Stagnation Risk

• Author: Huidan Lin

Stagnation Risk Finance & Development, June 2016, Vol. 53, No. 2

Huidan Lin

Ongoing economic problems make the euro area vulnerable to prolonged slow growth

Since the onset of the global financial crisis, real output in the euro area has failed to keep up with the population. As a result, output per person has stalled, and euro area output is now only $40,000 a person, about $16,000 below the U.S. level, after adjustment for price differences. This is the largest gap since 1991, when the Economic and Monetary Union began (see Chart 1).

The euro area is not the only place the crisis has left scars. In advanced economies in general, the growth rate of potential output—the maximum amount of goods and services an economy can turn out at full capacity—is expected to increase only slightly and remain below the precrisis level over the next five years (IMF, 2015).

These subdued medium-term prospects are particularly worrisome for the euro area, given the high level of unemployment and public and private debt in some member countries. Moreover, after several years of anemic growth, there is limited room for policy maneuvering. High unemployment and debt and constrained policymaking leave the euro area vulnerable to shocks that could lead to a prolonged period of low economic growth—often dubbed “stagnation.”

Lower growth for longerAlthough potential output cannot be observed, it can be estimated using a production function—an economic model that calculates an economy’s output based on key inputs (labor and capital) and how efficiently they are used. When applied to the euro area, the results suggest that the prospects for larger labor and capital inputs, as well as their more efficient use, remain weak. As a result, the euro area’s growth rate at its full capacity is expected to rise only modestly from 0.7 percent during 2008–14 to about 1.1 percent during 2015–20, which is significantly lower than the 1999–2007 average of 1.9 percent.

Moreover, the share of older people in the population is growing, while the share of working-age (15–64) people is shrinking. Because the propensity to join the workforce typically begins to erode after age 50, the average labor force participation rate is declining. At the same time, the capital stock is expected to grow slowly. The capital stock expands when new investment outpaces the rate at which that stock wears out (depreciation). This hasn’t been the case in the euro area, where business investment has expanded moderately...