The Dutch Economy Is Muddling Along, With Moderate Growth Prospects

The answer is "yes", if you respond to the question with the definition of two consecutive quarters of economic contraction in mind. According to economic figures from Statistics Netherlands, gross domestic product (GDP) contracted by 0.2% (QOQ) in Q2, after also contracting by 0.4% in Q1. Due to high inflation and an overheated economy we had already forecast this in the spring of 2022. However, the contraction manifested itself a quarter later than we expected at the time. The cooling of the economy was also slightly stronger than expected. In particular, the severe contraction in consumer spending in Q2 (-1.6% QOQ) came as a surprise. This is a sign that households are still struggling with high inflation.

However, that is not enough for economists to call it a recession, much less an economic crisis. That would include, among other things, a deterioration in the labor market. Job losses have a strong negative (temporary) impact on household consumption patterns (see, for example, Benito, 2006; Andersen et al., 2021; Browning and Crossley, 2008). A sharp rise in unemployment is therefore a much stronger economic shock than the gradual erosion of purchasing power that results from, for example, high inflation.

There are currently no signs of a sharp deterioration in the labor market. Unemployment is low by historical standards, the vacancy rate is high and the number of bankruptcies – although rising somewhat – is low. Entrepreneurs also continue to see a lack of personnel as the main barrier (in Dutch) to their business, which makes a sharp deterioration unlikely in the short term.

Inevitable Cooling of the Economy

We see the economic contraction of recent quarters primarily as part of an inevitable cooling of the economy. The Dutch economy is currently more than 6% larger than it was in Q4 2019, just before the outbreak of the Covid-19 pandemic. By comparison, many other eurozone countries, such as Spain and Germany, are only barely recovering from the effects of the Covid and energy crises (see Figure 1).

With the speedy recovery from the crisis, the Dutch economy overheated (see Table 2). According to our calculations, the current level of production of goods and services, is still about 2% above what we as an economy can maximally produce. An economy can temporarily operate above its maximum production capacity, for example by asking people to work overtime or postponing maintenance on machinery, but in the end excess demand for goods and services always leads to upward price pressure. Hence, overheating is clearly reflected in the sky-high core inflation rate (inflation excluding food and energy components), which remained at 7% in August.

Also, as mentioned earlier, we clearly see the overheating reflected in the labor market. The unemployment rate is still very low by historical standards (3.6% in July), with 122 job openings for every 100 unemployed in Q2 2023.

Looking ahead, we mainly expect a period of economic ‘muddling through’. We forecast Dutch GDP to grow by an average of 0.4% in 2023 and 0.8% in 2024 (see Table 1 and Figure 2). The number of bankruptcies is expected to increase further, so we anticipate a slight increase in unemployment as well. However, both are likely to remain low by historical standards. Below we will discuss the expenditure spending components of GDP.

Private Consumption and Inflation

We expect private consumption, which accounts for more than 40% of the total Dutch economy, to grow very moderately in 2023 (0.5%) and 2024 (1.2%).

Private consumption fell by 1.8% in the first half of this year compared to the end of last year, mainly because income growth has lagged behind high inflation. In addition, the inflation people actually experience is much higher than official statistics show (see Figure 3). This is due to a change in the way Statistics Netherlands measures energy prices (see the Inflation Monitor (in Dutch) for more information). Until May 2023, energy prices were calculated assuming that every household had a variable-rate energy contract that was renewed on a monthly basis (for convenience, we'll call this the ‘old CBS methodology’). However, this assumption does not accurately reflect reality. Many households had energy contracts with rates that had been fixed for a year or more. In the new methodology, Statistics Netherlands uses household contract data from energy suppliers, which is a much better reflection of what households actually spend on gas and electricity. The change in methodology has no impact on total measured inflation from mid-2021, the period just before energy prices began to rise sharply. However, it does cause a significant shift in average inflation between 2022 and 2023. If we recalculate the figures using the new methodology, the harmonized index of consumer prices (HICP) would have been 7.3% in 2022 (instead of 11.6% under the old methodology) and is expected to be 9.4% in 2023 (instead of 4.8%).

Looking ahead, it is mainly core inflation that will remain high next year (see Figure 3), while food and energy price increases will normalize. Core inflation will remain high mainly because commodity price increases have passed through to the prices of goods and services with a significant lag since the beginning of last year, and because corporate labor costs are rising due to accelerating wage growth (see also our Inflation Monitor from July last year (in Dutch) and this study by Bank Underground).

Figure 3: Inflation statistics versus actual rates of inflation

This also has implications for the trend in real wage growth. While according to the old methodology the year-on-year change in real wages would have been slightly positive in July, it is still expected to fall if we use the inflation rates according to the new CBS methodology (see Figure 4). Over the year as a whole, our calculations forecast a decline in purchasing power of -1.8% in 2023 and 2.5% in 2024 (see Figure 5).

Private Investment

While private consumption was disappointing in 1H 2023, the trend in private investment was actually unexpectedly positive, despite a slight decline in housing investment. Against the backdrop of deteriorating exports and increased interest rates, it is noteworthy that business investment in 1H 2023 grew by about 6% compared to the end of 2022.

Looking ahead, however, we expect business investment to contract in the coming quarters. In the Netherlands, a higher proportion of corporate debt is financed on a short-term basis (in Dutch) than in other European countries.[1] Maturing corporate loans may be subject to an interest rate review, leading to higher interest costs for a part of the corporate sector. Indeed, a European Central Bank (ECB) survey of Dutch banks shows that a majority have reported a recent decline in their corporate credit (see Figure 6). Higher financing costs affect the development of business investment, especially if the extra income from these investments does not outweigh the extra interest costs. In particular, investments that do not lead to cost savings or innovation are more often considered unprofitable than in a low-interest rate environment. Network congestion in many locations in the Netherlands also hinders companies in their establishment and expansion plans, and this is expected to weigh on business investment in the coming period.

