The Eurozone economy is growing at the fastest rate in a decade and the upswing is broad-based. Nonetheless, the recovery remains incomplete and still dependent on policy support, inflation has yet to pick up more meaningfully, and fragilities persist. Accommodative macroeconomic policies therefore remain appropriate for now. Looking further ahead, low potential growth risks putting a lid on the expansion. This highlights the need for fresh impetus to structural policies that increase the growth potential and help to share its benefits more fairly. To ensure resilience, further progress on the completion of EMU is required.
GDP growth in the Eurozone has increased and broadened
For the past four quarters, GDP has expanded at a quarterly rate above 0.5%. Very high levels of economic sentiment suggest that the expansion should continue at a similar rate in the last quarter of 2017. GDP growth in the Eurozone is thus expected to come in at 2.2% this year, the highest rate in a decade. The Commission’s Autumn 2017 European Economic Forecast projects growth in the Eurozone of 2.1% next year and 1.9% in 2019.
The Eurozone is benefitting from a synchronised global upswing.1 Growth has also picked up in other advanced economies after a more modest performance in 2016. Emerging markets have surprised on the upside, with growth in China outperforming expectations and a rebound in large commodity exporters, such as Russia and Brazil, helped by the increase in commodity prices. Global GDP growth outside the Eurozone is projected to pick up to 3.7% in 2017 and to plateau at just below 4% in 2018 and 2019. The pace of economic growth in advanced economies is expected to peak in 2017 and to moderate thereafter as their economic cycles mature.
Figure 1 Economic policy uncertainty in Europe
Investment, which took a particularly hard hit during the crisis (Buti and Mohl 2014), is finally rebounding as well. Total investment is now growing at a rate of almost 4% in the Eurozone as the combination of ample financing conditions, diminished uncertainties (Figure 1), high capacity utilisation and business confidence, as well as the pick-up both in external and domestic demand, have encouraged European firms to invest more. Following the bottoming-out of housing markets, construction investment in the Eurozone is now also growing at a higher pace. In some member states, it is rebounding from very low levels just as the first signs of overheating are emerging in others, and could lead to a slowdown in the next two years.
Figure 2 Eurozone investment ratio
Private consumption has benefited from thriving job creation and has been the backbone of the recovery so far. The robust pace of employment growth, at 1.4% in 2016 and 1.5% 2017, has contributed to the acceleration of consumption to 2% last year and to its resilience this year. Looking ahead, the pace of job creation is set to slow down somewhat, in part because some member states’ labour markets are starting to tighten for some skills segments. Amid still muted wage growth and gradually increasing inflation, private consumption growth is expected to ease slightly to 1.5% in 2019.
Figure 3 Eurozone real GDP and its components
The return of convergence
The synchronisation of the business cycle has increased, with all member states now participating in the expansion and seeing improvements in their labour markets. There are also early signs that the longer-term process of convergence in living standards has resumed, after being interrupted by the crisis. This real convergence is expected to be quite steep in the Eurozone as a whole, where it is driven by the member states that joined the Eurozone since 2007. But even among the 12 earlier member states, convergence is resuming after the setback during the sovereign debt crisis (Figure 4).
Figure 4 Dispersion of real GDP per capita (coefficient of variation)
Note: Changing composition of the aggregates excluding LU and IE.
