The main message for European policymakers from the IMK economic forecast last week – available in German here – is that while there are strong grounds to hope for the best, concrete steps need to be taken to avoid the worst. Let us start with the good news and then ponder the risks, before recommending appropriate policies.
A belated but broadening upswing
The European economy appears finally to have turned the corner. In the euro area the recession was overcome in the course of last year and employment has bottomed out. The IMK expects growth of 1% and 1.7% in the euro area in the current and coming year respectively. Thanks to faster growth in the UK, Poland and some smaller economies outside the common currency area, the EU as a whole will grow rather faster. Even in the crisis countries the signs are at last encouraging. Greece will continue to contract, on annual averages, this year but a substantial rebound is expected in 2015 (3.2%). Spain and Portugal will grow slightly below and rather above the euro area averages this and next year; unemployment is already falling, in Portugal rapidly. Meanwhile Italy continues to lag, stagnating this year and with sub-par growth in 2015 (0.8%).
The main drivers of this improvement are the easing of tensions on government bond and other financial markets and, in particular, the partial lifting of the austerity burden. A number of countries, notably France, have been given more time to bring deficits down, and Italy has been removed from the excessive deficit procedure. Government consumption will as a result no longer act as a drag on output, as it did with such disastrous results during the recession. As in the past two years, activity in the euro area excluding Germany will continue to be driven by rising net exports; the difference is that instead of the boost from trade being more than offset by contracting domestic demand, output will receive a positive contribution from the domestic demand aggregates, modest in the current year, but more substantial in 2015 (0.9 pp.). Just as output fell less than incomes in recent years, as households reduced their saving, so in the upturn consumption will lag behind that of incomes, as households rebuild their balance sheets.
Germany is firmly in an upswing and, moreover, it is one that is finally anchored in stronger domestic demand. Following tepid growth last year, the German economy is expected to grow by 1.6% in the current year and as much as 2.4% next year. Chronically export-dependent in recent years, it is private consumption and investment that will drive growth over the forecasting period. Indeed, net exports will actually be a slight drag on growth in the current and coming year and the German current account surplus will come down slightly, although at comfortably over 6% it will remain excessive. There will some mild discretionary fiscal stimulus (around 0.3-0.4% of GDP) in both years; this will be offset by the automatic stabilisers such that the German government budget will remain very close to balance over the entire period. Vital
Stronger domestic demand is being driven by a vibrant German labour market and, finally, faster wage growth. The forecast increases in employment of around ¼ of a million in the current and coming years are sufficient, given German demographics, to permit further small declines in unemployment rates – to 4.8% and 4.6% on standardised figures in 2014 and 2015 respectively. The short-time work (Kurzarbeit) that played a prominent role in smoothing German’s adjustment to the crisis will continue to be wound down. Collectively agreed wage increases will exceed 3% in both years, and the negative wage drift – the gap between collectively agreed and effective wages – that characterised the years prior to and during the crisis has given way to a positive gap that will see effective wages increasing at a rate of 3.6% in 2015. The planned introduction of a statutory minimum wage of EUR 8.50 an hour from the start of next year will play an important role here. The IMK estimates that it will directly – i.e. ignoring knock on effects on wages above the threshold – add one percentage point to the increase in total wage and salary income (4.3% in 2015), thus providing a substantial additional demand boost.
Serious downside risks
Three potentially significant downside risks are identified to this generally favourable forecast for the European and especially the German economy. One is that the geopolitical tensions with Russia over the Ukraine and Crimea could escalate, leading to the imposition of swingeing sanctions, or even military conflict. The probability and also potential outcomes of such a scenario are considered incalculable, however. Two more insidious concerns are addressed more fully. The first is political. The incipient recovery notwithstanding, the economic and social situation in the crisis countries remains dire, with unemployment at historically high levels. Euroscepticism is also on the rise in many core countries. Political uncertainty is considerable, not least in the light of the forthcoming European elections. At the same time an inadequate agreement has been reached on banking union, and the ECB’s OMT programme, which had been decisive in calming the panic, has been weakened, perhaps decisively, by the judgement of the German Constitutional Court. In short, negative shocks from the policy sphere cannot be ruled out and the political and institutional capacity to face them appears in doubt.
This interacts with a second crucial threat: deflation. Inflation is currently extremely low – the most recent monthly headline figure was just 0.5% – and has been on a persistent declining trend. Monthly figures for core inflation – consumer prices excluding energy, food, alcohol and tobacco – are consistently around half the ECB’s inflation target of just under 2%. The negative output gap is large, unemployment still appallingly high. Despite attempts to talk it down, the external value of the euro remains elevated. All these factors are bearing down on inflation. The peripheral countries have been forced onto an explicit path of disinflation and even outright deflation in order to regain competitiveness; unemployment and disinflationary pressure remain high there (see ch. 3 of the iAGS report 2014). But the counterpart in the surplus countries has been missing: the inflation rate in Germany is forecast by the IMK to be also substantially below the ECB’s target for the euro area as a whole. The above-mentioned acceleration of wage growth is welcome but still insufficient.
This raises a serious question as to whether the area-wide inflation rate will gradually move back towards target, as assumed by the ECB. There is a material risk that the euro area as a whole will slip into a self-reinforcing deflation, possibly pushed by a negative shock, with potentially disastrous consequences. Even if that does not occur, the monetary union could be stuck with extremely low rates of inflation that act as a drag on recovery by pushing up real interest rates and making it more difficult for economic agents to pay down debt.
Even if the conditions for economic recovery in Europe finally appear to be largely in place, substantial risks remain, and in any case the levels of output and employment in most of the currency area will remain woefully inadequate for the foreseeable future. In view of this policymakers cannot be allowed to indulge in complacency. Policy action is required to attenuate the risks and to ensure that the recovery is as stable and as strong as possible and normal levels of employment are regained as quickly as is feasible.
The ECB should not continue to eschew taking effective action and seek to counter the deflationary threat merely by jawboning the markets. The risks of a wait-and-see approach are great whereas those of taking what might prove to have been unnecessary steps are small. It should launch a programme of quantitative easing, purchasing asset-backed securities in support of lending to small and medium-sized enterprises in the countries worst hit by the crisis and/or government bonds facing excessive risk premia. Such measures, while they may appear discriminatory, are justified by the country-specific manner in which the usual channels of monetary policy are currently blocked in the euro area. Those countries less directly affected by the crisis, including Germany, should launch public investment programmes. If legal considerations prevent the – in itself sensible – deficit financing of such public investment, a positive effect on demand and on the supply side will be obtained if such spending is financed by taxes on higher incomes, wealth or environmental or other “bads”.
The outlook has finally brightened, after a miserable and unnecessarily protracted crisis, but we are not out of the woods yet.