You read it here first, in The European Conservative.
A month ago, I reviewed the latest numbers on the European economy and predicted that the continent is heading into a recession.
Now, as Bridget Ryder reports, IMF Managing Director Kristalina Georgieva has made the very same forecast. A month after us, Director Georgieva predicts that “half of the European Union will be in a recession next year.”
In my forecast, I noted that Europe’s recovery from the pandemic was disappointing and that at least “half of the EU member states show signs of stagnation or further decline” in consumer spending. Since private consumption is the core of developed economies, a negative outlook for it is a red flag signaling an economic downturn in the making.
Back in the second quarter, there were similarly gloomy signs in the business investment numbers. Since then, Eurostat has published a full set of third-quarter data, which gives us a deeper insight into where the EU economy is heading. These numbers confirm my prediction from early December, but I would suggest that Director Georgieva is too cautious in her statement that half of Europe will go into a recession.
Given the high level of economic integration in Europe, it is unlikely that a recession will be confined to half the continent. I would be surprised if the economic downturn did not spread to all corners of the EU.
The Good, the Bad, and the Ugly
Before we examine the evidence of a recession in the making, let us recognize the good news that is included in the latest pile of national accounts data from Eurostat. The recovery from the 2020 pandemic has for the most part been a success. Most of the EU member states have a gross domestic product, GDP, that exceeds 2019 levels by more than 3%. This is not impressive, especially since supply-chain problems are not to blame for high inflation and other problems. The culprit is instead a slew of poorly executed, market-distorting government policies.
That said, a 3% inflation-adjusted expansion of GDP in three years is good news in the context of, well, bad news—of which there is plenty. For starters, as of the third quarter of 2022, two countries still had not caught up with their 2019 economic activity levels: the Czech GDP was 0.4 percentage points smaller than in the third quarter of 2019. Spain was 0.63 percentage points behind.
These are minuscule numbers, but Czechia and Spain are only the worst examples of a group of nine EU member states that have either not caught up with their own 2019 economies or have just barely managed to do so.
In this group we find three of Europe’s largest economies:
- Germany, with a GDP only 0.6 percentage points larger in Q3 of 2022 than in Q3 of 2019;
- France, 0.7 percentage points ahead of three years ago; and
- Italy, with a meager 0.5 percentage point gain.
There are some examples of strong recovery: Bulgaria, Ireland, Croatia, Cyprus, Hungary, Poland, and the three Baltic states. However, Europe overall is struggling to recover economically what it lost in the past three years.
Real GDP growth numbers are equally disappointing:
- In the second quarter, only five countries had a year-to-year GDP growth of less than 2%;
- In the third quarter, that number rose to ten countries.
This growth slowdown shows that the European economy is stuck on a long-term trajectory of tepid growth. When the pandemic recovery is in the rearview mirror, more and more EU member states return to the quasi-stagnant economy they were trapped in before the pandemic. Once back on that trajectory, the slow growth makes them vulnerable to recessions.
Furthermore, when an economy falls below 2% real growth per year, the standard of living no longer advances. This phenomenon, which is explained by an adaptation of Okun’s law, reinforces and perpetuates the stagnation of overall economic activity that has plagued most of Europe so far during this century.
Generally speaking, with limited growth opportunities in their markets, entrepreneurs and investors are reluctant to invest for the long term. The economy reproduces itself, but stops evolving.
The recession vulnerability of the European economy is put on full display in the numbers for private consumption. In the second quarter, only four countries had a consumption growth rate below 2%; in the third quarter, eleven EU member states belonged to that group. Making matters worse, in six of those countries, household spending declined: Estonia (-0.4%), France (-0.7%), Lithuania (-1.9%), Austria (-2.1%), Denmark (-5.1%), and Czechia (-5.9%).
Business investments are on a similar downward trajectory. In nine countries, third-quarter growth was less than 2%, and in eight of those, the growth rate was less than 1%. It was negative in four: Malta (-0.9%), Belgium (-1.9%), Austria (-3%), and Bulgaria (-3.3%).
Business investments are generally more volatile than consumer spending. However, the current levels are uncharacteristic even of the European economy where investments tend to fluctuate quite a bit. This suggests a high degree of uncertainty among businesses, probably linked to rising interest rates, high inflation, and unreliable energy supply. I would, however, not discount the possibility that businesses are balking at new spending due to recession signs.
But wait—the worst part is yet to come. Europe may be heading into another public finance crisis. I warned about this already in August; in her recession forecast, IMF Director Georgieva also warned about the dire state of public finances. Her warning was not specifically about Europe, but it is nevertheless worth taking seriously, especially since she points to the ominous combination of high interest rates and a downturn in economic activity.
