The Dutch Economy Is Really Not Looking Good

• First quarter GDP growth revised upwards…
• …but shrinkage remains shrinkage
• I'm willing to bet that our economy will contract further in the second quarter
• Bank of England surprises with a sharp rate hike
• Inflation persistence is the crucial question
• Our central bankers should take an example from their Brazilian colleagues

Google Translated from Dutch to English. Here is the link to the original article in Dutch. The article was originally published on 23 June 2023. 

The Dutch economy did not shrink by 0.7% in the first quarter compared to the fourth quarter last year, as Statistics Netherlands had previously calculated, but by 0.3%. That doesn't surprise me because 0.7% shrinkage is exceptional. However, such an upward adjustment of 0.4 percentage points is quite substantial. Historically, the average difference between the first and second calculations by Statistics Netherlands is only 0.1%. But outliers do occur. Incidentally, for the year-on-year comparison, there is now +1.9% in the books and that was also the case with the first calculation. Incidentally, the growth for 2021 has been revised upwards from 4.9% to 6.2%, and that for 2022 downwards from 4.5% to 4.3%. Unlike many countries around us, our GDP is still significantly larger than before the pandemic.

The reactions to the GDP figures are rather laconic, 'not too bad', 'unemployment remains low', 'although the number of bankruptcies has risen slightly in recent months, it is still low'. There is no getting in between that in itself, but it is 'backwards economics'. We have to look ahead. I expect our economy to shrink again in the second quarter. You can see from all kinds of monthly series that the economy is weakening across a broad front. This was already the case during the first quarter and this trend has continued in April. In the table below I have listed the year-on-year figures of various relevant series.

Add to that the fact that the number of building permits issued for homes in the first four months of this year was 20.1% lower than last year and it is clear that the economic picture is not very rosy. The conclusion is inevitable: we are sliding further down, into a recession.

Incidentally, Statistics Netherlands reported that the real disposable income of households was 1.7% higher in the first quarter than last year. That still sounds reasonably positive, but it should be borne in mind that the number of households is increasing so that 1.7% is not an average per household. It should also be said that this 1.7% increase is meager from a historical perspective. In the first quarter of 2021, it was fractionally lower, 1.6%, but otherwise, we have to go back to 2018 in the statistics to see lower growth figures. Recall that massive government support during the pandemic has supported incomes.

Something that is weak can always become weaker

These figures show that the Dutch economy weakened in the course of the first quarter and that the second quarter got off to a very weak start. There must have been a significant improvement in May and June to prevent contraction. Anything is possible and numbers like this can be volatile, but I don't see where that recovery should come from. On balance, I am convinced that our economy will shrink again in the second quarter.

I've been regularly participating in discussions lately about whether we're in for a bad recession, a mild recession, or no recession at all. I've written before that I'm afraid it will all be quite painful. Others, however, believe that the tight labor market will prevent a recession. That is not what history shows. Recessions usually start when unemployment is low but has already risen slightly.

Still, others with whom I have had conflicts about this comment that I have been calling for months that a nasty recession is ahead of us and that it has not been too bad so far. That's right. But yes, I became gloomy when the European gas price rose so sharply last year.

In the 1970s, the world economy entered a deep recession when the price of oil tripled and later increased by a factor of three. Last year, the European gas price reached a level in August that was 23 times (!!!) before the pandemic. In Europe, gas supplies just under half of the total energy requirement, so perhaps you could say that total energy costs increased about tenfold (assuming that other energy costs remained the same). No one could have imagined that the gas price would subsequently fall sharply again. If that had not happened and that price had remained at the end of August, our economy would have been in a very much worse shape. Incidentally, the European gas price is still twice as high as before the pandemic and the damage caused by high energy prices is clearly visible in the contraction of energy-intensive sectors.

Meanwhile, inflation remains quite persistent. The ECB will undoubtedly raise interest rates further and the increased interest rates are reflected in the economy with a lag. So we haven't seen all the effects of higher interest rates yet. To that, I would add that policymakers currently have little room to counter a recession with an accommodative policy. The ECB must first get the hang of inflation. In a recent speech, ECB executive Isabel Schnabel explains that inflation may be more stubborn than hoped. For the time being, this leaves no room for the ECB to prop up a weak economy with interest rate cuts. Governments can of course always provide incentives, but the starting position for government finances is not favourable. As of 2024, the EMU budget norms will also come into force again. Of course, this can still be manipulated, but for the time being from that perspective cutbacks seem more likely than stimulus.

