The European economy is wading through syrup. While the American economy has been dynamic and resilient in the recovery from the 2020 pandemic, Europe still looks like it really would rather slide back into the comfort of a government caretaker.
Yes, the economic news out of Europe is that bad. But before we get to it, let us recognize some good news in terms of inflation. In February, the rate of price increases was down marginally in the EU, falling to 9.93% from 9.97% in January. The 20 members of the euro zone (Croatia joined at the start of the year) experienced a drop from 8.66% to 8.52%.
All in all, 17 of the 27 EU member states had a lower inflation rate in February than in January. While Eurostat still has not collected inflation data from all member states for March, so far, 16 of them have seen a further decline. Slovenia is alone with rising inflation, 10.4% in March compared to 9.4% in February.
There is nothing strange with inflation rising in a single month amid months of decline. Spain, e.g., had an inflation rate of 5.86% in January. It rose to 6% in February but fell to 3.12% in March. France had a similar experience, with inflation in the first three months of this year at 7.0%, 7.3%, and 6.6%. The Netherlands followed a similar path: 8.4%, 8.9%, and 4.5%.
There is more good inflation news: it looks like Europe’s exclusive club of countries with more than 20% inflation is losing members. After having previously had all three Baltic states and Hungary as members, in January this club consisted of only Hungary (26.2%) and Latvia (21.4%). In February, Hungarian inflation was down marginally to 25.8%, while the Latvian rate fell to 20.1%.
In March, Latvia reported an inflation rate of 17.3%. We can expect the Hungarian number for the same month to also have dropped.
Europe needs these good tidings from the inflation front. Most of the rest of the economic news is on the disappointing side, especially on the one issue that Europe does not need to face right now: unemployment. After topping out at 7.9% in January and February 2021, the EU-wide unemployment rate gently fell until it reached 5.9% in June 2022. Since then, it has been moving slowly upward, with the most recent number (February 2023) at 6.3%.
There are plenty of examples of countries where unemployment has either stalled or started trending upward:
- Austria: from 4.3% in July last year to 5.9%. in February this year;
- Belgium: from 5.6% in September to 5.9% in February;
- Bulgaria: from 3.5% in September to 4.1% in February;
- Cyprus: from 5.4% in September to 7.9% in February;
- Czech Republic: from 2.1% in October to 2.6% in February;
- Denmark: from 4.5% in September and October to 5.6% in February;
- Hungary: from 3.4% in May and June last year to 4,0% in February; and
- Portugal: from 5.6% in June and July to 7.1% in February.
These numbers, while not dramatic, suggest that parts of Europe are already in the first phase of a recession. To determine how strong of a recession this will be, we would need supplementary information on the gross domestic product, GDP, for the first quarter of this year. Unfortunately, Eurostat, the EU’s official statistics agency, is slower than its American counterparts in producing new statistical information, so a full review will have to wait a couple of weeks.
Looking at GDP data for 2022, we find a clear trend toward economic stagnation. When the recovery effect from the post-pandemic reopening of Europe’s economies had faded in the first quarter of last year, economic growth slowed down to problematically low rates. By the third quarter, the growth rate in nine member states had fallen below 2%, with Estonia at the bottom (-2.9%) and Latvia just behind (+0.2%).
By the fourth quarter, 16 of the 27 member states were below 2%. Five countries had contracting economies: Estonia (-4.1%), Luxembourg (-2.3%), Finland (-0.38%), Lithuania (-0.35%), and Sweden (-0.18%). Another 7 countries were below 1%, which contributed to a poor 1.5% average GDP growth rate for the entire European Union.
The 2% growth level is critical to a country’s ability to sustain its overall standard of living. An economy can grow at that level, or below it, during a recession and not much harm will be done, but if it sustains at that rate over an entire business cycle, the country will begin to slide into so-called industrial poverty.
Europe is on the brink of that experience. One recession does not do the trick, but one that follows this closely upon a major artificial economic shutdown may very well spell doom for Europe over the long term. One reason is the structure of government budgets and their spending commitments to their citizens. Regardless of the fiscal standing of individual member states—whether they are deeply indebted or not—they all have major entitlement obligations to meet. Spending on economic development, health care, education, social benefits, and recreational programs account for more than 70% of government budgets in all EU member states. In 11 of them, the welfare state consumes more than 80 cents of every euro that the government spends. The top three are Austria (84.8%), Denmark (82.9%), and Ireland (82.8%).
With a welfare state that dominates their budgets, European governments are exceedingly vulnerable to a recession. When economic growth slows down and unemployment goes up, tax revenue declines. Meanwhile, due to rising unemployment and household income shortfalls, the governments are forced by their entitlement obligations to increase spending. The inevitable result is larger budget deficits—and rising debt.
