Post recession Euro Area: what are the challenges? Lucrezia Reichlin London Business School and Now-casting economics Vienna 26 November 2013

The euro area entered a second recession in the third quarter of 2011 Observations: 1.Only the euro area got the double dip 2.Explained by the periphery – a first in historical perspective 3.Associated with a sovereign crisis coupled with the balkanization of the financial sector which had started in 2008 and a home bias in the government bonds market 4.If compared with the dynamics of the real economy, loans were weaker than in the 2008 global recession

The Euro Area had a second crisis – not the US

The euro area entered a second recession in the third quarter of 2011 Observations: 1.Only the euro area got the double dip 2.Explained by the periphery – a first in historical perspective 3.Associated with a sovereign crisis coupled with the balkanization of the financial sector which had started in 2008 and a home bias in the government bonds market 4.If compared with the dynamics of the real economy, loans were weaker than in the 2008 global recession

This time is different! The 2011 recession in historical perspectives

The euro area entered a second recession in the third quarter of 2011 Observations: 1.Only the euro area got the double dip 2.Explained by the periphery – a first in historical perspective 3.The second dip was associated with a sovereign crisis 4.Distinctive characteristics: (i) balkanization of the financial sector (started in 2008) (ii) home bias in the government bonds market (iii) compared with the dynamics of the real economy, loans have been were weaker than in the 2008 global recession

Banks’ balance sheets: how unusual since 2008? Liabilities: funding stress is from non-residents

Banks’ balance sheets: how unusual since 2008? Assets: shift from loans to government bonds

Weak loans: a puzzle given aggressive ECB action?

Did we see it coming?

Professor Lucrezia Reichlin London Business School London, 22 nd November, 2013 The IMF excessively optimistic – then became progressively more pessimistic

But real time data flow was signaling slowdown at east since May 2011 Now-casting economics got it earlier! And the market caught up

NOW-CASTING ECONOMICS: SIGNS OF A NEW SLOWDOWN FROM SPRING 2011 DECOUPLING WITH RESPECT TO THE US

Why was the IMF so late? Did not understand the effect of austerity (new IMF view) Did not anticipate credit crunch due to the combined effects of banks’ change in asset composition and no adjustment of leverage ratios

Source: World Bank BANKS’ SOLVENCY PROBLEMS NOT FIXED AT THE EARLY STAGE F THE RECESSION

BANKS, GOVERNMENT AND EURO-SYSTEM LIABILITIES: very little adjustment of size in total

Where are we now?

Professor Lucrezia Reichlin London Business School London, 22 nd November, 2013 The IMF view – around 1% steady state?

Recent data: Now-casting Recovery since Spring …. But recent softening ….

Signs of recovery in the Euro Area since the end of May EURO AREA NOW-CAST: TRAILING QUARTER % quarter-on-quarter GDP growth, 90 day moving average Source: Now-Casting Economics Ltd

Although the most recent data suggest some weakening, particularly for Germany NOW-CAST OF Q AND Q % quarter-on-quarter GDP growth Source: Now-Casting Economics Ltd Euro AreaGermany Q Q1 2014

Last week’s PMIs were interpreted by the model as a negative signal for Germany, though in fact the bad news was concentrated in France IMPACT OF PMIs ON Q4 GDP NOW-CAST FOR GERMANY Source: Now-Casting Economics Ltd

The adjustment Why is the recovery so slow?

Characteristics of the macroeconomics adjustment Current account surplus – most countries Build up of domestic excess savings in the private sector Large sovereign debt in most countries Weak nominal GDP Stable bond market Japanese scenario? Euro area countries have built capacity to absorb their debt Financial repression generates weak growth at best

Loans – retail (% banks’ assets) GermanySpainFranceItaly Jul Gov. Bonds – domestic (% banks’ assets) GermanySpainFranceItaly Jul THE GOVERNMENT BOND STORY STILL FORCEFULL

Asset compositions Jacques Cailloux, Nomura

Sectoral Flows: corporate sector is key

Spain and Japan Jacques Cailloux, Nomura

Italy and Japan Jacques Cailloux, Nomura

The recent story Adjustment via excess saving and financial repression points to weak nominal demand rather than credit crunch Inflation reading very weak – the ECB has acted but with a delay

EURO AREA INFLATION AND THE ECB’S POLICY RATE Sources: Eurostat, ECB HICP inflation, y-o-y % ECB marginal lending rate %

ECB EVOLVING FORECAST FOR HICP INFLATION Something is missing in their model! % year-on-year ECB forecast Eurostat flash (October) Sources: ECB, Eurostat

And inflation is weak everywhere in the euro area …..

Conclusions The EA area may have ceased to be a risk for the world economy But the adjustment points to financial repression and weak growth in the future Risks?  Banks (watch the AQR – many regulatory uncertainty and no agreement on the backstop)  Political risks