Europe is emerging from the first phase of the pandemic – full lockdown – to a ‘new normal’, where almost all the economy has re-opened, even if people still face social-distancing and some businesses face capacity limits. But after the direct impact of the lockdowns, a range of lingering effects will keep economic activity below where it would have been without coronavirus.

There are significant headwinds, including unemployment, weaker world trade, insolvencies and rising debt. Some, such as social-distancing, affect the supply side of the economy and should be inflationary; others will depress demand and are disinflationary.

Fear and job shedding are the main current demand headwinds. Eurozone consumer confidence continues to depress household spending. So far, firing has been limited but hiring has slumped, suggesting downward pressure on wages, then inflation.

But social-distancing measures are also constraining supply capacity – in restaurants, for example – mitigating the disinflationary impact of weak demand. And coronavirus-related measures can increase costs, not only for protective equipment, but if social-distancing reduces productivity.

At present, the disinflationary demand headwinds are dominating – eurozone CPI inflation fell to a record low this summer – with surveys suggesting that sales are being impacted by more than capacity. But insolvencies and the prospect of higher structural unemployment could damage the supply side over time.

So far government loan guarantees have limited business failures, but a wave of insolvencies may come through with a lag, not least if state support is tapered while the economy remains depressed. And persistently high unemployment could see workers lose skills, turning the pandemic shock from disinflationary to inflationary as labour demand strengthens.

If Phase 2 is the new normal, demand is likely to stay weak but the disinflationary implications should ease as supply capacity gradually erodes. GDP – and possibly long-run growth – would fall well short of pre-crisis trends.

However, a vaccine or other medical breakthrough could herald a Phase 3, removing many of the current headwinds – most obviously fear and social-distancing measures – thus boosting growth and jobs.

Nevertheless, some long-run scarring effects are almost certain to hold back economic activity in the long run. It could take years for long-term unemployment to fall, for instance, or to re-allocate resources from insolvent firms.

And the clearest legacy of the crisis will be debt, both corporate borrowing and governments financing support measures. Pressure may build for a lengthy period of fiscal restraint to repay public debt.

Given the scars that may linger for decades, what will be the long-run growth path for the European economy?

Looking at the past six eurozone recessions, three years after a downturn, GDP tends to be 5 per cent to 10 per cent below the pre-crisis trend. There are reasons to be more optimistic about this recovery – the fiscal response has been bigger while central-bank support has helped keep financial conditions for companies and countries benign.

Nevertheless, we see 2021 GDP being 4 per cent below its pre-pandemic path and beyond that, the prospect of growth reaching its pre-crisis trend of 1.5 per cent a year is unlikely. We see a eurozone potential growth rate of 1 per cent to 1.5 per cent, but post-crisis scarring could lower even that.

First published 18 September 2020.

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