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What’s Really Behind the Eurozone’s Economic Turnaround

Many economists may have underestimated the role of improvements to the supply side of the eurozone economy. And there are still plenty of supply side measures at both eurozone and national level that could improve actual and potential growth, writes Simon Nixon.

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Simon Nixon

It is now four years since the start of the remarkable Spanish economic recovery. Yet at the time, few saw it coming. Back in July 2013, the International Monetary Fund forecast that it would take until 2018 for Spanish economic growth to barely scrape above 1% while unemployment would remain above 25% for five years.

In fact, the Spanish turnaround had already begun: Growth exceeded 1% in 2014 and has been above 3% ever since. In that time, Spain has created more than two million jobs, bringing the unemployment rate down from a peak of 26.2% to an eight-year low of 17.2% today.

In the same way, few saw this year’s turnaround in the eurozone’s economic fortunes coming either. As recently as December, the International Monetary Fund and the European Commission were both forecasting that eurozone output would grow by 1.5% this year, while the average estimate among independent economists was for growth of just 1.3%, according to Consensus Economics Forecasts.

Yet the consensus now is for growth this year of 1.9%, while Citigroup Inc. has just raised its forecast to 2.2% while hinting at possible further upgrades in the light of recent data. These have shown eurozone consumer confidence at its highest level since 2001 and investor confidence at its highest level since 2007. The recovery is now spread across all sectors and countries: French business confidence is at a six-year high, Italian industrial production rose by 1.1% in June, smashing expectations of a 0.2% rise; even the Greek economy is likely to grow by 0.7% this year.

There are many reasons for the change in the eurozone’s fortunes this year. Partly it reflects an improving global outlook, including a recovery in global trade, which grew by 4% in the past year, outpacing global GDP growth for the first time in five years. The euro area is also benefiting from cheap energy prices and very low interest rates. Confidence has been boosted by the reduction in political risks following this year’s elections in the Netherlands and France which delivered strong majorities to pro-EU parties. Indeed, popular support for membership of the eurozone has risen to a 13-year high of 73%, according to the latest Eurobarometer survey.

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But while these demand-side factors likely played a role in the eurozone’s growth, many economists may have underestimated the role of improvements to the supply side of the eurozone economy—as they did with Spain four years ago. The trigger for Spain’s rebound in 2013—as with Ireland’s equally remarkable rebound around the same time—was its decisive action to clean up its banking system. This combined with ambitious overhauls to labor and product markets allowed resources to be reallocated to more productive parts of the economy.

Similarly, the eurozone over the past year has finally addressed remaining pockets of banking weakness in Italy and Portugal. With both banking systems now significantly better capitalized, bad debt ratios are falling as soured loans are either restructured, sold or written off. As a result, eurozone bank lending is once again starting to show healthy growth, according to European Central Bank data. Other structural changes, including labor market overhauls in Italy and France, may also help explain the unexpectedly strong jobs recovery. Indeed, much of the recent surge in French business confidence reflects expectations that President Emmanuel Macron will deliver further ambitious new labor market overhauls this year.

The good news is that this recovery now appears self-sustaining driven by strong business investment and household spending rather than external demand. True, a stronger euro, perhaps boosted by large inflows into eurozone assets, could dampen growth in the second half. But the main domestic risks remain political—whether from Italy which holds elections next year or spillovers from Brexit or from the referendum on Catalonian independence due in October this year—or a return of bond-market tensions as the ECB tries to wind down its government bond-buying program, leading to a growth-sapping tightening of financial conditions.

Indeed, the eurozone’s biggest medium-term challenge is to remove concerns over the sustainability of some countries’ debts that may resurface as the ECB fire blanket is removed. Some of the recent recovery of confidence in the eurozone may reflect excessive optimism that a widely anticipated push for deeper eurozone integration will lead to moves toward increased pooling of eurozone debts. That would be seen as addressing investor concerns that government debts contain credit and foreign exchange risk as well as inflation risk.

But the lesson from the Spanish and the eurozone recoveries is that pooling debts isn’t the only way to address concerns over debt sustainability. There is still plenty that can be done at both the national and eurozone level to improve the supply side of the euro area, including measures to encourage investment and cross-border capital flows. Not only would these lift short-term growth but they would raise the rate at which the eurozone can grow without generating inflation, enabling the ECB to hold off rate rises. Ultimately, this may be the key to the eurozone’s long-term resilience.

Write to Simon Nixon at simon.nixon@wsj.com

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