Germany’s economy isn’t as strong as Europe believes

Published: Dec 4, 2013 5:01 a.m. ET

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Commentary: Euro zone shouldn’t expect Germany to lead recovery



Election campaign posters of the top candidate of the Social Democratic Party (SPD) Peer Steinbrueck (L) and German Chancellor and head of the Christian Democratic Union party (CDU) Angela Merkel are pictured in Berlin last September.

SYDNEY (MarketWatch) — German Chancellor Angela Merkel will most likely preside over Germany in a “grand coalition” with opposition parties. But this time around she may have been handed a poisoned political chalice. Germany faces significant economic challenges and risks, and its economic power and financial strength may be overstated.

Germany’s economy relies on its export prowess. The assumption is that the country can decouple from the euro zone, increasing its focus on emerging markets. But German exports to European countries total around 69% of the total, including 57% to the member states of the European Union.

In 2012, Germany ran a trade deficit of 27 billion euros with Russia, Libya, and Norway, mainly for energy imports. Germany also had trade gaps with Japan (4.7 billion euros) and China (11.1 billion euros).

By contrast, Germany ran a trade surplus with the euro zone (France, Italy, Spain, Greece, Portugal, Cyprus and Ireland) of 54.6 billion euros. It also had a surplus with the U.S. (36.2 billion euros) and the U.K. (29.3 billion euros). In effect, Germany’s overall global trade surpluses are reliant on exports to the euro zone. Continued weakness in these troubled countries will negatively impact Germany’s economic prospects.

German export performance also depends on the value of the euro EURUSD, -0.2083%  . If the euro continues to rise due the U.S. continuing its quantitative easing plan for longer than expected, then Germany’s competitive position will weaken. High energy prices and the increasing problems in emerging markets will exacerbate its problems.

A slowdown in German exports will have ripple effects. The recovery in Spain and other teetering euro-zone economies is dependent on exporting intermediate goods to Germany, which are then re-exported as part of finished products. Reduction in German exports will decrease economic activity in these countries, in turn reducing demand for German exports within Europe.

German industrial competitiveness is also overstated. Not so long ago Germany was regarded as the sick man of Europe.

Between 2000 and 2010, German productivity increased by a modest 0.6% per year, roughly half the OECD average. Germany’s labor market remains inflexible, and its banking system is fragmented and weak. Meanwhile, Germany’s infrastructure is aging, requiring investment. Energy costs remain high, some 30% above that of the rest of Europe and double that of the U.S., reducing competitiveness. High natural gas costs (four times the U.S. cost) disadvantages Germany’s petrochemical industry.

OECD and World Economic Forum studies both rank Germany modestly in terms of education, communication infrastructure, financial-system soundness and business environment. The country ranks 106th for starting a firm, 31st for mobile broadband, 75th for soundness of banks, 127th for hiring and firing and 139th for wage flexibility.

German demographics, with an aging population, compound its problems. It has the highest median age (45 years) in Europe. In 1970, Germany’s dependency ratio (number of workers for each retiree) was 4.1. In 2010, it was 3.0 and is projected to fall to 1.6 by 2050, only slightly better than Japan.

The terms of Merkel’s grand coalition do little to address pressing issues and limits Germany’s operating flexibility. If anything, it seeks to reverse some of the Agenda 2010 reforms launched in 2003 by now vilified Chancellor Gerhard Schröder, who did much to restore German economic strength.

Whatever their social merits, the minimum wage and increased retirement benefits will reduce competitiveness, particularly in the former East Germany. The plight of younger workers is largely ignored. Constrained by rigid adherence to maintaining budget discipline and reducing debt, there are no major investment initiatives.

Europe at risk

Germany also remains vulnerable to continuing problems in Europe, where the need to support the weaker countries is increasingly problematic.

Governments in the at-risk economies are unlikely to meet agreed budget deficit or debt level targets. Banks will face rising bad debt losses and require capital infusions. For both troubled sovereigns and banks, access to financial markets will remain restricted. Cost of commercial funding will remain above affordable levels. Further funding assistance may be required.

Euro-zone members, including Germany, remain committed to avoiding the unknown risks of a default and departure of countries from the euro. This presumably means that assistance will be forthcoming, although the exact form and attached conditions remains uncertain.

Peripheral countries will be forced to rely on the European Stability Mechanism (ESM) and European Central Bank (ECB) to provide funding. Unless the size of the ESM is increased, the ECB will be forced to provide financing directly or indirectly, funding banks to purchase government bonds that will be used as collateral for the central bank loan.

National central banks will also use the “Target 2” payment system to settle cross-border funds flows between euro-zone countries, financing peripheral countries without access to money markets to fund trade deficits and capital flight.

Over time, financing will become concentrated in official euro-zone agencies, the ECB and the TARGET2 system. Risk will shift from the peripheral countries to the core of the euro-zone, namely Germany and France. This reflects the reality that the stronger countries stand behind each of the support mechanisms.

The ESM relies primarily on contributions of four countries: Germany (27.1%), France (20.4%), Italy (17.9%) and Spain (11.9%). Individual countries are required to provide capital equivalent to their quotas. While there is no legal provision that capital subscriptions or contingent commitments of remaining ESM members would increase, if Spain or Italy needs assistance, then the contributions of the remaining countries, especially France and Germany, may have to be increased to ensure the functioning of the ESM.


German guarantees supporting the ESM total 190 billion euros, that being Germany’s capital contribution to the ESM. But if the circumstances change and the ESM has to rely purely on German and France support, then Germany’s liability when recipients default could be much greater. There is also the indirect exposure via the ECB and the TARGET2 claims.

The size of these exposures and potential losses is large, in relation to Germany’s GDP of around 2.5 trillion euros and German private wealth.

German household assets are estimated at 4.7 trillion euros. Despite measurement issues, especially the attributed value of housing assets and pensions, Germans have lower-than-expected median net wealth within the euro zone.

German median net household wealth is estimated at 51,400 euros, well-below that of Spain (182,700 euros), Italy (173,500 euros), Greece (101,900 euros) and even Cyprus (266,900 euros). This reflects a period of prolonged deflation since the creation of the euro and low property ownership rates. Germany scores better on the average figure, reflecting wealth differentials and assets of rich families and foundations.

Germany also has substantial levels of its own debt (around 81% of GDP). If unfunded social security liabilities are included, then the level of German debt increases to over 190% of GDP, compared to 146% for Italy.

German voters generally approve of Chancellor Merkel’s handling of the European crisis, believing her reassuring message to the German public was that they are living in a prosperous recession-proof economy and the euro zone’s problems are largely contained. In September, German Finance Minister Wolfgang Schauble mocked critics about doubting Europe’s recovery strategy.

In fact, the German-led strategy for dealing with the European debt crisis shows limited progress and is unlikely to resolve the issues. A policy without debt write-offs and relief as well as major structural changes promotes European economic weakness, which will affect German performance. It will also require stronger euro-zone nations to increase financial support for the peripheral nations.

At best, increased commitments to support its European partners will absorb German savings, crippling the economy. At worst, default of one of the weaker countries or a break-up of the euro will result in large losses to Germany; the best estimates are in the range of 750 billion to 1.5 billion euros.

Germans have chosen to ignore that each step in the progress of the crisis has resulted in a transfer of risk, liability and losses to them. Given strong opposition to debt pooling and institutionalized structural wealth transfers, their eventual reaction to revelation of this increasing commitment and their status as Europe’s permanent creditor is unknown.

Only time will tell whether Germany is on the verge of yet another of the reverses and extremes that have characterized the nation’s history.


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