Growth Made At Home
One possible response to a weakening export engine is a more domestically driven growth model, in which the eurozone’s large pool of relatively wealthy consumers and businesses as well as fiscal stimulus become a larger source of growth through consumption and investment. This is more than a theoretical possibility. The eurozone combines high household wealth, substantial private savings and relatively low levels of household leverage with significant investment needs in defence, infrastructure, energy and digitalisation. If these resources can be mobilised more effectively, domestic demand could become a stronger source of growth than it has been for much of the past decade.
Recent initiatives could give such a shift additional momentum. Higher defence and infrastructure spending, particularly in Germany, are boosting investment demand. The Savings and Investments Union aims to channel Europe’s large pool of savings towards productive investment, while policymakers are increasingly focused on reducing barriers within the single market. Together, these developments could provide stronger support for domestic demand than Europe has seen in many years.
But how likely is it that domestic demand can simply take over? It’s a clear opportunity, but we don’t want to close our eyes to the complications either. Below, we focus on three limiting factors: the lack of historical precedents, the euro, and demographics.
The Precedent Problem
There are remarkably few examples of countries that have successfully moved from an export-led to a domestically-driven growth model. The United States is the obvious one: a large trade surplus at the end of World War II turned into the historically large deficits of the current era, while the economy kept growing. The dollar’s reserve currency role did not cause America’s shift towards persistent external deficits, but it made those deficits easier and cheaper to finance than they would be for almost any other country. The US could rebalance on other people’s savings.
The other precedents are less flattering. Historical experience suggests that external rebalancing is compatible with solid growth when it reflects higher productive investment, but not when it is driven by credit-fuelled demand booms or declining competitiveness. Or worse, often the so-called rebalancing happens in times of severe crisis. Finland’s current account surplus shrank sharply after 2008, but mainly because of the demise of Nokia and weaker export performance; GDP growth fell from around 3% to essentially zero. That was rebalancing out of weakness, not strength.
Spain, Portugal and Greece saw their external balances deteriorate after entering the monetary union as cheap capital fuelled consumption and construction booms. Growth was strong until the bubble burst. Too much of the capital flowed into housing and non-tradables rather than productivity-enhancing investment, leaving these economies exposed when financing conditions tightened after 2008. Ireland was, to a degree, in the same boat as Southern Europe but has recently become more of a rebalancing success story. However, its national accounts are so distorted by multinational activity that both GDP and current account figures need to be taken with a large pinch of salt.
This means there is no blueprint for a highly developed economy to deliberately and successfully transform its economic business model away from export-orientation to more domestic demand. The eurozone would be entering uncharted territory.
Can a ‘Global Euro’ Help Build a New Growth Model?
As the US was able to use the dollar’s status as the world reserve currency to rebalance, could the euro perhaps be of help as well? A successful rebalancing and a strong euro are best understood as a feedback loop rather than a one-way street. If Europe’s domestic investment story becomes credible, foreign capital would flow in and the euro could strengthen. A stronger euro, in turn, raises households’ purchasing power, lowers import costs and shifts relative incentives away from exporting and towards serving the home market – which is precisely what a rebalancing requires. This is the mechanism that dollar strength provided for the US for decades.
The loop, unfortunately, also runs in reverse. A weak euro flatters exporters, subsidises the old model and postpones the adjustment – while making imports, not least energy, more expensive for the domestic economy. European Central Bank President Christine Lagarde has been promoting a “global euro moment”. And while the euro’s international role has increased modestly (when measured at current exchange rates), it would be a stretch to call this a material shift towards euro assets in global financial markets.
Without deeper and more liquid capital markets, a genuine European safe asset and a larger pool of investable euro instruments, the euro will not get the reserve-currency tailwind that carried the American rebalancing. In short: the currency will not lead this transition, but it is a gauge of where the transition stands. Markets will reward a credible rebalancing with a stronger euro, and punish an unconvincing effort by keeping the eurozone dependent on the very export model it is trying to outgrow.
Ageing Makes Domestic Demand Growth More Challenging
Demographics are the second complication, and they lean against the domestic-demand story rather than for it. Eurozone population growth is grinding to a halt due to rapid ageing, and ageing societies are not natural consumption machines. Without much population growth, it is a lot harder to increase demand. On top of that, while the theory is ambiguous, we so far see that older households save well into retirement, run down wealth more slowly than the textbooks assume so far, and shift their spending towards services and pharma rather than the goods and housing that drive investment cycles. The effects of ageing on labour supply, potential growth and the composition of demand also make a domestically-led acceleration of economic growth hard to achieve.
Japan is the main advanced market that has already gone through a sizable demographic decline and their growth model has become more reliant on exports over time. The period of significant ageing of the Japanese population went hand in hand with a rising, not falling, share of exports in GDP although this also went hand in hand with a prolonged balance sheet recession. As the domestic market matured and shrank, Japanese companies increasingly looked abroad for growth, and the economy as a whole relied on earning income from the rest of the world to fund retirement at home. If Europe’s future would indeed rely on ageing consumers suddenly discovering their inner spender, this is again something that hasn’t really been done before.