Eurozone: Greater trust and greater uncertainty

Eurozone: Greater trust and greater uncertainty

Eurozone: Greater trust and greater uncertainty

Global Economic Outlook Q1 2013

Concerns about the future of the euro are giving way to uncertainty pertaining to the region’s economic health.

2012 was considered the decisive year for the survival of the Eurozone. It became the year of the European Central Bank. The ECB came to the rescue of the euro each time it was seriously endangered. This relief came either in the form of flooding the markets with liquidity—the long-term financing operations—or in the form of guarantees for the survival of the euro such as Mario Draghi’s “whatever it takes” announcement.1

While the ECB successfully increased trust in the future of the euro itself, the key challenge for the Eurozone pertains to reducing uncertainty. Uncertainty in the Eurozone remains at almost unprecedented levels, but its roots are changing. While uncertainty about the future of the euro itself dominated the European economy in 2012, uncertainty about the growth outlook clouds the economic prospects for Europe for 2013 and beyond.

The growing trust in the euro itself …

Although risks have not entirely disappeared, the ECB’s announcement of guaranteeing the existence of the euro was a game-changer that built trust among investors. The difference the announcement made is visible in the results of Deloitte Germany’s CFO survey,2 which was undertaken in April and October, before and after the ECB announcement (see figure 1).

While there is still a sizable portion of German CFOs who think that the Eurozone will shrink within the next five years, there is a clear trend: Considerably more CFOs think that the Eurozone will have the same members in five years’ time. And even more importantly, the number of CFOs who assume a large-scale disintegration of the Eurozone shrank substantially; only 3 percent consider this the most likely scenario. This indicates that the fundamental doubts about the future of the euro are receding.

… is not matched by decreasing uncertainty in Europe

In the wake of the financial crisis, the economic environment has changed drastically. The main change concerns much higher volatility and greater tail risks, not only in the financial markets but also in the real economy. The possibility of a breakup of the Eurozone, for example, is one of the previously unthinkable tail risks. In other words, the range of possible futures has increased massively.

Contrary to the financial crisis, which came as a complete surprise for most people, today’s uncertainties are known, but it is largely impossible to estimate their probability. The result is much greater uncertainty about the future state of the economy.

Despite greater trust in the future existence of the euro—the core component of uncertainty in Europe over the last three years—overall uncertainty in Europe remained high throughout 2012. Figure 2 displays an uncertainty indicator that combines economic forecasts with content analysis of leading newspapers to arrive at a measurable concept of uncertainty. It shows that despite the ECB’s action, uncertainty in Europe is still at an exceptionally high level. The uncertainty peak was reached shortly before the ECB started its long-term refinancing operations at the end of 2011, but it still stands at a level that is similar to the peak of the financial crisis in 2008—2009.

This is confirmed by other indicators. Deloitte Germany’s CFO Survey suggests that the level of uncertainty that German companies feel they are exposed to has actually increased between the second and fourth quarters (see figure 3).3

This is paradoxical, given the greater confidence in the euro. The roots of uncertainty must have changed; worries about the real economy have joined worries about the euro. Among the top three risk factors the German CFOs cited in the survey, sinking domestic and foreign demand came immediately after the risk of instability in the financial system. The remaining risks stemming from the euro crisis and the growing fears of recession thus create a new uncertainty cocktail.

The effects of uncertainty

While uncertainty is a principal ingredient of the business environment, an overdose of it is damaging in macroeconomic as well as microeconomic terms. Uncertainty has become the main drag on economic growth in Europe and elsewhere. The International Monetary Fund (IMF) has found that economic growth is strongly negatively correlated with uncertainty. Recessions associated with uncertainty are generally more severe than normal recessions, and they tend to be deeper and longer. The output losses in such recessions are nearly twice as high as those resulting from other recessions.4

The main reason for these negative effects is obvious. While the impact differs between sectors, firms tend to postpone investment, hiring, and project decisions. They tend to wait for less uncertain times to make important decisions that are potentially hard to reverse. The same is true for consumers who are hesitant to make bigger purchases, especially durable goods. Thus, uncertainty generates a wait-and-see attitude in the economy, with all ensuing negative consequences.

The growth outlook for the Eurozone

Ongoing uncertainty will continue to be a drag on the Eurozone’s growth in 2013. While the fundamentals in the crisis countries, such as unit labor costs and current account balances are beginning to improve,5 growth in 2012 was weak. At the time of writing in December 2012, production in the Eurozone has been shrinking since autumn 2012, the Eurozone’s GDP is on the level of 2006, and unemployment has reached a record level.

The Eurozone’s GDP shrank in 2012 by 0.4 percent (see figure 4). The fastest-growing countries (Germany and Austria) reached 0.9 percent, while the crisis countries shrank between 1.5 percent (Spain) and 6 percent (Greece). Currently, there are some positive signs from early indicators. While the economic sentiment index continues to be negative overall, it rose in November. Increases could be registered for industry and retail trade. The increase in economic sentiment in the EU as a whole was even stronger.

These are positive signs, but the case for strong growth in 2013 is weak. The most likely scenario for the Eurozone is a stabilization of production in the first half of 2013, followed by a slow and sluggish recovery.6 For the whole year 2013, the Eurozone is likely to achieve a growth rate hardly above zero (0.2 percent), and the Eurozone’s crisis countries will still have negative growth even if it is expected to be less negative than in 2012.

The scenario of stabilization and a following recovery is based on the assumption that uncertainty will slowly decrease. The key variable for all current growth predictions is, in fact, uncertainty. Most upside and downside risks are associated with it. If the Eurozone manages to decrease uncertainty in the markets—whether through greater investor confidence in the reforms of the crisis countries or reforms of the Eurozone’s governance structure—growth could be considerably higher. Unfortunately, the reverse is also true.

Which growth policy for Europe?

The key challenge for the Eurozone in 2013—finding a way to grow and consolidate budgets at the same time—remains largely unchanged. Traditional Keynesian recipes and the insights of modern growth theory target completely different levels in that regard. The Keynesians assume that higher public spending, financed with higher debt, will jumpstart the economy in the short run thanks to multiplier effects. Growth theory argues that sustainable growth is a supply-side matter and is fostered by investments in innovation and the infrastructure that supports it, such as education and R&D.

Public investments in growth-enhancing areas can be instrumental to bridge this tension and contribute to higher growth and higher growth potential. While they generate demand and stabilize the economy, they also contribute to a higher growth potential. Investments in higher education and training, as well as in R&D, have positive short- and long-term effects.

Investing in the levers of growth and redesigning public investments and budgets toward growth should therefore be the natural complement and part of structural reforms. Only in this way could the euro crisis have a positive effect; namely, it could help build the foundations of stronger growth.


View all endnotes
  1. On July 26 2012, the president of the European Central Bank announced that; “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This suggested that the ECB is ready to buy government bonds of the crisis countries to lower their yields
  2. Deloitte & Touche GmbH Wirtschaftsprüfungsgesellschaft “Controlled Defensive.” CFO Survey Germany 2/2012.
  3. Deloitte & Touche GmbH Wirtschaftsprüfungsgesellschaft “Controlled Defensive.” CFO Survey Germany 2/2012.
  4. International Monetary Fund. “Coping with High Debt and Sluggish Growth.” World Economic Outlook October 2012.
  5. See Deloitte Global Economic Outlook 4th Quarter 2012.
  6. German Economic Research Institute. Joint Economic Forecast Autumn 2012


Dr. Alexander Börsch

Dr. Alexander Börsch is head of research, Deloitte Germany.

Eurozone: Greater trust and greater uncertainty
Cover Image by Maria Corte Maidagan