From Financial Stress to Growth at Risk: Structural Drivers of Euro Area Downturns

The European Central Bank and Universität Leipzig study shows that downside risks to euro area GDP growth are mainly driven by demand and financial shocks, which simultaneously lower expected growth and raise uncertainty, making recessions deeper and more likely. In contrast, supply shocks generate more symmetric growth risks but are the main source of upside inflation risk, highlighting that different structural shocks shape growth and inflation risks in fundamentally different ways.

Researchers from the European Central Bank and Universität Leipzig set out to answer a question that has become increasingly urgent for policymakers: why do economic downturns seem to come with much larger risks than upturns? Drawing on the euro area’s experience of the global financial crisis, the sovereign debt crisis, and later episodes of instability, the paper argues that focusing only on average forecasts misses the real danger, which lies in the tails of the distribution. Policymakers are less worried about small forecast errors than about the risk of severe recessions or destabilising inflation episodes, and understanding what drives those extreme outcomes is essential.

A new way to look at economic risk

To tackle this problem, the authors combine two familiar tools in a novel way. They use a standard vector autoregression to model how GDP growth, inflation, interest rates, and financial stress behave on average. On top of this, they apply quantile regressions to the model’s residuals to track how uncertainty changes over time. In simple terms, the framework allows economic conditions to affect not just what is likely to happen, but also how uncertain the future is. This interaction between the “mean” and the “volatility” of economic outcomes is crucial because it can make bad outcomes much more likely without necessarily changing the best guess forecast by much.

Downside risks to growth are not symmetric

Using euro area data from 1980 to 2019, the study first shows that its model reproduces a key insight from earlier growth-at-risk research. When financial conditions worsen, expected GDP growth falls, and uncertainty rises at the same time. This combination makes the lower end of the growth distribution far more unstable than the upper end. In practice, this means that bad times mainly increase the risk of very weak growth, rather than reducing the chance of strong growth by the same amount. The distribution of future GDP growth becomes skewed to the downside, not because shocks themselves are assumed to be extreme, but because uncertainty rises precisely when growth prospects deteriorate.

Which shocks are the real troublemakers?

The main contribution of the paper is to identify which types of shocks generate these asymmetric risks. The authors distinguish between demand shocks, supply shocks, financial shocks, and monetary policy shocks. Their results are clear. Demand and financial shocks are the main drivers of downside risk to GDP growth. These shocks lower expected growth and raise uncertainty at the same time, creating a powerful amplification mechanism that pushes the economy toward the worst outcomes. Monetary policy shocks behave in a similar way, though their effects are smaller. Supply shocks, by contrast, look very different. While they affect growth, they do not systematically raise uncertainty when growth falls, so their impact on the lower and upper tails of the growth distribution is more balanced.

Inflation risks tell a different story

When the focus shifts from growth to inflation, the pattern changes. Inflation risks are driven mainly by supply shocks rather than demand or financial shocks. Adverse supply shocks tend to raise inflation and make it more uncertain at the same time, which increases the risk of very high inflation outcomes. Demand shocks also contribute to upside inflation risk, while financial shocks are more closely associated with downside inflation risk, reflecting deflationary pressures during financial crises. Overall, inflation risks are somewhat more symmetric than growth risks, but they still depend heavily on the state of the economy and the type of shock hitting it.

Lessons from the financial crisis

The paper concludes with a striking counterfactual exercise focused on the global financial crisis. The authors simulate what would have happened if uncertainty had not increased during the crisis by keeping shock volatility constant. The result is dramatic: the collapse in euro area GDP growth would have been far smaller. They estimate that around two-thirds of the drop in growth at the trough of the crisis can be attributed to the uncertainty channel alone. This finding underlines why financial and demand shocks are especially dangerous and why managing uncertainty is as important as stabilising average growth.

Overall, the study shows that extreme economic risks are not random. They arise from specific structural shocks interacting with financial conditions and uncertainty. By identifying these mechanisms, the paper offers policymakers a clearer and more practical way to think about vulnerability, crisis amplification, and the true sources of macroeconomic risk in the euro area.