Growth in the eurozone cannot pick up due to the destructive effects of a long recession, writes Patrick Artus, chief economist at Natixis
The economic crisis in the eurozone (excluding Germany) has been dragging on for five years and has become deep-rooted – lasting far longer than most recessions. Indeed, eurozone activity fell for a sixth consecutive quarter at the beginning of the year. And while the recession continues to deepen in the periphery, the economic slowdown has reached the core, what with Germany barely growing and the French recession being confirmed by another negative GDP change in the first quarter of this year (i.e. -0.2% quarter-on-quarter).
If this were a shorter recession – such as that seen at the turn of the 21st century – analysts would need only consider seven possible indicators of economic recovery: an improvement in surveys regarding future production or consumer confidence, a pick-up in business investment, an increase in production capacity, an upturn in building permits and residential investment, a fall in the household savings rate and an increase in household credit.
The effects of a ‘long’ recession are preventing a pick-up in growth
Yet, the fact the eurozone cannot reap more permanent positive economic results becomes understandable when you consider the extent of the current recession, which has been occurring and has become self-fulfilling. Because the recession has lasted so long, additional negative effects have arisen that wouldn’t usually appear during a shorter recession. And it’s these effects that are preventing a pick-up in growth throughout the eurozone.
The first effect to draw attention to is the loss of potential GDP. In a long recession, domestic demand is permanently weakened, so it’s common for companies to considerably reduce productive investment – more so than they would in a shorter recession. Moreover, companies use up their reserves when their business is suffering, and bankruptcies become more frequent as a result. Due to the decline in investments, there is a decline in industrial production capacity and therefore potential GDP. And this decline in potential GDP prevents any significant recovery in economic activity.
The second effect of a long recession is the loss of human capital, clearly due to persistently high headline unemployment, long-term unemployment and – in particular – youth unemployment. Unemployment rates have never been so high across the European Monetary Union (EMU) – at 12.2% on average – while youth unemployment is particularly alarming in the peripheral countries (e.g. 70% in Greece, 50% in Spain). Unsurprisingly, if there is high unemployment there is a slowdown in labour productivity and total factor productivity – which also affects potential growth. If there is a decline in both the level of potential GDP and potential growth, actual GDP cannot regain momentum.
And thirdly, a persistent decline in activity causes a sharp deterioration in public finances, which, after some time, leads to a restrictive fiscal policy. Fiscal policy therefore becomes pro-cyclical, which is not the case in a short-lived recession (for example: the eurozone’s fiscal deficit was reduced from 2004, once growth had already picked up following the recession in the early 2000s).
The fear of a resurging eurozone crisis still lingers
Of course, a common concern gripping the markets is the possibility of an exacerbated – and even longer – eurozone crisis. Such thoughts have taken shape due to four potential market shocks: the possible removal of the European Central Bank’s ability to use the Outright Monetary Transaction programme for large amounts (thereby rendering it largely ineffective); the expectation of a restructuring of public debt for countries with unsustainable public debt ratios (triggering a return to high correlations between sovereign debt and bank debt); an adjustment in the cost of corporate debt to the real level of credit risk; and, finally, the discovery – potentially during the ECB-led Asset Quality Review of Europe’s banks later in the year – of an unexpected need to recapitalise banks, the cost of which could be borne by governments.
Incidentally, it seems the onset of recessions can no longer be linked to the customary inflation and monetary policy cycle. Instead, recessions have – since the end of the 1990s – been triggered by the bursting of asset price bubbles and by the resulting banking crises (with the eurozone’s recession being a key example). Such a theory could also explain the magnitude of more recent recessions and why the scale of central bank intervention to stabilise activity has also stepped up (e.g. the ultra-expansionary monetary policies currently taking place in the US, UK, Japan and the eurozone). In terms of size, the decline in global GDP was far greater in the recession of the early 2000s than the recession in the early 1990s – and today’s recession has been greater still.
When discussing the practicalities of economic recovery across the eurozone now, however, it’s important to remember that it’s the effects of such a long recession – e.g. GDP continuing to adjust downwards, in addition to a loss of human capital and a pro-cyclical fiscal policy – that have generated its depth and obduracy.