As the economic recovery in Europe progressed and output started to grow faster in 2017, optimism returned to forecasters, although they were aware that Europe had particularly benefitted from strong growth in global output and trade. But they did not expect global crosscurrents and domestic growth impediments to impact on European growth as quickly and as massively as happened last year. In 2018, early hopes that adverse factors would be short-lived faded quickly. The emergence of trade tensions in spring and the downturn of the manufacturing sector as well as the subsequent tightening of financial conditions led to a series of downward revisions to forecasts of global, EU, and euro area GDP growth in 2018 and 2019. As a result, in spring 2019, most forecasters look ahead with diminished expectations (e.g. IMF 2019, ECB 2019).
The Commission’s Spring 2019 European Economic Forecast1 highlights the unexpectedly sharp slowdown in euro area GDP growth in the second half 2018, with Italy falling into technical recession and Germany on the brink of it. This slowdown was driven by a conjuncture of several factors, which it is important to disentangle in order to chart the economic outlook for the coming years and design appropriate economic policies. This column contributes to this by examining the relative impact of cyclical patterns and shocks, external and domestic, as well as transitory and more permanent drivers of the economic outlook for Europe.
The economic expansion in the euro area continued in 2018 at a pace of 1.9%. This was markedly lower than in 2017, when economic growth got a push from external factors with net trade contributing massively. Without the sizeable carry-over from strong growth in 2017, the annual GDP growth rate in 2018 would have been lower. Forecast revisions for euro-area growth in 2019 since last autumn were unusually large (-0.5 percentage points or more for the main international institutions as well as Consensus), reflecting the unexpected nature of the shocks at work since the second half of 2018.
In early 2019 there seems to be a divergence between continued weakness in survey data and some strengthening of hard data. Eurostat’s surprisingly positive flash estimate of 0.4% for first-quarter GDP does not provide a breakdown of GDP components. However, the robustness of consumption and, to a lesser extent, investment in France documented by INSEE,2 as well as the (exceptional) strength of construction and the rebound of consumption in Germany expected by the Bundesbank,3 lend some support to the idea of robust domestic demand. Starting from a low base because of the slowdown in the second half of last year, euro area GDP growth in 2019 is now forecast at 1.2% despite a slight rebound expected in the course of the year. In 2020, growth is expected to reach 1.5%, a number partly driven by the higher number of working days next year.
The maturing of the business cycle in Europe is not sufficiently advanced to explain the recent slowdown. Supply constraints have only started to become binding in a small number of countries and sectors in the EU and have now been easing for almost a year (Figure 1). There is also no evidence of imbalances that would imperil the cycle. A strong expansion that raises inflationary pressures and thereby triggers a strong monetary policy tightening is definitely not on the cards. Neither do we observe an over-accumulation of capital; investment has been rather weak during the recovery and has only recently accelerated.
Figure 1 Factors limiting production, euro area manufacturing survey (% of respondents)
Source: Commission Business and Consumer Surveys
Likewise, there is little evidence that a turning financial cycle would have caused the slowdown. Dynamics of leverage and financing conditions (credit availability and cost, asset prices) have received a lot of attention as potential causes of a downturn in recent years (Borio et al. 2018, ECB 2018). While the level and dynamics of private debt and high asset-price valuations require monitoring, recent episodes of financial market turmoil appear too limited and short-lived to have dampened economic activity in a meaningful way. All in all, it appears unlikely that the business or financial cycles are responsible for the slowing of growth in Europe.
The year 2018 saw a decrease in the pace of world (ex. EU) trade growth to 4.6% after an exceptional expansion in 2017 (5.4%). World trade even contracted at the end of 2018, driven by emerging market imports. The factors behind this slowdown are multiple and include the downturn in several EMEs (including China late in the year) amid increased financing costs, trade policy uncertainty, and a cyclical downswing of IT and communication equipment production in East Asia.
To be sure, new tariffs implemented in recent quarters directly affect only a small share of world trade. Nonetheless, they are likely to have affected manufacturing not only directly but also, more importantly, through the uncertainty about the future of trade policies and concerns that this may affect the economic viability of complex global value chains (Wozniak and Galar 2018, Gaulier et al 2019). Investment in the maintenance and extension of such value chains may therefore have slowed.
However, for the slowdown in world trade to explain the sharper drop in euro area growth, the impact would have to be over-proportional. Indeed, export demand addressed to the euro area fell more strongly than world trade during most of 2018 due to the weakness of activity in our main trading partners. Moreover, euro area manufacturing is very export-oriented. The correlation of quarterly manufacturing growth with goods exports is higher than with domestic demand components (0.87 for goods exports against 0.40 for private consumption and 0.55 for equipment investment, 1995-2018). This suggests a close link between the general weakness of euro area manufacturing observed since the start of 2018 and lower export demand.
