monetary policy

The dark side of Germany's economic boom

German Train Drivers To End Strike
The ECB: lighting up the German economy. Source: Bloomberg

Jürgen Abromeit doesn’t need data or surveys to figure out how the German economy is doing. The chief executive of INDUS, a holding company that invests in German mid-sized companies, just has to talk to managers at the more than 40 businesses in which he owns shares. “We’re heading for our fifth consecutive record year, with sales, profits and employment at an all-time high,” Mr. Abromeit said.

For the record, the survey data confirms his optimism: An exclusive survey of over 600 companies, conducted by the Munich-based Ifo Institute for Economic Research on behalf of WirtschaftsWoche, found that a majority expect the upturn to continue over the next year. One in 14 companies even expected their current rate of growth to accelerate year-on-year. Managers have therefore increased their investment budgets and expanded plans to take on new staff.

Analysts at banks and other institutions are also optimistic. Economists have raised their growth forecasts significantly in recent weeks, with some predicting growth in German GDP of as much as 2.6 percent for 2018 (see graphic below). Although many believe growth could slow somewhat in 2019, they still expect the pace to be higher than when capacity utilization is at a normal level.

For eight years, Germany’s economy has been expanding while unemployment has been falling and incomes and tax revenue have been rising. All the while, consumer prices have risen modestly. For the country once famously labeled the sick man of Europe, it’s been an impressive revival. But that doesn’t mean the good times will continue forever. In fact, many economists are starting to issue a warning: Don’t be dazzled by Germany’s new economic miracle.

“The boom carries in it the seed of a crisis.”

Stefan Kooths, Kiel Institute for the World Economy

“If you think a booming economy is harmless as long as consumer prices don’t get out of control, you’re wrong,” said Stefan Kooths at the Kiel Institute for the World Economy (IfW). “The boom carries in it the seed of a crisis.”

Part of the concern goes back to the rather well-worn German fear about loose monetary policy, something Germany’s Bundesbank has been towing the line on for years. Mr. Kooths explained that the money being poured into the economy since the financial crisis by the European Central Bank was making investment plans and business models appear profitable that, on close inspection, prove not to be. As positive as the boom might seem, it’s also dangerous, particularly as it has been fueled by interest rates that are far too low.

The ECB’s phase of buying up trillions in government and corporate bonds may be coming to an end. But out of concern for highly indebted countries in the southern euro zone, the ECB is still expected to keep interest rates low for a long time – too low for Germany, Europe’s largest economy. “Consumption, investment and exports will become unbalanced. There’s a risk of overinvestment and misallocation,” said Henning Vöpel, director of the Hamburg Institute of International Economics.

Those concerns are compounded by the fact that many believe the German government has done little to help. While the upturn is a big part of the reason Chancellor Angela Merkel is headed for a fourth term in office (assuming she finally manages to put together a governing coalition), some worry the economy is booming despite the braking effect of the government’s policies.

For critics, Germany’s government is lying back in the mistaken belief that the ‘Made in Germany’ quality seal will have eternal appeal, instead of making the economy fit for the challenges posed by an aging population and competition with other countries. Instead, the government has made life difficult for businesses in recent years, with rising taxes, unnecessary regulations and high energy costs.

Given the uncertain political situation in Berlin, this is unlikely to change in the next few years. Yet without reforms to the market economy, “policy will become a risk to Germany as a location,” warned Alexander Krüger, chief economist at German private bank Bankhaus Lampe.

WiWo53 p93 Expert’s forecasts for 2018-01

First, the good news. For the moment, Europe’s largest economy is seen running at full steam, in no small part due to a revival among its neighbors. While the ECB’s low interest rates have long propped up Germany’s economy, they are now bearing fruit in other euro-zone countries. Even crisis-hit countries such as Italy and Greece are growing at respectable rates of between 1.5 percent and 2 percent. This benefits German companies, which sell 37 percent of their exports to euro-zone countries.

The mood is buoyant beyond the euro zone too. Stefan Kreuzkamp, chief investment officer at Deutsche Asset Management, the asset management arm of Deutsche Bank, expects 79 percent of all countries to grow by more than 2 percent in 2018. The world is experiencing a “synchronized upturn,” he said. That, too, is good news for German exporters, whose exports are set to grow by more than 5 percent in 2018, twice the rate for 2016.

The German economy is also being boosted by robust domestic demand. Companies’ order books are full and there is a shortage of skilled staff. “Our companies are hounding schools and universities to find suitable workers,” said Mr. Abromeit at INDUS. 73 percent of companies surveyed by Ifo regarded the skills shortage as the biggest brake on the economy.

