Eurozone in Recession: How to Get Out of It ?

A Stimulative Policy Mix Would be More Efficient Today than in 1993

- We expect a serious recession in the Eurozone for 2009, with a decline of 1.5% in GDP. However, we believe that if a large monetary and fiscal stimulus package is implemented now, the recovery could start in earnest late next year.

- With inflation expectations back in check, monetary policy can now be bold. The flight to quality ensures that, unlike in the early 1990s, a greater share of any fiscal package will stimulate the economy instead of simply pushing the debt service up.

- So far, the national governments and the ECB have focused on helping the banking sector go through the current credit market turmoil. The crux of the problem now lies in the corporate sector. In our view, a fiscal stimulus should take businesses, rather than households, as the primary targets.


The 2008-2009 Recession in Perspective

There is no NBER in the Eurozone to officially call the recessions. Yet, by the customary definition (2 consecutive quarters of negative GDP growth), as well as by looking at key surveys (PMIs, European Commission survey) and labour market data, it seems clear that the Eurozone fell into recession sometime in the summer of 2008. The economic debate has now shifted from whether or not a recession is unavoidable to whether or not the recession could be a prelude to some nastier configurations. We think that the Eurozone will face a serious and protracted recession, but will avoid a descent into deflation or depression. True, the credit market turmoil poses unprecedented challenges to the economy. Still, compared with the last recession, in 1992- 1993, economic policy has regained much of its firing power. Timely action could prove decisive.

Since the early 1970s, what is now the Eurozone had to cope with 4 recessions, defined here as two consecutive quarters of declining GDP. Their duration, which we define as the number of quarters it took for GDP to return to the pre-recession level, varied from 4 quarters (1980-1981) to 9 quarters (1992-1994). The early-to-mid 1990s recession stands out as very protracted (see Figure 1 ). We think that the current recession will be even longer and deeper.

Recessions often start with an exogenous shock. In 3 of the 4 recessions observable in the Eurozone since 1970, the downturn was triggered by a steep increase in oil prices (1974, 1980, 2008). Those shocks were of course beyond the direct control of monetary and fiscal authorities. However, the response of the policy-mix to the external shock can have a significant impact on the profile of the ensuing recession.

The 1974 and 1980 recessions, in spite of their common origin in a sharp increase in oil prices, were very different in terms of policy response. To gauge this, we look at two simple indicators:

• The change in the monetary stance, defined as the cumulative variation of the short-term interest rate in real terms in the 4 quarters following the start of the recession (first quarter of negative GDP growth).

• Second, the change in the fiscal stance after one year, measured as the variation in the cyclically adjusted primary general government balance. This captures the impact of decisions by policy makers on taxation and public spending.

We use for these two indicators data from the OECD, available from 1991 onwards for the Eurozone. For the pre-1991 period, we aggregated the data for Germany, France and Italy.

Figure 2. Eurozone Recessions in Perspective


In the mid 1970s, Keynes reigned supreme. The policy response to the first oil shock was a kneejerk combination of ample monetary accommodation (-367 bps in one year) and a sizeable fiscal push (1.3% of GDP). Although the output loss (difference between the pre-recession GDP level and GDP at trough) was significant (2.3%), the economy resumed a fast growth pace from 1976 onwards. However, none of the structural issues of the time (ever-increasing inflation expectations, deterioration in corporate profitability, deceleration in productivity) were addressed. The policy reaction to the 1979 oil shock and subsequent recession was entirely different. To a large extent, the downturn was consciously triggered by policy makers, as a way to end overinflation.

While output was falling, monetary policy was tightened (+167 bps in 4 quarters) and the structural fiscal balance improved slightly (+0.4% of GDP in one year). The recession was initially shallow in the Eurozone, since the output loss was erased in only 4 quarters. However, the economy relapsed into negative GDP growth in mid-1982. Still, the extreme pro-cyclical policy tightening had one clear benefit: disinflation. In February 1983 inflation fell under 10% yoy for the first time since August 1979. Corporate profitability, which had been significantly eroded in the 1970s, started to improve in 1983 as the wage indexation spiral was stopped. After years of under-investment, which had plagued the European economies, capital expenditure rebounded.

