There was a lot of noise in the media last month about the German economy sliding into a recession. The BBC declared that “inflation has helped push Germany into recession in the first three months of the year.” British newspaper The Guardian proclaimed that “Europe’s largest economy contracted by 0.3% in the first quarter of 2023” while CNN blamed the recession on the energy prices of last year, which they claimed motivated consumers to cut spending.
From EuroNews came the explanation that
seasonally adjusted figures from the national statistics institute, Destatis, meet the technical definition of a recession: two consecutive quarters of economic contraction.
Deutsche Welle concurred, offering a grim outlook:
If a recession persists over a sustained period, it can turn into a tangible economic crisis. Unemployment and the number of insolvencies rise, goods pile up in warehouses, and financial crises, stock market crashes and bank failures round off a nightmare scenario.
Politico told us all to “be worried”.
These are powerful statements indeed. There is only one problem with them: they are false. Germany was not in a recession in the first quarter of this year.
There is a lot of blame to go around for this erroneous reporting. Media outlets rarely hire reporters with more than rudimentary knowledge of economics. The statistics agencies that produce the data and report them to the media fail to explain the data they publish. Due to lack of competence on their end, the media are unable to ask the questions that would invite better explanations.
There is one more culprit involved here, namely the economics profession. Economists in general are uninterested in issues that intersect theory with reality. This lack of interest is rooted in the academic structure of modern economics, which means that we cannot expect them to improve their contributions, at least not in the near future.
Unfortunately, when the media, statisticians, and economists together produce an erroneous impression of where the economy is heading, all of us could end up paying a high price. As I noted in another article on this subject, when the public image of the economy is distorted, politicians can make decisions about taxes and government spending that do not have the intended consequences. Even worse: they can make policy decisions that exacerbate a recession or aggravate an inflationary episode. This in turn can raise the cost of living for millions of people, and even destroy jobs.
In the case of Germany, the risk is apparent that politicians come rushing to the aid of an economy that is not in need of it, at least not yet.
But what exactly did all these media get wrong?
To answer that question, let us first go back to the aforementioned quote from EuroNews. They did get one thing right, namely that a recession is defined by “two consecutive quarters of economic contraction.” What they did not discuss—likely out of subject-matter ignorance—is how exactly that economic contraction is measured.
If we follow the references in the press stories cited earlier, we find that they refer to changes in the German gross domestic product, GDP, from one quarter to the next. Specifically, the claim is that the German economy contracted in
- The fourth quarter of last year compared to the third quarter of last year, and
- The first quarter of this year compared to the fourth quarter of last year.
Statistically, this is correct: according to Eurostat, which publishes the same numbers as Germany’s Destatis does, the change in GDP in Q4 of last year was -0.5%. It was followed by -0.3% in the first quarter this year.
Case closed, right?
No. There are two reasons why these numbers should not be used to define a recession. First of all, these numbers represent the change in GDP after the GDP data have been adjusted for calendar days and seasons. These are tricks that national-accounts experts use because they claim that seasonal variations can distort our image of economic activity: if there is an unusual concentration of holidays in a month—because of how the dates and weekdays adjust with the calendar from year to year—then economic activity can be lower simply because people had more time off from work.
In principle, this is a correct point, and it does have some value from an empirical perspective. If we go one step back in the economic data and look at ‘raw’ GDP numbers, i.e., before they have been adjusted for seasons and calendar days, we find that German GDP contracted by -0.2% in the fourth quarter last year and by -1.1% in the first quarter this year. These are notably different numbers from when we adjust for seasons and calendar days.
Economists generally would argue that this is precisely why we adjust GDP data for seasons and calendar days. Again, they are correct, but that still does not mean that we should use either the ‘raw’ or the adjusted GDP data to assess whether an economy is in a recession or not.
Figure 1 explains why, and gives us the second reason why it is wrong to define a recession based on quarter-to-quarter changes in GDP:
Figure 1
Source of raw data: Eurostat
The line in Figure 1 looks like a screen shot from a medical monitoring device. It is not: it reports the quarter-to-quarter changes in real, seasonally adjusted GDP for the entire European Union. All the low points represent the first quarter of each year. The only exception is 2020, when there is a two-quarter low point: the ‘usual’ first-quarter dip, and a dip in the second quarter due to the pandemic-related artificial economic shutdown.
Figure 1 teaches us something important about the natural ebb and flood of economic activity: there is always a contraction in the first quarter. It happens in good years as well as bad ones, and it shows up in the data even as we adjust for seasons. This means that if we happen to have a contraction of GDP in a quarter right before or right after Q1, it suddenly looks like we have a recession.
