Eurozone Output Gaps and the COVID-19 Shock

Abstract

The eurozone was marked by economic divergence in the decade before the COVID-19 shock, something that was a starting point for our Campaign against Nonsense Output Gaps (CANOO), which we unveiled in Brooks and Fortun (2019a) over a year ago. In the years leading up to the pandemic, countries in the euro core had recovered quickly from the global financial crisis in 2008/9, while the periphery suffered stagnant and intermittent growth, leaving GDP in some cases well below pre-crisis levels. One reason for this divergence can be found in financial conditions, which tightened substantially for countries like Italy and Spain during the sovereign debt crisis in 2011/12. That tightening in financial conditions made a uniform recovery across the eurozone difficult and some echoes of this can be found in financial markets today. Concerted ECB action has prevented real yields on the euro periphery from rising materially, but it is still the case that real Italian bond yields exceed those in the euro core. As a result, the potential for continued economic divergence within the eurozone exists, which may also exacerbate deflation risk for the region overall.