2018 annual forecast

Dec 22, 2017 | 20:17 GMT

11 mins read

Europe

To the west of Eurasia lays Europe, a region predisposed to division. It is surrounded on nearly all sides by islands and peninsulas that make it difficult for Europe to cohere. The northern half of the continent, moreover, sits on a plain whose short, meandering rivers tend to empower countries without forcing them to work with others. The southern half is situated on more mountainous terrain that has historically impeded the creation of strong, unified economies. As a result, Europe is a continent riven by pockets of distinct cultures whose differences are all too often irreconcilable.

Europe is a continent riven by pockets of distinct cultures whose differences are all too often irreconcilable.
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section Highlights
  • The debate over how best to reform the European Union will take the spotlight in 2018, laying bare the regional rifts that divide the Continent.
  • Though France and Germany will be at the heart of this debate, they will prove more willing to cooperate than to confront each other. To that end, Paris will agree to water down or postpone many of its proposals for the bloc.
  • General elections in Italy will generate uncertainty about the eurozone's future. Though the country won't leave the currency area in the coming year, its next government will lobby for the authorization to boost public spending.
  • The United Kingdom will spend 2018 negotiating the terms of a trade agreement with the European Union. Though leaders probably will reach an arrangement for the transition period following the Brexit, a trade deal will be tougher to obtain.
  • The Continental bloc also will seek out free trade agreements with other countries, a strategy that will become a cornerstone of the bloc's foreign policy.
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Debating a Continent's Future

Talks about the shape of the European Union's structure and governance will take center stage on the Continent this year. Among the items on the bloc's agenda are ways to deepen financial integration, mechanisms to cope with future crises and strategies to increase security and defense cooperation. But finding a way forward won't be easy. While most EU members agree that political, institutional and economic reforms are needed, they do not agree on what those reforms should look like or how to go about implementing them. Over time, these issues will once again expose the enduring divisions between Europe's north and south and its east and west.

At the center of the debate will be France and Germany. Though the two powerhouses are eager to preserve their alliance, they have different visions for the European Union. The French government, which campaigned on a promise to transform the bloc, has already introduced economic reforms at home. Now that it is on more equal footing with Berlin than it has been in many years, an emboldened Paris will aim to advance its interests at the Continental level. France hopes to create new structures that would allow for greater public spending and financial risk sharing within the bloc — a goal that many countries in Southern Europe, including Italy and Spain, share. These states also advocate the introduction of a common unemployment insurance for EU workers and a common deposit insurance for EU banks.

Germany isn't necessarily opposed to these ideas. It does, however, want to make sure that they are accompanied by more efficient oversight of the fiscal policies and financial sectors of member states. Berlin believes that countries often bend the bloc's fiscal rules and that the institutions tasked with enforcing regulations are too politicized. Several Northern European states, such as Austria and the Netherlands, share this view.

Still, France and Germany will have to wait to hash out a compromise until Berlin settles one of its own pressing political problems: the formation of a new government. The process of trying to build a governing coalition in Germany will consume the first few months of the year. Should the talks fail, early elections will ensue, delaying any European negotiations.

Regardless of when the bartering between Germany and France begins, Berlin will protect its interests, and Paris will not get everything it wants. Instead, many French proposals will be watered down or adapted to meet German demands; others will be postponed. Room for cooperation certainly exists on some issues, such as boosting security and defense cooperation and harmonizing the tax systems of EU members. But other topics — especially those that involve financial transfers from Northern Europe to Southern Europe — will be more controversial.

For the most part, France and Germany will be more interested in cooperation than confrontation. But it is unclear whether their willingness to work together will be enough to keep Europe united. 

The Fate of the Eurozone

Italy will be the main source of uncertainty for the eurozone next year. The country will hold general elections by May, and most of its political parties have criticized the EU's deficit targets. Some are also critical of the eurozone. No matter who wins the elections, Rome's next administration will push to increase public spending and redesign the bloc's deficit goals.

