• The EU has backed down on climate policies
  • But what if they have a much bigger problem?
  • Just ask the Germans what could go wrong

Over the past few weeks, we saw the first great revolt against the climate change campaign. Right across Europe, farmers came out in force and were cheered on by supporters.

The EU eventually backed down and withdrew many of its climate policy proposals. European national governments and even their opposition parties are joining in the unravelling at an increasing pace. Suddenly, nobody can tear up green tape and spending fast enough.

But why did all this happen inside the EU? And why did it only spread to the EU’s borders and not beyond? The same mad policies were being rolled out right across the world, after all. It’s not called the European Economic Forum. And Davos isn’t in the EU.

Most people will tell you it’s to do with the EU’s governing structures. But I suspect there is actually an economic reason behind this odd divergence. Let me explain it like this…

How would you feel if the UK was in a severe economic downturn and the Bank of England refused to cut interest rates?

You might call it economic sabotage, blind ignorance or wilful negligence.

Not that anyone would be surprised. The latest real Andrew Bailey blunder was to complain that wages are rising fast. Awful, I know. And I wonder whose fault it might be that wages are rising to meet rising prices?

But consider what’s going on in Germany right now. There, the central bank is making a very dangerous mistake. But you can’t blame it because it has no choice.

You see, the European Central Bank (ECB) must set the same interest rate for the eurozone as a whole. Everyone shares the same currency, after all.

The problem is that the economic conditions in each country vary substantially. In some countries, inflation is much higher than in others. Also in some countries, the economy is doing just fine, while in others it is crashing.

In some countries, housing bubbles are bursting due to unaffordably high interest rates, causing financial devastation for many borrowers. In others, housing bubbles are still inflating on the very same interest rates, which are much too cheap for that country’s more buoyant financial conditions.

Until the Covid pandemic and energy crisis, it was Germany’s turn to ride high on interest rates that were too cheap for its booming economy. But now, the worm has turned and interest rates are much too high instead.

The German economy has been in a downturn since mid-2022, outright shrank last year, and this year isn’t looking much better. Remaining in the doldrums for such a long time is very rare because, usually, your central bank starts to cut interest rates to try and get things moving again.

The key issue for Germany is industrial production, with many commentators describing a process of “deindustrialisation”. The Financial Times recently alerted readers to a measure of this process:

German industrial production in longest-ever downturn, surpassing 2008 financial crisis

German factory output has fallen for the seventh consecutive month, surpassing the 2008 financial crisis for the longest-ever downturn as Europe’s largest economy continued to languish at the end of last year.

Industrial production fell 1.6 per cent month to month in Germany in December, undershooting economists’ forecasts of a 0.4 per cent decline. German factory output has been falling since May, dragging it down 1.5 per cent over the whole of last year and 10 per cent since before the Covid-19 pandemic hit.

The biggest drop in December was for chemicals output, which fell 7.6 per cent from the previous month, taking the sector to its lowest annual production since 1995.

Imagine going through such a slump without your central bank even flinching. In fact, the ECB doesn’t even seem to be acknowledging Germany’s economic rout. Perhaps it hopes nobody will notice.

For the moment, German energy policy is getting all the blame for this economic debacle. The chemicals industry is notoriously energy-intensive and it seems to be suffering the most. It also requires highly reliable sources of energy too, which Germany is struggling to provide.

The Germans have realised their mistake… to some extent. The latest plans are to build 15-20 new gas power plants! I wonder why they can’t build more renewables instead. And what does this imply for other countries’ energy plans?

But what I want to point out is that monetary policy is a key culprit here too. After all, it was higher interest rates that popped the green energy bubble and made renewables so uneconomical.

Here’s how to think about it…

How much do you think a German central bank might already have cut interest rates given, as Reuters put it, “German home prices tumble amid property rout”?

According to one German think tank, it’s the worst property bust in 60 years. Although that’s largely because Germany’s frugal monetary policy before the euro prevented housing bubbles from forming in the first place, without which busts are rather difficult to have.

How much do you think a German central bank might already have cut interest rates given crashing industrial production for a record length of time?

How much do you think a German central bank might already have cut interest rates, given the soaring popularity of so-called far-right-wing parties?

How much do you think a German central bank might already have cut interest rates, given the damage high rates did to the energy sector – a source of much of the inflation we saw?

The answer is that it doesn’t matter because the German central bank can’t set the right monetary policy for Germany. Not to mention that a German central bank would’ve acted much sooner to prevent the inflation we saw in the first place.

Anyway, as CNBC summarised the most recent meeting, the “European Central Bank holds rates steady, gives no hint at cuts ahead”.

This is an economic nightmare scenario for Germany. A record contraction in industrial production, a persistent GDP slump, severe political discontent… and no interest rate cut?

It’s economic masochism that no country with its own independent currency would accept from its own independent central bank. Andrew Bailey would’ve had to do yet another embarrassing U-turn by now if he pulled the same stunt in the UK.

Then again, the ECB can’t just focus on Germany. Setting the right monetary policy for Germany would be too loose for many other countries in the eurozone and could reignite inflation there. French industrial production is booming. The Spanish GDP is growing fine. Cut rates, and the population there could be up in arms instead.

So, the ECB is stuck, keeping interest rates in no man’s land: too high for Germany, too low for other countries. ECB governors are hoping the Germans don’t figure out what’s going on, turn their tractors around and head for Frankfurt, where the true source of their ills keeps its offices.

But here’s the problem with the theory of running monetary policy for the entire eurozone: if people can’t hold their central bank to account, they look for someone else to blame. And while nobody can vote for the European Commission, people do still vote for national governments.

It was political pressure from farmers on national governments that pulled the rug out from under the EU’s environmental policies. What if that doesn’t solve the underlying economic problems in the months to come?

What happens when you get a key economic lever pulled without accountability and at the eurozone level while having national elections? Economically, you get divergence between countries on measures like inflation and GDP growth. Politically, you get discontent of the sort that encourages less savoury political parties who question the way the system itself works.

Ironically enough, the Germans understand this situation better than most. When Germany was reunified, the country faced a similar problem. One monetary policy for a country divided in its economic fortunes. Only vast fiscal transfers made it politically palatable.

The German central bank, the Bundesbank, famously refused to ease monetary policy to make the economic transition of reunification easier – the value of the currency was paramount over political and economic considerations. Good luck trying that ploy on the eurozone as a whole today without feeding vast waves of Euroscepticism.

The man who oversaw the Bundesbank’s policy during this time warned about the consequences of the euro. He understood how it could drive populations and economies apart instead of unifying them…

These days, the controversial Alternative für Deutschland party is powering into the lead in former East Germany, where the economic divisions with the West still haven’t healed. I expect the same consequences for the eurozone. Those countries struggling with interest rates set for their neighbours’ benefit will eventually revolt. Unless people wake up and realise what’s causing it.

At a politically perilous time like this, it’s difficult to know where investors can turn. Few sectors can survive wild economic policy. But some are independent enough to perform regardless of what the politicians have in store for us. This could be your best bet.

Until next time,

Nick Hubble
Editor, Fortune & Freedom