This essay is the second part of a two-part discussion on whether and to what degree the U.S. and the EU have entered a recession. In Part I, I explain that so far, the American economy is not showing any signs of a recession. Here I consider the extent to which the same can be said for the European Union.
On September 8th, the European Central Bank, ECB, announced a radical increase in interest rates, hiking its three major rates by 0.75%, or 75 basis points. The ECB explains the decision as a pivotal shift in their monetary policy:
[It] frontloads the transition from the prevailing highly accommodative level of policy rates towards levels that will ensure the timely return of inflation to the ECB’s 2% medium-term target.
While the increase was sharp, especially on the heels of the ECB’s rate hikes earlier this summer, their interest rates remain very low, spanning from 0.75% on commercial-bank deposits to 1.5% on marginal lending. For reference, the Federal Reserve’s key policy indicator, the so-called federal-funds rate, is currently at 2.3%.
There is a similar trans-Atlantic difference in return on sovereign debt. On September 7th, a 10-year, euro-denominated treasury bill with AAA credit rating, paid an interest rate of 1.6%. On the same day, a U.S. Treasury bill of the same maturity paid 3.3%.
With such differences in yield, it is not difficult to see why the euro has weakened vs. the dollar. Investors with easily mobile portfolios prefer the U.S. currency and dollar-denominated securities. Consequently, on August 22nd, Forbes Magazine reported that the euro had fallen below par with the dollar.
When a currency depreciates, it can lead to a self-reinforcing outflow of capital—especially when the depreciation is unprecedented. Since the euro has never been this weak against the dollar, for so long, it is only logical to expect more capital outflows.
As the euro weakens, it buys less of foreign goods and services. For an energy-starving Europe, this means immediate increases in the cost of imported oil and natural gas. Needless to say, the ECB had no choice but to raise its interest rates.
There is a fair chance that the ECB will have stopped a major financial hemorrhaging of the euro zone, at least for the short term. The problem for the ECB is that its rate hike is reactive, basically a no-choice move by someone with his back against the wall. The Federal Reserve has been far more proactive in its monetary policy, lending it more credence as a reliabl e reference point for the financial markets.
Let me right off the bat reject the first proposal. An interest rate hike from virtually nothing to very little is far too small to affect the overall trajectory of the real sector of the economy. If the rates had increased from, say, 1-1.5% toward 2.5-3%, things would be different; at those levels the rates do make themselves known in bank credit issued to the general public.
Other macroeconomic variables would also suffer from rate hikes at that level. A higher cost of credit would have a limited negative effect on business investments. Government spending would suffer as well, in particular in heavily indebted countries; depending on the structure of the debt, i.e., how large a part of it consists of short-term securities, the government could see its debt-service costs go up as it refinances (rolls over) its debt.
Again, there will be no significant macroeconomic impact from the current rate hikes. However, if these are not enough—in other words, if investors continue to flee the euro and the currency resumes its decline—the ECB could find itself locked in on a path where it has no choice but to keep raising rates, regardless of the macroeconomic fallout.
Indebtedness varies considerably across the EU member states, from 24% of GDP in Luxembourg, 25% in Bulgaria, and 37% in Denmark and Sweden, to 127% in Romania, 151% in Italy, and 193% in Greece. As a result, there is a great variety from country to country in how higher interest rates impact government finances. However, while the nations that are deepest in debt will feel the pain, the effects on private-sector economic activity are going to be both stronger and quicker.
The question is: when the impact hits, will it be strong enough to bring about a recession? Or will a recession be on its way independently of the rate hikes?
I recently explained that the American economy is not showing any clear signs of a recession—not yet. The picture is not as clear when it comes to Europe, although from the viewpoint of the entire economy, the continent looks pretty healthy. In the second quarter of this year, inflation-adjusted gross domestic product, GDP, for the EU as a whole, grew by 4.1%. As many as 12 countries recorded a real GDP expansion in excess of 5%; only four countries, Estonia, Germany, Lithuania, and Slovakia, fell short of 2% real growth.
The only signs of a possible recession are isolated exceptions. Germany is a basket case, with GDP growth below 2% in three of the last four quarters. The EU as a whole, however, has been at or above 4% annual growth since the second quarter last year.
So far, so good. But what about the spread of this growth? In other words, how did Europe’s economies perform in the first two quarters this year compared to the last two quarters of last year?
This question is appropriately answered with a dive into the closest thing to raw-data, GDP numbers that Eurostat provides, namely those that are adjusted for inflation but not for seasons, and which are not annualized. (I discussed the methodology behind these concepts in the first part of this article.) From this data we get the growth numbers by quarter, allowing us to see any shift in strength in the individual EU member-state economies.
