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08 Dec. 2014 | Comments (0)

Despite widespread skepticism toward European Commission president Jean-Claude Juncker’s proposal for an investment fund, it is clear that his timing is excellent. Investment in the Euro Area declined for a second quarter in a row in Q3, making investment now 1.3 percent lower than a year before. Boosting investment in Europe is essential now for two reasons: to mitigate the disappointingly slow growth we project for 2015 in our Global Economic Outlook, and to fight the erosion of potential output. The Euro Area has started to recover from the twin crises of the past six years, but investment has barely improved from its lowest point since the crisis, and is currently 17 percent lower than in the first quarter of 2008, before the world financial crisis hit. Investment is heavily influenced by credit availability and confidence in the economy, and both have been severely lacking in the aftermath of the European sovereign debt crisis. The fact that the investment recovery has barely started is troubling, and not only from the perspective of immediate recovery of economic output. The lack of investment also has the effect of eroding potential economic output. Charts: industrial production and capacity utilization in Euro Area, Italy and SpainWhen investment in fixed assets does not match depreciation of capital, capital stock starts to decline, which affects total potential output in the economy. With investment 17 percent lower than it was in 2008, it’s no surprise that some capital stock in Europe has been falling. This shows from the fact that  capacity utilization (the relation between actual and potential output) has increased from 77.2 to 80 percent between the fourth quarter of 2012 and the fourth quarter of 2014, but industrial production only grew by 1.7 percent between the fourth quarter of 2012 and September 2014 (the latest data available). The effects of eroding capacity are much more pronounced in the larger troubled industrial countries. Italy saw its industrial output decline since 2012, but capacity utilization increased by about 4 percent in the same period. This means that it now takes 4 percent more of total capacity to produce 1.2 percent less output. We see the same in in Spain and Greece especially, but even in France. This brings European industry closer to utilization levels that we saw in years of overheating (high levels of consumer demand leading to production capacity shortage and inflation)—as in 2007. When capacity limits are reached, it becomes difficult to increase output, which leads to price increases. If the Euro Area gets into a situation where the economy overheats without having closed its pre-2008 potential output gap, then potential output will be lost, and Europe will have to live with lower levels of wealth. Now that credit standards are starting to ease again and demand for credit is picking up, one hopes that investment in European industry will increase (more on that here). The European investment fund proposal could help to bring this about: overheating would be avoided, and European’s economic potential would increase. If not, Europe will likely reach its speed limit earlier than expected and slow growth will become the new normal. It is therefore 5 to 12 for Europe, because if we want to see faster growth return, a return of investment should come sooner rather than later.
  • About the Author:Bert Colijn

    Bert  Colijn

    Bert Colijn is a senior economist that focuses on the European market. He works on the European Commission FP7 project NEUJOBS, focusing on productivity and economic growth in Europe in 2025. Besides …

    Full Bio | More from Bert Colijn

     

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