Dutch economy will shrink by ¾% in 2009, meagre recovery in 2010

The Dutch economy is expected to shrink by ¾% next year. Exporting firms are being hit particularly hard by the international economic malaise. Furthermore, private non-residential investment is being inhibited not only by diminished production but also because the sources of financing are drying up.
The new projections include a modest recovery of both world trade and the granting of credit. This will stimulate Dutch economic growth, resulting in an increase of 1% GDP in 2010. The uncertainties about the timing of the recovery are considerable, however. Due to the slackening economy, unemployment will rise markedly in the next two years, to 6½% in 2010. Lower prices of energy and raw materials will push down inflation, which will help to sustain purchasing power. The unfavourable economic situation will also be visible in the government balance. The budget surplus in 2008 will change to a deficit of 2.4% GDP in 2010. This deterioration can mainly be attributed to lower taxes, social security contributions and natural gas revenues, in combination with rising expenditure on unemployment benefits.

These are some of the headlines in CPB's December projections, published today. These quarterly projections contain analyses and forecasts for the world economy and the Dutch economy in the years 2008, 2009 and 2010. Because of the extraordinary economic situation due to the credit crisis, these projections include not only the usual forecasts for the present year and next year, but also a forecast for 2010. A separate document, also published today, explores in greater depth the causes of the credit crisis and the possible consequences for economic policies.

World trade volume will decrease next year
The problems on the international financial markets, which were already substantial, have intensified since the bankruptcy of Lehman Brothers on 15 September 2008. And the outlook seems rather bleak for nearly all of the western economies. The economies of both the US and the euro zone will shrink. Emerging economies will not be able to escape the financial crisis, although GDP growth in China will remain high, compared to growth in the rich countries. This will be followed by a limited recovery in the US and the euro zone in 2010. Expansive monetary and budget policies in several western countries will contribute to this upturn.
CPB, in contrast to other analysis and forecasting institutes, expects world trade volume (the part that is relevant to Dutch producers) to diminish by 2¾% in 2009, due to the worldwide recession. These other institutes expect a small increase in world trade in 2009. World trade has not decreased since the early 1980s. (Dutch-relevant) world trade may show a modest growth of 3% in 2010, as a result of the limited economic recovery in the US and the euro zone.

Unprecedented uncertainties
The projections for the Dutch economy are surrounded by considerable uncertainties. For how long and to what extent will the financial markets remain hostage to the economic crisis? There are substantial downward risks. The financial crisis might affect the real economy more than projected. Research on financial crises in the past decades in Spain, Sweden, Norway, Finland and Japan shows that crises such as the one we are now experiencing usually last longer than normal cyclical downturns. Furthermore, the present crisis stretches worldwide. To take account of the risk of even more severe developments, CPB has made projections for an alternative scenario that assumes lower world trade growth.

Unemployment will rise rapidly
This year will see an end to a period of three years of decreasing unemployment. The labour market always reacts with a certain delay to a decline in production. Unemployment will thus rise rapidly, especially in 2010- although in 2009 already it is expected to grow to 4½% of the labour force. Unemployment is projected to be 6½% in 2010. The average number of unemployed persons will then be almost 200,000 higher than it was in 2008. This will undo the reductions in unemployment that occurred during the last three years.

Moderate inflation and wage increases
As a result of the worldwide slackening of economic activity, prices of raw materials- particularly the price of oil- have dropped considerably during the last months. The oil price is projected at $50 per barrel Brent in the next two years, almost half the average price in 2008 ($98). This will temper inflation. The expected rise in the consumer price index is 1½% in 2009 and 1% in 2010, vis-à-vis 2½% in 2008. Together with the worsening labour market situation, this lower inflation will have a moderating influence on wage developments. Contractual wages are projected to rise at 3% in 2009 and 1½% in 2010.

Wealth losses temper consumption growth
Household consumption, which will increase by 2% on average this year, will show zero growth next year. It is remarkable that real disposable household income will rise more in 2009 than in 2008, thanks mainly to lower inflation. This positive effect will be undone completely by the effects of the losses in wealth that have occurred. By the end of November 2008, the Dutch stock market price index (the AEX) was almost 50% lower than it was at the end of 2007. This will considerably hamper consumption growth next year. The projections assume that there will be no further losses in wealth in 2010. In addition, since real disposable household income is expected to improve somewhat in 2010, consumption will probably grow by 1½%.

