Recession in EMU: Not if, but how long is the question

This week, there were a number of new indicators that the euro area actually might already be in recession: For July, Eurostat reported another drop in industrial production and revised prior months’ data downwards, leaving the July figure now 1.1 percent below the figure for Q2. Moreover, the unemployment rate has already increased by 0.2 percent in the second quarter and surveys point to increasing plans by the private sector to shed jobs over the coming months.

This clearly does not bode well for GDP data for the third quarter. In fact, increasingly, the main question is not whether the Euro-area will experience its first recession since the introduction of the euro in 1999, but rather how long and how deep the recession will be. For the first time in about 15 years, all large countries of the euro-area would be experiencing simultaneous economic contractions. This is especially scary as trade and financial links have clearly grown closer over the past decade, making negative self-amplifying effects possible and thus bringing new downside risks into the picture.

“Europe in recession” was also the message of this week’s forecast published by the German Institute für Weltwirtschaft (IfW), one of the leading economic think tanks. For Germany, it now predicts three more quarters of quasi stagnation with growth around 0 percent. Only for spring 2009, the economists see a recovery. Resulting from this negative statistical base effects, the overall GDP forecast for next year becomes quite gloomy: The economists now only see a 0.2 increase in German GDP for 2009, even less than I had roughly calculated in a previous post.

That being said, another interesting development might get lost underneath the recession story: After a short narrowing of GDP growth rates in the second quarter when Germany’s economy slowed down sharply and bringing it closer to the laggards such as Italy and Spain, divergences are now set to increase again. While for 2009, the Eurozone as a whole is forecast by the IfW to stagnate roughly in line with the German economy (0.0 percent vs. 0.2 percent), Spain is set to experience a hard landing with a whopping contraction of GDP of 1.2 percent – something we have forecast at Eurozone Watch for quite a while (see here or here).

Gilles Moec from the bank of America also sees increasing risks for Spain. He writes in a commentary from today:

“Spain is clearly at risk of a prolonged recession. The recovery in France and Italy will probably be very subdued. Conversely, Germany, free from any domestic imbalance and at liberty to make a full use of the fiscal automatic stabilizers, could draw on the remarkable resilience of its labour market to lead the European recovery.”

Well, while I would share the assessment that Germany has ample room to use fiscal policy to prevent a full-blown recession, I am much more sceptical whether politicians will actually go for it. Fiscal stimulus was never very popular among the German elite (and has been harshly criticised in the IfW’s forecast again). Given the experience of the past decade, I would be not surprised if the government in contrast shifts again to a pro-cyclical tightening of fiscal policy once they find out that the recession will make their target of having a balanced federal budget by 2012 is in conflict with doing the economically right thing of cushioning the recession.

This post has been co-posted at Eurozone Watch.