One should never understate the importance of the 1980 recession in shaping European economic policy since then. The notion, still emphasised today by ECB President Trichet, that the best support that monetary policy can give to the economy in troubled times is anchoring inflation expectations, gradually became the textbook wisdom of every central bank in Europe in the 1980s.

That means that the ECB accepts that some tightening may occur even if incoming data point to a downturn. This is how we can understand the decision to raise the policy rate by 25 bps in July 2008, the very month when the PMI in both manufacturing and services stood below the stagnation line for the first time since 2003, while inflation hit 4.0% yoy.

The 1992-1993 downturn was also, to a large extent, a policy-induced recession, but involuntarily this time, since it was much more the product of the unfortunate institutional settings of the European Union at the time than a response to genuine inflationary pressure. Initially, the reunification of Germany led to a policy tightening in this country which was perfectly adapted to the local circumstances. However, this induced a generalized monetary tightening in the rest of the Eurozone through the necessity, brought about by the European Exchange Rate Mechanism, to follow the Bundesbank policy. The mid-1990s was a period of aborted recoveries and heightened uncertainty, plagued by wide gyrations in intra-European exchange rates and interest rates.

How does the current economic situation compare with the previous two recessions ?

• Unlike in 1980, inflation expectations are today well-anchored. They even fell sharply below the ECB’s definition of price stability, “below but close to 2%” (see Figure 3 ), after some drift in the first half of 2008. The ECB wants to ascribe the improvement to its unexpected rate hike in July 2008, while we think it was more driven by a spontaneous correction in oil prices in line with a sharp downward revision in demand prospects. Beyond this debate, what matters now is that the central bank can be comfortable in cutting rates fast without reigniting inflation.

• Unlike in 1992-1995, economic policies can make full use of the “euro umbrella”. True, some heightened discrimination across sovereign issuers has recently triggered an increase in interest rates on public debt in a number of Eurozone countries. However, owing to the “flight to quality” away from private sector assets, the absolute level of interest rates on government bonds remains much lower than in the mid-1990s. On 1st December 2008, 10 year yields on Italian government bonds stood at 4.42%, against 13% in early 1993. A fiscal push in the Eurozone would, at this juncture, only have a limited impact on debt service costs. This is a key difference to the early 1990s, when the extremely high level of interest rates meant that a significant fraction of the fiscal push was neutralized by the soaring debt servicing costs.

• Unlike in 1992-1995, public finances in the Eurozone were in a reasonably healthy situation before the downturn started (see Figure 4 ). For instance, in 2007 the general government deficit in Italy stood at 1.6% of GDP, against 11.4% in 1991. Germany also has much more firing power today than in 1991, when the cost of unification was weighing heavily on its budget.


There is a compelling case for a major policy relaxation in the Eurozone in 2009. Of course, such a growth-friendly attitude must not jeopardize 20 years of progress in macroeconomic management. On the monetary side, Bundesbank chairman Weber is right in insisting – already – on the need to “normalize” policy rates relatively quickly when the first signs of recovery will appear, in order to avoid the repetition of “boom and bust” episodes on asset prices. On the fiscal side, the European Commission is right in calling for further structural reforms in public finance management in exchange for a transitory discretionary push. Still, timeliness is of the essence. It is too late to avoid the recession. There is still time to make it “only a recession” and nothing nastier.


The Crux of the Problem Now Lies in the Corporate Sector

The ECB and national governments have so far – justly – focused on avoiding a meltdown of the banking system. We now have in place a comprehensive package to help the Eurozone banking sector work through the credit market turmoil:

• Government guarantee on new debt issuance by banks helps to circumvent the funding difficulties on the money market.

• State capital injection in banks should help maintain regulatory ratios.

• The reform in the ECB money market operations aims at steering more tightly credit market rates.

This multi-faceted strategy has started to bear fruits. The “Ted” spread (the differential between money market rates and government rates) is receding (see Figure 5 ), even if it remains extremely high by historical standards. Of course, a major disruptive accident in the banking sector cannot be ruled out, but at least the institutional system now looks well equipped to deal with it. It is time to focus on the “second round” effects of the credit market turmoil: the reduced access to funding for the corporate sector.
 
