Germany – Home of Another Economic Miracle?

This year Germany will once again enjoy strong economic growth, and prospects for 2012 are also good. But we should not draw the conclusion from the currently positive developments that the medium- to long-term outlook has improved markedly. The economy is currently benefiting primarily from excellent cyclical conditions. Should these conditions normalise – and the European Central Bank’s first rate hike was a first step in this direction – growth rates too will return to normal levels.

Germany is once again the talk of the town. Back in 2006 and 2007, many people had already spoken of a second economic miracle, but this debate was stifled by the sudden collapse triggered by the global financial crisis. Now it has returned. Even by the most optimistic standards the German economy has recovered at a surprisingly quick pace from the deepest recession since the foundation of the federal republic and has left most other countries in the Eurozone far behind. 

The cycle continues

But we should not overlook the backdrop against which this heady upturn is unfolding. Firstly, it follows a dramatic drop in activity in late 2008/early 2009. Only this quarter will real GDP probably return to its pre-crisis levels.

Secondly, cyclical conditions in Germany are currently better than they have been since reunification:

• Despite the ECB’s first rate hike in early April, monetary policy remains extremely accommodative and is boosting corporate investment in particular.
• The global economy is thriving. We assume that economic growth in the US will even tend to increase, which ought to compensate for somewhat slower growth in Asia. Activity in most other Eurozone countries looks set to remain sluggish, with demand for German products rising only slowly. But the situation will hardly be any worse than it was in 2010.
• Whilst the euro has appreciated strongly versus the US dollar, it has lost much ground against many other currencies. The real external value of a notional D-mark even fell by more than 6% during 2010, which means that German products have become even more competitive on the global market

Germany remains the outperformer in the Eurozone

Naturally, all these factors apply also to the other countries in the Eurozone. But many of them are struggling with the after-effects of past exaggerations: a sharp rise in household and corporate debt levels and, in several countries, a burst housing market bubble. All these exaggerations must now be corrected, which is imposing a drag on growth. Moreover, public finances in some countries are in disastrous shape and require sharp public spending cuts and sizeable tax hikes. 

The trend of interest rates will probably be up at the short and long ends of the curve this year and next. 

Germany experienced no such exaggerations and its need for consolidation is much less severe. As a result, the very favourable cyclical conditions are almost fully reflected in a strong upturn. And since other countries will long keep struggling with the consequences of earlier exaggerations, Germany should continue outperforming the Eurozone average for now.

In addition to the cyclical drivers, the increasing flexibility of the labour market that has evolved in recent years, especially where it relates to wage setting, has a positive influence now. It has clearly improved Germany’s price competitiveness, particularly within the monetary union, which is why the upturn is no doubt stronger than it would have been without these reforms. But for the most part, what we are currently seeing is quite a normal cyclical upturn.

This allows two conclusions to be drawn. The good news is that whilst cyclical conditions are gradually becoming less favourable, they will remain above average for a long while yet. In consequence, the economy should expand rapidly this year and next. We forecast growth rates of 3% and 2.5%, respectively.[[[PAGE]]]

Whilst the euro has appreciated strongly versus the US dollar, it has lost much ground against many other currencies.

The bad news is that once cyclical conditions normalise because the ECB is raising interest rates and the global economy is losing steam, growth rates too will return to more normal levels. And with the working population stagnant, growth rates will move in the region of productivity growth, which in Germany has averaged about 1.5% in the past 20 years.

Interest rates will rise despite problems in the periphery

It may take a while until framework conditions return to normal. While  the ECB made it clear with its first rate hike in early April that it is ready to respond to mounting inflation risks despite the sovereign debt crisis in the Eurozone and weak economic activity in the peripheral countries, it will surely not ignore the problems of several member countries of monetary union and therefore proceed more slowly than it did in earlier cycles. But nevertheless, the trend of interest rates will probably be up at the short and long ends of the curve this year and next.