Friday, September 26, 2014

The Inbetweeners - German Economic Update

The economy has been on a roller coaster ride for quite some time. In the short run, fundamentals remain strong but preparations for the longer run should start quickly. Only judging from German GDP data, the economy has been on a roller coaster ride for quite some time. The impressive first quarter performance was followed by a disappointing contraction in the second quarter. This contraction had given rise to new speculations that the German second Wirtschaftswunder might already be over. Is it? The answer to this question is not easy and not straight forward. There are currently several, partly opposing, trends and developments affecting the economy’s growth prospects. In many ways, Germany is currently inbetween. Here are at least three: i) inbetween strong domestic demand and weaker external demand; ii) inbetween strong short-term fundamentals but weaker long-term prospects; and iii) somewhere inbetween the sometimes religious debate on growth versus austerity. The composition of second quarter growth sent two opposing signals for the German economy’s prospects: the sharp drop in the construction sector should have been a weather-driven one-off and should be reversed in the third quarter. Demand for housing continues to be strong, backed by low interest rates and low homeownership ratios. The inventory build-up seen in the second quarter, however, was less encouraging for activity in the third quarter. Moreover, the only marginal improvement of new orders from other Eurozone countries shows downside risks for the German economy do currently not mainly come from geopolitical tensions but rather from longer-than-expected weak demand from Eurozone peers. It is still too early to tell which of these opposing trends will eventually predominate. This is why Germany is an inbetweener. In our view, the solid fundamentals, domestic demand and exports to the US still form a substantial safety net against widespread fear and a period of economic drought in Germany. Looking beyond the short term, however, the economy and policymakers face new problems. The current strength of the German economy is still the result of structural reforms from the early 2000s. In fact, the economy has reached the final stage of textbook business and reform cycle: from the sick man of Europe to structural reforms and wage moderation to regained competitiveness and increasing exports to dropping unemployment and strengthening domestic demand to wage increases and a fully self-sustained recovery. Additional stimulus will have to come from new structural reforms. Otherwise, Germany could have problems facing its long-term challenges like ageing, an investment gap and surviving global competition. One of the crucial questions for long-term growth prospects is how the industry will react to emerging market economies’ attempts to climb up the quality ladder. Or put differently, what will happen if and when emerging market economies are able to produce same quality products as the Germans. In this context, new developments and trends known as industry 4.0 are of high importance. To manage the transition from the rosy short-term to the rather challenging long-term, investments play an important role. Both public and private investments have remained sluggish in the current recovery. At the same time, however, several investment-intensive sectors offer an enormous potential to improve Germany’s long-term growth. Just think of infrastructure (rail, road but also internet), transition towards renewable energies and education. Up to now, the government has been reluctant to address this issue, giving the impression of some kind of complacency and refusing calls to use the still good (economic and fiscal) times and extremely low interest rates to tackle weak investments. This could change. In recent weeks, there has been anecdotal evidence of a slight, subliminal change within the government, with for example the start of an expert group on new investments. More emphasis on investment would be a shift in policymakers’ stance on austerity and structural reforms. In the European debate, German policymakers have been relatively quiet, hardly commenting on increased calls for more growth and demand-oriented policies. There are, however, some domestic signals that Germany is giving up its principle of leading by example. The German mantra of austerity and structural reforms seems to wobble; at least domestically. In the latest debate on how to reform the German system of transfers between the federal states, a proposal by finance minister Schäuble foresees that the debt brake for the states could be eased. Moreover, the issuance of common bonds of all federal states is also discussed. Last year, the federal government and some regional states issued already one common bond for the first time ever. Needless to say that these changes to the own transfer system would have a strong signalling effect to the rest of Europe. All in all, despite the still strong fundamentals, Germany seems to have reached an interesting transitional period in many different ways, making it the economy of the inbetweeners.

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