Improving purchasing power in 2009 and 2010
Static purchasing power (which does not allow for individual changes such as promotion, unemployment, marriage or divorce) will, on average, improve by 1¾% next year. Projected purchasing power in 2009 has improved considerably compared to the previous projection (in September), thanks to the drop in the oil price. Average income growth will be rather high in 2009, due, in part, to the fact that many contractual wage settlements were based on expectations of high inflation and low unemployment. Furthermore, employees will be left with more disposable income because they no longer have to pay unemployment insurance contributions as of 2009. The purchasing power of many old-age pensioners will increase in 2009, in spite of the lagging indexation of additional pensions. Pensioners 65 years and older with an income of over 34,000 euro will likely see a loss in purchasing power because they do not benefit from the increased tax deduction for the elderly.

Firms invest less
The volume of private non-residential investments is projected to decline in the next two years. There will be little need to invest in new machinery, due to weak demand. Moreover, lower profits diminish the return on investments. The credit crisis also leads to higher interest rates, making investments more expensive. Finally, the stiffer credit conditions employed by banks will make it more difficult for firms to find investment financing.

International slump strikes exports
The deteriorating international economic situation will probably lower the exports of goods by 2¼% in 2009. Although price competitiveness will improve because of the recently depreciated euro, this will be to little avail, since both domestically produced exports and re-exports decline. It is expected that especially re-exports will be touched severely. Compared with exports in general, re-exports consist of relatively more goods that are cyclically sensitive. World trade will pick up somewhat in 2010, followed by an increase in exports. Re-exports, in particular, will profit from this development.

Public finance
The rapidly deteriorating economic situation will also rear its head in public finance. The surplus in the general government budget balance of 1.3% this year will become a deficit of 1.2% in 2009 and 2.4% in 2010. The adverse economic development will manifest itself through substantially lower receipts on taxes and social security premiums, and through higher expenditure on unemployment benefits. In addition, government supports the cyclical development by decreasing the tax burden. Next to the reduction in the tax burden that has already been decided upon for next year, an additional relief measure will allow an accelerated fiscal depreciation on investments. The Dutch EMU debts are increasing considerably as a consequence of the central government interventions in the financial sector. These debts are countered by more possessions, so the net wealth position will not change at first. The effect on the budget balance is limited, as the higher interest payments will be accompanied by larger dividends and interest receipts.

CPB has published several articles today, all on the credit crisis:

• Tough times ahead: an article on the development of the Dutch economy and world economy in the years 2008-2010 (see above);
• The credit crisis and the Dutch economy...in eight Frequently Asked Questions: an article on the causes of the crisis and the actions that will be needed in reaction;
• Pension savings up in smoke: this article discusses the consequences of the credit crisis for pension funds;
• Don't throw out the baby with the bathwater: a column by CPB director Coen Teulings on the credit crisis.

Major changes needed in the financial sector and in supervision of the sector
The credit crisis will lead to adjustments in supervision of financial markets. Over the course of the past few years, too much credit has been made available worldwide, due to financial innovation, overly optimistic expectations and loophole-ridden regulation. The difficulties started last year with sub-prime mortgages in the US, leading to heavy losses for banks. Subsequently, banks lost money on other products, which strongly undermined their capacity to extend credit. At the same time, mistrust increased among banks, while disquiet grew among bank clients. Governments worldwide rightly took steps to avoid a situation of massive bank failures. This would, as it did in the 1930s, lead to a deep recession and widespread unemployment. The Dutch government has thus far committed 30 million euro in capital to banks, promised 200 million euro in credit guarantees, and extended the legislation governing deposit insurance. This crisis will lead to major changes in the financial sector and in the regulation of that sector. In creating new legislation, governments should take care not to overshoot, since efficient financial markets stimulate both investment and innovation. While the recent interventions by the Dutch government have been necessary, it is desirable that the state moves as quickly as possible toward decreasing its stakes in the financial sector, in order to avoid harmful economic effects.

All of the above-mentioned articles were written for CPB Newsletter 2008/4 (in Dutch), which will appear on 18 December, 2008. Due to the special circumstances brought about by the credit crisis, all of these articles are also available in English.