The second quarter of 2013 brought long-awaited good news to the Eurozone. It grew for the first time since autumn 2011, bringing the end of the longest-lasting recession since the Eurozone’s inception within reach. The growth rate, in itself, was not spectacular. But the hopeful sign was not only that the Eurozone grew at all, but that its second-quarter growth was broader-based than anticipated. Contributing further to a better economic climate, early indicators developed better than expected and have been on the rise for several months. The main questions for the Eurozone are therefore twofold: What are the chances that this growth signals the beginning of a sustained recovery? And if it does, what will such a recovery look like?
The main questions for the Eurozone are therefore twofold: What are the chances that this growth signals the beginning of a sustained recovery? And if it does, what will such a recovery look like?
Is the recession ending?
The Eurozone economy grew by 0.3 percent in Q2 on a quarter-over-quarter basis. Growing at 1.1 percent, Portugal showed exceptional performance. As a whole, the recessionary tendencies in the crisis countries weakened substantially. Taken together, these countries shrank by 0.1 percent, but compared with their substantial contraction in the first quarter (−0.5 percent), moderate change for the better seems underway.
Growth was mainly driven by the two big Eurozone economies, Germany and France. Both showed stronger growth than expected (Germany grew by 0.7 percent). The main drivers were catch-up effects from construction and an upswing in industrial production. France followed not far behind (growing by 0.5 percent). Spain and Italy still showed negative growth rates, but at ‒0.1 and ‒0.2 percent, both economies are stagnating more than shrinking.
The main early indicators also outperformed expectations. For the Eurozone as a whole, all components of the economic sentiment indicator—industry, services, consumer, and retail trade—improved except for construction. A look at the big Eurozone countries confirms a clear upward trend in expectations (figure 1). Since April, economic sentiment has improved across the board; it has come much closer to the threshold of 100, which separates negative from positive expectations and which Germany has already crossed. Also, the purchasing manager index reached positive territory, recording its second straight month of expansion and the fastest rate of growth in two years.
Figure 1. Economic sentiment indicator (ESI)
The better-than-expected performance of the crisis countries and the positive early indicators raise hopes that most of the crisis countries could return to growth next quarter. This would imply that the Eurozone as a whole will grow in a broad-based way during the second half of the year, potentially beating most current forecasts, which expect growth of 0.1 and 0.2 percent for the coming two quarters. That said, there is no reason to cheer. For the entire year, the Eurozone will still record negative growth rates. The consensus view expects its growth to be in the vicinity of −0. 6 percent.
Drivers of growth
The Eurozone’s most recent growth was based on increases in consumption, investments, and exports. Exports grew most strongly, by 1.6 percent (after falling by 1.0 percent in the first quarter). Investments increased by 0.3 percent, which is an encouraging sign after a fall of −2.2 percent in the preceding quarter.
As described in the previous issue of Global Economic Outlook, the Eurozone’s current growth strategy is based on export growth to non-Eurozone countries. Balanced growth needs a reversal of the sharp drop in investment that has been ongoing since the outbreak of the financial crisis. The slight increase in investment could be a first weak signal that European firms are more bullish regarding investments.
One major factor that supports increased investment activity is that, after the Cyprus crisis in the beginning of the year, the euro crisis has been fading into the background. While there were no major political decisions regarding the future shape of the Eurozone—not least due to the German federal elections in September—turbulence has not re-emerged. The acute phase of the euro crisis seems to be over.
Whether this is a permanent easing of the crisis is far from certain. Even less certain is whether the crisis has gone from an acute to a chronic one. Nevertheless, the uncertainty that has dragged on Europe’s growth and investments has been declining lately. Figure 2 tracks two indexes from January 2008 through September 2013. The European sentiment index reflects business climate and expectations; the Economic Policy Uncertainty Index measures the level of political uncertainty. While the correlation between the two is not perfect, it confirms the intuition that high uncertainty affects business climate and lowers the propensity to invest.
Figure 2. Economic sentiment indicator (ESI) and economic policy uncertainty index
Besides a smaller fiscal drag, another factor supporting the notion of a recovery is simply that the recession has lasted for so long; at some point, it can be argued, the recession must hit bottom, after which a countermovement sets in. Empirically, the turnaround point depends on the type of recession. Normal recessions last for about a year. They last longer when associated with an oil shock or an external demand shock. The worst recessions are associated with a big financial crisis; in these cases, the recession lasts between six and seven quarters.1
This timeframe seems to fit the developments in the Eurozone nicely, as growth has returned after six quarters of recession. This empirical match supports the view that the early indicators signal not only a transitory break, but the beginning of the end of the recession.
Tailwinds: The known unknowns
Notwithstanding the above, a technical economic rebound will not be enough to sustain a recovery. There are several risk factors that could interfere with the trend toward recovery.
First, capital flight from emerging markets following the Fed’s announcement of ending the quantitative easing program endangers emerging markets’ stability as well as their growth rates (see “The impact of Fed tapering on emerging economies: Struggling with the ebb” in this issue of Global Economic Outlook). Given that emerging markets have become the main export engine for the Eurozone, further instability could severely strain European exports.
Second, the recovery takes place against a background of a relaxation in the Euro crisis. But as many of the reasons for the Euro crisis and the recession are not solved yet—unstable banking systems, over-indebtedness, the architecture of the Eurozone, and difficult access to credit in southern Europe—it is far from impossible for the Euro crisis to return. For example, while borrowing costs have been falling in the Eurozone’s crisis countries, the gap between their financing costs and Germany’s remains substantial.
Third, political risk factors still exist. The most important one remains the high unemployment rate in Southern Europe, which might result in political instability and a threat to the integrity of the Eurozone (for example, if it brings anti-European governments into power). In order to substantially reduce unemployment, much higher growth rates are needed. Because southern European labor markets are highly regulated, there is no straight relationship between growth and employment. Therefore, growth must be substantial before it spills over to the labor markets.
Research undertaken by Deutsche Bank suggests that in Italy, for example, a GDP increase of 1 percent leads to employment growth of only 0.1 percent, while the crisis countries generally need GDP growth between 0.7 and 1.3 percent just to keep employment constant.2 Labor markets and the unemployment situation are thus likely to remain the Eurozone’s principal Achilles’ heel. Given ongoing labor market reforms, these thresholds might be lowered in the near future so that even modest growth will have an impact on the labor markets. But until that happens, or until growth reaches substantially higher dimensions, political tensions will remain.
Shape of the recovery: L meets U
Pessimists interpret the quarter’s tentative growth as a short intermezzo in the ongoing deep recession. Optimists think that it was a strong positive sign and a turning point toward a sustainable recovery. Consequently, the pessimists expect not a real recovery, but stagnation at best. In this scenario, the recovery would take the form of an L. The optimists expect a rebound in the form of a U.
If one or several of the above-mentioned risk factors materializes, the first camp could end up being right. In a more upbeat scenario, risks will not materialize, and the more positive current expectations would spill over to investment and consumption.
Given the still-shaky state of the Eurozone’s economy and politics, the safest bet is that the Eurozone will work itself out of the recession in a rather slow and bumpy way. Uncertainties in the Eurozone are currently receding, but they still exist and will put a strain on the recovery. The recovery is likely to proceed in a stop-and-go fashion, driven by domestic and European politics and volatile financial market expectations. The result will probably be something like a combination of an L and a U.
- International Monetary Fund, “Crisis and Recovery,” World Economic Outlook, April 2009.
- Deutsche Bank Securities, “Will the Euro area recovery be strong enough?,” Global Economic Perspectives, September 6, 2013.