This is exactly what happened in Germany. If we stick to the seasonally adjusted GDP, we can see the same statistical phenomenon in Latvia in Q2 and Q3 last year, as well as in the Finnish economy in Q3 and Q4 last year. After these two-quarter dips, both countries returned to growth again; if we stick to the quarter-to-quarter measurement of a recession, we now have recessions that are only two quarters long (in contradiction to established economic theory). Furthermore, since the first-quarter slump happens every year, this would mean that we can suddenly have recessions every year.
It is also worth noting that while the erroneous news about the German economy made its way through the media, Estonia recorded its 5th quarter in a row with shrinking GDP, again on a quarter-to-quarter basis. Their economic ordeal has escaped the press, probably because of the small size of this Baltic economy.
But if we are not going to use the quarter-to-quarter growth rate as a measurement of recessions, then what numbers are appropriate?
There is no better statistical ‘gauge’ than the year-to-year GDP growth rate. It compares economic activity either from one full year to another, or from the same quarters in two different years. For this reason, it basically eliminates the need for seasonal and calendar-year adjustments, but most importantly: it eliminates the first-quarter effect we saw in Figure 1.
The definition of a recession as two consecutive quarters of economic contraction is still valid, but when it is based on the year-to-year calculations, we suddenly get a more relevant picture of the European economies. Germany still experienced a GDP decline in the first quarter this year, but not in the last quarter of 2022. Hence, they are not yet in a recession.
The same happened in Czechia, Hungary, Ireland, and Poland.
Estonia has now had four quarters of economic contraction, with the last three in the 3-4% range. Finland, Lithuania, and Luxembourg have all had two quarters in a row of economic contraction; together with Estonia, they are technically in a recession.
Now that we have a workable way to identify recessions, it is time to ask whether or not Europe will actually experience one.
As I explained back in April, there is a considerable risk that the continent gets a brief but painful experience of bona fide stagflation, i.e., simultaneously high inflation and high unemployment. I still see an elevated risk for that, which also means that I expect a recession in Europe. In fact, I warned about a recession already in December last year; other analysts did not see it coming until a month later. Therefore, I also believe that the countries that have thus far experienced one quarter of economic decline will see the same happening in the second quarter this year. I also believe that once the recession begins, it will last for an extended period of time.
The main reason for this forecast is that Europe still is not out of its inflation bubble. With a recession on its doorstep, and the high inflation that follows, the European economy is actually in a fair amount of stagflation trouble. The combination of high inflation and high unemployment would trap Europe in an extended recession.
Stagflation is far more problematic than regular inflation is. The reason is found in the nature of inflation. In normal episodes of rising prices, the cause is almost always to be found in very strong demand for goods, services, and labor. This form of inflation is self-regulating in free-market economies: when inflation gets high enough and cost of living thus puts strains on wages and salaries, consumers cut back on spending. Since consumption normally accounts for 60-70% of all spending in an economy, this leads to a cooling off throughout the economy and to a decline in inflation.
In a stagflation episode, the inflation is of a different kind. Due to high unemployment and therefore a recession in real economic activity, inflation cannot originate in high spending. Its only possible source is monetary, which is bad news: if the central bank fails to take a firm, contractionary grip on money supply, but instead continues to expand it, then monetary inflation will eventually spiral out of control and become hyperinflation.
Even if the European economy narrowly escapes the stagflation trap this time, the near-miss experience is going to leave its marks on both economic policy and private economic activity. Caution will replace optimism, and therefore stagnation will trump economic growth. This means a longer-than-normal recession.
In addition to the threat of stagflation, Europe also faces the threat of another fiscal austerity episode. Governments across Europe have seemingly unending fiscal problems. Those problems have not surfaced now; budget deficits are almost a chronic disease in Europe’s welfare states.
When a recession hits and people lose their jobs, they go from being taxpayers to takers of government benefits. Tax revenue falls, government spending goes up.
The strain on public finance across the EU will once again put stress on the euro. How will governments respond to this? If they repeat the practice from the Great Recession in 2009-2011 and resort to harsh austerity policies, they will accelerate and aggravate the recession.
Given the experience from that time, it is by no means certain that austerity will make a comeback. However, we cannot rule out another round of systemic tax hikes and spending cuts, if the alternative is enough market stress to fracture the euro.
In all, when we measure economic activity correctly, we find that Europe is on the verge of a recession. With a little bit of luck, Europe can escape it without serious economic harm; with only a small portion of bad economic policies, that recession can turn into a bad experience for the whole continent.
