in the industrial and auto sectors.

An indication of Germany’s reliance on its car industry came when figures for the third quarter 2018 showed a 0.2 per cent contraction in GDP growth, which analysts attributed to a sharp drop in production among companies such as Volkswagen and Daimler. Germany’s auto giants are scrambling to tool up new vehicles to meet the emissions standards enshrined in the EU’s Worldwide Harmonised Light Vehicle Test Procedure (WLTP), introduced last September. According to the latest official figures, the economy is estimated to have grown 1.5 per cent in 2018, the slowest rate in five years.

“Regulation is likely to continue to weigh on growth in the German auto sector over the medium term,” says Ed Kevis, European equities fund manager at Aviva Investors, who also points to the impact of rising trade protectionism on German exporters. “If trade wars result in slower Chinese growth, this will hit car companies too, as well as German multinationals in other sectors with exposure to China, such as Bayer and BASF.”

The DAX, the German benchmark stock index of mostly multinational companies, fell more than 18 per cent in local currency terms in 2018, its worst performance for a decade. In addition to the big carmakers, shares in electronics firms (Siemens), pharmaceuticals (Bayer) and banks (Deutsche Bank) slumped. Kevis says regulation will continue to weigh on the big exporters in 2019 – as will trade tensions, if they persist – though German banks could rebound in line with the wider European financial sector if the European Central Bank (ECB) starts raising interest rates this year.

As for German bonds, fixed income investors are keeping a close eye on the effects of the ECB’s withdrawal of quantitative easing (QE) in December. Despite some political grumbling in Germany about the programme supporting spendthrift economies in southern Europe, QE has helped keep German bond yields low (the ECB’s purchases of German bonds have exceeded the country’s allocation under the ‘capital key’, which divvies up each member’s share of bond purchases based on the amount it has paid in).

Table showing german exports slowing
The German economy looks unbalanced by the dominance of large export companies

“German 10-year bond yields have fallen and hovered around 0.2 per cent since the beginning of 2019, but as the ECB starts normalising policy we can assume yields would move higher,” says Geoffroy Lenoir, head of euro sovereign rates at Aviva Investors in Paris. “That would apply to other countries as well; a risk to this scenario is that macroeconomic data disappoints further.”

So what about Italy, commonly regarded as Europe’s most vulnerable economy? Some of the key investment risks have dissipated since the resolution to the stand-off between Italy and the European Commission over the Italian budget in December. This reduced the spread between German and Italian bonds – the so-called ‘fear gauge’ – which means Italy should be in a better position to weather the normalisation of ECB policy.

The budget agreement should also benefit Italian financial stocks this year, although some of the country’s smaller banks remain vulnerable due to funding concerns. In early January, the ECB appointed temporary administrators at troubled northern Italian lender Banca Carige, which is struggling to complete a €400 million capital strengthening plan.

Despite these issues, the benchmark FTSE MIB index was up more than ten per cent as of February 19, making it one of the best performers among European equity markets, according to Bloomberg data. The budget agreement has calmed investor nerves surrounding Italy’s public finances, while the addition of football club Juventus to the index, along with strong gains at oil services company Saipem, have given the market a further short-term boost.

Over the longer term, Italy still faces big political and economic issues, although investors’ worst fear – an Italian exit from the euro zone – is unlikely to be realised. It remains a wealthy country in per capita terms. Leaving the bloc would probably involve redenominating the currency at a sharp devaluation, wiping out much of this wealth. “When push comes to shove, we don’t believe voters would countenance this,” Kevis says.


  1. ‘Victor Orban calls for anti-migration politics to takeover the EU,’ The Guardian, January 2019.
  2. See ‘Drain the EU swamp,’ Project Syndicate, October 2018.
  3. See Bickerton, The European Union: A Citizen’s Guide (Pelican Books, 2016).
  4. ‘Macron and Merkel’s treaty tests European nerves,’ Politico, January 2019.
  5. See The Future of Europe portal at
  6. Claus Offe, Europe Entrapped (Polity Press, 2015).

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