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Recovery at last?

Economic Report

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To the Outlook 2017 overview page

  • Dutch GDP has returned to above the crisis level, but growth is lagging the pre-crisis trend
  • The output gap  shows that there is still significant underspending in the economy 
  • The illiquid assets of Dutch households and lagging incomes are putting a brake on spending
  • Whether we are entering a lengthy period of underspending depends mainly on how further debt reduction will develop and how relatively high unemployment and low investment will affect the economy in the long term
  • All in all, it is quite likely that actual economic growth will be lower than potential growth in the coming years.

There has undeniably been a recovery in the Dutch economy in recent years. With a growth rate of around two per cent, the worst of the crisis is over. But the gap in GDP created by the Great Recession has not been closed. The output gap is also still negative. This article asks whether we are now in a situation of long term stagnation, with extremely low inflation due to chronic underspending and structural damage due to hysteresis. What are the determining factors of a demand-driven recovery, or the absence thereof? 

Steady recovery

Recent figures show that the Dutch economy is in good shape. The economy has now posted growth for ten consecutive quarters and the annual growth rate is above two per cent. Whereas the economic recovery was previously driven by exports, consumer spending is now contributing to growth. The housing market is recovering steadily and employment has returned to positive growth since the second quarter of 2014, reducing unemployment to below 6%.

However, eight years after the beginning of the crisis, GDP is still well below its pre-crisis trend. The gap created in comparison to the pre-crisis trend is approximately 15 per cent (Groenewegen, 2016). GDP per capita is thus still not at its pre-2008 level. It is mainly domestic demand that has declined in recent years. Private consumption has still not returned to its pre-crisis level, and has only picked up strongly more recently, partly due to the recovery in the housing market.

Figure 1 GDP now above crisis level, but below trend
Figure 1 GDP now above crisis level, but below trendSource: CBS
Figure 2 Economic recovery mostly export driven
Figure 2 Economic recovery mostly export drivenSource: CBS

Output gap indicates lack of spending

The output gap confirms that there is still a situation of underspending in the Dutch economy. The output gap measures the difference between actual GDP volume and potential GDP volume. The potential GDP is the production level of goods and services in an economy at a constant inflation rate, given the structure of an economy. The output gap is also an indicator of the amount of unused potential and the cyclical phase of the economy. A positive output gap means that production is above potential and therefore that there is inflationary pressure. A negative output gap indicates that demand is lower than what the economy can produce. The output gap, estimated by various institutions, shows that there is still significant underspending in the economy (see figure 3).

Figure 3 Output gap is still negative
Figure 3 Output gap is still negativeSource: Macrobond

However, the estimates of the output gap also show immediately that part of the growth expected before 2008 will no longer be realised. The CPB, the Netherlands Bureau for Economic Policy Analysis (2016) estimates that this underspending will continue until 2021. It should be noted that while the output gap is a useful instrument from a conceptual point of view, it is difficult to measure in practice. Just before the crisis, in 2008 many institutions estimated that the output gap was still negative, while now the estimate is that there is a positive output gap of four per cent. The major policy institutions also seriously miscalculated this during the most recent crisis. There has thus been much discussion of alternative methods of estimating the output gap (Weernink, 2014).

Illiquid capital is the problem

The fact that consumption has not recovered sufficiently in recent years is largely due to the illiquid nature of the assets of Dutch households. Partly due to tax incentives such as the allowances for pensions and owner-occupied homes, Dutch households have on average accumulated sizeable net assets. These assets are mostly locked up in property and pension funds. There are however large obligations against these assets, mainly in the form of high mortgage debt (DNB, 2015). Workers in employment are obliged to save for a pension. Since 2013, new homeowners and second-time buyers have been obliged to pay down their mortgages to qualify for deduction of mortgage interest from income tax. Moreover, the costs of health care are mainly funded collectively. All this limits individual freedom of choice and pressures freely disposable income (Badir et al., 2016). As a result of this limited liquidity, households tend to spend less when asset shocks occur: they need to repair their balance sheets. This is exactly what happened during the crisis (CPB, 2013). Workers’ pay has also on average lagged behind labour productivity since 2000 (Badir et al., 2016) and an increasing number of self-employed people have entered the labour market (Badir, 2014). On average, their earnings have lagged behind the wages of those in employment.