The difference between the parties, however, is in their tone. Some, like the anti-establishment Five Star Movement and the right-wing Northern League, will be more willing than others to threaten Brussels with unilateral measures if the European Union does not meet their demands. These threats could include ignoring the bloc's fiscal targets or leaving the eurozone.

Of course, Italy isn't likely to exit the currency area in 2018, but the rise of a Euroskeptic government in the eurozone's third-largest economy could still put the currency bloc at risk. The mere threat of flouting eurozone rules or quitting it outright could cause concern in financial markets, lead to higher borrowing costs for Southern European countries, and raise questions about the prospects of Italy's fragile banks. On top of these economic risks, a more Euroskeptic Italy would face the prospect of political and institutional isolation within the European Union.

Who Owns Italy's Sovereign Debt?

Given the fragmentation within Italian politics, the approaching elections are likely to end in a hung parliament. Yet even if the parties fail to cobble together a coalition government, they could still appoint a prime minister by consensus. EU institutions and financial markets would welcome such a decision because it would temporarily avert a financial crisis. But it would come at a steep cost, creating a government that is constantly on the verge of collapse, weakening Italy's influence in international affairs and undermining Rome's ability to introduce sweeping economic reforms. If, on the other hand, lawmakers are unable to agree on a prime minister, Italy might hold another round of elections by the end of 2018, prolonging the uncertainty obscuring the country's future.

Italy won't be the only eurozone member grappling with tough questions next year, either. Greece's bailout program ends in August, at which point Athens will try to reduce the sway foreign lenders have over its policymaking. At the same time, however, Greece will ask its creditors to alleviate its debt burden. Athens' financiers will refuse to write down parts of Greece's debt. But they may be more amenable to other measures, such as an extension of debt maturities, lower interest rates and a grace period for debt repayments, particularly if Greece agrees to keep introducing economic and institutional reforms. Athens may indeed be willing to make this commitment if the requested measures are less painful than those attached to its bailout. So although Greece will remain a source of concern for the eurozone in 2018, its membership in the currency area won't be in jeopardy.

Spain will have two problems of its own to deal with next year. The country's minority government will have difficulty pushing through legislation, suggesting that it will make only modest economic and institutional reforms in 2018. Moreover, Catalan secessionism will remain a concern for Madrid as friction persists between the central and regional governments. Though Catalonia won't secede from Spain next year, questions about the region's future will linger.

Brexit

Meanwhile, the United Kingdom will spend most of the year figuring out what its relationship with the European Union will look like after it leaves the bloc. Hoping to give companies and households more time to prepare for the Brexit, London and Brussels will negotiate a transitional arrangement as they work to settle a comprehensive trade agreement. Leaders likely will find it easier to approve the transitional agreement in 2018, buying themselves more time to haggle over the trickier aspects of the trade deal, including the movement of services and capital. The trade talks could last into 2019, but even if they wrap up sooner, the parties involved can't approve a deal until the United Kingdom has formally exited the European Union in March 2019.

British Trade

In the United Kingdom, the negotiations will call into question its economic and territorial integrity. Political interests in Northern Ireland, Scotland and Wales will keep a close eye on the talks between London and Brussels, doing what they can to shape the negotiations and voicing their expectations to the British government. London has the ability to resist some of the demands made by Scotland and Wales while reaching compromises on others. But the situation in Northern Ireland will be more delicate. There, tension between unionists and nationalists could complicate the already thorny issues the Brexit has raised regarding the region's shared border with the Republic of Ireland. To avoid introducing controls along its border with Ireland, the United Kingdom may have to soften its stance on leaving the EU single market, where goods and people move freely.

All told, 2018 will be a politically charged year for the United Kingdom, and not just because of the Brexit. The British government will encounter constant political challenges, both from the opposition and from within the ruling Conservative Party. Though the country may replace its prime minister, the Conservative Party will try to avoid early elections in which it could make a poor showing.

