An in-depth look at the Eurozone’s booming economy and the challenges that lurk in the shadows

stephen_brown_photo.jpgStephen Brown joined Capital Economics in 2014 and works in the European Economics team, with a focus on the Eurozone and Nordic economies. Stephen holds a degree in Economics from the University of Bath and an MSc in Economic History from the London School of Economics.

Capital Economics is one of the world’s leading independent economic research companies. The team of over 60 experienced economists provides award-winning macroeconomic, financial market and sectoral analysis, forecasts and consultancy, from offices in London, New York, Toronto, Sydney and Singapore.

FocusEconomics: What is your forecast for Eurozone growth in 2018? What will drive growth?

Stephen Brown: Our forecast is for GDP growth of 2.5% this year, implying that the euro-zone’s recovery should continue at a very similar pace to last year. We suspect that growth will be broad-based. For instance, prospects for household spending growth are bright. Not only is employment set to rise further, but lower unemployment should help to push up wage growth. And with consumer confidence at 17-year high in January, households seem likely to spend most of these income gains.

Investment is an area where we see scope for an acceleration in growth. After all, business sentiment is very strong and there are signs in some countries that capacity constraints are starting to bite. Meanwhile, the strong global economic backdrop will help to drive export growth. In fact, the euro-zone’s exporters appear to be benefitting more than most from this pick-up in global demand, so we expect net trade to make a small positive contribution to euro-zone GDP growth this year.

FE: Recent months have seen renewed interest in the idea of a common Eurozone budget (e.g. Emmanuel Macron’s proposal). In your opinion, do the potential upsides from establishing and maintaining such a budget offset the added political and economic complexity and the set-up costs? If they do, what should be the size of such a budget, and what should be its priorities?

SB: In principle, we think that a common euro-zone budget would be a good idea. Emmanuel Macron suggested that a common budget would fund investment across the currency area and deal with economic shocks, and that it might be worth “several points” of euro-zone GDP. This is a reasonable estimate of the size of a fund that might be needed to deal with asymmetric shocks facing individual countries at a given time. In theory, expanding the size of the EU’s budget shouldn’t add too many extra administration costs. While it might add another layer of political complexity, there should still be a benefit from the fact that the new euro-zone finance minister would face the scrutiny of the European parliament, thereby hopefully increasing perceptions of political accountability among the regional population.

That said, in practice we suspect that a common budget big enough to make a significant difference is a distant prospect. Tensions between countries are already evident in discussions on how to make up for the UK’s net contribution to the EU budget once it leaves the Union. This amounts to less than 0.1% of EU GDP, so we seem a long way from the euro-zone countries agreeing to contribute a few percentage points of GDP to a communal budget. Moreover, it is important to remember that fiscal union alone wouldn’t solve all of the euro-zone’s problems. A lack of reform in some countries, as well as an incomplete banking union, are also issues that need to be addressed.

FE: What, in your opinion, are viable options to successfully reforming the Euro area’s fiscal governance?

SB: Leaving to one side the issue of whether the austerity measures prescribed during the debt crisis were the right or wrong policies, one obvious way in which the euro-zone’s fiscal governance is lacking is that there have never been any penalties for those countries that have consistently missed the EU’s fiscal targets. That is mainly because, once a country misses its targets, the other countries have to vote on whether to impose a fine, making the decision very political. One proposal that therefore looks quite appealing is implementing an automatic link between economic reforms and the receipt of EU structural funds. This would sever the political link and in theory help to solve another issue, which is that countries often take the so-called “easy options” when it comes to improving their budgets. Unfortunately, these easy options, such as cutting infrastructure spending, can have negative implications for long-term growth. In an ideal world, structural funds would be linked to growth-boosting reforms, which might normally be harder to implement for political reasons.

FE: Do you see a great economic risk to the Eurozone from Brexit?

SB: At Capital Economics, we think that leaving the EU will have a somewhat less negative effect on the UK economy in the long run than other forecasters expect. Of course, the exact scope of the future relationship remains very uncertain, but, over the next few years at least, the prospect of a transition deal that preserves Single Market and Customs Union membership will help push back the so-called “cliff-edge” for businesses.

