Economics Q&A: Why might Europe’s weaker economies struggle to grow in the next few years?

A starting point to this question is to discuss what “weaker EU countries” might mean. We can use some of the conventional indicators of macro performance to help us namely:

1. Slow or negative economic growth
2. Rising unemployment and falling employment rates
3. Deteriorating public sector finances and higher government debt
4. Relatively high inflation or perhaps an economy experiencing a period of deflation
5. A high deficit in trade in goods and services

Other indicators might be used to identify weaknesses in performance - for example:

1. Relatively low labour productivity
2. A falling share of global trade
3. Rising yields on long term government bond issues
4. Weaknesses in non-price competitiveness

Describing an economy as weak involves a degree of judgement about (a) which indicators to select and (b) the weighting we attach to each measure.

Who are the weaker EU countries? After all there are twenty seven of them of which seventeen are members of the Euro Area.

Much of the media coverage during 2010 has focused on the economic problems facing the PIIGS group - Portugal, Ireland, Italy, Greece and Spain. This answer will concentrate on these countries too.

Economic growth is measured in the short term by the annual percentage change in a nation’s real GDP. Growth is also a long run concept - shown by the estimated trend rate of growth.

Why is it that the PIIGS grouping may be facing up to a period of relatively slow growth at best, at worst another descent into recession and perhaps a lengthy period of semi-permanent downturn?

1/ Fiscal Austerity

The governments of nearly all of these countries have been required or forced into using cuts in government spending and raising taxes as part of a fiscal austerity package. Cuts in state sector spending have a direct negative effect on aggregate demand and will cost many thousands of jobs not just in the public sector but also in private businesses that supply goods and services to the government. Higher taxes will cut into people’s real disposable incomes and reduce domestic consumer spending - for all of these countries, consumption is far and away the biggest single component of demand.

All of these weaker economies have been targeted by speculators in the bond markets. The yields on long term government bonds have risen sharply which means that the cost of servicing debts has gone up.

2/ High unemployment
In all of these countries, much of the recent progress in reducing unemployment has been completely reversed. Unemployment in Spain is now over 20% of the labour force and the jobless rate in Greece has more than doubled. High unemployment reduces demand and often leads to a further rise in precautionary saving as job security ebbs away. It worsens government finances and leaves an economy with a large negative output gap raising the prospect of an economy suffering prolonged price deflation.

3/ Falling asset prices
In many of the PIIGS countries there has been a sustained decline in property prices after the bursting of an unsustainable housing bubble. Falling prices causes a fall in household wealth and a steep fall in new house-building, bringing about huge job losses in the labour-intensive construction and materials industries.

4/ An uncompetitive exchange rate

All of the PIIGS are locked into the single currency. This means that policy interest rates are set by the European Central Bank (who seems reluctant to use quantitative easing as an additional instrument of monetary policy). It also implies that these countries share the same nominal exchange rate against the US dollar, sterling and other currencies. The Euro is set to strengthen in 2011 following a strong rebound of the German economy and global US dollar weakness. This will hit export industries in the likes of Spain and Greece - sectors that have already become competitive within the Euro Area because of previously high rates of inflation.

The European Union economy as a whole is growing relatively slowly at the moment and since the EU is the dominant export market for all of the weaker EU countries, there is big pressure on them to find new export markets - for example in faster-growing economies in far-East Asia. Improving competitiveness to increase exports will take time in the absence of a depreciation in the exchange rate.

Nothing is certain about the rate of growth that any one European economy will achieve from year to year. A faster-than predicted rebound in demand and production in Europe might improve the picture for the weaker economies. And the financial & economic crisis is likely to usher in a period of policy reforms designed to speed up restructuring of the economy and create new jobs.

But overall there are plenty of reasons to expect GDP growth to be disappointingly slow in the next few years and this will make it harder for these governments to restore their public sector finances into better shape.

Data Charts
PIIGS_Data.pptx