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Brace for Impact: Europe’s Upcoming Recession

By Sashank Rajaram

Abstract 

Europe is heading for a recession. With sky-high energy prices, a surging dollar, and China’s slowdown, most economists have now begun to discuss the severity of the recession and what it would entail. On that front, this article takes a hypothetical trajectory and predicts three possible scenarios that might pan out for Europe in the coming years: a) a severe recession, b) a cataclysmic recession and lastly, c) a relatively mild recession. It further takes a hypothetical path and explores how each of these scenarios will unfold and the likelihood of them occurring.

Introduction

As the world sought to rebound from the devastating impacts of the pandemic, this year has brought yet another challenge for the global economy. The Ukrainian war has caused a massive food and energy crisis and even prompted questions about a nuclear threat that has kept the world on edge since it began in February. Moreover, with inflation at all-time highs due to expansionary fiscal policies, most western economies, particularly Europe, are now predicted to head for a prolonged recession. Taking the crisis as an opportunity, this article looks to predict three possible scenarios for Europe in the coming years: a) a severe recession, b) a cataclysmic recession and lastly, c) a relatively mild recession. It further proceeds on a hypothetical path and explores how each of these scenarios will unfold and the likelihood of them occurring. 

Act 1: Severe Recession

Assuming a severe recession is around the corner, Europe’s GDP will soon start contracting sharply and as per predictions from Deutsche Bank, it would plummet by -1.5% to -3%. Such a large-scale contraction, however, would be determined by the following four factors: energy prices, the strength of the USD, an ailing export sector, and China’s slowdown. 

Ever since the outbreak of the Russian-Ukraine conflict, energy prices have skyrocketed like never before. For example, the price of gas used by most Europeans for heating purposes rose from 15 MWh to 343/MWh over the summer. Though these prices have now cooled down to around 200/MWh, it is still more than ten times the increase compared to last year. Moreover, electricity prices have climbed by up to 600% and consequently, poorer households in the Netherlands, UK and Estonia have already experienced a sharp rise in their cost-of-living increase by 10% to 25%.

To counter the immediate shock, many households compensated by drawing down on their limited savings, but as winter approaches, that does not seem plausible anymore on a long-term basis. Even if prices stabilise over a period, these households would be coerced to rein in their consumption expenditure, thereby affecting the economy. Similarly, as energy costs remain exorbitant, businesses and firms will have to limit their investment spending. In the aftermath of COVID-19, reduced consumer spending and investment would be a double whammy for European economies. Though governments have tried to combat rising prices by imposing price caps, such measures can only provide temporary relief. Sooner or later, the price caps will have to be lifted due to the fear of increasing government debt and current account deficit plaguing the economy. 

Besides rising energy prices, the recession could also be exacerbated by the strengthening of the US dollar and rising interest rates. Though the two events – the US increasing its interest rate and Europe heading for a recession – seem independent, a deeper analysis would reveal otherwise. This is because, if the US raises interest rates faster than Europe, then investors would find it attractive to sell their low-interest rate-yielding Euros (Pounds) and buy higher interest rate-yielding US dollars. This capital flight would increase the supply of the Euro and cause it to depreciate even more increasing import costs. It would in turn drive energy prices higher. To counter the strengthening of the USD, the Bank of England would have to follow suit in increasing interest rates. Again, though it could help to fight inflation, it could reduce investment and affect real income even more. Moreover, given that household debt in Europe has been on the rise, increasing interest rates might affect the housing sector and aggravate the crisis further.

Apart from affecting the household and private sectors, the recession could also pose a risk to Europe’s export sector as the global economy slows down considerably due to rising interest rates and high energy prices. A dampened export market would translate into higher imports and hence an outflow of essential foreign exchange reserves. To add to the misery, China – Europe’s second biggest export market – is navigating an economic slowdown due to a variety of structural reasons such as collapsing real estate, zero COVID policy, and a crackdown on tech companies. As the recession worsens, southern European countries that have historically been poor in their management of deficits could again face a near collapse and trigger another Eurozone crisis. Though one could expect the European Central Bank (ECB) to bail out the countries in such circumstances, the recession could get cataclysmic if that does not occur.

Act 2: Cataclysmic Recession

The Eurozone accounts for most of Europe’s economic activity and due to the presence of a common currency – the Euro – no individual central bank has monetary authority over it. This lack of monetary independence has the potential to push Europe into a cataclysmic recession. For example, European countries such as Italy and Greece could face an extreme level of debt due to the expansionary fiscal policy that was pursued to sustain the economy during the peak of the pandemic. And since these countries do not have monetary autonomy on the Euro, they cannot print more currency to wade through the crisis. Subsequently, they would be forced to approach the ECB to buy their debt. However, in case the ECB declines to bail out such countries, they could default on their debt causing an economic collapse. The dynamic could soon spread to similar high-debt countries like Greece, thereby spiralling into another Eurozone crisis. In short, this scenario begins very similarly to the severe recessionary model; however, it extends for a longer period and spills over into a second Eurozone crisis.

Act 3: Mild Recession

The least dreadful scenario is that Europe faces a mild recession. As per economists at the IMF, Europe’s economy is predicted to shrink by 2% to 3% in 2022 but recover slightly and fall by -1% next year. This optimism (better than a severe or cataclysmic recession) comes from two main reasons. At the beginning of the conflict in Ukraine, Europe had no alternatives to Russian gas imports. However, since then, Europe has already been able to roughly double its liquefied natural gas imports due to an increase in the usage of floating terminals that are newly constructed. This has been one of the reasons for the decline in gas prices from their peak during July. Moreover, the conflict has pushed Europeans to become more mindful of their electricity consumption. According to Pierre Andurand, Europeans can make behavioural changes such as reducing average indoor temperatures from 22 degrees Celsius to 19 degrees Celsius to eliminate their dependence on Russian gas. They could also reduce the overall energy cost, which could reduce interest rates.

For example, if energy costs declined, taming inflation would become easier which in turn, enables policymakers to slow down on interest rate hikes. At the same time, if interest rates continue to remain high, then the slowdown in the economy would translate into lower demand for energy. In the end, prices will inevitably cool down. In consequence, several indicators suggest that industrial production is declining rapidly in Europe, creating some optimism about central banks easing their inflationary stance.

Looming Uncertainty

The world economy has been hampered by several challenges and the Western world seems to be facing the brunt of them. With global inflation skyrocketing, central banks have been trying their utmost to control it by hiking interest rates to an all-time high. While such a measure would surely induce a recession in Europe, the region must brace itself for some tough times. Assuming that the cataclysmic recession is the most unlikely as it is in nobody’s interest, the region hangs in the balance between a severe recession and a mild one that lasts for about two years. With such unpredictability, only time can tell.

Image Source: https://www.bloomberg.com/news/newsletters/2022-09-28/europe-s-recession-may-mirror-financial-crisis

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