This is not a pleasant outlook, especially not given the fact that 14 of the EU’s 27 member states have a debt that exceeds the 60%-of-GDP limit stipulated in the Treaty of the European Union. Six of them have a debt in excess of 100% of GDP: Greece (186.6%), Italy (151.2%), Portugal (124.1%), Spain (116.8%), France (113.8%), and Belgium (108.7%). Even Germany, the largest economy in the EU, is in breach of the rule with debt at 67.3% of GDP.
As of mid-2022, the average debt level for the 19 members of the euro zone was 94.3%.
What will the EU, the European Central Bank, and member-state governments do when a recession opens up new holes in public finances? More pointedly: will the ECB stick to its current monetary conservatism?
The realistic answer to this question is: probably not. The memories of the political fallout from the austerity episode of the early 2010s are still fresh, as indicated by the fact that the EU Commission decided to suspend enforcement of the constitutional Stability and Growth Pact (SGP) during the recent pandemic.
In May last year, the Commission decided to extend the suspension through 2023. Their motivation was an economic outlook that reduced expected annual GDP growth for the EU from 4% to 2.3%.
This is not the first suspension of the SGP, which raises questions about how seriously the EU actually takes its own constitution. However, if we assume that the Commission decides to once again enforce the SGP—if for no other reason than to calm sovereign-debt markets—member-state governments will be in for a ride as the new recession unfolds.
In recent years, it has been cheap for governments to borrow money, especially in the euro zone. Using four maturities as examples, Figure 1 recalls the recent history of interest rates (or yields) on sovereign-debt securities within the currency area.
Figure 1
Source: European Central Bank via Eurostat
The austerity crisis from a decade ago (1) started with rising interest rates on the market for euro-denominated government debt. The situation was different from country to country, but the overall interest-rate level was pulled up by the implied risk sharing that came with sovereign debt being denominated in the same currency between multiple countries.
In response to rising interest rates, the European Central Bank entered the debt market with a slew of measures to calm worries of debt default among investors. The common denominator to all the ECB’s measures was an expansion of the money supply, which technically manifested itself as a decline in interest rates (2) as sharp as the preceding increase.
The monetary expansion during the so-called Great Recession was accompanied by harsh fiscal austerity measures. The outcome of these measures was tragic, in particular for Greece which lost one-quarter of its economy. Toward the end of 2011, rumors started flying that despite all its attempts to rein in the budget deficit and stop its runaway debt, Greece was going to default on its obligations to its creditors. Reactions in the sovereign-debt market were swift, as exhibited by the spike in interest rates at the end of 2011.
In response to these rumors, the EU, the ECB, and the International Monetary Fund, IMF, negotiated a partial debt default for Greece. Creditors, primarily commercial banks, were convinced to accept a 25-percent write-down of the value of the Greek treasury securities they owned. This was, of course, devastating to the credibility of Greek government debt, and the ECB had to work hard in the coming years to convince investors that all treasury securities denominated in euros were safe investments.
Part of its hard work consisted of a continuation of its program to buy government debt. This European version of the American Federal Reserve’s ‘quantitative easing’ program resulted in a protracted depression of euro-zone interest rates (3). In 2016, interest rates were so low that even the longest maturity, the 30-year bond, cost the debtor less than 2% per year. During the pandemic, that rate fell below 1%.
Some treasury securities even paid a negative interest rate: for every €100 a government borrowed, it paid back less than €100 upon maturity.
All that has changed now. In a desperate effort to fight inflation, the ECB has reversed its monetary policy from expansionary to contractionary. This has resulted in sharply rising interest rates (4) forcing euro zone governments to pay 3% and more on new debt. On top of that, due to the so-called rollover effect, the debt they already have is becoming more expensive. This effect works as follows:
- A government sells a one-year security worth €100 in January of 2023, at an interest rate of 1%;
- Joe, the buyer of the security, earns €1 for lending the government his money;
- In January 2024, the government pays Joe €1 in interest; it also needs €100 to pay back the loan to Joe;
- To finance the repaying of the loan, the government sells another €100 security; this time, though, the interest is 4%.
Joe gets his money back, and the buyer of the new government security can look forward to earning €4 over the course of 2024.
There are no concise, publicly available statistics on the composition of euro zone government debt. Therefore, we cannot say how quickly the higher interest rates are eating their way into the budgets of euro zone governments. However, if they borrowed money during the recent pandemic in the same way as the U.S. government did, the higher interest rates on sovereign debt will quickly become a cost problem for them.
With all this in mind, the big question is: what will the ECB do? Given the aversion toward more austerity programs in the EU, it is a pretty safe bet that the ECB will return to monetary accommodation in the next year. It might do so through some indirect measures, such as support for commercial banks buying euro-denominated government debt, much like the U.S. Federal Reserve has done through its new Bank Term Funding Program, but the effect will be the desired one: lower interest rates for governments with big budget deficits.
The price that everyone will have to pay for this is going to be high—as in the return of high inflation.
