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What is the state of the EU economy? The latest growth data led some to breathe a sigh of relief. Overall, the eurozone stabilised at 0.2 per cent gross domestic product growth in the third quarter — not very satisfying, but stable from the previous quarter when there were risks things could worsen. Most importantly, the pace of growth in Germany, the centre of the current slowdown, picked up to 0.1 per cent growth from a contraction in the spring quarter. (The UK, too, went from contraction to a modest expansion. But continuing Brexit uncertainty makes it hard to read much into this for the future.)

The slowdown has been caused by an industrial recession. The volume of industrial production in the eurozone is about 4 per cent lower than two years ago. The stability of output growth in the third quarter reflects that industry has stopped its slide and remained roughly constant since the early summer. Policymakers may hope that things will turn more positive, which may remove the need for continued difficult discussions about how to stimulate the economy through monetary or fiscal policy.

That hope would be premature for two reasons that are acknowledged in the European Commission’s latest economic forecasts. First, industry itself remains very vulnerable. Many of the possible shocks to European manufacturing — such as a hard Brexit or a US tariff war against EU producers — could still happen. Second, the big question has long been whether industrial weakness would spill over into the much bigger services sector. So far, that has not happened, as the commission’s chart (below) shows.

But this could be changing. In the past few months, the purchasing managers’ index for services has dropped significantly even if it still indicates modest growth. But Capital Economics highlights that the future activity component of the index is “close to a five-year low. On past form, it points to eurozone private services output growth slowing sharply in the coming months.” All this justifies the weak growth forecast by the commission, as well as its warnings that the risks are to the downside.

That raises the other big question. Does this weakness hit the eurozone more or less at full capacity — in which case it may be more manageable — or is it hampering a recovery that is still far from complete?

Robin Brooks, of the Institute of International Finance, recently launched a “campaign against nonsense output gaps” (covered in an earlier Free Lunch) in which he argued that Europe’s economic policy institutions were underestimating how far the eurozone economy was from full employment, or the “output gap”. Now he and his colleagues have published details on their own preferred measure of the “unemployment gap” — how far the economy is from a level of unemployment at which inflation is stable.

The IIF calculations had already estimated an output gap for crisis-hit eurozone economies much larger than the official estimates (see chart below). The unemployment calculations naturally show the same patterns and are worth restating. Brooks and his colleagues say that on standard estimates, current eurozone unemployment at 7.5 per cent is a bit lower than what the bloc can sustain over time without inflation risk (7.9 per cent), but on their estimates there are another 2 percentage points of unemployment that could safely be eliminated because the eurozone’s real non-inflationary unemployment rate is 5.5 per cent.

There can be many quibbles with the IIF’s methodology. (One of the most thoughtful comes from former eurozone central banker Vitor Constâncio.) But to any close observer of the European economy, the detailed estimates of where each country finds itself feel right. On the IIF’s calculations, Germany and the US are running their economies slightly above normal capacity at the moment, but France has a bit of slack remaining, Italy much more, and Portugal, Spain and Greece a lot.

It could be that weak inflation and growth, rather than indicating slack as the IIF would have it, reflects a decline in the expected trend of inflation and permanently damaged production capacity after the last crisis. This argument has recently been made by Thomas Hasenzagl, Filippo Pellegrino, Lucrezia Reichlin and Giovanni Ricco. But, even if so, the implication is that macroeconomic stimulus can be more aggressive without much risk to inflation picking up. As I have argued before, however we interpret the macroeconomic data — whether the Phillips curve relationship (between unemployment and inflation) is dead or alive — it is hard to deny a case for a strong demand boost. If that does not come from the fiscal side, a central bank legally mandated to keep inflation stable is legally obliged to provide it.

Launching our 2019 Seasonal Appeal

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Other readables

  • The best path towards an EU banking union could be to offer banks a too-good-to-turn-down opportunity to submit themselves to a pan-EU insolvency regime — that is the idea suggested by the experts I interviewed for an FT analysis piece.
  • GiveDirectly, an organisation that provides cash grants to poor communities and uses state-of-the-art economic methodologies to assess the consequences, has just released its findings from a big experiment in Kenya. Large cash grants turn out to provide a significant boost to local economic activity, increasing demand and output, also from businesses belonging to non-recipients, and without people working less as is sometimes feared.

Numbers news

  • Our societies are ageing — or are they? The UK’s Office for National Statistics finds that while the number of over 65-year-olds in Britain has been rising, the number of people with a remaining life expectancy of 15 years or less has been falling (hat tip: Daniel Tomlinson).
  • Also from the IIF: Global debt has hit a new record of more than $250tn.
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