Beware, Europe: this is no time for complacency

The European economy will continue its gradual recovery in 2016-17. Europe’s medium to long-term growth prospects, however, look decidedly mediocre. In a fast-changing global economy, Europeans have no time to waste to improve the functioning of their economies.

The EU’s workforce is ageing and shrinking: there will be 16 million fewer people of working age by 2030, even with steady net migration. Labour productivity growth in the EU has been trending downwards for decades and has been stuck at around 0.5% since 2010. With a shrinking pool of workers and almost flat productivity, Europe’s economy will not be able to grow in the long term.

Low productivity is, to some extent, the flipside of an improving labour market, as liberalisation has brought more low-wage, low-skilled workers into jobs. It is worrying, however, that Europe does not seem to be able to reap substantial productivity gains from years of single market integration, improving education levels and, more recently, large-scale investments in digitisation and other new technologies.

Short term the picture is less gloomy: GDP growth in the EU reached an estimated 1.8 percent in 2015 and is poised to continue growing this year at a similar rate. Moreover, the employment rate in the euro area is now back to its pre-crisis peak. The fact that job creation is proceeding well does not fit with the general picture of an economy still stuck in crisis mode.

The key reason why average unemployment in the EU is still well over 10% is that participation rates are rising across Europe – in stark contrast to the US, where the share of people available for work is falling. Europe’s superior performance in this respect is due mostly to the growing numbers of older workers in jobs – a sign that changes to early retirement rules and other reforms are having some effect.

The risks that could derail Europe’s recovery

The financial market turbulence which started in January threaten to derail the recovery since banks have lost over a third of their value, but banks must provide the bulk of financing for investment in Europe.

Financial markets seem to be unimpressed by the fact that both monetary and fiscal policy are getting more and more expansionary.

The European Central Bank seems baffled by that fact that its massive bond-buying programme had had little impact, as inflation - just 0.2% in December 2015 - remains stubbornly far from the ECB’s target of “below but close to 2 percent”. The ECB’s own explanation is that that this is due to global deflationary forces, such as lower oil and commodity prices. But it would do well to consider the hypothesis that its latest approach of ever more negative interest rates might not work for a creditor economy like the euro area. This will be the big policy debate in 2016: what should the ECB do if inflation stays low, but the economy continues to grow?

Fiscal policy had already become expansive last year, as ‘austerity fatigue’ spread. There is little guidance from the European Commission, which is using exemptions and loopholes in EU fiscal rules to pursue a more “political” approach to monitoring and enforcement. Although individual countries will welcome a little more fiscal leeway in the short term, the lack of rigorous oversight might undermine fiscal sustainability further down the road. Risk premia in the periphery might then increase even further.

Unfortunately, these short-term policies are likely to overshadow the long-term issues. The European Commission’s various initiatives to remove remaining obstacle to pan-European business and investment (Capital Markets Union, Energy Union, TTIP) could improve European growth prospects in the medium term.

These should be the central issues for the current year. Demands for flexibility on deficits (from Italy, France or Spain) or the latest decimal changes of the inflation rate (emphasized by the ECB) should not overshadow the need for long-term competitiveness.

Europe: What to watch out for in 2016-2017 report is now available.