Three Reasons Why the Eurozone Recovery Will Be PoorTags Big GovernmentGlobal EconomyTaxes and Spending
The eurozone economy is expected to collapse in 2020. In countries such as Spain and Italy, the decline, more than 9 percent, will likely be much larger than in emerging market economies. However, the key is to understand how and when the eurozone economies will recover.
There are three reasons why we should be concerned:
- The eurozone was already in a severe slowdown in 2019. Despite massive fiscal and monetary stimulus, negative rates, and the European Central Bank's (ECB) balance sheet above 40 percent of GDP, France and Italy showed stagnation in the fourth quarter and Germany narrowly escaped recession. The eurozone weakness had already started in 2017, and disappointing economic figures continued throughout the next years. Many governments blamed the weakness on Brexit and trade war, but it was significantly more structural. The eurozone abandoned all structural reforms in 2014, when the ECB started its quantitative easing program (QE) and expanded its balance sheet to record levels. Manufacturing PMIs were already in contraction, government spending remained too high, and the elevated tax wedge weighed on growth and jobs. In 2019, almost 22 percent of the gross value added (GVA) to the eurozone GDP came from travel and leisure, a sector that unlikely to come back any time soon, while the exporting sector is also likely to suffer a prolonged weakness.
- The banking sector is still weak. In the eurozone, 80 percent of the real economy is financed via the banking channel (compared to less than 15 percent in the United States). Eurozone banks still have more than €600 billion in nonperforming loans (3.3 percent of total assets vs. 1 percent in the US), an almost unprofitable business with a poor return on tangible assets (ROTA) due to negative rates. This is a significant challenge ahead, as most of the growth investments may reduce capital strength significantly in the next months (this is true of Latin America in particular). Most of the eurozone governments are relying on leveraging the banks’ balance sheets in their “recovery plans.” A massive increase in loans, even with some form of state guarantee, is likely to cause significant strains on lending capacity and solvency in the next years, even with massive targeted longer-term refinancing operations (TLTROs) and capital requirement reductions.
- Most of the recovery plans go to government current spending, and tax increases will surely impact growth and jobs. The eurozone tax wedge on jobs and investment is already very high. According to the Paying Taxes 2019 report, the majority of eurozone economies show highly uncompetitive taxation levels. As most governments massively increase deficits to combat the COVID-19 crisis, there will be a high likelihood of massive tax increases that will make it more difficult to attract investment and jobs. Most of the recovery plans are also aimed at bailing out the past and letting the future die. There are massive bailout packages for traditional conglomerates and industries, but investment in technology and R&D (research and development) continues to have high burdens and no support. Considering that the eurozone was already in contraction in the middle of the massive Juncker plan (which mobilized more than €400 billion in investments) and the large green policies implemented, it is safe to say that relying on a Green Deal is unlikely to boost growth or reduce debt. The main problem of these large investment plans is that they are politically directed and as such have a large tendency to fail, as we saw with the Jobs and Growth Plan of 2009.
Almost 30 percent of the eurozone labor force is expected to be under some form of unemployment scheme, be it temporary, permanent, or self-employed cessation of activity. After a decade of recovery from the past crisis, the eurozone still had almost double the unemployment rate of its large peers, the US, and China. Germany may recover jobs fast, but France, Spain, and Italy, with important rigidities and tax burdens on job creation, may suffer high unemployment levels for longer.
The eurozone also faces important challenges in a recovery. The reality of having more flexible job markets and higher support for entrepreneurial activity in the form of attractive taxation will help China and the US recover faster. Considering the severity of the crisis, the eurozone is likely to need at least 10 percent of its GDP to rebuild the economy, but that figure is almost completely absorbed by the traditional sectors (airlines, autos, agriculture, tourism). Furthermore, the Green Deal initiative includes severe restrictions on travel and energy-intensive industries that may act as a brake on future growth.
The ECB policy of the past years was already unnecessarily expansionary, and now it has run out of tools to address the unprecedented challenge of recovery post-COVID-19. With negative rates, targeted liquidity programs, asset purchases of private and public debt, and a balance sheet that exceeds 42 percent of the eurozone's GDP, the best it can do is disguise some of the risk, not eliminate it. We should also warn against adding massive monetary imbalances when demand for euros globally is acceptable but shrinking according to the Bank of International Settlements and the risk of redenomination remains in a politically unstable eurozone.
Our estimates show that, even with large fiscal and monetary stimulus, the eurozone economy will not recover its output and jobs until 2023. Debt rising to record highs as well as monetary imbalances due to a massive supply of euros in a diminishing demand environment may also cause significant problems for the stability of the eurozone.
The eurozone needs to understand that if it decides to increase taxes to address the rising debt due to the COVID-19 response, its ability to recover will be irreparably damaged.