For the time being, bank loans are still flowing to the corporate sector, albeit at a much lesser pace than in 2006 and 1H 2007 (see Figure 6 ). The existence of pre-definite credit lines for the corporate sector may explain at least part of this resilience. Still, the credit market turmoil started more than a year ago. It is likely that some of the existing credit lines have been renegotiated and that banks, in aggregate, could impose a cut in the maximum amount businesses can draw. However, long-term relationships between banks and corporations may protect to some extent the credit lines.


However, even if lending flows remain relatively satisfactory, the corporate sector will be hit by the credit market turmoil. The interest rates on corporate debt have increased markedly over the last three years (see Figure 7 ), with an acceleration in the last 2 months, and are at 8% for BBB rated signatures, by far the highest level since the mid-1990s. Of course, this is still much below the record levels in the early 1990s, when yields stood in two-digits territory, but the quantity of debt to roll-over has significantly increased since then (see Figure 8 ).

Even if bank credit remains available, the increase in financing costs, weighing on a larger debt, will force businesses in the Eurozone to scale their investment programs dramatically down. The need to de-leverage will also have a significant negative impact on hiring.

The downturn started when households went into a “consumption strike”, in response to the loss in purchasing power triggered by elevated oil prices. The recession will likely be prolonged because it is now the turn of the corporate sector to dramatically cut spending. This should have a strong bearing on the design of fiscal stimulus packages. Instead of stimulating consumption, which may prove ineffective if households react by raising their savings ratio on the back of deteriorated employment prospects, governments should target the corporate sector.

In some countries, most notably France, the government seems to be ready to inject state funding directly into the non-financial corporate sector, thus bypassing banks. This strategy is questionable, since the government would have to choose which industries/companies would be at the receiving end of the taxpayers’ generosity. A less distortionary approach would be to implement large-scale cuts in corporate taxation.

Tweaking the headline corporate tax would not be very efficient, in our view, since this tax is usually paid only on the profitable companies. It would not help the already struggling businesses. A more efficient solution would consist in granting a corporate tax holiday on past profits. Indeed, in most Eurozone countries, the tax base is calculated over several years of profits. Some companies may be paying now taxes levied on large past profits while their current cash receipts are shrinking dramatically. Deferring these payments would bring some relief to the business sector. A large holiday on payroll taxes and some permanent cut in these social contributions would also be efficient. It would reduce costs and would help maintain labour demand. The decline in energy costs is boosting households’ purchasing power. What is at stake now is the utilization of this income. Reducing labour costs, by limiting the unavoidable correction in employment, would reduce the risks of a spectacular rise in precautionary savings.


Help Thy Neighbour !

In 3Q 2008, GDP growth declined at the same time in the US, the UK and the Eurozone for the first time since 1980. Since the recession was synchronised throughout the industrial world, it is probably illusory to expect any meaningful recovery in the Eurozone without a similar upturn in the US and the UK. In 1992-1993, the recession started later in the Eurozone than in the US and the UK. Consequently, the depth of the Eurozone recession was limited by some external traction in 1993/1994, since global demand had already started to pick-up. The higher degree of synchronisation this time probably means that European policy-makers cannot simply wait for the global recovery to take shape. Some decisive action on domestic demand is necessary.

Yet, if a recovery in the US and the UK is of course beyond the control of the Eurozone policymakers, they can still have an impact on the economic situation in Eastern Europe, their “emerging neighbour”. Since the start of the Monetary Union in 1999, central and Eastern Europe has roughly brought the same contribution to Eurozone exports as the US. Some of these countries are currently undergoing serious financial stability difficulties. The swift EU commitment, together with the IMF, when Hungary was threatened with a major financial crisis last month, was more than welcome. Helping this region is within the means of the European Union. Avoiding a major contraction in economic growth in Eastern Europe would be a powerful means to support growth in the Eurozone.

We expect GDP to decline by 1.5% in 2009 in the Eurozone. This would be much worse than 1993 (0.7%). However, we still believe that the right combination of fiscal and monetary relaxation could ensure that, by the end of 2009, the recovery would start to appear.