A Dilemma for Central and Eastern Europe

As the European Union wrestles with the existential questions before it, countries in Central and Eastern Europe will take different approaches to their own relationships with the bloc. Hungary and Poland, for instance, will fend off Brussels' attempts to interfere with their internal decision-making. Nationalist parties are positioned to perform well in Hungary's general elections in the second quarter of 2018, signaling continuity ahead in Budapest's Euroskeptic domestic and foreign policies. Poland's government likewise will continue to censure the European Union and maintain a tense relationship with Germany. All the while it will preserve its alliance with the United States, which underpins Warsaw's security strategy.

So far this tack has proved popular among Hungarian and Polish voters, but it is risky. Budapest and Warsaw rely on the European Union for money and protection. And although neither Hungary nor Poland is interested in exiting the bloc, their actions could result in their marginalization within it and the degradation of their influence over Continental affairs.

By contrast, Austria, Slovakia and the Czech Republic will pursue more balanced foreign policies. While they will use Central European cooperation as a means of promoting their agendas and defending their interests, they also will continue to collaborate with Western Europe. The motive behind their strategy is simple: Though these countries are skeptical of further integration into the European Union, they are also closely linked to the German economy. In addition, Austria and Slovakia belong to the eurozone.

An EU Foreign Policy Based on Free Trade

Amid a surge of protectionism around the globe that has clouded the future of international trade, the European Union will seek out new free trade agreements. Though the bloc signed a free trade deal with Japan in late 2017, the parties will have to separately negotiate the issue of investment protection in 2018. At the same time, the European Union will try to forge ahead in its talks with Australia, New Zealand, Mexico, India, Indonesia and the Common Market of the South, known as Mercosur. Within these negotiations, issues like agriculture, investment protection and the flow of private data to third-party countries could become sticking points. The process of reaching final deals will be lengthy, likely lasting well beyond next year, but Brussels will stay committed to expanding its collection of trade deals. However, it will also keep looking for ways to better vet non-EU investors that seek to buy companies that are part of sensitive or strategic sectors in member states.

In the meantime, the European Union's relationship with Russia will remain distant. Moscow will try to exploit (and at times, create) friction among the bloc's members with the tools at its disposal, including pipeline politics and propaganda. The European Union, for its part, will continue to argue that it will lift sanctions against Russia only if Moscow fully complies with the peace deal in Ukraine. Because the sanctions are already a point of contention in Europe, the bloc probably won't expand them, though it may prolong the punitive measures if conditions on the ground in Ukraine do not improve. Brussels will also denounce Moscow's attempts to interfere in European politics while searching for ways to counter Russian propaganda and cyberattacks. Its success on this front, however, will be only modest.

Europe will face a foreign policy challenge to the south as well. Next year, the European Union will study options for addressing immigration from Africa and the Middle East, in part by reforming its migration rules. The most controversial decision the bloc must make is whether to implement a mechanism to more proportionally distribute asylum seekers across the Continent — a move that, in the end, it is unlikely to make.

Central and Eastern European Migration Routes

Meanwhile, the European Union will work with migrants' countries of origin to try to prevent people from leaving their homes in the first place and to disrupt human-trafficking organizations that funnel migrants into Europe. The number of people crossing into Italy from Libya fell in 2017, but the Continent's migration troubles aren't over. After all, Libya remains politically unstable, and it may not be able to consistently work with Europe to stem the flow of migrants across its borders as its internal turmoil persists. Moreover, migrants have begun using new departure points, such as Tunisia and Algeria, en route to Europe.

Against this backdrop, the European Union will be eager to preserve its migration deal with Turkey in hopes of blocking floods of people from entering its territory. To that end, Brussels will promise Ankara financial assistance and stronger trade ties, including an update to the existing customs union agreement between them. But if the Turkish government continues to crack down on the media and opposition at home, Europe will increase political and financial pressure against it, adding further strain to their migration agreement.

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