Europe: in sickness and in health

Some European economies could emerge from the slump above their pre-pandemic trends

6 July 2020 Simon Wells, Chief European Economist

Could European economic activity end up higher than if the pandemic hadn’t happened? The recovery still depends on the virus but the European Central Bank’s ‘mild’ scenario projects eurozone output to exceed the pre-pandemic trend by the end of 2022.

Our own forecasts imply ‘lost output’ of just 0.4 per cent in the eurozone with no loss in Norway and Sweden. Such minor permanent scarring after a deep recession would be unprecedented.

Renewed COVID-19 outbreaks are still the biggest downside economic risk: UK cases are rising again with the Delta variant starting to spread across the continent.

The biggest upside risk is the personal savings accumulated during the pandemic. Eurozone households saved over 500 billion euro – around 4 per cent of GDP – more in 2020 than in 2019 and if that is run down quickly, consumption growth could exceed expectations.

Demand is already chasing supply that is being disrupted by rising shipping and commodity prices or capacity restrictions, causing eye-watering rises in input and output costs.

Near-term inflation is likely to be much higher and unusually volatile. But this should be temporary and our new eurozone forecast of 1.5 per cent for 2022 is still below the target.

However, UK wage growth has accelerated and inflation is expected to exceed the 2 per cent target next year. Bank Rate could rise by 15 basis points to 0.25 per cent next May with another 25 points in November then at least 25 more during 2023, but this shouldn’t derail the economy.

By contrast, the ECB’s policy will likely remain very loose with Pandemic Emergency Purchase Programme purchases being tapered from September and ended next March before 'normal' QE asset purchases are increased – possibly doubling to 40 billion euro a month.

But monetary policy alone won’t make Europe stronger. If a demand-led recovery finds supply constrained, inflation could eventually rise more persistently with fiscal balances deteriorating.

The EU’s 750 billion euro Next Generation fund will raise public and private investment and if individual countries’ plans for structural reforms – covering employment, tax and public administration – can be delivered, then longer-term growth potential could rise. However, much of the bloc still faces structural headwinds, including unfavourable demographics and rigid labour markets.

Emergency policy support must also be removed if Europe is to emerge stronger. If governments wind down emergency short-time work-compensation schemes this year, as expected, around 500,000 short-time workers in the eurozone may not be re-employed. Similarly, the credit facilities, loan guarantees and moratoria that have kept corporate insolvencies low must also be wound down.

Policymakers must tread a narrow path between not pushing viable firms over the edge without keeping alive ‘zombie firms’ that hinder re-allocation of capital to more productive sectors.

We have raised our forecast for 2021 eurozone GDP growth to 4.4 per cent with the biggest increases in Spain and Italy, while leaving 2022 unchanged at 4.0 per cent. After last year’s deep contraction, we now expect 7.1 per cent UK growth in 2021 with unemployment peaking at only 5.3 per cent, compared with the eurozone’s 8.4 per cent.

Europe can learn lessons from the pandemic and invest, reform and build back better. But politics, the pandemic and structural challenges still cast a shadow over the outlook. It remains unclear if Europe’s economy is in sickness or in health.

First published 30th June 2021.

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