Can Europe Escape a Lost Decade?

by Thomas Cooley, Kellie Forrester, and Peter Rupert

The latest release from Eurostat of GDP for the fourth quarter of 2013 showed the Euro Area GDP up by 0.3% and the EU28 up by .4%. This is encouraging news for a continent that has been battered by the Financial Crisis and a debt crisis for six years now. It may well be that they can escape the possibility of a decade of economic decline that we discussed in the last post (here). Real GDP increased slightly in the major economies with the strongest upward trend appearing to be in the U.K. Even some of the small, worst performing, economies where the crisis has been felt most acutely show very slight signs of a turnaround. But that is the optimistic view. A more realistic view would argue that the slight upward ticks in France, Spain, the Netherlands and Italy are too timid still to declare recovery. Indeed, the fact that 0.4% is seen as good news underscores the severity of the current situation.

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But, the European picture is very much a tale of two Europes, with Southern Europe showing tremendous weakness and the Northern European Economies and the U.K. showing morobust signs of recovery. This becomes apparent when we look at consumption, capital formation and the labor market.

Only Germany and France show consumption above its prior peak and for many of the periphery countries it remains at least 5-10 % below its prior peak.
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Capital formation ( Fixed Investment) tells an even more discouraging story.  For all but Germany and France  it remains severely depressed and the periphery countries show no recovery at all. Indeed many of them continue to trend lower.

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The employment to population ratio is an interesting indicator of the impact of the Great Recession and recovery.  With the exception of Spain, the larger European economies declined but not as severely as  the U.S..  Germany, a country that undertook significant structural reforms of its labor markets, has actually improved in the aftermath of the Great Recession. But again, this is a tale of two Europes. Employment in the periphery countries has declined dramatically, some as much as 10%.  This is a staggering blow to these economies and it means they are going to have lost generations of workers.  It is very hard to know what the long term impact of that might be.

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So will the little green shoots of growth save Europe from a lost decade?  Our previous post argues that there are many factors – the Balkanized banking system, the failure to reform labor market institutions – that weigh against an optimistic view.

Europe’s Lost Decade?

by Zach Bethune, Thomas Cooley, Espen Henriksen, and Peter Rupert

Is Europe about to repeat Japan’s lost decade? Six years after the Great Recession began, the Euro area has shown little sign of sustained growth. Japan’s so called lost decade began in 1991 after several decades of rapid economic progress and sustained increases in asset prices that were suddenly reversed. The average growth rate of real GDP per-capita declined from about 3.5% per year in the 1980s to about 0.5% per year in the 1990s and was accompanied by rapidly decreasing equity and real-estate valuations. But, when we compare the performance of Japan’s economy with the European economy since the beginning of the Great Recession it is clear that Europe is in far worse shape than Japan ever was.

The following Snapshot-style comparative charts show the paths of key economic variables in Japan after the peak of its equity and real-estate valuations and contrasts these with the paths of these variables in the U.S. and Europe in the years since the onset of the Great Recession. For Europe and the U.S. we set time “0” at the peak before the Great Recession. Judging from this and the charts that follow, halfway into the decade following the onset of the Great Recession, the performance of the U.S. and, in particular, the European economy are substantially weaker than Japan’s economy was halfway through its lost decade.

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Japan’s growth rate slowed dramatically at the beginning of their lost decade – GDP rose only 10% in the first six years and then flat-lined more or less completely. Europe, by contrast fell by six percent in the first six quarters and then flat-lined at a level three percent below their peak. The U.S. stands in contrast to both of these stories – after falling by nearly four percent in the first six quarters U.S. growth has been steady at a rate slightly less than before the collapse.

Consumption paints an even more dire picture for Europe. During the lost decade in Japan consumption expenditures never really slowed down. In the Great Recession, U.S. consumption fell initially for about 6 quarters and has been rising ever since. Europe on the other hand started out similar to the U.S. for the first 6 quarters but then consumption growth stalled and has not improved since. It has not returned to its 2008 peak.

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The labor market picture for Europe is even more discouraging and strongly reinforces the message of a lost decade. The unemployment rate in individual countries like Spain and Italy has been widely noted. But, here we focus on aggregate employment and the data are for the EU-28 which includes some countries, like Germany, where the labor market has not really declined. Japan, Europe and the U.S. showed remarkably similar paths of employment up until the inflection point following which there was a sharp contraction in both the U.S. and Europe. In Japan, employment like output, simply stagnated. In terms of a recovery, the U.S. labor market, after a sharp decline, is showing slow growth while Europe looks to be stuck at a permanently lower level.

