A Missing Piece In Europe’s Growth Puzzle

moghadamsmallBy Reza Moghadam

Even before the latest euro area GDP numbers and Italian elections cast a shadow over the continent, economists were struggling to reconcile the steady improvement in market sentiment with the more downbeat data on the economy, production, orders, and jobs.

This video looks at this puzzle from a somewhat different perspective than the usual—and still correct—narrative of weak banks and over-indebted public sectors caught in a vicious cycle. More specifically, we examine the role of household and corporate balance sheets in the countries under financial market stress and the implications for policy priorities.

Some countries in the euro area do not just suffer from over-extended government and bank balance sheets, but also from over-extended household and corporate balance sheets. While the type of stress (household, corporate, or bank) differs from country to country, it is sufficiently large to be a potential drag on domestic demand. The negative relationship between pre-crisis indebtedness and post crisis growth—in incomes, consumption, and investment— is striking.

Private Sector Growth and Balance Sheet Stress

The downdraft on growth from corporate and household balance sheet problems is likely to be with us for some time. Obviously this affects the financial situation of governments and banks, worsening the interdependence between flagging growth, public finances, and banking health. This has resulted in lending rates that are still too high in countries such as Spain and Italy, despite strong efforts from the European Central Bank. As this chart makes clear, the transmission of easy monetary policy remains impaired.

Corporate Lending Rates and ECB Policy Rate

Meanwhile, there have been spillovers via trade, financial linkages, and confidence to Europe more widely. Growth has been weak even in economic powerhouses like Germany and in the emerging markets to the east.

Exports to Euro Area and Investment

Total Exports of Goods

Screen Shot 2013-03-01 at 12.33.20 PM

All this argues for a more nuanced policy response by countries and European institutions that allows balance sheets to adjust but with minimum output and job losses:

  • For countries: Given the downdraft on consumption and investment, fiscal policy should emphasize long-term measures to raise primary balances and/or cyclically adjusted balances—as opposed to headline deficit targets. Structural measures on the supply side (labor and product market reforms) are crucial to offsetting some of the output cost of depressed demand. We also need to take a second look at whether the legal framework supports timely workouts of household debt.
  • For the European Union: Fully translating easy monetary policy into easier lending rates is probably the most pressing issue to tackle. Initiatives such as the European Central Bank’s Outright Monetary Transactions framework, which would allow for the purchase of government bonds will help but a faster move to a banking union also seems essential, as argued in a recently-released staff paper. Policymakers will need to make progress on the broader reform of the European Monetary Union’s architecture, including fiscal union and—more urgently—the use of the European Stability Mechanism for direct recapitalization of banks.

Pressing ahead with orderly balance sheet repair at the national level, and supportive monetary policy and European Monetary Union architecture will help translate the financial market recovery into a real economic rebound.

Watch the video:

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