Of course, there are also positive factors. For example, the financial position of households, banks, and most companies is better than when the financial crisis broke out in 2008. Corporate profits are also generous on average, which acts as a buffer. And finally, the labor market is so tight, not just here, but elsewhere that employers will think twice before laying off staff.

Nevertheless, I am convinced that we are currently sliding into a recession that will be more annoying than many now think. Hopefully, I'm wrong.

Bank of England surprised

The Bank of England raised official interest rates by 0.5% this week. It was the thirteenth increase in a row and exceeded expectations. The last two times the British central bank had raised interest rates by 0.25% and that was now also expected. It is clear that the Bank is deeply concerned about the persistence of inflation. In May, UK inflation stalled at 8.7%. Although this is lower than the more than 11% in October, the fall is mainly due to energy prices. Core inflation, ie excluding food and energy, continued to rise and now stands at 7.1%. The Bank of England's comments resemble the thrust of Isabel Schnabel's speech to which I referred above.

Last week, the Federal Reserve decided to leave US interest rates unchanged after a series of ten rate hikes. Market participants had previously assumed that the Fed would cut interest rates before the end of the year, but the Fed dashed that notion last week by announcing that interest rates would fall even further before the end of the year. raised. The Reserve Bank of Australia and the Bank of Canada recently hiked interest rates after taking a break.

The crucial question now is how stubborn inflation will be. Economists are befitting modesty because as a profession we have not shrouded ourselves in glory with our inflation forecasts in recent years. "In my humble opinion" I did a little better than the average, but past results...

Fed boss Powell appeared in Congress again this week. Politicians don't like rate hikes, so representatives from the Democrats and Republicans agreed that last week's decision to leave interest rates unchanged was a good one. And almost everyone expressed his or her concern about the effects of any further interest rate hikes.

At these appearances, Powell invariably declares that the Fed realises that high inflation is painful for everyone and that the Fed will do everything it can to get inflation back to 2%. Some believe in what is called "immaculate disinflation," literally "immaculate fall in inflation," actually a fall in inflation that is not accompanied by economic pain in the form of rising unemployment. History shows that such a thing is highly unusual. When inflation is as high as it is today and wage growth is as strong as it is now, inflation has only been able to fall sharply in the past with a significant rise in unemployment. Hopefully, things are different now, but those who bet on that bet against past experience.

Are we willing to accept the pain?

The big question is what about the willingness to accept the pain of higher unemployment? Under pressure from public opinion and politicians, central banks may eventually give in and cut interest rates before the 2% inflation target comes into view. In that case, that target will remain an illusion and we will have discussions about how objectionable a structurally higher inflation is. That is fodder for later comment.

Brazil is a shining example

The difference between inflation and policy response in different countries is interesting. Like other countries in Latin America, Brazil has struggled with high inflation more times than we have in recent decades. The following picture shows that inflation in that country started to rise slightly earlier than in the Netherlands, but the difference – certainly also with the US – is not great. The second picture shows that the central bank in Brazil raised interest rates much earlier than the ECB and the Fed.

The first picture also shows that inflation in Brazil did not rise as high as in our country and is now lower than in ours. I've been following the Brazilian economy (from a distance) for almost 40 years and I never thought I'd see our inflation rate higher than theirs.

Source: Macrobond

Source: Macrobond

Finally, what is most notable is that the Brazilian central bank has not yet cut interest rates despite their inflation being back to pre-pandemic levels. The central bank is criticised for this in its own country, but apparently, it considers it necessary to prevent the inflation genie from escaping from the bottle again. Perhaps our central bankers should take an example from their Brazilian counterparts. After all, they have more experience in combating inflation than ours.

Closing

Our economy contracted not by 0.7% in the first quarter but by 0.3%. It seems to me inevitable that it will later become apparent that the economy also contracted in the second quarter. This means that we meet the definition of a recession: two-quarters of contraction. Unlike many others, I think it will be a painful process, although there are certainly arguments for a less somber vision.

The Bank of England fears persistent inflation and has therefore raised interest rates more than expected. In a speech, ECB executive Schnabel also points to the danger of persistent inflation. The central banks in Canada and Australia have raised interest rates in the recent past after previously holding back.

Finally, I think our central bankers should talk to their Brazilian colleagues. That country has more experience with inflation than we do. Brazil's central bank started rate hikes much earlier than ours. Inflation is now lower than ours. Nevertheless, the Brazilian central bank keeps interest rates high to ensure that the inflationary threat has been contained, although this has led to criticism at home. Will our central bankers stand their ground and continue to prioritise fighting inflation when the economy starts hurting? The moment of truth is fast approaching.