Despite recent good news, the recovery remains incomplete and dependent on policy support
Several features of the economic expansion remain atypical, such as its dependence on policy support, the continuing presence of fiscal and financial fragilities stemming from the crisis, and the relatively subdued domestic demand compared to past recoveries. This also indicates that the recovery is still incomplete at this stage. The quadrants of Figure 5 illustrate this point. Despite stronger investment growth recently, the share of investment in GDP is only slowly rising towards its long-term average (top quadrant). While the recovery of equipment investment is fairly advanced, the share of construction investment in GDP remains very low. Public investment in particular has been cut back significantly during the crisis. Past (equipment) and current (infrastructure) underinvestment is weighing on potential growth by reducing the level of the capital stock but also its quality, as old machinery and infrastructure have been kept for longer and new technologies are only slowly incorporated. Unemployment (right quadrant) remains very high in some member states, and the remaining labour market slack is larger than the unemployment rate for the Eurozone (projected at 8.5% next year) suggests. Extended measures of underemployment, such as involuntary part-time work, point to remaining slack (ECB 2017) even in countries with low unemployment rates. Together with low productivity growth, this contributes to the sluggishness of wages, even in a context where the output gap is closing.2 Low wage growth, itself also a reflection of low inflation expectations, in turn stands in the way of a faster pick up of inflation towards the ECB’s definition of price stability (left quadrant). It also caps the growth of real disposable incomes and hence the possible rate of consumption growth. This leads to the lower quadrant of Figure 5 – the large current account surplus of the Eurozone, which reflects a frailty of domestic demand that has yet to be overcome.
Figure 5 Remaining slack
Notes: I-I* is the absolute difference between the investment share for the total economy and its long-term average 1995-2008; 2%-π core is the absolute difference between core HICP and the ECB target rate; CA-CA* refers to the absolute difference between the CA balance and the CA fundamentals benchmark3 and u-u*to the absolute difference between unemployment and the NAWRU.
The incomplete nature of the recovery and the persistence of low inflation have important implications for the appropriate macroeconomic policy stance. The ECB has indicated that monetary accommodation will be required until the path of inflation towards its definition of price stability is self-sustained. Given the remaining fragilities and slack, the broadly neutral aggregate fiscal stance for the Eurozone as a whole is also appropriate for now. However, a proper differentiation across countries is crucial to ensure debt sustainability while supporting growth and employment. In this context, the quality of public finances, which relates to the growth-friendly orientation of taxes and spending rather than the level of expenditure or the deficit, is vital for social fairness as well as stronger growth in the medium term. In member states at risk of housing market imbalances, this should be accompanied by macroprudential measures.
Figure 6 Eurozone wage developments and employment
Don’t accept a diminished potential!
As the cyclical upswing advances, the focus increasingly has to be on potential growth and the deployment of measures dubbed as ‘structural reforms 2.0’. Cushioning the impact of population ageing on the workforce requires improving the functioning of labour markets and increasing labour-market participation. Reversing the decline in productivity growth will require better education and training, stimulating the take-up and diffusion of technology, and improving the performance of product markets (IMF 2017b). A big push for the completion of the Single Market, including its digital and service dimensions, is needed. The cyclical recovery has already been ongoing for 18 straight quarters. Only a determined effort to tackle the remaining fragilities and boost potential growth will allow the expansion to last. And only major efforts in the area of education and lifelong learning will advance the equality of chances and allow the fruits of growth to be shared more equitably.
Stability in the years ahead also requires the completion of EMU and convergence towards resilient economic structures. Outside the Eurozone, the normalisation of monetary policy has begun. The prospect of higher interest rates has exposed vulnerabilities in the global economy (IMF 2017b), and past experience has shown that the Eurozone cannot de-couple from major tensions in global financial markets, let alone from a slowdown in the world economy. An important lesson from the crisis is that member states with resilient economic structures have suffered less and recovered faster. Convergence towards more resilient structures is therefore closely interrelated with the structural reform agenda for the coming years.
At the same time, the completion of EMU is required to make the Eurozone economy better able to weather future shocks. Vulnerabilities remain, for example, in terms of high public and private debt as well as weak profitability in the banking sector. Moreover, the crisis has seen the partial reversal of financial integration achieved in the first decade of EMU. Moving towards more resilient economic structures at the Eurozone level must include the completion of banking and capital markets union as well as advances towards economic and fiscal union. The Commission will make detailed proposals to this end in December.
-Marco Buti, Björn Döhring