The eurozone is at last enjoying an upturn. Economists are savouring the unaccustomed pleasure of revising their growth forecasts up, rather than down, and investors are getting increasingly excited.
Yet as policymakers make a conscious effort to communicate that Europe is finally at a turning point, there is reason to fear that 2017 will be a very bad year for its economy.
Growth is picking up thanks to a series of variables that are stimulating demand. The depreciation of the euro, low oil prices, low interest rates as a consequence of the European Central Bank’s (ECB) quantitative easing (QE) programme and the postponement of fiscal adjustment in several countries are all helping to boost the region’s economic health.
Given the numerous positive shocks, the economic upswing in the eurozone is not surprising. But we also know that Europe’s potential growth is very low due to poor corporate investment and productivity gains. There are therefore two possibilities: either the positive variables continue for a prolonged period to lift potential growth; or the volatile variables that are stimulating demand disappear and Europe’s economic ills will return. We estimate it will take two years for this second scenario to unfold.
A varied picture?
The European Commission is forecasting economic growth of 1.5% in 2015, which would be the euro area’s best outcome since 2011 when it grew by 1.6%. Indeed, economic data in April was so impressive that it kick-started rumours that the ECB may exit QE early. Of course, the financial markets herd-like behaviour took to this farfetched belief, which has subsequently gained quite some momentum.
However, France and Italy, the zone’s second and third largest economies, stagnated in the final quarter of the year, while Greece’s return to the headlines has unsettled markets. And while a rise in real wages and cheap energy prices is expected to spark strong growth in household spending across Europe, consumption will not return to pre-crisis levels for some time.
A pathway to the big crash
Despite the seemingly rosy outlook, we need to address the insufficient foundations of Europe economic architecture. First, a stable economic model relies on solid corporate investment. Yet as the region enjoys relative growth throughout 2015-2016, it is unlikely that companies will use this period to increase corporate investment – limiting productivity gains and subsequent potential growth.
Indeed, companies will anticipate that the increased demand is merely temporary. What’s more, many countries – France and Italy in particular – have supply-side problems, such as excessive job protection, a heavy corporate tax burden, inadequate competitiveness and profitability, and low labour-force skills. These qualities make Europe’s economic model fundamentally weak and susceptible to collapsing.
Second, the oil market looks set to rebalance in 2017. The rise in the oil price will have a direct negative impact on demand and activity, but it will also have a very significant impact on the ECB’s monetary policy. A price rise is likely to lead to a loss of demand and growth, and a return of inflation to a level close to the ECB’s target of 2%.
The ECB would therefore have to stop its QE programme, leading to a renewed appreciation of the euro (which would be negative for exports and growth), a rise in long-term interest rates on government bonds, a sharp increase in risk premia on bank bonds and corporate bonds, and a fall in share prices. The overall cost of financing the economy will increase significantly, but the main thing to be feared is the effect on governments and investors.
Adverse effects on borrowers and investors
During the period of 2014-2016, most eurozone countries will have continued to increase their public debt ratios due to very favourable financing conditions and the postponement of fiscal consolidation. Therefore, if growth slows down and interest rates rise in 2017, public finances will be hit.
Furthermore, institutional investors will have accumulated financial assets with very low yields and extremely small risk premia. The halt in QE combined with the return to normal risk assessment will trigger a fall in the value of these financial assets, with substantial losses for investors.
Of course, Europe’s failure to act on its poor nominal growth has meant that the foundations of its economic architecture are weak. And so, if oil prices rise and the ECB commit to ending QE, then the subsequent appreciation of the euro, the rise in long-term interest rates and fall in share prices will lead to a public financial crisis, a crisis of insolvency amongst institutional investors and, ultimately, a resurgence of the recession by the end of 2017.