Figure 4: Illiquid household balance sheets
Figure 4: Illiquid household balance sheetsSource: CBS

The strict budgetary policy by the Dutch government in the crisis years in comparison to the countries around us also put a brake on spending. The austerity measures in the 2011-2017 period amount to EUR 47 billion (CPB, 2015). If households reduce their debt and the policy interest rate is around nil, the government will have to intervene and stimulate the economy (Stegeman and Kamalodin, 2013). In this situation, interest rates cannot go lower in order to encourage households and businesses to spend more. If the government also cuts spending, underspending and what is known as a balance sheet recession will loom on the horizon (Koo, 2011). The various sectors in the economy cannot all cut spending and pay off debt at the same time, unless part of this process can be shifted abroad. Spending in one sector provides income for another.

Further recovery?

The current growth rate of around two per cent is partly catch-up growth driven by the recovery in the housing market, but also by a relatively positive international environment. Trade with other countries has also contributed to economic growth in the past period. The question is how sustainable is this growth rate, and whether we are now actually emerging from a long period of underspending. The growth is there at the moment, but unprecedented loose monetary policy with historically low interest rates has not as yet led to increased economic activity, as can be seen from the continuing low level of inflation. This suggests the notion that we could be looking at a long period of low growth, also known as secular stagnation (as propagated by Larry Summers (Summers, 2016). According to Summers, most Western countries are in a liquidity trap. If households consume less and businesses invest less, there will be a recession caused by underspending. In normal circumstances, the central bank can cut nominal interest rates to encourage spending so that the economy emerges from recession. In a liquidity trap on the other hand, the nominal interest rates of the central banks are at the lower limit of zero – as we have seen in almost the entire Western world for the last couple of years. The central bank can then no longer stimulate the economy. In other words, if the economy gets into a situation of underspending and the lower limit of zero  interest rates has been reached, the economy will enter a destructive spiral of stagnation and debt deflation (Werning, 2012) or secular stagnation (Summers, 2015). Furthermore, the economy will no longer recover its equilibrium by itself.

This situation entails numerous problems. The result of higher saving is a decline in demand and yet more stagnation and disinflation (a continuing decline in the rate of inflation) or deflation, a situation in which ultimately savings and restoration of balance sheets will not be achievable. This is what we have seen so far happening in the Netherlands. Despite efforts to pay down mortgage and other debt, private debt has risen from 216 per cent of GDP in 2008 to 229 per cent of GDP at the beginning of 2016. And despite huge cuts and tax increases, government debt continues to rise, from 55 per cent of GDP in 2008 to 68 per cent of GDP in 2014. Government debt will fall slightly now to 62 per cent of GDP in 2017, mainly due to the privatisation of ABN Amro and treasury banking. As we said before, it is not possible for all parties in the economy to restore their balance sheets at the same time. One party’s debt is another party’s asset. Debtors cannot repay their debts as long as creditors do not save less. And the private sector cannot repay its debt as long as the government refuses to take on more debt.

Figure 5: Pay down of private debt is not sufficient
Figure 5: Pay down of private debt is not sufficientSource: CBS
Figure 6: Still many long term unemployed
Figure 6: Still many long term unemployedSource: CBS

Hysteresis is another channel through which the problems on the demand side can damage growth. Hysteresis the destruction of production capacity in the long term as a result of a temporary fall in demand. Long term unemployment can for instance lead to the loss of human capital of workers, while low economic activity leads to lower investment or the destruction of knowledge and the physical and technological capital of businesses (DeLong and Summers, 2012). The last time we saw this happen in the Netherlands was in the 1980s. Long term unemployment can lead to a situation in which part of the working population loses skills and knowledge relevant to the labour market to such an extent that those concerned can no longer make a useful contribution to the labour market. Certainly in the event of large-scale unemployment, this can lead to entire sections of society no longer being connected to the labour market. Unemployed people can also become discouraged from making themselves available in the labour market. With the current high level of unemployment, these type of effects are entirely possible (Stegeman and Badir, 2014). Currently, four out of every ten unemployed persons in the Netherlands have been looking for work for 12 months or more. The highest level of unemployment is among the age group of 45 years and over. More than six out of ten unemployed persons aged 45 or over (63 per cent) are long term unemployed. 

Estimate of hysteresis effects are by definition uncertain since it is extremely difficult to establish which part of the under-utilisation will lead to structural damage to the economy (Fatas and Summers, 2016; Ball, 2014; DeLong and Summers, 2012). Research (Blanchard and Summers, 1986) shows that a lengthy recession such as in the 1980s in Europe often leads to long term effects on potential production. Guichard and Rusticelli (2010) find that a one percentage point increase in long term unemployment leads to between a third and two thirds of a percentage point increase in the structural level of unemployment, depending on the structure of the labour market in the country in question. They also note that these effects are not in principle structural, but they are very long-lasting. The effects on the labour supply for example disappear if the people concerned have reached retirement age. The same applies to the capital goods stock: the effect disappears at such time as the stock not accumulated would have been written off. These effects could affect estimates of future economic growth in the Netherlands.

