The Anatomy of a Recovery in the Eurozone
This piece is an op-ed written for MNI-news, Euro insight.
Pantheon Macroeconomics’ Eurozone team had the pleasure of spending the Thanksgiving break in Madrid, where we witnessed the cyclical recovery first hand.
We saw busy bars and full restaurants as far as the eye could see, and on the Gran Via -- one of the main shopping streets in the Capital -- we struggled to move due to people coming in and out of shops. Such anecdotal evidence doesn’t pass for economic analysis, but it provides a good fit to the story told by the macroeconomic data.
Consumer spending has so far, almost exclusively, driven the cyclical rebound in the Eurozone economy. In the eight quarters ending in the second quarter, household consumption was responsible for almost two thirds of GDP growth. Moribund investment added a mere 13%, even lagging the 18% contribution from government spending. Final GDP data from the third quarter next week will continue this trend. Reports from France and Germany show that households saved the day for GDP growth, yet again, amid weakness in investment and a drag from net trade.
A strong consumer represents rare good news in an economy ravaged by two severe recessions since 2008, and a near-meltdown of key countries’ government bond markets. It is a sign the Eurozone has partly succeeded in leaving the recent years of misery behind it. But even a slight slowdown in household consumption could spoil the party amid weak investment.
Investment in the euro area has been devastated since the crisis, partly because of a depression in construction -- 49% of total investment -- in France, Spain and Italy. Manufacturing investment, though, has also been struggling due to headwinds from slow growth in emerging markets, and unwinding of excess investment in the commodity sector. Weakness in global manufacturing and resources production will not last forever, but it is difficult to expect a convincing rebound in the short term, leaving the Eurozone economy vulnerable to a sudden shift in consumers’ sentiment and spending.
The unbalanced economic recovery is probably one of the main reasons why the European Central Bank remains committed to a very aggressive monetary policy, despite signs that economic growth and inflation. especially in Germany. will increase next year.
We see risks of inflation rising faster than the market and central bank expect. That, and a tight labour market in Germany, means the argument for quantitative easing and negative interest rates will be more difficult to sustain next year. But the doves will remain in charge in the short run, and the ECB chief Mario Draghi will continue to emphasize downside risks to the economy and inflation in coming central bank meetings.
Fundamentally, the president is trying to steer monetary policy according to two ideas. Firstly, Draghi is probably happy to “risk” overheating and above-trend growth in Germany, if it means making a dent in persistently high unemployment in France and the periphery. Higher wages and consumer spending in Germany are furthermore welcome news from the point of view of eradicating intra-Eurozone current account imbalances.
Secondly, Draghi has repeatedly reiterated the need for structurally low interest rates in an economy with fragile private and public balance sheets due to high debt levels. This view will not go down well in Germany, where the economic focus is on fiscal discipline and the risks of too easy money. But it is fully consistent with the weight of rapidly ageing populations and expensive pension and social security systems on the economy.
Monetary policy can’t prevent a fiscal crisis, but the evidence from Japan shows the combination of an accommodative central bank and a current account surplus can shield even a ridiculously high government debt level.
The experience in Japan also suggests that rapidly ageing economies with external savings can become suppliers of excess liquidity to global financial markets, driving a hunt for yield and fuelling carry trades. The rise in the Eurozone current-account surplus since 2011, and intensifying rising portfolio outflows due to negative interest rates show the euro area slowly, but surely, moving down the same path.
Draghi has said before that the Eurozone is not Japan, but we think it will come to look an awful lot like it in coming years.