Is There Still Light at the End of the Tunnel For Southern Europe?

By Julius Probst

After suffering from almost a decade of economic stagnation in the aftermath of 2008, the current pandemic is another deadly blow to Southern Europe. And no, this time is unfortunately not a metaphor as tens of thousands of people have died already from COVID-19. Even worse, looking at excess deaths, it is certain that the official death count in most countries understates the true number of deaths from the virus.

Obviously, I am not an epidemiologist, so I will not go into very great detail about why the virus has spread to a greater extent in some countries than others or why mortality rates and total deaths counts differ. Let me just say that mortality rates obviously depend on the current testing regime. The more tests you do, the higher will be your confirmed case count, which will then drive down the mortality rate.

Also it might not be entirely correct to blame Southern Europe‘s problems on cultural or institutional reasons. First, Italy was hit first by the virus, which gave other countries more time to formulate an adequate response. Second, there are other socio-economic factors that make Southern Europe more vulnerable. Population density in Southern European cities like Milan, Rome, Madrid or Paris is much higher than in Northern Europe, including German cities like Cologne, Munich, or Berlin. This undoubtedly allows the virus to spread. Second, household structure in Southern Europe is very different, both in terms of size as well as in terms of composition. First, the average household size in Southern Europe is higher. Second, the family structure is also different. It is much more common for older and younger generations to cohabitate in countries like Italy and Spain. Given the extreme high mortality rate of older age groups, this is now a deadly factor.

Finally, while the German government’s response to the pandemic might have been better than average, it must also be pointed out that the country also got somewhat lucky. The average of infected and tested people in Germany is significantly lower than in France, 49 compared to 62, which is also a factor in explaining why Germany’s mortality rate and death count is so far significantly lower.


However, as pointed out above, in this post I will mainly have a look at some macroeconomic fundamentals. The punchline of this post is that Southern Europe’s economic situation is indeed quite dire as a result of the current macroeconomic shock that comes from the COVID-19 pandemic.

Unfortunately, I believe that Europe in general, and Southern Europe in particular, will suffer immensely from this crisis. The main reason is that the entire region entered what will be a global depression with already very weak fundamentals, mainly a result of inadequate policy responses during the Global Financial Crisis and the Eurozone crisis. Furthermore, while policy makers have certainly been much more aggressive this time around, I fear that in general the response will
still be inadequate and that we might have to look forward to another few years of economic stagnation in the periphery countries. In short, another macroeconomic  disaster. Let me explain why.

As the chart below shows, the macroeconomic performance of Northern Europe and Southern Europe could not have been more different over the last decade. Greece and Italy have lower real GDP than before the Financial Crisis. Portugal and Spain stagnated for almost a decade and only exceeded their previous peak some 10 years after the original shock in 2008. While the severity of the initial decline was much less severe than during the Great Depression, the longevity of this economic stagnation is completely unprecedented.

Macrobond Moment: You can rebase all the time series for a specific date with one click, using our Rebase tool.

Of course, total GDP might not be the best measure in terms of economic welfare. So below, I have also plotted real GDP per capita. As one can see, Italy and Greece have basically the same per capita GDP as in 2000. Again, this kind of long-lasting economic stagnation has not been observed since the beginning of the Industrial Revolution.

Portugal and Spain fared somewhat better and finally made up some ground in recent years since the Eurozone economy started to recover again after the ECB finally implemented a more expansionary monetary policy with a QE program that started in 2015.

As a result of the economic stagnation, property prices in Southern Europe have deflated as well. Especially Spain saw rapidly inflating real estate prices before the crisis. Now, more than a decade later, they still haven´t reached their previous peak. The negative wealth effect from falling house prices certainly has played its part in the economic stagnation that has plagued Southern Europe over the last decade.

Deflating asset prices have surely been a key factor in weak domestic demand. As wealth is falling, the private sector has been in a deleveraging cycle since 2008, paying down its debts. As the chart below shows, private sector credit to GDP ratios were extremely high and rising in the runup to the financial crisis. Southern Europe’s growth in the early 2000s was therefore partially financed by private sector debt, which was also facilitated by capital inflows from Northern Europe.

As these capital flows have reversed during the Eurozone debt crisis, the private sector had to go on a painful deleveraging cycle to repair its balance sheets, which led to a severe contraction in domestic demand. Southern Europe has therefore experienced a balance sheet recession similar to Japan after its collapsing real estate bubble and stock market bubble in the 1990s (Koo, 2012).
The big difference though is that Japan, being the issuer of its own currency, has been able to offset massive private sector deleveraging with an equally impressive increase in public sector debt that is exceeding 200% of GDP.

However, as Southern European countries are trapped in the common currency, they do not enjoy this exorbitant privilege. Moreover, the monetary policy mistakes before Draghi
allowed for sovereign debt runs as the ECB did not take its role as lender of last resort seriously. Therefore, on top of the contraction in private sector credit, unnecessary austerity on the public side aggravated the decline in nominal demand.   

As research by the IMF and others later showed, austerity turned out to be extremely contractionary (Blanchard and Leigh, 2013), just as neo-keynesian theory predicted (Krugman, 2005), and played a large part in the decade-long economic stagnation that Southern Europe has faced.

Moreover, Southern Europe also has a competitiveness problem that is to some extent no fault of its own, but rather created by policies pursued by other countries, Germany in particular. As one can see below, nominal wages rose significantly in Southern Europe before the crisis, while they actually stagnated in Germany. Germany’s competitiveness and export sector have been built on a macroeconomic policy based on domestic wage restraint. While this has been very good for German producers, it has come at the cost of German workers, and especially low-income labor.

