Can Germany take its foot off the brake?

Budget orthodoxy

However, Germany is officially wedded to a budget orthodoxy. The call for more spending is a direct challenge to Germany’s decade-old constitutional commitment to a balanced budget. Known as “Schwarz null” or “black zero”, the policy targets fiscal balance. Since 2012 Germany has built a budget surplus that is now edging toward 2% through a period of, until recently, healthy expansion (see chart 1). Income tax revenues and total tax income have risen and Germany’s debt-to-GDP ratio has fallen from 81.8% in 2010 to 60.9% last year. At almost 8% of gross domestic product Germany also runs the world’s largest current account surplus (the balance of trade and primary income) in absolute terms and enjoys a weak, export-friendly currency.

That focus on balance may have made sense in the aftermath of the financial crisis, but German infrastructure from roads to broadband is run-down. While the German economy places third globally in the World Economic Forum’s competitiveness ranking, it is 31st in digital infrastructure while its road network slipped to 19th last year. In comparison, the WEF ranks Germany’s ‘debt dynamics’ no.1.

Promised package

The German government argues that it is already investing more in its physical and digital infrastructure and is considering a spending programme. The last time it did so was in 2008/2009 with a 50 billion euro package.

In practice, there is room for Germany to both increase public spending and respect its commitment to a balanced budget. Our calculations suggest that a German package of 50 billion euros now, assuming a fiscal multiplier for government spending of 0.8 (in other words a relatively efficient 80 centimes increase in GDP per euro spent, as suggested in a 2014 IMF paper), would boost growth by 1.1% (see chart 2). That would still leave the German budget in surplus. It would also have a positive impact on the wider eurozone, with a boost of around 0.3% to the region’s GDP.

The German government forecasts economic growth will slow to 0.6% for this full year, compared with a rate of 1.5% for 2018. That is slower than the eurozone, where the consensus forecast is for growth of as much as 1.1% in 2019.

Protectionism and cars

Trade remains the biggest economic theme of 2019 and Germany’s economic slowdown tracks with the arrival of the US president’s protectionist measures against China and threats to the European Union. The US administration has so far held off from imposing import tariffs on EU goods and services, but continues to reference its trade deficit with the bloc in general and the German car industry in particular. Germany accounted for 55% of EU car exports in 2018 while the second-largest exporter, the UK, shipped 17% of the total.

“Dealing with the European Union is very difficult; they drive a high bargain,” Trump told reporters on 20 August. “We have all the cards in this country because all we have to do is tax their cars and they’d give us anything we wanted because they send millions of Mercedes over. They send millions of BMWs over.”

Trump has threatened raising duties as high as 25% on car imports (a ten-fold rise) on national security grounds. Americans bought 1.34 million German cars and vans last year, of which 60% were US-built (and then in many cases exported to China).

It is worth remembering that US/EU trade is considerably larger than US/China trade. In 2018, the US exported goods and services worth USD 574.5 billion to Europe vs USD 179.2 billion to China. The same year, US imported USD 683.9 billion from EU and USD 557.9 from China. Any impediment to trade between the EU and US, coming on the back of the US/China trade dispute, would be hugely damaging.

In addition, the uncertainty of Brexit adds more potential downside. The UK is Germany’s fifth-largest export market (buying almost 100 billion euros of German goods in 2018) and any disruption, compounded by weakening manufacturing at the same time as a hard Brexit, would further undermine the German economy.

Politics and a catalyst

In domestic politics, Germany finds itself in a sort of limbo. Support for Chancellor Angela Merkel’s Christian Democratic Union party is falling after her almost 14 years as head of the German state. Protégée Annegret Kramp-Karrenbauer took over as party leader in December. In something of a coup, ‘AKK’ outflanked rivals in July to take on the role of Defence Minister (replacing Ursula von der Leyen who will become European Commission president). That may increase AKK’s chances of succeeding Mrs Merkel as chancellor in 2021.

Unlike Italy’s current political crisis, which has implications for the eurozone since it is capable of triggering yet another EU-level budget confrontation, Germany’s self-imposed economic clouds and aging economic model have far wider consequences for the rest of the world. Fortunately, the spending tools to dissipate those clouds are already in the hands of the country’s government.

A German stimulus package, taking advantage of its significant fiscal cushion, would serve Germany well in decades to come. It would also calm critical voices within Europe and beyond.

In an increasingly protectionist trade environment, it may also be time for Germany to question whether it makes sense to continue with an economic model that depends on producing goods for export. More broadly, unless the EU’s biggest economy can become a source of demand, the bloc will suffer as a whole.

In the very short run then, the threat of a recession may be just what is needed to jolt Germany out of its damaging obsession with balanced budgets and toward a more balanced economy.

This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.

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