What to expect in 2016:

Political will to preserve Eurozone remains strong Recovery has arrived, but growth is well below pre-crisis trend The external risks are significant, too

In anticipating macroeconomic conditions for the Eurozone in 2016, three themes are relevant. The first is that the political will to preserve the Eurozone, and to deepen European economic integration, appears to be as strong as ever. Since the start of the Eurozone debt crisis in 2008, this political will has been underestimated. This also largely explains why during the crisis DBRS maintained its sovereign ratings on Italy, Spain, Ireland and Portugal higher those of other credit rating agencies.

During the crisis DBRS downgraded these ratings, but no lower than ‘Single A (low)’ in the cases of Italy, Spain and Ireland, and no lower than ‘BBB (low)’ in the case of Portugal.

There is some evidence to support the theory that the more Europe is tested, the greater the impetus to deepen integration. Integration is in fact proceeding in both fiscal policy and financial policy. The European Commission has a mandate to impose sanctions on countries that do not adhere to the Stability and Growth Pact. However, the treatment of member states’ budgets is complex and allows for significant exceptions to the rules. For example, the Commission’s November 2015 assessment of the member states’ 2016 draft budgetary plans permits higher incremental spending linked to unusual events outside the control of the government, such as the exceptional inflow of refugees. However, only some member states have included the net extra costs of the refugee crisis in their draft budgetary plans. While greater fiscal flexibility may be appropriate to accommodate cyclical downturns or unexpected shocks such as the influx of refugees, the application of the rules is unclear.

To enforce oversight, the forthcoming European Fiscal Board will coordinate the monitoring of national budgets with national fiscal councils. Presumably, this should improve the monitoring of member states’ budgets, and could result in greater consistency of the application of the fiscal rules across member states.

Greater integration is also occurring with the banking union. The supervisory pillar is in place and the resolution mechanism is being implemented. As of January 1, 2016, all member states will apply a single rulebook for the resolution of banks and large investment firms as part of the Bank Recovery and Resolution Directive. The BRRD requires shareholders and creditors of banks to contribute to the costs of a failing institution through a bail-in mechanism. Although this could dissuade investors from purchasing shares or bonds, these rules are nevertheless likely to make the winding down of a bankrupt financial institution more predictable.

The Eurozone’s evolving financial backstop, in the form of ECB monetary accommodation and the support facilities, is further evidence of willingness to preserve the Eurozone. The ECB’s extraordinary monetary accommodation has been the single most important factor in stabilizing the region, from the Securities Markets Program to the promise of Outright Monetary Transactions – Governor Mario Draghi’s July 2012 statement that the ECB would do “whatever it takes to preserve the Euro” – to Quantitative Easing (QE). The EFSF and ESM financial backstops rolled out since the first support programme for Greece also demonstrated this willingness. These programmes may not have necessarily restored debt sustainability in all cases, but they did stem the panic and prevent contagion to other countries. The preservation of Greece and Cyprus as member states in the Eurozone further demonstrated this willingness.

The second theme is that the recovery has arrived, but GDP growth is well below the pre-crisis trend. The IMF’s October World Economic Outlook GDP growth projections appear to be reasonable: the IMF expects the world economy to grow by 3.1% this year and 3.6% next year, while in the Eurozone growth is expected at 1.5% this year and 1.6% next year. In the third quarter, the Eurozone grew 0.3% quarteron-quarter, slowing from 0.4% in the second quarter. Yearon-year, the Eurozone grew 1.6%, slightly higher than 1.5% in the second quarter. As Exhibit 1 shows, the United States and United Kingdom are growing well above their pre-crisis peak; the EU has just surpassed it; the Eurozone and Japan not quite. This is an uneven picture, and the uncertainties facing the Eurozone present downside risks to growth.

Indeed, it is doubtful that the Eurozone has emerged stronger after the crisis. When the output gap closes, it is likely to do so at a lower level of output. As Exhibit 2 shows, the dotted black line represents the slope of potential GDP as it would have been had the crisis not occurred; the yellow line is the new projected rate of growth of the economy; the blue line below is the actual rate of growth. The output gap – the gap between the blue line and the yellow line – is expected to close at a lower level of output than it would have given the original projected potential GDP. By one measure, the loss to potential GDP for a selection of 22 advanced economies is 8.4% below the pre-crisis path would have predicted.

The question is, why has trend growth declined? One would expect a rebound in exports given the weaker exchange rate, higher consumption and investment from lower world oil and commodity prices, and greater consumption and lending from low interest rates because of bond purchases by the ECB. However, domestic demand has yet to rebound in a more robust manner. The most convincing argument for why growth in the Eurozone is so far below potential is the “savings glut” argument – “secular stagnation” – or the tendency for demand to be weak relative to potential supply.

Weak domestic demand, supply side constraints, and political fragmentation may all be contributing to this phenomenon. Despite some signs of a pickup in consumption, both consumption and investment remain lacklustre. This deficient domestic demand is at least partly the result of deleveraging governments, households, nonfinancial corporations and banks. In such an environment, it is no surprise that spending is lower. Second, with low investment, especially public investment, labour productivity has declined. Exhibit 3 shows that the labor productivity growth that is attributable to investment has declined sharply in the G7 countries – not only in the US, the UK and Japan, but also in Germany, France, Italy and Spain. Therefore, this is a worldwide phenomenon. With lower productivity comes lower growth.

Second, there are significant supply side constraints. One sign of this is in persistent unemployment, which is affecting human capital. For long-term unemployed, inactive or discouraged workers, their adverse experience may negatively affect their attitude toward work, as well as their aptitude for work. The risk is that in the event of persistent low growth, or worse, a severe downturn, the bad cycle might permanently damage the trend. An equally important supply side constraint is sluggish credit growth. In spite of QE, which has kept bond yields low and expanded the ECB’s balance sheet, credit growth to households and non-financial corporations has been limited.

A third possible reason for low growth is political fragmentation. There have been several layers of fragmentation. Austerity fatigue and other factors are resulting in the splintering of traditional centrist political parties, and this is drawing mainstream politicians to the