The Euro Area has a growth problem

January 10, 2025

The Euro Area has a growth problem¹

Matteo Barigozzi, Claudio Lissona, and Matteo Luciani

The decomposition of GDP into potential output-the level of output consistent with current technologies and "normal" use of capital and labor-and the output gap-the percentage deviation of GDP from its potential-is a fundamental task for policymakers. Potential output tells us how fast an economy can grow in the long run; the output gap helps assess the cyclical position of the economy and, thus, potential inflationary pressures (Jarociński and Lenza, 2018).

Potential output and the output gap are essential for the common Euro Area (EA) monetary policy and the fiscal policy of individual countries-they are among the main pillars of the EA fiscal surveillance framework, ultimately affecting the fiscal capacity of each member country (European Commission, 2018). However, since both quantities are unobserved, policymakers need a model that can extract them from the data.

This note presents a new measure of potential output and the output gap for the EA based on a non-stationary dynamic factor model estimated on a large dataset of EA macroeconomic and financial variables. Compared to the prevailing literature, which focuses on theoretical structural models with few variables of interest, we adopt a distinct approach because we let the data speak by pooling information from many indicators of EA economic activity. Using a rich information set is essential when estimating potential output and the output gap because many economic factors can influence them. To our knowledge, there have been no previous estimates of the EA output gap based on a comparably rich information set.

Our analysis shows that the EA has a potential output issue, not a business cycle issue. Hence, EA member countries should implement supply-side structural reforms that have long-run effects.

Methodology

To measure potential output and the output gap, we first disentangle the co-movements across series from idiosyncratic dynamics-that is, local dynamics or measurement errors-by estimating a non-stationary dynamic factor model (Barigozzi and Luciani, 2023, 2024). Then, we extract a common trend from the estimated co-movements and compute the cyclical component by subtracting the common trend. To account for the Covid shock, we run this procedure twice: we first estimate the model using only pre-Covid data; then, we estimate the effects induced by the Covid shock (level-shift and increased volatility). Lastly, we re-estimate the model on the full dataset, after purging the data from Covid-induced dynamics. Having estimated the common trend and the common cyclical component, we measure potential output as the part of GDP explained by the common trends, and the outaput gap as the part of GDP explained by the common cyclical component.

Empirical analysis

We conduct our analysis on a new large-dimensional dataset comprising 119 EA economic indicators from 2001:Q1-2023:Q4. The dataset contains a wide range of publicly available macroeconomic indicators-national account statistics, industrial production and turnover indicators, labor market and compensation indicators, price indexes, oil prices, natural gas prices, house prices, and confidence indexes-as well as relevant financial variables-exchange rates, interest rates, a stock market index, monetary aggregates, and household liabilities-which have proven to be informative of business cycle dynamics (Borio et al., 2017).

The left chart in Figure 1 presents our year-on-year (YoY) potential output growth estimate, together with those from the European Commission (EC) and the International Monetary Fund (IMF). Three main results emerge. First, potential output growth decelerated after the 2008-2009 Global Financial Crisis (GFC), and the 2011-2012 Sovereign Debt Recession (SDR) further compounded this deceleration. Second, while the EC and IMF also estimate a slowdown in potential growth after the GFC, they do not estimate any effects of the SDR on potential growth. Third, in contrast with the GFC, the Covid recession had only a transitory effect on potential output growth.

The right chart in Figure 1 presents our output gap estimate together with those from the EC and the IMF. Our output gap estimate is similar to the EC's and IMF's in that the dates of the turning points perfectly coincide. The three estimates closely align until the SDR, as they all suggest a substantial overheating of the economy in the pre-GFC period, followed by a persistently negative output gap during the two recessions. However, our measure increased after the SDR, hovering at about 2% from 2017 to the Covid pandemic, thus signaling a much tighter economy than the EC or the IMF.

In summary, we estimate that as of the end of 2023, potential output growth has yet to return to the pre-GFC pace, and the output gap is 3 percentage points above potential. These results indicate that the EA has a potential output issue, not a business cycle issue. Hence, if the goal is to achieve better economic conditions in the EA, European countries should implement supply-side structural reforms that have long-run effects, while policies aiming at stimulating aggregate demand will have only short-term effects at best.

