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European Recession on the Horizon

Updated: May 23

High-interest rates, low economic growth, fiscal mishaps and enduring inflation: an explosive cocktail is hindering the Eurozone’s economy again.

The enduring economic difficulties in the last two or so years have contributed to Europe’s current instability in terms of economic growth, debt and fiscal measures. As we approach the end of 2023, several indicators are flashing red for Europe’s economy, which leads markets to believe a recession is right around the corner.

What are the seeds of Europe’s current hardships, and what can be done to dissolve them?

This December, indicators like the Purchasing Managers Index (PMI) and economic growth levels in key European economies have raised the alarm for the upcoming months. In fact, the PMI is a key indicator for economic health because it provides forward-looking monthly updates to the manufacturing sector, considering over 50 industries. This extensive data is valuable when it comes to anticipating the upcoming economic environment, and in this case, it seems unlikely that 2024 will start with optimism. Reuter’s survey on the matter indicates that two of Europe’s biggest economies – Germany and France – are also experiencing contractions, which will have ripple effects on the whole Eurozone.

Yet, compared to the last two quarters of 2022, the inflation rate has massively improved (though far from the ECB target of 2%), and business conditions have improved.

So, what is hindering better economic conditions in the Euro area?

Well, as mentioned, the inflation rates are still not where the European Central Bank (ECB) wants them: 2.4% on average and across the Eurozone in November 2023 is closer to target, but what is still worrying is the 4.6% of core inflation. These high inflation rates, combined with record-high interest rates from the ECB and low economic growth, are a cocktail for a recession. And, because this would be the second quarter with economic contractions, it fulfils the criteria for a recession.

How can we explain the enduring economic difficulties?

First of all, the ongoing war in Ukraine and the continued supply shock regarding gas and oil from Russia are important factors regarding the persistence of high inflation rates. Despite attempts from the ECB to keep high interest rates in hopes of decreasing consumption in the Eurozone, the nature of the shock cannot be resolved using interest rates only. Further, the economic outlook in the bloc’s second-largest economy is still struggling: France’s GDP growth would be of a modest 0.8% for 2023, with a flat 0% growth rate in the last quarter of the year. Similarly, Germany’s attempts at structural change in its energy industry have affected its economic recovery from the COVID-19 pandemic and the energy crisis.

The high uncertainty levels negatively affect consumption and borrowing, and inflation levels are still high in these two economies (3.7% in France and a soaring 6.2% in Germany). Combined with limited public expenditures in both countries and a general slowdown in business activity, there seems to be little that can be done to ease out of the upcoming recession.

Moving forward, the European Central Bank will rely on regular data changes and updates to adapt its decisions. Whilst some economists such as François Villeroy de Galhau, director of the Bank of France, advocate for cuts in the interest rate, this move is definitely not on Christine Lagarde’s agenda for the upcoming quarters. Lagarde’s data-by-data approach entails that any changes in monetary policy will be done according to the current situation. Yet, this seems like it would just be waiting for an empty pot to boil; indeed, the delicate balance between inflation, interest rates and the looming threat of recession paralyzes any sort of proactive solutions at the European level.

At the national level, measures to boost employment have been undertaken (i.e. in France with the unpopular pensions reforms), and the Euro area has seen a modest increase in employment levels, which could arguably become the only way forward out of recessionary territory. The task is complicated; creating and sustaining employment necessitates increasing national expenditures, which feeds inflation.

Unfortunately, the trade-off is one which needs to be made. In the short term, creating and sustaining employment might be costly, but in the medium and long term – if spending is done in strategic sectors – it could permanently restructure economic growth.

For now, though, national politicians are still reluctant to make these structural changes, mostly because it would come at economic costs, the first one being high debt. And, as the European fiscal rules are about to come back into force, there seems to be little room for spending.

Indicators like employment levels, business activities, and core inflation should be scrutinised, as this will determine the severity of the recession on the continent.

Image: Lukasz Kobus - European Commission

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