Any signs of improvement in eurozone?

Patrick Artus

Natixis chief economist

Potential growth in the eurozone, calculated in the usual manner, is very low, i.e. around 0.5 percent per year. This raises a number of problems: difficulties in financing spending linked to population ageing, healthcare or pensions in the future; difficulty in reducing debt ratios to obtain long-term interest rates that are lower than growth rates - as is the case in the United States; problems in generating exportable production capacity.

So we cannot become really optimistic about the eurozone until we see signs of a future improvement in potential growth, which is absolutely not the case today. This ought to dampen the current optimism with respect to the eurozone.

When we measure eurozone potential growth in the usual manner ― based on long-run productivity gains and demographic prospects ― we find a very low figure, around 0.5 percent per year, versus for example 2.5 percent per year in the United States and 1.7 percent per year in the United Kingdom.

This very low potential growth in the eurozone has a number of negative consequences. Firstly, the problems of financing spending linked to population ageing, healthcare or pensions in the future. The increase in this spending will take a significant share of the increase in GDP, i.e. roughly 60 percent per year, which means nothing will be left to increase employees' purchasing power. Secondly, difficulties in reducing public and private debt ratios, for two reasons: the slow growth in the denominator, nominal gross domestic product, which is growing by around 2 percent per year versus more than 4 percent in the United States, and the impossibility of obtaining long-term interest rates that are lower than growth rates in the eurozone. In the United States, the fact that growth is markedly higher than long-term interest rates is making a significant contribution to the reduction in debt ratios. Lastly, problems in terms of generating exportable production capacity if potential GDP, or rather industrial production capacity, does not increase fast enough. Eurozone exports continue to grow slower than global trade in 2012-2013.

Until we can see signs of an improvement in potential growth in the eurozone, we therefore cannot seriously talk about an end to the eurozone crisis. Such an improvement could be an upswing in investment (corporate or public), an increase in spending on R&D or education, larger productivity gains, or increasing industrial production capacity. What can we see? Public investment has been declining sharply since 2009, from 2.8 percent to 2.2 percent of eurozone GDP, productive investment has declined by 15 percent since 2008 and investment in new technologies by 6 percent. However, spending on R&D and education in the eurozone has increased, from 4.8 percent of GDP in 2008 to 5.1 percent of GDP for total spending on education, but this increase is small.

That has not prevented labour productivity from stagnating and total factor productivity, i.e. the productivity of capital and labour as a whole, from declining since 2008. Also, the production capacity of the eurozone’s manufacturing industry decreased by 8 percent from the end of 2009 to the end of 2012, a sign of the decline in the zone’s supply capacity ― and in its export capacity in the future.

Investors have regained confidence in the eurozone’s situation, as shown by the trend in financial markets: equities, government bonds, bank bonds and exchange rates. Yet, there is no sign of any improvement in the eurozone’s very low potential growth of 0.5 percent per year: investment is declining, spending on R&D or education is hardly increasing, labour productivity is stagnating, total factor productivity is declining and industrial production capacity is falling.

This means that the eurozone’s future problems in terms of financing expenditure linked to ageing, export capacity, ability to reduce debt ratios and to have a really expansionary monetary policy will be massive, which ought to dampen investor optimism. This will probably lead to a downward correction in eurozone financial markets in 2013.