Why our output gap estimate differs from those of the IMF and EC?

Our estimate of the output gap has a different meaning than those of the EC and IMF. In the models used by these institutions, the output and unemployment gaps are linked through the Okun's law-the unemployment gap decreases whenever the output gap increases, and vice-versa. Likewise, in these models, the output gap is linked to inflation through the Phillips curve-higher inflation means a lower output gap. Instead, in our model, there is no Okun's law or Phillips curve, just the data. The output gap is the part of GDP driven by the common cyclical component, and as such, it is about whether or not the recent GDP growth pace is sustainable in the long run. So, what is driving our results? The answer is: the labor market, price inflation, and financial indicators.

In our model, the unemployment rate gap-the part of the unemployment rate driven by the common cyclical component-decreases on average 0.6 percentage points for every percentage point increase in the output gap. Moreover, the core inflation rate gap-i.e., the cyclical common component of core inflation- increases on average 4 basis points for every percentage point increase in the output gap. In other words, on average, in our model, the Okun's law relationship and the Phillips curve are satisfied, even though we do not impose either of them.

Finally, we find that credit indicators (mainly household liabilities) are crucial for pinning down the cyclical position of the economy (Figure 2). Indeed, when we exclude household liabilities from our dataset (red-dashed line in Figure 2) we estimate a lower output gap in periods of debt build-up (e.g., before the GFC) and a higher gap in periods of deleveraging (e.g., from 2013 to 2016).

Figure 3 shows the impact of a scenario in which household liabilities increase faster than in the baseline for about 3-1/2 years and then return to baseline after about 8 years. This exercise clarifies why credit variables matters for estimating the output gap.² As shown in the left chart, in response to the increase in household debt, GDP increases for a little over three years, reaching a peak at 3 percentage points above the baseline. Then it declines and after six years turns negative. The response of the output gap (right chart) mimics that of GDP, but it is a little faster. Potential output slowly increases for the first five years and then returns to the baseline. These results show that growth financed through household debt is not sustainable in the long run.

Conclusions

In this note, we presented a new measure of potential output and the output gap for the EA, based on letting a large number of macroeconomic and financial indicators speak. Our output gap estimate is in line with those published by the EC and the IMF for most of the sample. However, our estimate diverges significantly after the 2011-2012 Sovereign Debt Recession, when our measure of the output gap suggests that the EA economy was tighter than estimated by either the EC or the IMF. Moreover, we find that growth financed through household debt is not sustainable in the long run.

Our results suggests that the EA has a potential output issue, not a business cycle issue, a conclusion in line with that reached by the CEPR business cycle committee, which has been denouncing declines in labor productivity since November 2023 (EABCDC, 2023, 2024), and the European Central Bank (ECB, 2024). Hence, if the goal is to achieve better economic conditions in the EA, its member countries should implement supply-side structural reforms that have long-run effects, while policies aiming at stimulating aggregate demand will have only short-term effects at best.

References

Barigozzi, M. and M. Luciani (2023). Measuring the Output Gap using Large Datasets. The Review of Economics and Statistics 105, 1500-1514.

Barigozzi, M. and M. Luciani (2024). Quasi maximum likelihood estimation and inference of large approximate dynamic factor models via the EM algorithm. Finance and Economics Discussion Series 2024-086, Board of Governors of the Federal Reserve System.

Borio, C., P. Disyatat, and M. Juselius (2017). Rethinking potential output: embedding information about the financial cycle. Oxford Economic Papers 69, 655-677.

EABCDC (2023). The latest findings of the CEPR-EABCN Euro Area Business Cycle Dating Committee, November 2023.

EABCDC (2024). The latest findings of the CEPR-EABCN Euro Area Business Cycle Dating Committee, March 2024.

ECB (2004). Financial Stability Review, November 2024.

European Commission (2018). Staff working document on the review of the flexibility under the Stability and Growth Pact. COM(2018) 335.

Jarociński, M. and M. Lenza (2018). An inflation-predicting measure of the output gap in the euro area. Journal of Money, Credit and Banking 50, 1189-1224.

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