Why the View of Europe’s Prospects May Be Too Pessimistic

Citi’s European economists recently explored the euro area’s prospects and how they compare with those of the U.S. Their conclusion: Despite pessimism about the “old continent,” the gap between the European and U.S. recoveries is much smaller than Citi had expected at the beginning of 2022, and by several measures the euro area’s economy looks less unbalanced than that of the U.S. While that doesn’t change a challenging outlook, it suggests Europe’s underlying economy needs neither aggressive support to return to pre-pandemic growth trends nor aggressive tightening to bring endogenously generated inflation under control. 

In the Citi Research report, the authors go back to the beginning of the year, when GDP readings show the euro area had fallen far off the pace set by the U.S. But Europe’s first and second quarters featured strong growth while activity was receding in the U.S. The gap between today and pre-pandemic growth has shrunk from 4% to 3%, while the gap with the U.S. has shrunk from 3% to 1%. What was seen as U.S. exceptionalism, the authors note, now looks more like a head start on normalization. 

Despite this head start for the U.S., the pandemic’s influence on Europe appears to have ebbed more comprehensively, as shown by Oxford University’s Stringency index of health restrictions, the incidence of severe COVID cases, mobility data from Android phones, and measures of workplace presence. 

Strength, or froth? 

US -- Private Consumption (Q4 2019 = 100)	Euro Area -- Private Consumption (Q4 2019 = 100)
© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.   Source: Citi Research, Bureau of Economic Analysis	© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.   Source: Citi Research, Eurostat

Europe’s recovery does look weaker than that of the U.S. when measuring private consumption—in the second quarter, U.S. private consumption was 5% above pre-pandemic levels, while in Europe it was still 2% below those marks. This relative weakness remains concentrated in goods consumption, which the authors see as a reflection of the effectiveness of the U.S.’s fiscal stimulus —though they note that U.S. demand wound up supporting goods because opportunities to spend on services were lacking. 

The two regions’ different approaches—consumer-focused support in the U.S., business-oriented support in the euro area—have also impacted the labor market. In the U.S., the labor force remains smaller than it was pre-pandemic while in the euro area it’s now larger, though still below pre-pandemic trends. Furlough programs in Europe kept workers attached to the workforce, the authors note, while workers dropped out in the U.S. That suggests restoring worker productivity may prove easier in Europe. 

Fiscally generous vs. frugal 

The flip side of fiscal support, the Citi Research economists note, is visible in public and private finances. Both the U.S. and the EU saw only a moderate rise in private debt during the pandemic, although the rise was smaller in the U.S. But public debt rose dramatically: The U.S. general government deficit was 14.5% of GDP in 2020 and 10.7% of GDP in 2021, with the euro area’s percentages coming in at 7.2% and 5.5%. Europe’s frugality could be one of the reasons growth has underperformed. 

Central banks played their role, delivering price stability in an acknowledgment of the interdependence of monetary and fiscal policy. The money supply rose more than 42% in the U.S. between the fourth quarter of 2019 and the second quarter of 2022, and by just over 20% in the euro area and the U.K. That monetary-fiscal expansion, combined with supply shortages, drove up prices. The authors note that core prices rose on an annualized basis during the above period by 4% in the U.S., 3% in the U.K. and 2% in the euro area, mirroring the fiscal and monetary expansions. 

The authors’ conclusion is that the euro area is emerging from the pandemic crisis with fewer imbalances than in the U.S.: demand is less hot and supply is lagging to a lesser extent. That supports the narrative that inflation is far more exogenous in Europe than in the U.S., with less need for monetary and fiscal policy to slow its rise. 

The authors expect the euro area to fall into “a significant recession” over the coming quarters, widening the gap with the U.S. once again, and add that Europe’s energy challenges are likely to linger. But Europe will face those challenges from a more solid basis than looked likely at the beginning of 2022. And that suggests its economy should be better able to adjust to what lies ahead. 

For more in depth analysis, please see https://www.citivelocity.com/t/r/eppublic/2TBYZ 

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