Euro area economic data remain disappointing. Even though it marginally beat expectations, Q314 GDP growth of 0.2%Q/Q represents little more than stagnation. The most notable upside surprise came from France. But growth of 0.3%Q/Q still left French GDP up a paltry 0.4%Y/Y and we certainly do not expect a similar quarterly growth rate in Q4. Italy, meanwhile, was confirmed in recession and has now failed to post a single positive quarter of growth since Q211. That dire performance is hardly unexpected. But less predictable since the start of the year has been the marked slowdown in Germany, which had been expected to provide a boost to the rest of the euro area. And while growth there of 0.1%Q/Q in Q314 was a touch firmer than we feared, it merely reversed the drop recorded the previous quarter suggesting an economy that has alarmingly lost momentum.
Surveys suggest that the German economy has fared little better in Q4. While Germany’s Commission Economic Sentiment Indicator and composite PMIs were slightly stronger in October, these were still below their Q3 average with negligible improvement in terms of orders and new business. And the Ifo indices have maintained the downward trends in place since the spring. At the very least, further firming in these surveys would be needed before a convincing recovery in economic growth could be expected. For now, therefore, we expect German GDP growth of only 0.1%Q/Q again in the final quarter, suggesting no immediate end to the soft patch.
So, why the weakness? The oft-heard explanation of the Ukraine/Russia dispute harming German exports doesn’t hold much water on its own. Russia isn’t among the country’s top ten trading partners, and we think the sanctions will have knocked no more than 0.2ppt off GDP growth over the past 12 months. But events in Russia, stacked alongside other geopolitical strife and disease, have likely cumulatively weighed on economic confidence. Expectations of lasting stagnation elsewhere in the euro area – fuelled by negativity from the Bundesbank towards the ECB – have also likely weakened domestic demand. And – given adverse demographic trends and other deficiencies of the country’s current economic model – recognition of Germany’s own declining future growth trend might also be generating a negative feedback loop, further depressing domestic spending and investment.
But could the coming year offer cause for optimism? Notable forecasters, including the German government and the network of Germany’s top research institutes, are sticking to a fairly bullish growth outlook for 2015. Although both lowered their forecasts for this year and next to 1¼%, suggesting practically no growth in H214, this also implies average growth of around ½%Q/Q in each quarter of the coming year. But judging by Germany’s performance in the post-OMT period, during which growth has barely averaged 0.2%Q/Q, this seems unlikely. Over this period, net foreign demand depressed GDP growth and fixed investment hardly contributed to it, leaving household spending as the main, but still weak, source of growth.
More generous recent wage settlements, and the introduction of the federal minimum wage, do at least suggest a stronger household spending outlook for 2015. But the favourable impact on average labour earnings is likely to be counteracted by a further slowing of employment growth, not least due to the rise in labour costs, which looks set to be marked among lower skilled workers. Moreover, the GfK’s most recent consumer sentiment survey saw households report a greater inclination to save than on average throughout the past year, so don’t hold your breath for a household spending bonanza. Other expenditure categories (investment, net exports, government spending) show even fewer reasons to be positive, given the deterioration in business sentiment, a still weak and unpredictable external environment and, above all, the Government’s determination to keep Germany’s budget in balance whatever might happen to economic growth.
Therefore, we forecast economic growth of just 0.8% in the coming year, almost exclusively driven by domestic demand. And that growth is likely to be inadequate to counter the persistent deficiency of demand that lies behind many of Germany’s pernicious economic ills. The current account surplus will remain huge, perhaps still above 7% of GDP. And German inflation (just 0.7%Y/Y in October) will remain far below the ECB’s target of close to 2%. That will continue to force deflationary adjustments on other member states, leaving euro area inflation continually at risk of slipping into negative territory and the ECB still ensnared within its liquidity trap.
So, what should be done?
- Fiscal stimulus. The persistent deficiency of demand calls for macroeconomic policy stimulus. With monetary policy constrained, not least by the Bundesbank, the case for more active demand management through fiscal policy is all the stronger. Yet, Merkel and Schäuble appear adamant to deliver a balanced budget this year and next, come what may, meaning that fiscal policy might even be tightened. Having planned on the basis of a structural budget surplus of ½% of GDP this year and next, Germany will continue to exceed by far the budgetary requirements placed on it by the EU as well as its own, stricter national constitutional ‘debt brake’ rule set legally to bite from 2016 on. This seems unnecessary as well as economically harmful, and certainly contrary to what Draghi advocated in Jackson Hole.
- Extra public investment. Pointing to the country’s crumbling infrastructure, international institutions (EC, IMF, OECD, etc.) have called for greater German public investment. And they are right. Having trended lower over the past two decades, gross public investment is now well below the EU average (1.6% vs 2.2% of GDP), and net of depreciation it is negative, leaving a steadily eroding capital stock. Various studies estimate annual investment needs for transport, education, etc. at up to €120bn over the next decade. Add to that insufficient current expenditure on education and childcare services and there seems to be no shortage of deserving causes for extra public spending. Given the negative yields on Bunds of maturities of up to three years, if managed correctly the returns to such expenditure, which can support both current and future growth, seem bound to exceed the costs.
- Tax cuts. Given the lags involved in readying public infrastructure projects, tax cuts might also play a role to boost near-term demand. And from a supply-side perspective they would support employment and productivity growth too. Lower payroll taxes might negate the additional costs related to the increased minimum wage faced by firms employing lower-skilled workers, while a permanent VAT rate cut might directly support consumer spending. And reforms to the tax system might also be used to stimulate private fixed and housing investment too.
- Structural reforms. German policy-makers never seem to stop hectoring other member states about the need to implement structural reforms. But the government estimates that potential growth will decline over the coming three years to less than 1½% per annum – and lower still over the longer term – which in itself risks deterring increased private investment. Following Merkel’s bizarre anti-nuclear U-turn in 2011, greater clarity about the regulatory and cost framework seems required to facilitate the required sizeable boost to energy sector investment. Deregulation in the services sector – not least related to professional and retail services – could also boost both productivity and demand. The highly elevated business savings rate – a major contributor to the current account surplus – seems indicative of corporate governance failings. And with concerns about Germany’s adverse demographics also likely contributing to high precautionary household saving, the decision earlier this year to reduce the retirement age for certain workers was plain perverse.
So, there appears no shortage of action that German policymakers could take to boost growth at home, while providing a more benign influence on the currency union as a whole. But will they? Complacency at the country’s current pre-eminence within the euro area, coupled with the compromises that inevitably result from a Grand Coalition government, seem likely to conspire against any new impetus to growth-boosting reforms. And most alarmingly, the near-religious obsession with balanced budgets – not unrelated to misdiagnosing the euro crisis as a predominantly fiscal one – suggests that Merkel will continue to resist urges to loosen her own purse strings. That, of course, is bad news for Germany, which seems likely to endure little more than mediocre growth next year and beyond. And it is terrible news for the rest of the euro area and the ECB, with stagnation and deflationary risks likely now here for the long term.
This is an updated version of the blog of the same name issued on 13 November,
updated for the subsequently released Q314 GDP data.