For a moment in the first quarter, it looked as if the euro crisis would raise its head again. Italy’s elections were considered the biggest risk for the stability of the Eurozone in early 2013. Indeed, their inconclusive results, along with the looming risk of paralysis in government formation and reform implementation, seemed to reinforce investors’ biggest fears.
Nevertheless, markets got over it remarkably well. After a short jump in interest-rate spreads, they eased at a level well below last year’s peak. Also, the uncertainties and the policy confusion about the rescue package for Cyprus have not unsettled the financial markets in a substantial way. At the same time, other crisis countries could restore their access to the capital markets. Ireland managed to issue a substantially oversubscribed 10-year bond in March, the first after its bailout in 2010.
The financial markets’ indifference to potential crisis triggers and Ireland’s return to the capital markets support a point made in the last Global Economic Outlook: The immediate danger of the Eurozone’s breaking up has been fading to the background. True, there are scenarios in which the crisis could erupt again. However, this tail risk has shrunk substantially. Investors trust the European Central Bank to prevent a breakup. The root factors of economic uncertainty have changed relative to the growth prospects of the Eurozone.
Looking at the growth prospects of the Eurozone, 2013 will be a year of transition. The good news is that the GDP fall in the Eurozone’s crisis countries has slowed down. The worst is likely behind us. The bad news is that short-term growth will likely be anemic rather than explosive.
Return to feeble growth in 2013
Real GDP in the Eurozone in 2012 fell by 0.6 percent, and the Eurozone experienced a very weak fourth quarter with the recession deepening. In all, 2012 was a nasty year for the Eurozone economy. According to the Organization for Economic Cooperation and Development (OECD), the actual GDP was 3.7 percent below the potential GDP.1 Several factors have contributed to the dismal growth performance. The two most important were that the restrictive fiscal policy in the Eurozone reduced domestic demand, while the uncertainty about the future of the euro strained private investment as well as private consumption.
Both factors will continue to influence the Eurozone’s growth in 2013. However, their negative impact will get weaker. Fiscal policy will be less restrictive than the year before, and, assuming no escalation of the debt crisis, uncertainty will decline and business and consumer confidence will recover.2
Exports in combination with the expansive monetary policy are the relatively bright spots for the Eurozone. Assuming accelerating growth in the emerging markets and a slightly higher growth in the United States, Eurozone exports will increase, helped by improved competitiveness. The shaky domestic economic situation will continue to constrain domestic demand and, by implication, imports, so that exports and the external balance should be the main growth driver for the Eurozone.
In this scenario, the Eurozone should stabilize in the first half of 2013 and return to weak growth in the second half. Growth will be weak as the Eurozone continues to need to strengthen household, firm, bank, and sovereign balance sheets.
Early indicators indicate trend reversal
The main early indicators and the stock markets anticipate this trend reversal. The Euro Stoxx 50 has gained around 30 percent since June 2012. While the main confidence in the Eurozone indicators went down the most part of 2012, in autumn the trend stopped and reversed. Confidence in almost all major sectors has been increasing, especially in industry and services, even if the upward trend is slow and bumpy (figure 1). Although overall economic sentiment is still in negative territory—the combined Economic Sentiment Indicator stands at 90, while a positive outlook starts at 100—this suggests that the Eurozone economy has bottomed out in the first quarter.3
Figure 1. Eurozone economic sentiment indicatoR—components (net balance positive-negative expectations)
This trend reversal is even more pronounced in the early indicators for the German economy. After a weak fourth quarter, with GDP decreasing by 0.6 percent, fears of a coming recession emerged but are likely exaggerated. The two most important confidence indicators, the Ifo Business Climate Index and the ZEW Index, rose substantially. In February, the Ifo index increased the most since mid-2010, rising, as did the ZEW index, the fourth time in a row. In March, both indices largely stagnated. However, given the strong increases before, this indicates stabilization of a basically upward trend. Correspondingly, the German stock index DAX broke the 8,000-point mark in early April, the first time since 2008.
Phoenix vs. Japan
While these signs are encouraging, they are no guarantee that this trend reversal indicates an accelerating and substantially higher growth trajectory beyond 2013. Recent economic history suggests two scenarios for growth performance after a financial crisis. One is the relatively rapid recovery of the real economy in the emerging Asian countries after the financial crisis in the late 1990s. The other is Japan’s lost decade following the burst of its housing bubble and the resulting banking problems in the early 1990s.
Both analogies are not perfect, and starting points differ substantially, but they illuminate the range of broad paths conceivable for the Eurozone. In a “phoenix from the ashes” scenario, the current crisis countries in Southern Europe would emerge much leaner and more competitive from the current crisis and could export their way out of the crisis, similar to Germany a few years ago. A stronger tradables sector, combined with reforms in the service sectors, would boost productivity and growth. A Japanese scenario with no or low growth would likely emerge with continuing uncertainty and absent reforms.
The Eurozone’s investment gap
The biggest danger for the Eurozone to fall into a low-growth trap comes from a dramatic investment gap. Longer-term growth and employment prospects depend on investments. Looking at the main components of the Eurozone’s GDP shows that investments have been the hardest-hit component during the crisis. As displayed in figure 2, the growth rates of government expenditure and household expenditure declined substantially but continued to grow since the onset of the crisis, compared to the preceding boom years.
Figure 2. Growth-rate GDP components (%)
The most dramatic drop, however, took place in investment activity. While investments grew by 30 percent (in nominal terms) between 2003 and 2007, they fell by 12 percent between 2008 and 2012. Investments in 2012 were €220 billion below the 2007 value. At the same time, corporate cash holdings rose massively, indicating a grossly heightened risk aversion on the part of companies.4
Jumpstarting private investment activity is therefore one, if not the key, way to avert a Japanese-style scenario. Corporates seem to need some convincing to invest more. Stable expectations regarding the economic environment, low uncertainty, and possibly effective investment incentives would definitely help.
The worst part of the current downturn in the Eurozone seems to be ending, and it is likely that a shaky recovery will set in. Exports are the main driver for this recovery, while demand and investments do not lend support to economic growth. The Eurozone continues to struggle with many growth-inhibiting aftereffects of the financial crisis and the euro crisis, and with a deeply divided economic performance. Seen from this perspective, even a shaky recovery would be good news and something to build upon.
- OECD, “Interim Economic Outlook,” Economic Outlook Annex Tables, March 28, 2013, http://www.oecd.org/eco/outlook/economicoutlookannextables.htm, accessed April 15, 2013.
- European Economic Advisory Group, The EEAG Report on the European Economy, CESifo Group, 2013.
- European Commission, European Economic Forecast—Winter 2013.
- “Iron enters the soul,” Economist, October 6, 2012.