The first thing we notice is that practically every economy in Europe contracted in the first quarter this year. This is normal seasonal behavior: in Western countries, the last quarter of every year sees a significant rise in consumer spending due to Christmas, the New Year, and—at least in America—Thanksgiving. There can also, on occasion, be a seasonal rise in business investments due to calendar-year planning.
Keeping in mind that GDP growth was negative for the first quarter of this year, the growth numbers for the second quarter are best compared to the third and fourth quarters of last year. Looking at the growth trend this way, we find that only four countries had a weaker GDP expansion now than they did in the second half of last year.
In Germany, the inflation-adjusted increase in GDP in the third quarter last year was €20.1 billion, but only €7 billion in the fourth quarter. This was still better than a decline of €5.9 billion in Q2 for this year. Since their GDP also declined in Q1 of this year, Germany is now technically in a recession.
France has also seen a clear weakening of its GDP growth. In Q3 last year, its economy grew by €24 billion, followed by €7.4 billion in Q4. After the seasonally expectable contraction in Q1 this year, Q2 generated a meager €4.7 billion in growth. While not a contraction per se, this weakening precipitates a recession.
Lithuania experienced strong growth in the third quarter last year, with roughly one third of that expansion in Q2 this year. Then their economy contracted for two quarters, the technical definition of a recession. Since Q2 this year generated a tiny expansion, it is difficult to firmly assess the Lithuanian economy based on its GDP numbers alone. However, the country does suffer from high inflation—above 20% three months in a row now—which is known to dampen economic activity. Businesses become less interested in investing, and consumers spend less on credit-financed durables than they otherwise would.
In short, Lithuania is at the very least teetering on the edge of a recession.
The Polish economy is also showing the first signs of an economic slowdown. While technically not there, its growth in Q2 this year was less than one tenth of its average for Q3 and Q4 last year. This is a clear weakening, putting Poland right next to Lithuania on the precipice of a bona fide economic downturn.
While Germany is the only country to experience an economic contraction in the second quarter this year, a few others joined Lithuania in a two-quarter decline last winter. Greece, Croatia, Malta, and Slovakia all experienced a real GDP decline in Q4 of 2021 and Q1 of this year. All of them went back to a growing economy in Q2, and did so with relative vigor. For now, there is no reason to expect a recession there, but I would cautiously monitor their monthly labor-market numbers for the remainder of the year.
At the other end of the stick, there are a couple of EU economies that still exhibit strength and resiliency:
- The Czech Republic, e.g., had a very good second quarter, with GDP growth at more than four times its rates from Q3 and Q4 last year;
- Ireland hums along, although that economy is driven primarily by business investments, not consumer spending;
- The Italian economy had a good quarter, almost doubling its quarterly growth from Q3 and Q4 last year;
- Cyprus is also growing steadily, as is Latvia, Austria, Portugal and Slovenia;
- The Hungarian economy accelerated its growth from last year’s two final quarters, again showing that it remains one of Europe’s absolutely strongest.
All in all, as of the end of the second quarter this year, Europe as a whole was not on its way into a recession. However, since GDP numbers only tell us what happens quarter by quarter, and with a little bit of a lag, we need more updated information before we can draw any definitive conclusions.
The best place to go to for virtually ‘real time’ economic data, is monthly labor-market statistics. Starting with unemployment figures, the following countries have seen the number of unemployed people increase three months in a row: Belgium, Estonia, Cyprus. At the same time, Estonia and Cyprus experienced rising employment in two of the last three months.
During the same period of time, Spain, Portugal, and Sweden experienced rising employment in May, June, and July. That said, Sweden is a bit of an oddball. The ranks of the unemployed increased four months in a row, from 435,000 in February to 504,000 in June. Then in July, 131,000 of those individuals disappeared from the unemployment rolls; that same month employment increased by 98,700.
Overall, the July employment numbers were neither spectacular nor depressing: compared to the period 2015-2019, the monthly change in employment in July this year was better in 14 countries and worse in 13.
Shifting now to the unemployment rate, i.e., the number of unemployed as a share of the total workforce, only two countries report a higher unemployment rate for July than they reported in January: Belgium and Cyprus.
However, a full ten countries reported higher unemployment in July this year than the same month last year, with Estonia, Cyprus, Finland, Belgium, and Germany suffering the highest increases. Together with the ho-hum employment numbers, we actually now have a first-indicator sign of a recession to come. It is too little to ‘call recession’—the GDP numbers for Q2 do not predict a recession—but if the labor-market numbers for August look similar to July, we can with relative confidence establish that a recession is here.
While the overall picture of the European economy is one that is on the edge of a recession, rather than in it, other variables—think energy supply—point more sternly in that direction. If we add an outlook of deteriorating public finances, it will take a small miracle for Europe to avoid the dungeon of an economic downturn.