Within a decade, conditions on the labor market have been reversed. While workers were worried about their jobs 10 years ago, today they can pick and choose the jobs they want and negotiate good conditions. Economists at the IfW expect wages and salaries to go up by 3 percent over the next year, including bonuses. As the inflation rate is only about half this amount, employees will be left with more money in real terms. Consumer spending is thus expected to remain an important pillar of the economy.

Companies are struggling to meet growing demand from Germany and abroad with their existing capacity. That means they are investing more in new machinery and equipment. “Next year we will spend about €90 million ($109 million) on investment in our subsidiaries, 10 percent more than this year,” Mr. Abromeit said.

Bottlenecks in capacity are also a dominant issue in the construction industry, where low interest rates, stable income prospects and immigration are driving up demand for property. Hauptverband der Deutschen Bauindustrie, the association for the German construction sector, said the industry could not expand fast enough to keep up with demand. A total of 350,000 new homes will be completed over the next year, which is 50,000 fewer than needed.

WiWo53 p93 Growth kills reform-01

So that’s the good news. But will it really last? The fact is many experts believe Germany’s upturn could well be corrected with a crisis. And if that happens, it is doubtful the German economy will get off as lightly as it did in 2008.

Those fears are largely due to politics. Back in 2008, the country was seen as fit for the challenge thanks to the “Agenda 2010,” an ambitious set of social and economic reforms adopted under former chancellor Gerhard Schröder. But many of these have since been reversed under Ms. Merkel’s watch, admittedly prodded by the center-left Social Democratic party that was long uncomfortable with their former leader Mr. Schröder’s more centrist approach. Recent years have seen the adoption of a minimum wage, equal pay for temporary and permanent staff and growing bureaucratic burdens.

This shift may be admirable in its effort to tackle inequality, but it has robbed companies of some of some of their flexibility in a downturn. Added to that is an unbridled growth in unit labor costs, which means Germany’s attractiveness has suffered compared to its neighbors. These have been rising faster than average for the euro zone for years, and as productivity is expected to lag behind wage growth in 2018, Germany is set to continue becoming less competitive in terms of price.

About time, say Germany’s critics abroad, who have long demanded higher wages to reduce the country’s trade surplus and restore some competitive balance to the global economy. But Germans worry that the country’s quality as a location has dropped too far. The situation is aggravated by the fact that social security contributions, taxes and energy costs have also been rising for years. Germany’s Commerzbank has calculated, based on data from the World Bank, that Germany’s quality as a location has declined massively compared with top locations in the European Union since 2009.

Berlin, meanwhile, has lost the urge to keep that competitive advantage alive. The ECB’s low interest rates not only take pressure off the government to implement new reforms, but also provide an incentive to get into debt. That goes for consumers too: A survey by pollsters YouGov showed that 12 million Germans were planning to buy their Christmas presents for 2017 on credit, with 87 percent not planning to repay their debts for a year. For a country that prides itself on a savings culture, this is quite the shift.

A large proportion of cheap loans in Germany are going into the property market. Economists at the Bundesbank, the country’s central bank, believe the risks of a bubble are “fairly limited” given that lending has grown just under 4 percent. However, properties are already overvalued by 15 to 30 percent in cities, as Germans pile their savings into real-estate, and as prices continue to rise. If the market undergoes a correction, “risks arising from revaluations, interest rate changes and loan defaults could intensify each other,” said Claudia Buch, vice president of the Bundesbank central bank.

The dangers also apply to companies: If the phase of low interest rates continues, Germany could face a similar trend to that seen in France, where there is currently a boom in loans for commercial acquisitions. Corporate debt has risen from 60 percent of GDP in 2010 to 72 percent. Even the French central bank is wondering whether to be alarmed at the boom in loans, which are recording growth rates of 7 to 8 percent.

Low interest rates are masking the precarious situation of many companies. A study of 7,400 companies by the credit reporting agency Creditreform showed that more than 15 percent are not generating sufficient profits to cover their borrowing costs. It is only access to cheap loans that is keeping these ‘zombie companies’ alive. If interest rates were to rise by just 3 percentage points – which would be reasonable for a strong economy – Creditreform calculates that almost 20 percent of German companies could become insolvent. The percentage is likely to be even higher in southern euro-zone countries. The ECB is therefore not expected to raise interest rates in the foreseeable future.

But what if inflation does rise faster than anticipated? Then the ECB will have to decide what is more important: keeping prices stable or rescuing over-indebted companies, individuals and governments. No one knows exactly when the ECB might face this kind of dilemma, which makes Mr. Abromeit cautious. “The potential for a setback is growing,” he said. Rather than expanding their capacity, many companies in the INDUS group are investing in improving efficiency. “In the late phase of the economic cycle, a careful captain mustn’t lose sight of costs,” he added. The only question is how many other German companies have such careful captains at the helm.

A version of this story first appeared in the business weekly WirtschaftsWoche, a sister publication of Handelsblatt. To contact the author:

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