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While the declines in employment were steep in both the US and Europe, the path of labor productivity has been very different. In the US the recession had a negligible effect on labor productivity, which has only recently started to show signs of slowing down (see here for instance). Europe on the other hand experienced a sharp drop in productivity at the beginning of 2008, when it fell by nearly five percentage points. Data until 2010 suggest that European productivity hasn’t shown any signs of ‘catching up’ to its previous growth trend. Measuring labor productivity is particularly difficult for Europe because one needs a measure of total hours worked. Ohanian and Raffo (2011) do the heavy lifting by constructing this series for many European countries, although it is only available until 2010.

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Why the Lost Decade?

Economists have offered a range of different explanations for Japan’s lost decade: (i) the government failed to deal with undercapitalized banks that were allowed to carry “zombie” loans on their books and did not have the capacity to finance new investment, (ii) a sharp drop in productivity caused desired investment to be low, (iii) frictions caused by labor law amendments in the late 1980s resulted in declining work weeks, (iv) the monetary policy response was too timid (something Abenomics is finally trying to remedy), and (v) Japan’s prospects for recovering were seriously hampered by persistent deflation. While it is not clear that there is one compelling account, all of these elements undoubtedly played some role and all of them loom large in the current European experience.

As in Japan, European banks are most likely under-capitalized and carrying loads of overvalued (“Zombie”?) sovereign debt on their balance sheets as well as other assets of dubious quality. The European Central Bank has only gingerly approached the problem of looking at asset quality in European banks, promising to deliver results later this year. But then what? There is no plan for dealing with under-capitalized banks. In contrast to Japan and the U.S., there is no common bank regulation or resolution mechanism and there has been only tentative progress toward creating it.

As the picture below shows, investment / capital formation stagnated in Japan, both consistent with the slower growth in total factor productivity and insolvent banks that deterred lending. The picture also shows that investment in both the United States and Europe fell relatively more at the onset of the Great Recession than investment in Japan did at the onset of the “lost decade”. In contrast to both Japan and Europe, U.S. capital formation has rebounded after an initial collapse. Again, the European situation looks more alarming than the situation in the United States and Japan.

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Whatever the reasons may have been for Japan’s ‘lost decade’, one thing is certain: more than halfway into the decade following the start of the global recession in 2008, the European economy is far worse and deteriorating. Even though economic growth in Japan stagnated in 1991, the economy continued to grow. In contrast, the economy in Europe has contracted and is, according to all measures of economic activity surveyed in this post, at a lower level than they were five years ago. Unless economic growth in Europe rebounds within the next couple of years, Europe is headed for a substantially worse decade than Japan’s. Surprisingly, there has been recent optimism about a European recovery, but the data do not seem to support it except for possibly Germany and the U.K.

Just as there were no quick fixes for Japan during its “lost decade”, most likely there are no quick fixes for Europe’s economy. The challenges lie in fostering economic institutions that create individual incentives and market structures that both discourage rent seeking and encourage and allow people to use their efforts to develop and produce goods and services other people value. On this score Europe has failed. They have not reformed institutions sufficiently to make their markets globally competitive and adaptable. Until they do, Europe will continue to face the possibility of an entire decade of lost income, consumption, and jobs.

A European Recovery? Not Exactly!

There has been much celebration in the media of the fact that several European economies showed positive growth in the Second Quarter of 2013 based on the most recently released data from Eurostat. If this upward trend was widespread and robust this would indeed be encouraging news because virtually all of Europe has been suffering from a double-dip recession (Germany, UK, and France being moot) following the financial crisis of 2007-2009.

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The latest data from Eurostat shows Real GDP increasing for the biggest economies – Germany, France, and the U.K.  The flash estimates of quarter-to-quarter growth rates also suggest an up-turn in Portugal. But Spain Italy and The Netherlands are still declining, suggesting that the optimism should be seriously moderated.

In this post we also show the path of the percentages changes in Real GDP for the so-called PIIGS or GIPSIs. The picture for these economies is decidedly more bleak.  Only Iceland is showing signs of recovery while the others continue to contract with little sign of moderation. Also worth noting is the scale of the graph for the smaller economies which underscores how much deeper the contraction in these economies was.

Looking at all of these economies together it would take a colossal leap of the imagination to see this as a picture of recovery, as was widely reported last week.
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GDP Components
The pattern of consumption in the major European Economies pretty much mirrors the pattern of GDP. One exception is France, where consumption fell very little during the recession and has since recovered. The decline in consumption in the GIPSIs has been deep, reflecting the tremendous toll of the continuing fiscal crisis. Perhaps more alarming is the continued double-dip decline in capital formation in all of the European economies. This hardly seem like a signal of impending recovery.
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LABOR MARKETS

If it is difficult to see signs of recovery in the data for GDP and its components, it is equally difficult to see it in labor markets. Perhaps the good news is that the unemployment rate is no longer rising in Spain, the U.K. and France. It is also falling somewhat in Ireland and Portugal. But many of these countries are now stuck at levels of unemployment that will take a generation to moderate given the sclerotic state of European labor markets.  The employment/population ratio is also falling across the board. Some of this reflects the changing demographics of the population but mostly it reflects the state of the post-crisis European Economy.
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European Woes

Weakness Across the Board

Real GDP has declined in all of the European countries shown below for the last quarter of 2012; and, all countries except Germany remain below the level of real GDP five years ago. German real GDP declined after relatively solid growth over the past several years.  Real GDP in Spain and Italy is now actually lower than it was at the depths of the recession in 2009-2010.