[1] However, this picture is clouded by a relatively high share of foreign multinationals that operate in the Netherlands or book part of their holding company’s debt in the Netherlands.

The annual average growth in business investment is still 6.2%, but this is due to growth in 1H 2023 and positive carry-over effects from 2022. In 2024, we expect business investment to contract by 2.8%.

Housing investment – the sum of investment in new construction, renovation of existing homes, and transaction costs, among other things – also accounts for a significant share of private investment. We expect housing investment to fall sharply this year and especially next year, by 1.2% and 7.9%, respectively. After peaking in 2021, the number of residential building permits issued in 1H 2023 fell by about 30% compared to 1H 2021. Meanwhile, this is also reflected in a downward trend in the number of new homes completed, which is expected to continue through next year.

Government

Government spending will contribute positively to economic growth this year and next. The collapse of the Dutch government has a limited impact on this: its effects are likely to be felt mainly in later years.

The fourth Rutte cabinet started with an ambitious coalition agreement, including specific funds for climate, science, and investment. While we would have preferred to see permanent (in Dutch) funding for these goals, it was at least a step in the right direction. The ambitions were not fully realized, due in part to the unforeseen energy and inflation crises, the nitrogen deposition problem, and shortages of personnel and materials.

From this perspective, the economic slowdown is an opportunity: as the private sector's demand for labor and materials declines, the government can take over. We expect government consumption to grow by 2.6% this year and 2.4% next year. Government investment is expected to grow by 2.0% and 5.9%, respectively.

However, dark clouds are beginning to gather over these figures. Rising interest rates are rapidly leading to higher interest costs for the government. In August 2023, the Netherlands Bureau for Economic Policy Analysis, CPB expected these to reach 0.3% of GDP in 2024; the current estimate is 0.8%. The difference is over EUR 5bn; money that will have to be come from some other part of the budget.

The support packages for households and businesses to mitigate the effects of high energy prices are also having a significant impact. The government deficit in 2024 (2.4 percent according to the CPB) will come awfully close to the European limit of 3%..

International Trade

The Dutch economy has been, is, and will continue to be heavily dependent on trade with other countries. Both for the import of products and services not produced in the Netherlands, and for the export of goods produced in the Netherlands. Recent evidence has again shown that exports of goods have made a major contribution (in Dutch) to economic growth over the past two years. However, we do not expect this to be the case in 2023 and 2024. Exports are under pressure as many western economies face stagnant growth, so foreign demand for Dutch goods and services is not expected to grow in 2023 and only very slightly (1.2%) in 2024. We expect limited export growth of 0.6% and 1.5% in these years (see Figure 7).

Imports are also not expected to grow rapidly this year or next. Low growth in both exports and domestic spending is leading to similarly low demand for goods from abroad. The expected contraction in private investment in the coming quarters is the most notable development in this regard.

On the eve of the Dutch general election in November and a new coalition, it is useful to shift the perspective on the Dutch economy a bit further into the medium term. What is the growth potential of the Dutch economy in the absence of additional measures? This is essentially determined by the following three components:

1. Labor developments (change in employment in hours worked).
2. Changes in the quantity of capital goods (machinery, computers, buildings, infrastructure, etc.) per hour worked.
3. Technological developments in a broad sense.

Growth in Labor Contribution Still Possible in the Short Term

Due to the upward revision of the population projections by Statistics Netherlands, an expected recovery in the number of hours worked per employee, and rising participation rates of older workers, there is still some upward potential for growth through further expansion of the labor supply (see Figure 8). For 2023, we expect labor supply to contribute 1.0 percentage points to economic growth, and for 2024, we expect it to contribute 1.5 percentage points. After that, the potential for additional labor capacity declines rapidly in our calculations due to the aging of the workforce. By the end of the decade, labor supply is expected to contract.

Productivity Growth

The expected positive contribution of labor in 2023 and 2024 implies that the contribution of labor productivity per hour worsens in 2023 (-0.5%) and does not grow in 2024. As the additional labor capacity comes to a halt in the medium term due to aging, economic growth later this decade can only be achieved through growth in hourly labor productivity. Although we are currently still mapping the potential labor productivity growth of the Dutch economy, it is not very encouraging that productivity growth has fallen sharply over time, from an average of 1% to 1.5% per year between 1990 and 2010 to a paltry 0.4% in the period since 2010 (see Figure 9).[2]

[2] Even adjusting for the Covid and energy crises, average annual labor productivity growth does not exceed 0.3% per year.

The slowdown in productivity growth is partly due to lower growth contributions from IT and non-IT capital stock (see Figure 10). In addition, the efficiency of the economy (TFP growth) has declined markedly. This is probably partly due to employment shifts to sectors with below-average labor productivity levels (such as the catering sector, other business services, and healthcare), while the employment share of some highly productive sectors (such as wholesale trade, telecommunications, chemical industry, and financial services) in the overall Dutch economy is actually shrinking.

This analysis shows once again that productivity growth is essential to increase our economic prosperity beyond 2024. The Rutte-IV administration has taken steps in the right direction by releasing money for productivity-enhancing investments, including the National Growth Fund (‘Nationaal Groeifonds’), the Climate Fund (‘Klimaatfonds’), and additional money for research and science. However, these are only temporary injections. Permanently higher productivity growth requires a permanent budget to stimulate and facilitate it. It is up to the next cabinet to follow through.