Figure 2 Manufacturing output and extra-euro area exports
While the impact of the external environment may help to explain why growth has been slowing since the start of 2018, the euro area has also been hit by a number of sector- and country-specific factors that have weighed on economic activity throughout last year. These include strikes, social unrest in France, extraordinary weather conditions (which inter alia disrupted inland water transport on the Rhine river) as well as policy uncertainty, which in Italy led to a worsening of financing conditions.
Among the specific factors, the production disruption in the car manufacturing sector in the second half of 2018 stands out for its macroeconomic relevance. European carmakers, particularly in Germany, had problems with the introduction of the new Worldwide Harmonised Light Vehicles Test Procedure (WLTP) that led to production disruptions, as certifications had not yet been obtained for a large number of models when the regulation took effect in the EU on 1 September. Since many vehicle types had no certification by that date, inventories were increased and production was temporarily interrupted. The WLTP effects added to regulatory discussions on limitations to the use of diesel cars in cities, the ongoing ‘Dieselgate’ affair,4 and falling Chinese and global demand for European cars. The impact of these factors overlaps with more fundamental structural changes affecting the demand for combustion-engine cars (e.g. alternative power sources, automated driving, car sharing).5
Figure 3 GDP loss due to 8% decrease in the German automotive sector output (percentage points)
Source: OECD, own calculations
Production in car manufacturing in Germany decreased by 8% in the third quarter of 2018, with a direct mechanical loss of German GDP of more than 0.4% due to the high share of the automotive sector in total value added in Germany (close to 5%). Inter-country input-output (ICIO) tables released by the OECD further allow an estimation of the direct and indirect impact of the decline in automotive output on other sectors. Taking into account the decrease in output faced by the direct suppliers of the German automotive sector (‘first-round effect’), the impact amounts to 0.5% of GDP in Germany, and between 0.05% and 0.1% of GDP in Hungary, Czechia, and Slovakia (Figure 3). Including the spillovers to the whole value chain (‘indirect effects’), the impact on GDP is significant in several countries: GDP would have been 0.6% higher in Germany without the fall in the automotive sector, 0.2% higher in Czechia, Hungary and Slovakia, 0.1% higher in Slovenia, and between 0.05% and 0.1% higher in Austria, Poland and Romania. For all other countries, the impact is estimated to be below 0.05 percentage points.
Disconnected factors: Manufacturing and services, wages and core inflation
The ongoing weakness of manufacturing and export orders has so far coincided with dampened, but still robust domestic demand and continued employment growth. Will the domestically oriented part of the economy (proxied in Figure 4 by confidence in the services sector, which represents 73% of value added) be able to withstand the slowdown of the manufacturing sector (17% of euro area value added)?
Figure 4 Euro area manufacturing and services surveys and GDP
Source: Commission Business and Consumer Surveys, Eurostat
It is not necessarily the case that services activity follows developments in manufacturing with a lag. Statistically, there is no lead-lag relationship between the business surveys for services and manufacturing. Also, the evidence from previous episodes of diverging manufacturing and services developments does not point to services performance systematically following manufacturing performance. For instance, service and manufacturing confidence dropped at the start of 2005, but then services recovered as of March, while manufacturing continued declining and only increased as of June. Clearly, services confidence better reflected the turnaround in GDP growth in the second quarter. In 1999, both services and manufacturing confidence decoupled from GDP growth; they signalled a slowdown in the first quarter, while GDP growth actually accelerated. Manufacturing confidence started ‘correcting’ for this decoupling already in the second quarter, while services continued to (wrongly) signal a further decline.
This suggests that domestic demand may well carry the economy through the current weakness of manufacturing if it is not too deep or protracted.
The resilience of domestic demand in the euro area benefits from the strength of the economies of the former programme countries. They not only achieved remarkable growth rates in the years after their exit from financial assistance programmes, but sustained their strength and recorded up to last year growth rates above the average of their peers in the euro area (see Table 1). The unwinding of the macroeconomic imbalances accumulated before the crisis, improved competitiveness, and the positive impact of reforms have in the short term helped them to maintain their growth momentum. While crucial challenges remain in place, recent positive developments are projected to allow all former programme countries to grow in 2019 and 2020 above the average of the rest of the euro area.
