The Eurozone economic recovery, the darling of the global cyclical upturn over the past year, hit something of a speed bump in the first quarter of 2018. The latest activity and survey data have been disappointingly weak. Indeed, a measure of Eurozone data surprises – the difference between consensus expectations for economic data, and actual data prints – is at its lowest level since the depths of the Eurozone debt crisis. Temporary weather aberrations and a severe flu season, particularly in Germany, are partly to blame. But some observers are putting the deceleration down to a more fundamental cause: limited or no spare capacity, meaning that the Eurozone recovery could be running out of room to grow above the economy’s trend growth rate.
Assessing the margin of spare capacity in any economy is difficult at the best of times; in the Eurozone at present it’s harder still. Twin recessions in 2008-09 and 2011-13; differences in product and labour market settings in member states; and the varying pace of structural reform across the member states, mean that estimates of Eurozone potential output and therefore spare capacity are clouded with uncertainty.
The combination of a period of strong Eurozone output growth could be healing the scars of the earlier downturns.
But we suspect that one commonly cited cause of a lower path of potential output in the Eurozone post the financial crisis and the Eurozone debt crisis – permanent scarring of the labor force – is overplayed.
Economists talk of “hysteresis effects” impacting the labor market after a severe downturn: a temporary slump in economic activity can cause workers to become permanently detached from the labor market, as a long period of unemployment causes their skills to become obsolete and re-entry into the world of work becomes difficult. Alternatively, labor market hysteresis can arise from “insider-outsider” effects: labor market insiders, perhaps whose who remain in employment during a downturn or who are members of a union, set the prevailing wage rate, raising it above a level that would encourage firms to hire outsiders. Insider-outsider wage setting is readily applicable to the unionized, two-tier, labor markets of Europe. Either way, the upshot of hysteresis is that recessions can cause lasting scarring, raising the structural rate of unemployment and meaning that potential output never again attains the level implied by its pre-crisis trend.
Most estimates of Eurozone potential output either implicitly or explicitly incorporate deep hysteresis effects from the global financial crisis and the Eurozone debt crisis. The algorithm behind common econometric filtering approaches to estimating potential output perceives the weakness of output growth over the financial and debt crisis periods as a permanent development, lowering the path of potential output in the future. And the production function approach to estimating potential output often incorporates the assumption of a higher structural rate of unemployment as a result of labor market hysteresis.
However, there may be reasons to think that the Eurozone has suffered less from hysteresis effects than these canonical estimates of potential output would suggest.
For a start, the combination of a period of strong Eurozone output growth over the past year, and structural labor market reform in many member states, could be healing the scars of the earlier downturns. Recent strong growth appears to be bringing down the number of workers who are in part-time or temporary positions but who would prefer full-time, permanent jobs, as they move from the former to the latter. And rising labor market participation rates, particularly among women and older workers, appear to be the upshot of structural labor market reforms in Spain, Portugal and Italy in the years since the Eurozone debt crisis. Encouragingly, France is now taking steps to improve the flexibility of its labor market, which should lower its unacceptably high structural rate of unemployment.
Moreover, there is an increasing body of research which suggests that the econometric techniques used to estimate potential output are overly sensitive to cyclical fluctuations, misinterpreting temporary shocks for permanent ones. For example, revisions to potential output estimates are strongly correlated with movements in actual consumption and investment outturns. Estimates of the structural supply potential of an economy shouldn’t be as pro-cyclical as they actually are – which suggests that economists aren’t great at estimating potential output in the first place.
What does all this mean for Eurozone economic growth and monetary policy?
Given these doubts about quite how much scarring the Eurozone economy has suffered, the balance of uncertainty around estimates of Eurozone potential output appears to be largely to the upside. That is to say, it is more likely that most estimates are underestimating, rather than overestimating, Eurozone potential output. In turn, that means that there could be more, not less, spare capacity in the Eurozone economy than official estimates would indicate; in aggregate, the Eurozone could still be some way from running into binding capacity constraints.
That makes the current, accommodative stance of European Central Bank (ECB) monetary policy look broadly appropriate. ECB board member Benoit Coeure, for example, has noted that the current monetary policy stance has been calibrated on the view that the uncertainty around spare capacity estimates is considerable and that spare capacity could be larger than thought.
But the flipside is that, if potential output growth hasn’t been permanently lowered by labor market scaring, then the neutral rate of interest – to which monetary policy should return once the economy is in equilibrium – may not have fallen as far as many think.
That opens up the less reassuring corollary that, once monetary policy tightening does become appropriate (we expect policy interest rate hikes to begin around the middle of next year), the pace of tightening could be quicker than the glacial pace markets are pricing.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.