Andrew Sheets: Welcome to Thoughts in the Market, I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.
Reza Moghadam: And I'm Reza Moghadam, Morgan Stanley's Chief Economic Advisor.
Sheets: And today on the podcast, we'll be talking about the recovery timeline for Europe post pandemic and the resulting impact on markets. It's Thursday, February 18th, at 3:00 p.m. in London.
Sheets: Reza, traditional business cycle theory looks at booms and recessions as deviations around a longer-term trend. But you've been talking lately about this notion of economic scarring where recessions are more than deviations, but they're really about longer lasting impacts on labor, investment and innovation. What do you mean by economic scarring?
Moghadam: I think the idea of economic scarring is that recessions pull down and sometimes even bend the long term trajectory of the economy. In that sense, just like a bad injury, recessions are long-term scars on the economy. Let me give you an example. Euro area experienced significant scarring after the back-to-back crises of 2008 and 2011. By 2014, euro area growth had returned to its pre-crisis growth rate. But even later than that, in 2019, euro area output was some 10 percentage points lower than what it would have been had the two crises had not occurred. That 10-percentage point is the magnitude of scarring.
Sheets: So when we think about that scarring, that kind of longer term loss of economic potential, right? There are different elements of the economy. There's the labor force, there's the capital stock, there's technology, productivity. When you look at Europe and you look at the scarring that we've seen, how do you see that impacting those elements of labor, capital and technological productivity?
Moghadam: I think you can think of economic output as produced by essentially three factors: labor, capital and technology, or what economists call total factor productivity. If a recession knocks the economy below its original path, then it must be the case that some or all of these inputs have been knocked below their previous trajectory. Now, Labor's scarring happens because of, say, prolonged periods of unemployment that degrades your skills and knowledge and reduces your employment prospects and your wage prospects. And in the extreme, work has dropped out of the labor force or work part time. Capital scarring happens because investment drops and never recovers to its previous level. Firms believe that their future profitability prospects, for example, have been affected and don't invest as much. Now, technological scarring happens because, for example, lower investment delays innovation and adoption of new technology. Or you lose workers that have had important knowledge in what you do as a firm and therefore your capacity as a firm is reduced after the recession.
Sheets: So I think these are really interesting concepts, not just from an economic standpoint, but from the perspective of, well, what should policymakers do about them. So as you think about this scarring issue in Europe, what do you think it implies for how European monetary policy, how European fiscal policy should be responding to the crisis? And what do you think are some of the implications of that?
Moghadam: The policymakers, having gone through the last two recessions here in Europe, they are much more aware that you need to have policies that it reduce this long term scarring to the economy. And you do see that. I mean, for example, on monetary policy, you see that the ECB has been acting much more quickly, much more forcefully, and it's very likely that interest rates would be low for a long time to come. That obviously will help, for example, with investment.
Moghadam: Equally, you see that the policymakers in Europe have a different attitude to fiscal policy. Now, our work shows that fiscal austerity actually worsens scarring. And clearly the politicians in Europe, the policymakers and the officials have learned that lesson. And what you see, for example, is they have done two things: they have relaxed fiscal targets, so you do not have the austerity you had last time around. And on top of that, they have put in place the recovery fund. And the recovery fund addresses a key part of scarring, which is the accumulation of capital through investment. And in particular, the priority in Europe is to upgrade the infrastructure in order to make the economy more ready for green transition. So you see that the policy making mindset is very different and that makes me optimistic about lower scarring this time around.
Sheets: Interesting. So a more aggressive policy intervention earlier can reduce some of that loss of skill in the labor sector and then more aggressive public investment can help plug that gap and reduce that scarring in the capital portion of the economy.
Moghadam: I think if you think about investment and labor, protecting employment and making sure investment doesn't fall, those two by themselves will make a big difference and they will make a difference in terms of the third factor, technological progress, because they enable you to make that technological progress.
Sheets: So maybe a final question for me is, you know, as you've highlighted, this has been a really disappointing decade for the euro area.
Sheets: You know, as you think out over the next decade in Europe, I would be really interested if you could maybe paint what you think is the most realistic, optimistic case for Europe in light of a kind of a disappointing last decade. And, you know, what do you think is kind of a realistic, pessimistic case if you know the region, isn't able to make the economic choices it needs to?
Moghadam: I think on the optimistic front, the recovery fund, I think is a game changer. It's a game changer because it takes one area that is the green transformation about which there is enormous political consensus in Europe about the need to fight climate change. And that's at the heart of the recovery fund. It takes that idea and then provides central funding. And that funding goes to countries not on the basis of GDP, as it usually does in Europe, but on the basis of need. So the countries that were scarred most after the last recession, Greece, Portugal, Italy, Spain, they get much higher ratio relative to others from the recovery fund and they spend those on investment and in particular green investment. I think that's a very good way of matching good economics with political consensus. And so that makes me optimistic.
Moghadam: Now, where would my optimism be tempered? If Europe reinstates the Stability and Growth Pact in the same strict way that it had after the last recession, then obviously the room to make that investment would be much less and the room to make that transformation would be much more curtailed. I'm optimistic they will not do so. But I think these are in terms of policy, the two key issues going forward.
Moghadam: Andrew, I think our listeners would also be very interested to hear your perspective on the market implications and investment implications of scarring.
Sheets: Yeah I think it's a really interesting debate because, you know, I think it factors into also an element of recency bias where, you know, as we just discussed, the last decade has really been defined in the euro area by this really disappointing recovery and almost interlocking and overlapping disappointing recoveries where the great financial crisis gave way to the European sovereign crisis. And now we have this large covid related drawdown. And so I think that's generated this impression among investors, certainly an impression in some market pricing that growth in the region is just going to be low forever. It's going to be significantly lower forever.
Sheets: And so I think what you mentioned about that change in mindset is potentially really important. That this idea of a shift in monetary policy, a bigger shift in fiscal policy that's trying to not make maybe some of the mistakes that were made after the last recessions in terms of fiscal austerity, that could be really impactful to, you know, where growth in the region could get to over the medium term. And that could also impact the way the market thinks about pricing European assets.
Sheets: I also think it's interesting that when it comes to, say, the European equity market, I think it's easy for people to kind of mistake that as a proxy for the European economy, when, in fact, a pretty significant share, you know, well over half of the revenue of European equities does come from other regions, comes from outside of Europe. And so, this is a market where, you know, when you talk about European equities, yes, you're exposed to the European economy, but you're also exposed to other economies elsewhere. And I think that can get somewhat lost a little bit in this debate.
Sheets: Reza, thanks for taking the time to talk.
Moghadam: Great speaking with you, Andrew. Thank you.
Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.