For similar reasons, we do not think that Brexit presents serious economic risks for the euro-zone as a whole. That said, due to particularly strong trade links, there are heightened risks in some countries, in particular Ireland and to a lesser extent the Netherlands. And further ahead, we need to bear in mind that Brexit could have political consequences for the euro-zone. For instance, while eurosceptic political parties across various euro-zone countries performed worse than expected in elections last year, if the UK prospered outside of the EU then it’s easy to imagine that those parties might regain some momentum.

FE: What are the greatest risks to Spain as a result of the current political uncertainty in Catalonia? Can the political crisis undermine Spain’s economic growth outlook? If yes, could the impact be felt across the Eurozone? 

SB: Historic episodes of regions pushing for independence suggest that we should not be too concerned about the effects of political uncertainty in Catalonia for the Spanish economy. For instance, there was no obvious hit to activity in Canada during Quebec’s push for independence in the 1980s and 1990s.

Given Madrid’s refusal to enter into a dialogue with pro-independence politicians in Barcelona, the situation in Catalonia is somewhat murkier. Because of this, our best guess when we analysed the situation last year was that the political crisis might knock 0.1 or 0.2 percentage points off Spanish GDP growth for as long as it lasted. As things stand, even this assessment seems to have been too downbeat. While business surveys took a small hit around the time of the referendum, they remain very strong. And regional data show that after rising in October and November, unemployment in Catalonia fell again in December.

While we are relatively sanguine about the economic effects for Spain as a whole, as long as these political issues drag on there could be a transfer of activity from Catalonia to other Spanish regions. Indeed, it was reported last year that 2700 companies moved their headquarters out of Catalonia after the independence referendum. While these moves are currently only on paper, companies will presumably now think twice about expanding operations in Catalonia rather than elsewhere in Spain.

FE: What are the long-term economic impacts of high youth unemployment in Eurozone, particularly in Southern European countries?

SB: It is hard to put exact figures on this, but naturally the long-term economic effects of high youth unemployment are unambiguously negative. Moreover, the situation is arguably even worse than the youth unemployment rate figures might seem to imply, given that many of those young people that are in work are either only working part time or are employed on temporary contracts, or both. Indeed, the data show that since the financial crisis the proportion of young worker on temporary contracts has increased disproportionately.

All these young people lack the opportunities to gain skills and experience. At best, this will hamper these workers’ productivity in the longer term, and at worst it may result in them leaving the workforce altogether. Either way, it will weigh on potential GDP growth in the years ahead. In turn, this has other important implications. For instance, lower potential growth reduces the sustainability of a country’s debt.

The good news is that politicians are well aware of the issue. For instance, in November the Eurogroup discussed plans to raise educational attainment. And some national governments are attempting to pass reforms to reduce the cost to companies of hiring those that have been unemployed. The bad news is that these reforms will take years to have full effect, and, given their long-term payoffs, may not receive the full attention of politicians focusing on short-term gains.

FE: EC President Junker said that the future shape of the 19-country Eurozone “should expand to take in all the other EU members that are not yet part of it and do not have a formal option to opt out of using the euro”. What are the potential upsides and downsides of expanding the Eurozone to all EU member states? Does allowing countries such as Denmark, Sweden, and Poland to keep their national currencies undermine the Eurozone’s economic potential?

SB: Only the UK and Denmark have formal opt-outs, so President Juncker’s proposal implies that the euro-zone would be expanded from 19 countries currently to 26, bringing in Sweden, Hungary, Poland, Czech Republic, Bulgaria, Romania and Croatia.

Leaving to one side the fact that popular support for the euro in many of these countries is low, we are doubtful that including these countries would have significant positive economic implications for either the euro-zone’s current members or the new ones. After all, while the number of countries would increase by 37%, the euro-zone’s combined GDP would rise by just 14%. And numerous studies have found that the biggest gains to trade from the European project have been due to initiatives to expand the single market, rather than use of the euro.

Those marginal benefits could easily by outweighed by potential costs. After all, adding another seven seats to the negotiating table would make it even harder for politicians to reach agreement on the reforms that we think are needed to help the euro-zone become an optimal currency area, such as completing a fiscal and banking union. So far from undermining the euro-zone’s potential, as things stand it seems more likely that the euro-zone will be able to improve its potential by first tackling these issues within a smaller group.

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