Table 1 Economic growth in euro area member states after their exit from financial assistance programmes
Notes: * This average includes real GDP growth of 25.1% in 2015, which reflects the reclassification of economic activities of multinational corporates. Real GDP growth, annual averages, years 2019 and 2020 are forecast years. Figures in brackets indicate growth in the rest of the euro area in the respective period.
A second divergence at the current juncture concerns wage and price (core inflation) developments. In line with falling unemployment and gradually tightening labour markets, wage growth picked up to 2½% last year. This has led to upward pressure on unit labour costs, which increased by almost 2% in the euro area last year and are set to expand further this year. However, this cost pressure has not yet translated into higher core inflation (HICP excluding energy and unprocessed food prices), which has continued to remain broadly stable throughout 2018 (Bobeica et al. 2019). With the recent weakening in economic activity, the already muted pass-through of higher wage growth to underlying price pressures is set to take longer than previously anticipated. Figure 5 illustrates the divergence by comparing a wage Philips curve (in black) with a price Philips curve (in red). Over the whole observation period (2001-2019Q1), wage growth has tended to be stronger than inflation (dots and dashed regression lines). This is also true for the most recent period since 2016 (solid). However, while wage growth has picked up amid lower unemployment while inflation has hardly reacted, thereby diverging both from wage developments and the inflation regression line.
Figure 5 Wage and price Philips curves for the euro area
Source: Eurostat, own calculations
As downside risks remain large, economic policy must stand ready to deal with a possible sharper downturn
Several important downside risks surround the forecast’s central scenario of a rebound in the course of 2019. Many of these are related to bad economic policies. Outside the euro area, an escalation of trade conflicts or persistent uncertainty surrounding trade policies, the possibility of a ‘no-deal’ Brexit, a more protracted slowdown in China, and a sharper or longer slowdown in export demand constitute major risks. Within the euro area, risks relate to remaining fragilities of financial-sector balance sheets and the possibility of sovereign-bank vicious circles. Also here, some risks relate to the implementation of bad economic policies, such as a roll-back of structural reforms or imprudent fiscal policy. Many of these risks appear interconnected and non-linear, which could magnify their impact on the economy if they were to materialise. This would put significant strain on the capacity of macroeconomic policies to stabilise the economy.
Persisting gaps in the economy leave room for the economic expansion to continue before inflationary pressures build up, but also point to vulnerabilities. Low inflation and the external surplus suggest that domestic demand can further increase before inflationary tensions emerge. The current account surplus of the euro area suggests that the economy remains reliant on external demand. Investment is in turn dependent on export demand and therefore vulnerable to trade tensions as well as global economic sentiment.
Considering the uncertainty surrounding the economic outlook, policies should be designed to cover also the risk of a sharper and more protracted slowdown. The distinction between preventive and curative action is particularly difficult. However, one of the lessons of the crisis is that a very cautious policy response in the face of pervasive uncertainties – the so-called conservatism principle of Brainard (1967) – may not be sufficient to avoid ending up in a bad equilibrium. In any policy package, short-term measures (aiming at sustaining demand and investment) and longer-term measures (aiming at boosting potential growth) should be combined. It is important to take into account that the social fabric of euro area Member States in many cases appears less robust than before the crisis. Despite overall improving employment numbers, rising wages and strengthening economic activity, the perception of an unfair distribution of the pain during the crisis and of the benefits during the upswing has fuelled social protests as well as anti-establishment political currents in many parts of the EU and globally.
Figure 6 Structural balance and government debt, 2019
Source: European Commission
The expected macroeconomic policy mix, with continued monetary support and a slightly expansionary fiscal stance in the euro area as a whole, would allow the expansion to continue (albeit at a more moderate pace) provided that the prospects of a rebound are confirmed by incoming indicators. Monetary policy has provided most of the macroeconomic stimulus over the past years and is expected to remain accommodating, whereas the fiscal policy stance for the euro area as a whole is expected to be slightly expansionary in 2019. Member states with very high public debt should, however, pursue a more prudent fiscal policy than currently envisaged (Figure 6). Reducing uncertainty by committing to structural reforms aimed at increasing sustainable growth and to debt reduction where it is most needed would help households’ and companies’ spending and investment decisions and preserve favourable financing conditions for the public and private sectors.
Several member states with fiscal space currently plan fiscal expansions in 2019. Its effective delivery is important under the baseline of a moderate slowdown, with additional measures if the downturn is sharper than expected. By focusing on public investment, both physical and intangible, member states with fiscal space could in addition improve their own growth prospects for the medium term and generate positive spillovers within the euro area. In a context of policy interest rates at the effective lower bound, government investment in surplus countries can have positive GDP spillovers to the rest of the euro area (in ‘t Veld 2016).
