With the growing popularity of the term of ‘secular stagnation’, the talk about the Japanification of the Eurozone economy and increasing worries about an aging population, the contrarian reality is that the world economy is currently on the upswing.
And another surprise is that underlying growth in the Eurozone is currently stronger than in the US. In 2016, the economy grew 1.8% in the Eurozone compared to 1.5% in the US. In 2017, we expect these figures to reach 2.25% and 2.0%, respectively. This is exceptional given that the US is generally assumed to have a higher potential growth rate than the Eurozone due to more favorable demographics. Based solely on population growth and thus disregarding changes in participation rates, the US rate would be around 0.5% higher.
Other factors that contribute to potential growth are total factor productivity and capital investment. Total factor productivity cannot be measured directly, and is therefore usually estimated in the form of a residual by stripping away the estimated impact of capital investment from the economy’s average output per hour.
Most of the declines in output observed since the Great Recession are now attributed to declines in potential GDP. Pessimism about productivity growth has become rampant, but there is no reason to believe there is much of a difference between the two economic blocks. Current estimates hover around 1.0%, which is far below the 1.5% to 1.75% range observed over the longer term. As US output is assumed to grow more or less in line with potential growth, according to these estimates, the Eurozone is growing above its estimated potential.
By contrast, the monetary policies in the two blocks are diametrically opposed: in the US, the Fed has started normalizing interest rates and reducing its balance sheet, while in the Eurozone, the European Central Bank is only just beginning to phase out quantitative easing. The ECB deposit rate is still negative and any rate hikes are a long way off.
The solution to this apparent mismatch is of course linked to the fact that the Eurozone is not a single economy. This is best illustrated by the development of the output gap, the difference between actual and potential growth in the participating counties. According to the OECD, in Germany, this gap already closed in 2015, so its economy is facing increasing inflationary risks, while France and Italy are still showing huge gaps (above 2%).
Of course, these potential growth estimates must be treated with caution. Not long ago, and well after the over-optimistic ‘new economy’ debate, the ECB estimated the potential growth of the euro area in 2005 at 2.0%-2.5%. But it seems fair to say that the Eurozone’s current monetary policy is extremely accommodative, which will allow the region to boom for a while longer. We are playing in extra time. Due to the huge differences in output gaps, Germany will probably have to accept an above-target inflation rate (> 2.0%), as the ECB allows France and Italy to catch up.
This article forms part of the Robeco 2018 outlook entitled Playing in Extra Time.
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