European Economic Outlook 2023 – The Global Economy in the Grip of Inflation

The year 2022 was characterized by shortages and rising prices. In the winter of 2022/23, high energy prices, in particular, dampened economic development, so a recession is expected in the European Union in the coming months. From summer 2023 onwards, slight economic growth is possible but depends to a large extent on the level of energy supply achieved during the winter of 2023/24.

2022 – Shortages and inflation shape economic development

Europe was already experiencing high inflation rates at the start of 2022. Russia’s attack on Ukraine led to a noticeable shortage of important goods, above all, energy and agricultural products. The result was even higher inflation rates, which in some cases reached double digits.

A high inflation rate dampens economic development through various channels. The most important of these include a decline in demand for consumer and investment goods:

• Rising prices for consumer goods reduce the purchasing power of private households’ incomes. As a result, they curtail their demand for consumer goods.
• In response to high inflation rates, central banks raise their key interest rates. Rising interest rates mean that it is more difficult for companies to finance their investments. At the same time, it makes less sense for companies to expand their production capacities when demand for consumer goods is falling. Demand for capital goods is therefore also declining.
• Companies whose consumer and capital goods are in less demand cut back on production. As a consequence, the level of employment goes down resulting in lower incomes for the employees affected. This leads to a further reduction in overall economic demand for consumer goods.
• The final effect is a downturn in the economy as a whole. In Europe, however, the extent of this economic slump varies in individual countries.

Central and Eastern Europe suffers particularly severely from the consequences of the Ukraine war

The global shortage of raw materials and the disruption of trade relations with Russia are hitting the Central and Eastern European economies particularly hard. This is partly because these countries have had especially intensive trade relations with Russia due to their geographical closeness to Russia and their history. Falling imports and declining export opportunities are hitting these countries hard.

On the other hand, some of the Central and Eastern European economies are particularly energy-intensive and, therefore, dependent on fossil fuels such as natural gas, coal and oil. Rising energy prices also hit these countries disproportionately strongly.

As a result, inflation rates in Central and Eastern Europe in 2022 are significantly higher than in most other EU countries. Even though annual inflation rates are expected to fall in 2023, inflation rates in Eastern Europe will remain well above the overall EU price level increase.

Recession in winter 2022/23

The negative economic consequences of high inflation outlined above will lead to a technical recession in the winter of 2022/23. (Real gross domestic product (GDP) declines in two consecutive quarters)

In its economic forecast published in November 2022, the European Commission assumes that such a recession will occur in the EU at the turn of 2022/23. However, the recession is expected to last only two quarters and to be small.

Due to the anticipated economic recovery from summer 2023 onwards, the European Commission expects real GDP in 2023 – with the exception of Germany, Latvia and Sweden – to be higher than in 2022.

Impact of the American economy on Europe

Europe’s economic development also depends on the development of the American economy. The U.S. is both an attractive sales market and an economic competitor for European companies.

The U.S. government launched enormous economic stimulus packages when the corona pandemic broke out, and the economic slump in 2020 was much less severe than in the euro area. In 2021, the U.S. was already almost back to full employment, and demand for goods was high. As a result, inflation in the U.S. in 2021 was significantly higher at 4.7 percent than in the euro area at only 2.6 percent.

The U.S. Federal Reserve therefore had to raise its key interest rates earlier and more sharply than the European Central Bank (ECB). The International Monetary Fund expects the inflation rate in the U.S. to be significantly lower than the inflation rate in the euro area in 2023 because of this monetary policy.

The price paid by the U.S. for this fight against inflation is lower economic growth in 2022, but the ECB will also have to continue to raise its key interest rate because of the high inflation rates. In 2023, economic growth in the euro area should therefore be lower than in the U.S.

As a sales market, the US economy will develop positively for European companies in 2023. However, competitive pressure from the U.S. will increase.

Competitive advantages for American companies

American companies have at least three advantages over their European competitors:

• The U.S. has fossil fuels and is therefore less dependent on imported natural gas, oil and coal. Consequently, energy costs are noticeably lower than for European companies.
• The U.S. has a more growth-friendly age structure of the population. The wage-increasing labor shortage is therefore lower than in Europe.
• The U.S. has passed an “Inflation Reduction Act” worth billions of dollars, which will come into force on January 1, 2023. At its core, this is a massive support program for American companies consisting of subsidies and tax breaks to promote climate-friendly technologies.

These competitive advantages have two key disadvantages for the European economy:

• First, it gives American companies a competitive price advantage – within the U.S., in Europe and on export markets in the rest of the world. This has a negative impact on the level of production and employment in Europe.
• On the other hand, it becomes more attractive for European companies to invest in the U.S. and relocate their production facilities from Europe to America. For Europe, this also means lower production, lower employment and consequently, lower economic growth.

However, it should be noted that European countries are also implementing measures to support their companies. For example, the German government decided on a 200 billion euro package in the fall of 2022. Among other things, this money will be used to enable companies to purchase gas and electricity at lower prices than the prevailing market prices.

Conclusion and outlook

As in 2022, 2023 will be characterized by supply shortages in energy and agricultural products. A combination of energy-saving measures and the development of new energy imports has, so far, prevented energy shortages in Europe. In particular, a feared shortage of natural gas has been avoided.

The decisive factor for European economic development in 2023 will be how abundant the energy supply is in the winter of 2023/24.

• If it becomes apparent in the course of 2023 that natural gas storage facilities are well-filled and companies have sufficient alternative sources of energy or intermediate inputs, the economic upturn will continue from summer onwards.
• However, if it becomes obvious in summer 2023 that energy supplies are not high enough to get through the winter of 2023/24, there is a risk of a renewed economic downturn.

Securing energy supply is, therefore, a top priority for 2023. In addition, other economic risks must be kept as low as possible – in particular:

• The forecasts presented by the EU Commission assume that a wage-price spiral in Europe can be prevented. By contrast, sharp rises in nominal wages would accelerate inflation.
• Trade disputes with the U.S. that could result from the “Inflation Reduction Act” should be avoided in the interest of both the U.S. and Europe. The resulting trade disruptions would dampen production and employment in all countries involved.
• For a long time, China was the economic powerhouse of the global economy. Now, however, economic growth is slowing, currently mainly due to the former rigorous zero-covid strategy. Though strict lockdowns have become unlikely due to recent developments, the situation in China remains unpredictable to a certain extent. Any production interruptions in China would cause further supply bottlenecks in Europe. The result would be a weakening of economic growth.

The conclusion to be drawn is the year 2023 will be associated with major challenges for economic policy.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Among others, he has recently worked on the effects of carbon pricing and the benefits of a potential global climate club.

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