Real private consumption expenditures have collapsed in Italy, Spain, and the Netherlands–about 6% below where they were in 2008. Capital formation has also seen a disheartening decline in all countries except the UK. While Germany had seen a comeback in gross capital formation, getting back to its 2008 pre-recession level in the middle of 2011, German capital formation is now 10% below that level.

Despite contracting output across the Eurozone economies, there are no signs of (increased) turmoil in labor markets. The unemployment rate for Germany, Italy, and the UK maintained a slow downward trend. Spain’s unemployment rate decreased for the first time since the peak of the cycle. France and the Netherlands maintained a slow upward trend.

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Spending Differences of Government

Government spending in both Italy and Spain have fallen considerably as has the U.S. In most of the other countries government final consumption expenditures continue to rise. However, as a fraction of GDP, government expenditure is approximately flat, except in the U.S., where it is falling and is now below its level since the previous peak.

Europe on the skids?

GDP data for 2012 Q4 is scheduled to be released mid-February, here is the schedule. Recent news and notes from the blogs suggests that the German economy has slowed and may continue to do so, promoting fears of a slip back into recession territory. In terms of labor market outcomes, Germany remains the only country significantly above its employment levels compared to the 2008 peak. Spain continues its freefall, while most other countries have climbed back to roughly the same employment level of four years ago. Moreover, unemployment rates in many of the countries (Germany still falling and the U.K. moving sideways) in the EU have begun to drift upwards. While the U.S. had a larger percentage increase in the unemployment rate than any country except Spain over the past 4 years, it has now seen a decline in unemployment rates similar to that of Germany.

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EU Back in Recession

One of the remarkable features of the current economic distress that began in late 2007/early 2008 is the extent to which the initial collapse was common across economies (including the U.S.) in both timing and severity.  What is not common is the path of recovery as the following analysis shows. The U.S. now looks to be in good shape compared  to many of the E.U. economies…most of which have slipped back into negative growth. For the E.U. as a whole it is the second consecutive quarter of decline in aggregate real output. The business cycle dating committee of the Center for Economic Policy Research -CEPR- has declared that the Eurozone Economy slipped back into recession beginning in the 3rd quarter of 2011.  Oue analysis focuses on the largest European economies including the U.K.

E.U. Growth Slows Compared to the U.S.

Many of the economies in the EU continue a decline in GDP  that started in late 2011. These economies reached a nadir about 6 quarters after the recession began in 2008, then grew for about 6 quarters, stagnated, and have been  in various rates of decline for 6 quarters or so. Moreover, none of the countries in the EU in the graph shown below has come back to its 2008 peak, except Germany. Indeed, the only positive signs are the Germany continues to grow and the U.K. has turned up a bit.  It is far too early to suggest a U.K. turnaround given that they remain well below their previous peak.

Consumption continues to collapse in all but Germany and France where it has remained stagnant.  More alarming is the complete collapse in capital formation. Only the U.K. shows a possible recovery in capital formation after a dramatic decline.  Even more dramatic is the decline in residential capital formation. The total collapse in Spain is well understood but, except for Germany, it is remarkably weak everywhere.

One of the few bits of encouraging data is the recovery of exports in several of the most impacted economies. Spain in particular has had robust export growth as have Germany and the Netherlands.  Imports have recovered in Germany, the Netherlands, and France.

Labor Markets in Europe – A Largely Discouraging Picture

There is nothing like a major shock to an economy to expose weaknesses and strengths in economic institutions.  There was a time a couple of decades ago when Europe was famous for poor labor market institutions and stubbornly high unemployment rates.  The term of art was “eurosclerosis” which was shorthand for high rates of unemployment and weak job creation even in growing economies. The particulars were different across economies but the generic problem was poor labor market institutions.  The dream was that European integration and the advent of the Eurozone would finally break the historical record of inefficient labor markets.  Unfortunately, the prosperity that followed European integration made institutional reforms less compelling for  economies like France, Spain and Italy and they  put off making some of the fundamental reforms that were widely viewed as necessary. As a consequence the pain is great in Spain and Italy. Germany, once a problem state,  enacted important labor market reforms beginning in 2003 that improved the incentives to work. The U.K. enacted a variety of reforms in the 1990′s that made the U.K. labor market more efficient.

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