Within the currency union, policies aimed at keeping domestic wages low are effectively beggar-thy-neighbor. A race to the bottom in terms of domestic wages is in no country‘s interest. While German economists have pointed out the fact that policy makers are not responsible for the national wage bargaining process, there are a number of policies that effectively can boost domestic wages, higher minimum wages being one of them.

In terms of the macroeconomic adjustment before the current COVID-19 shock, what the Eurozone desperately needed was significant higher nominal wage growth in the North as to avoid deflationary pressures in the South. Alas, this was never well acknowledged or even understood by Berlin.

Going forward, rising wages in Germany and therefore higher than average inflation is desperately needed to bring the Eurozone back to balance.

In terms of prospects for long-run economic growth, one should note that the investment rate has also been depressed as a result of the crisis. Gross capital formation as a percentage of GDP is lower than before the financial crisis and on a downward trend.

Macrobond Moment: Using Macrobond ratios, it is extremely easy to transform a series into % of GDP. If you don’t have Macrobond, you can now try it for free.

What is even more concerning is that net investment, meaning gross capital formation minus capital depreciation, has been on a downward trend in recent years, not only in Southern Europe but also in Germany. Even more shocking, as a result of the austerity measures, public sector net capital formation has been negative, meaning that our public infrastructure is now deteriorating at a faster pace than we repair. This is obviously bad news! You don’t need to be an expert in endogenous growth theory (Aghion and Howitt, 1997) to understand that low levels of investment, both public and private, will come at the expense of future growth. So here we have one additional cost of running a low-pressure economy: depressed investment levels that will subtract from future growth.

Finally, in terms of demographics, Southern Europe also does not have anything to cheer for, unfortunately. While Germany’s age pyramid is certainly not great, given its very low fertility rates for decades, the last economic expansion has attracted a number of foreign workers, including from Southern Europe. Moreover, Merkel’s commitments during the refugee crisis have also led to an inflow of migrants, which in the long-run will help to ease Germany’s supply constraints and need for workers.

The dependency ratio measures the number of dependents, those under the age of 15 or older than 64, relative to the working-age population. The dependency ratio was equally high in the 1960s, but for an entirely different reason, namely the baby boom, whereas the recent increase is all about rapidly aging societies.

The old age dependency ratio, the fraction of people over 64 relative to the working population, has increased continuously in recent decades, and especially over the last two decades. As one can see, Southern Europe’s demographics are not very different than those of Germany. Especially Italy’s demographic trend is particularly concerning and will turn out to be a very challenging and burdensome for the pension system.

Macrobond Moment: In chart annotations, it is very easy to add chart ornaments to graph, such as arrows, text boxes, etc.

Furthermore, the aging of the European population will depress investment demand even further and thereby also put more downward pressure on interest rates. Adverse demographics are therefore at the core of the secular stagnation problem that is hitting European countries particularly hard. Population dynamics are therefore very concerning and one more reason to be more pessimistic about Europe than some other advanced economies that have better demographic outlooks also because of much higher immigration flows, such as Australia, Canada, and the US.

The current macroeconomic shock, a result of the shutdown of our economy that we have implemented to prevent the virus from spreading and ending many lives, will only aggravate many of the long-run challenges that I have outlined above. And I am worried that Europe’s fundamentals will only worsen. As of now, Oxford Economics is predicting severe declines in real GDP for the current year and most European countries will only recover by 2022. Furthermore, I think that these forecasts are actually a tad optimistic and that in a worse-case scenario we might experience more severe decline in output than what is currently anticipated.

Macrobond Moment: I first used the Scalar function and then the bar chart to create this table in Macrobond.

The chart below shows that Southern Europe is extremely dependent on the travel and tourism industry. As of now, there is little hope that European tourism will normalize even if the borders are going to open again in a few months as many people might simply avoid travelling and the risks associated with it for a while.

Since I have started blogging here at Macrobond, my analyses have been extremely pessimistic, and I have become our own in-house Dr. Doom if you will. However, I really would like that to change and I will therefore end this post on a slightly optimistic note.

The ECB has been more aggressive so far than I initially thought would be the case. I had feared more complacency, but instead their moves are holding the Eurozone together now. What is more, ECB policy makers are publicly calling out European officials and asking for more fiscal support. This is greatly needed.

If I had my way, here is how I would kickstart the European economy over the next couple of years after this lockdown period has ended:

1. Set up an equivalent to what the Marshall plan was for postwar Europe. The Eurozone desperately needs an infrastructure investment plan. I would set it up at 1 trillion Euros. Sounds big, but it’s less than 8% of GDP and the actual fiscal impulse is even smaller since you have to spread out the infrastructure investment over several years. And don’t tell me that there are no investment opportunities. Europe could massively invest in green energy, build smart electricity grids, invest in the health care sector – we need it right now! – repair crumbling highways, build up a better railway system, invest into schools and Universities… The list goes on!

2. The 1 trillion should be financed with Eurozone bonds and the ECB should buy up the entire amount and keep it on their balance sheet.

3. In order to maintain adequate nominal demand, the ECB desperately needs to switch to a nominal GDP level target (Beckworth, 2019).

Is there any hope for any of these policies to be implemented? Maybe not. However, policy makers in Europe and the ECB in particular seem to have understood that this is a break or make moment for Europe and that we need a whatever-it-takes policy. The current responses are helpful but still inadequate in my opinion. So hopefully more to come. 

Disclaimer: We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of the author. While we think our writers are very smart, Macrobond Financial does not expressly endorse the views presented here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have Macrobond, you can easily check everything that’s mentioned here, and decide for yourself. If you don’t Macrobond, now you have a great reason to get it.

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