The U.S. economy, Georgieva predicts, will go relatively unscathed through 2023. This means that the Federal Reserve will keep its interest rates high for some time to come. Other central banks will have to follow suit, even as a recession emerges. This combination, says Georgieva, “is a devastation” for highly indebted countries.
This is precisely the warning that Europe’s governments need to listen to. They are not alone, for sure: almost all of the world’s advanced economies have deeply indebted governments. However, Europe is ground zero for the coming debt crisis, due in large part to its combination of slow GDP growth and excessive welfare states.
Tax revenue chronically falls short of government outlays, causing perennial deficits. Over the past 20 years, most of the current 27 EU member states have run deficits. The practice of spending more than government earns has been so pervasive that there have only been seven quarters in that period when a majority of the EU states have had a budget surplus.
That’s right: the EU has seen good government finances in a majority of its members only during less than two years out of the past 20.
The Stability and Growth Pact
Plain and simple: Europe is addicted to government debt, and the problem seems to be worse within the euro zone than among EU member states with their own currencies. (This is one reason why, earlier this year, I warned the Croatian government about the repercussions of joining the euro zone.) However, Europe’s debt story is made even more tragic by the EU’s own Stability and Growth Pact. Written into the constitution of the union, it caps a member state’s permitted budget deficit at 3% of GDP.
This has been a tough requirement for member states to comply with, even in the strong part of the business cycle. At any time during the good economic years of 2015-2019, an average of six member states ran deficits in excess of 3%. While Eurostat has yet to release public finance data for the third quarter of 2022, its published numbers are troubling: in the first quarter, ten states exceeded the budget-deficit cap.
That number was down to five in the second quarter, but given the apparent slowdown in economic activity across the union, we can expect a surge in countries running afoul of the EU’s deficit cap. If the IMF and I are correct in our predictions of worse economic times ahead, Europe is diving head-first into a new fiscal crisis.
The big question is how markets will react to this. During the austerity crisis a decade ago, we saw how investors in the sovereign debt markets responded when countries had trouble complying with the Stability and Growth Pact. While the 3% deficit cap is the most apparent component, and the one that markets can respond to with some immediacy, the more fundamental number is the debt-to-GDP ratio: EU member state deficits must not exceed 60% of GDP. Any debt above that is defined as “excessive.”
Here, again, Europe has unending problems. Looking again at 2015-2019, when the entire European continent had left the Great Recession of 2009-2011 and its aftermath behind it:
- At the start of 2015, 16 EU member states had a debt that exceeded 60% of GDP;
- By the end of 2016, that number had fallen to 15;
- It fell to 14 and stayed there over the next two years;
- By the end of 2019, the number of countries with excessive deficits was down to 13.
As of the first half of 2022, 14 countries were in violation of the 60% rule. In six of them, the debt exceeded 100% of GDP: Greece (187%), Italy (151%), Portugal (124%), Spain (117%), France (114%), and Belgium (109%).
Again, the euro zone is the epicenter of public debt: taken together, the 19 members of the euro zone (before Croatia joined on January 1st) have violated the 60% rule every single quarter since the euro was minted. In the past ten years, the total government debt in the currency union has consistently exceeded 85% of its GDP.
Let us not forget that these problems with government deficits and debt emerged, became entrenched, and in some cases worsened since the euro was minted 21 years ago. Throughout all of that period, the EU member states have been constitutionally obligated to get their fiscal houses in order.
Darker Clouds on the Horizon
This is an embarrassing CV for any government that wants to borrow money. It is a bad record to have when a whole group of governments, tied together under one currency, need to seek the help of sovereign debt investors. But when this is happening as a recession is approaching, past failures to avoid or even contain budget shortfalls will rapidly become a real problem.
Again, some countries with strong economic fundamentals, like Hungary, will do relatively well; others, like Sweden, are in for a very rough ride. Overall, though, Europe can look forward to rising interest rates as sovereign debt investors demand an elevated risk premium to buy new government securities.
To make matters worse, unlike the fiscal crisis a decade ago, when the European Central Bank intervened and supported debt-ridden countries by buying their debt, there can be no meaningful help expected from the ECB. Back in 2009-2001, the ECB came into the debt market from a position of monetary strength: its first decade, from the turn of the millennium to the Great Recession, was characterized by monetary conservatism. Since then, the ECB has maintained its accommodating policy and thereby eroded its own monetary policy authority.
Its recent attempt at repentance, with the rolling back of its active purchases of government securities, has thus far only made a symbolic difference.
For reasons I will address in a separate article, it is simply impossible for the ECB to return to its decade-long policy of debt purchases while expecting to have any meaningful impact on interest rates and the reliability of government debt. In short: this time, individual governments with big budget deficits will be left to fend for themselves.