An uncertain future

It is difficult to quantify exactly what the effects from the demand side on economic growth in the Netherlands in the coming years will be. Escaping from chronic underspending or long term stagnation is not easy. How the process of further public and private debt reduction will develop is unclear. It is also difficult to predict the long term effects on the economy of relatively high unemployment and low investment. Taking everything into consideration, it is quite likely that actual economic growth in the coming years will be lower than potential growth. And this means we are approaching long term stagnation: a lengthy period in which growth will be less than what is potentially possible and nearer to actual stagnation than the growth we were used to until 2008. If innovation contributes more to growth than we have so far assumed, growth could of course be higher. The recent positive cyclical indicators, the strong recovery in the housing market and the labour market could help households and businesses to escape the negative spiral. An active macroeconomic policy could also help. Now that the monetary policy instruments have been more or less used up, budgetary policy is the only remaining way to stimulate the economy, for example through government investment. As a result of extremely low interest rates, government investment in areas such as infrastructure, sustainability, research and education has never been more profitable (see: Facilitating progress).

Given all these uncertainties, we have created three scenarios for the future of the Netherlands. First, a scenario in which the Netherlands enters a lengthy period of underspending. Second, a middle scenario in which we continue to muddle through: a very gradual closing of the output gap and limited balance sheet recovery. Finally, a positive scenario in which economic growth picks up strongly driven by innovation. This would ultimately remove any problems on the demand side.

References

Badir, M., van de Hei, L. & Stegeman, H. (2016). Hoe kunnen we zorgen voor meer inkomen deze eeuw? (Dutch) Rabobank Special. 16 September 2016.

Blanchard, O. and L. Summers (1986), Hysteresis and the European Unemployment Problem, NBER Macroeconomics Annual. 1: 15-90

Cowen, T. (2011), The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better, Dutton Publishing, Penguin.

The Netherlands Bureau for Economic Policy Analysis (2013). De Nederlandse woningmarkt – hypotheekrente, huizenprijzen en consumptie. The Hague: CPB.

The Netherlands Bureau for Economic Policy Analysis (2016). Middellange-termijnverkenning 2018-2021. The Hague: CPB.

The Netherlands Bureau for Economic Policy Analysis (2015). Tekortreducerende maatregelen 2011-2017 (inclusief 5-miljard-pakket). The Hague: CPB.

DeLong, J. & Summers, L. (2012). Fiscal Policy in a Depressed Economy. Brookings Institute, BPEA.

De Nederlandsche Bank (DNB); De vermogensopbouw van huishoudens: Is het beleid in balans? Amsterdam: DNB:

Gelauff, G. D. Lanser, A. van der Horst, A. Elbourne (2014), Roads to recoveryCPB Boek, CPB: The Hague.

Groenewegen (2016), Rutte II brengt begroting op orde; nu tijd om vooruit te kijken (Dutch), Rabobank Special. 20 September 2016.

Guichard, S. and E. Rusticelli (2010), Assessing the Impact of the Financial Crisis on Structural Unemployment in OECD Countries, OECD Economics Department Working Papers, No. 767, OECD Publishing.

Jacobs, B. (2016). Langdurige stagnatie? Je gaat het pas zien als je het door hebt. ESB, 101, 616-621.

Koo, R. (2011). The world in balance sheet recession: causes, cure and politics. Real-world economics review. 

Stegeman H.W. and S.A. Kamalodin (2013), Mind the fiscal speed limit, Rabobank Special 13/04, Utrecht: Rabobank Nederland.

Stegeman H.W., Badir M. and Weernink M.(2014), Het groeipotentieel van de eurozone, Rabobank Special, Utrecht: Rabobank Nederland.

Summers (2014), Reflections on the ‘New Secular Stagnation Hypothesis’, In CEPR Press Perspectief, CPB: Amsterdam:

Summers (2014), Secular Stagnation in the Open Economy NBER working paper, April 2016

Teulings, C. and R. Baldwin (2014), Secular stagnation: Facts, Causes and Cures.

Weernink, M. (2014), De zin en onzin van de 'output gap' (Dutch), Rabobank Special, September 2014, Rabobank: Utrecht

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