Structural reforms and a focus on the quality of public finances should complement macroeconomic policies. In view of the constraints to macroeconomic policies, moving towards a structure of public revenues and expenditure that favours education, employment and investment is a means to increase the growth potential while being deficit-neutral. At the same time, a redesign of tax and expenditure systems could be used to make them more inclusive. Other structural reforms that increase the growth potential and resilience should also be brought forward.6
Measures to complete EMU would increase the effectiveness of macroeconomic policies. Respecting the deadline of June 2019 set by the Euro Summit in December is important for the budgetary instrument for the euro area to be implemented with the next Multiannual Financial Framework. The absence of a euro area central fiscal stabilisation function complicates the task of smoothing shocks and increases the risk of avoidable output losses; more work is needed on such a function. The completion of the Banking Union, including an agreement on the European Deposit Insurance System, and a continued impetus to Capital Markets Union are urgent to improve the financing opportunities for companies and households and increase the shock-absorption capacity of the euro area economies.
Bobeica, E, M Cicarelli and I Vansteenkiste (2019), “The link between labour cost and price inflation in the euro area”, ECB Working Paper 2235.
Borio, C, M Drehmann and D. Xia (2018), “The financial cycle and recession risk”, BIS Quarterly Review, December: 59-71.
Brainard, W (1967), “Uncertainty and the effectiveness of policy”, The American Economic Review 57(2): 411-425.
Bundesbank (2019), “Konjunkturlage”, Monatsbericht 71(4).
Cordano, G A (2019), “How do crises influence sales: the impact of the Diesel scandal on Volkswagen’s and the automotive industry’s sales”, Louvain School of Management and University of Cologne.
Frederiksson, G, A Roth, S Tagliapietra and R. Veugelers (2018), “Is the European automotive industry ready for the global electric vehicle revolution?”, Bruegel Policy Contribution 26.
European Central Bank (2019), “ECB staff macroeconomic projections for the euro area”, March 2019.
European Central Bank (2018), “Real and financial cycles in EU Countries: stylised facts and modelling implications”, ECB Occasional Paper 205.
European Commission (2018a), “Post-Programme Surveillance Report, Greece, November 2018”, Institutional Paper 90.
European Commission (2018b), “Post-Programme Surveillance Report, Spain, Autumn 2018”, Institutional Paper 91.
European Commission (2018c), “Post-Programme Surveillance Report, Cyprus, Autumn 2018”, Institutional Paper 92.
European Commission (2019a), “Post-Programme Surveillance Report, Portugal, Autumn 2018”, Institutional Paper 97.
European Commission (2019b), “Post-Programme Surveillance Report, Ireland, Autumn 2018”, Institutional Paper 98.
European Commission (2019d), “European Economic Forecast Spring 2019”, European Economy Institutional Paper 102.
Gaulier, G, A Sztulman and D. Ünal (2019), “Are global value chains receding? The jury is still out. Key findings from the analysis of deflated world trade in parts and components”, Banque de France Working Paper 715.
International Monetary Fund (2019), World Economic Outlook April 2019.
Institut National de la statistique et des études économiques (2019),"Le PIB progresse de 0,3% au premier trimestre", Informations rapides N° 2019 110.
In ‘t Veld, J (2016), “Public Investment Stimulus in Surplus Countries and their Euro Area Spillovers”, European Economy Economic Brief 016.
Wozniak, P and M Galar (2018), “Understanding the weakness in global trade”, European Economy Economic Brief 033.
 See https://ec.europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-forecasts/spring-2019-economic-forecast-growth-continues-more-moderate-pace_en
 See https://www.insee.fr/fr/statistiques/4132945
 See https://www.bundesbank.de/resource/blob/793790/fe14349c7d4f06c3a09fa7b631d5b9ad/mL/2019-04-monatsbericht-data.pdf
 The notice of violation of the Clean Air Act to the Volkswagen Group in September 2015 issued by the US Environmental Protection Agency resulted in ‘Dieselgate’, which also involved other manufacturers that manipulated the emissions of diesel engines. For an overview of implications see e.g. Cordano (2019).
 In an investigation of the position of the European car industry, Frederiksson et al. (2018) concluded that “[i]t is not too late for Europe to lead the global electric vehicle race, but it has to step up if it wants to remain at the frontier of automotive technology”.
 See the Council Recommendation on the economic policy of the euro area (https://www.consilium.europa.eu/en/policies/european-semester/2019/).