The normalisation of the German economy
July 30, 2019
The news about the German economy is not encouraging. Various survey measures show that expectations declining to levels last seen years ago and the actual growth rate was just above zero for the last quarter.
Germany is supposed to represent the powerhouse of Europe. One would thus expect that if ‘Germany sneezes, the rest of Europe catches a cold’. However, this is not the case. Most other European economies are slowing down less than Germany. The exception is, of course, Italy. But the slowdown in Italy has many domestic, politically induced, reasons.
Domestic demand has been solid, but not spectacular, contributing about 1.5-2.0 % to GDP growth, on average, over the last years. A key component of domestic demand is domestic consumption, which constitutes the bulk of domestic demand growth. The other components of domestic demand, public expenditure and investment appear rather stable. What is surprising is that the contribution to growth from private consumption has declined recently (2018/9).
This is difficult to explain against a backdrop of steadily increasing wages and employment. In the US, which also has a booming labour market, he contribution of private consumption to GDP growth is more than twice as large. One reason for the relative weakness of domestic consumption might be due to the fact a large part of the additional employment generated in Germany goes to immigrants. In 2018 more than one half of all the new jobs created were filled by foreigners. Only a small part of these were refugees who are slowly being integrated into the labour market. Most of the foreign workers are EU-national, especially from Eastern and Southern Europe who are attracted to the country by the high number of job openings which cannot be filled by Germans, whose number is declining.
This high degree of labour mobility has two macro-economic effects. First of all, it diminishes the pressure on the German labour market, thus reducing wage increases. But there is a second effect, in that most of these newly arrived workers have a low propensity to spend, or at least a low propensity to spend in Germany. Many of the EU-workers in the country have not immediately brought their family (understandably given the tight situation of the housing market); they are thus likely to save a large part of their earning, and to send a substantial part home – thus supporting demand in their home countries.
Another reason for the underlying weakness of consumption in Germany might be the weakness of productivity growth. Over the last years, employment has increased by almost as much as GDP. This makes for a booming labour market (and high tax revenues), but it also implies that expectations of future growth must be limited as the domestic labour force is by now almost fully employed. Consumers tend to spend more than their current income if they expect high growth and thus a high future income. Wages can increase on a sustained basis only if productivity does as well. As long as productivity growth does not accelerate, domestic demand is likely to remain weak.
Germany would not be close to a recession if this relative weakness of consumption had not been aggravated by a negative contribution from the external sector of O.7 % of GDP this year. The weakness of German exports is thus another central reason for the present slowdown. However, global trade started to slow down already last year. The impact on the German economy was delayed by a high built up in inventory (worth 0.6 % of GDP last year). It seems German exporters were over-confident last year, producing for inventories. They now make up for this error by reducing production and investment.
There remains one element in this picture which does not fit the prevailing narrative which puts the German economy at the heart of Europe.
The countries in central and Eastern Europe which are tightly integrated in the German industrial value chain, especially in the automotive sector, are not showing any sign of a slow-down. Czechia, Hungry and Poland, are actually recording increasing growth rates. In principle, one would have expected these countries to slow down before Germany since they are providing intermediate inputs for German cars which are then exported as ‘made in Germany’ to the rest of the world although they are really ‘made in Europe’.
The fact that these countries can continue to grow while Germany has problems indicates that the country’s industry has lost some of its advantage. Unit labour costs have increased for several years by much more in Germany than in other countries while productivity has stagnated. It is thus not surprising that the German current account surplus is also declining steadily, now below 7 % of GDP, compared to close to 10 % some years ago.
All in all, it appears that the German economy has been over-rated in the past: it is solid, rather than dynamic. It remains the biggest of the Euro area and government finances are in surplus. But productivity growth has been rather low, limiting the long term growth potential absent further massive immigration.