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A Macroeconomic Analysis of Germany Introduction

Sitting in the heart of Europe, Germany is home to 83m people and the worlds fourth largest economy (nominal GDP). The country is governed by a CSU, CDU and FDP coalition led by Chancellor Angela Merkel. The past century has seen a rapid recovery from the ruins of post-World War II to present day status as the powerhouse of Eurozone economies. An understanding of this process is fundamental to this analysis. The economic model adopted during this period was the social market economy, a compromise between socialism and capitalism which is characterized by encouraging but regulating the free market economy, targeting high growth, high employment and low inflation. This has developed an approach to company management, industrial relations, social welfare and the stakeholder concept which compels companies to act in the interests of employees, customers, suppliers and local communities as well as shareholders [1]. This approach was cultivated while focusing on an export led growth, whenever possible. In 1946, millions began returning to Germany post World War II, increasing demand and imports until 1949 when domestic supply adjusted and a modest devaluation of the DM stimulated overseas demand for German products [2]. An export surplus was noted for the duration of the 1950s with government continuing to investment in industry to bolster exports. This focus remains today with Germanys status as the worlds largest exporter of goods only recently being taken by China. Conservative wage policy and price stability were fundamental contributors to lower price inflation and an undervalued DM making German exports internationally competitive [3]. Subsequent to this the Bundesbank became the worlds first to introduce a strategy based on monetary targets bringing with it price stability and low inflation. Policies and targets were openly communicated to the public fostering transparency and anchoring medium term inflation expectations. The Bundesbank Act, outlining its policy as that of safeguarding the currency, developed the DM into the worlds most stable currency after 1945 and enshrined its policies in ECB statute (Maastricht treaty) after. The collapse of the Bretton Woods agreement meant in March 1973 the DM could float against other currencies following years of fixed exchange rates coming at the expense of price stability. The sole focus of the Bundesbank could turn to price stability. Initially hampered by the 1973 oil crisis, this was soon retraced and between 1960 and 1998, German inflation averaged 3.1%, the lowest recorded internationally [4]. Having established price stability the Bundesbank moved to address problems posed by reunification. Volumes of spending required to address the poorer Eastern State initially increased money supply from Western stocks by 15% leading to a large expansion in aggregate expenditure, government deficit and increased inflation. Between 1990 and 2007 reunification is estimated to have

cost 2,000bn [5]. Recent movement of the German yield curve is comparable to 1990 as the country braces itself for potentially absorbing part of the weaker Eurozone members debt.

GDP and Labour Market

With predicted 2010 nominal GDP of 2,462 bn, the German economy is approaching pre-crisis levels thanks to the quick response of an expansionary fiscal policy. Since 2005 private consumption has noted large annual increases which have been relatively unaffected by the world economic downturn and reduced the impact of steep declines in exports. The export led economy has a large exposure to the health of the world economy and broadly speaking measures taken between 2007 and 2009 to address the slump have worked as exports approach 2007 levels. The largest impacted contributor was machinery (40% of total exports) as company deleveraging and limited credit takes hold. Stripping out inflation we see German growth over the first half of the decade being far less aggressive than world counterparts with a similar recovery trajectory to the USA, though measures taken to achieve these recoveries are hugely contrasting. The fiscal policy specifically targeted increases in private consumption and investment spending while other factors such as the stage of the inventory cycle and global economic conditions bolstered trade. While GDP continues to expand, its sustained growth is doubtful. Government introduced automatic stabilizers (short term working subsidies) and spending increases have not come cheap changing the government balance from zero in 2008 to a deficit of 4.1% in 2010. Fiscal policy is now changing to rectify this deficit with spending reductions of 80bn to be implemented by 2014. This constitutes 17% of 2010 government investment and is a significant decrease in investment in the economy. Since May 2009, ECB interest rates have been at 1% with deposit rates at .25%. Inflation pressures in Europe and money markets pricing in an ECB interest rate rise as close as April suggest persistent rate rises in the coming 18 months. This will take a considerable amount of money out of the pockets of German consumers. The increased interest rates will dampen appetite for investment which may affect exchange rates and net exports outside the Euro area which are currently enjoying

foreign exchange benefits from the weaker Euro. Demand will be tested in coming years as stimulus packages and cheap money are phased out. While recent performance has surpassed expectations, the potential growth has remained weak. Between 2000 and 2008, an average of 1.1% was recorded at almost half that of its fellow OECD members. The gap in GDP per capita has also widened over the same period. Replicating the export success story in other areas of the economy remains a challenge. Policy and regulation often favor industry and manufacturing, restricting the services sector that could be participating in the expanding world markets, statistics show no element of international competition in a variety of services [5]. Competing on costs in this market will prove difficult; with quality and service standards stemming from a highly educated workforce offering a sustainable path as was the case in the 1990s [6]. Boasting a highly educated workforce and strong infrastructure Germany has not attracted the foreign investment it should.. A highly regulated marketplace bringing significant barriers to trade and entrepreneurship when compared to OECD counterparts further has reduced the appeal of undertaking business in Germany. Structural reforms to address this are warranted with attempts to have Ireland relinquish their low corporation tax rate to make Germany more competitive a token effort Large consumption figures noted are affected largely by employment trends with peoples ability/willingness to spend a function of their income and perceived future incomes. Since 2005 there has been a steady decline in unemployment with job center vacancies doubling to 10%. Cyclical unemployment is noted approaching 2009 before the introduction of stabilizers. Reduced unemployment is consistent with confidence levels noted in the PMI. There has been notable adjustment within the labour market with volatile hours worked by employees noted suggesting flexibility in industry with working arrangements between employees, which is accommodated by labour law, helping to keep people in employment. A short-time working scheme was introduced whereby the government will subsidies any foregone employee income attributable to the economic downturn. Firms must agree to undertake this scheme and do so in their best interests by allowing redundancies and accept challenges of rehiring in time if there is more savings to be made by doing so [5]. Roughly 1.5 million workers subscribed to this scheme during 2009 with a 45% reduction by Q2 2010. The effect of this on the labour market is an increase in efficiency with people who are matched to employment remaining in same but potential displacement effects when unsustainable jobs are supported. Striking a balance between keeping people in work and finding long-term sustainable employment becomes a problem. With spending on labour and social services to be targeted in coming cutbacks and the phasing out of the short-time working scheme, there could be a noted increase in

long term unemployment where intensive job counseling and expanded training programs will not go far enough to expedite the structural reform. Productivity has been in decline to 2009 with sustained increases in pay noted. Pay levels were impacted in 2009 and workers are asked for more work for less remuneration in an attempt to maintain profit levels in a tough economic climate. The export led nature of the German economy exposes it to international competition and higher productivity relative to the domestic sector. This aboveaverage productivity in the export markets is accordingly rewarded which sets the standard for the domestic market, resulting in an above-average rise in labour costs, evident from graph to 2009. Known as the Samuelson effect, the lower profit growth reduces employment potential in the domestic sector and increases price levels where domestic competition is weakest putting further pressure on consumers, which in turn affects company revenue and ability to fund salary base. This trend ultimately results in layoffs [3]. Offshoring has grown in popularity as a means of tempering this upswing in costs. Taking the arithmetic mean of past growth rates over the past years i.e. one complete business cycle; we note the potential for 2011 growth to be 2% (using figures from 1970) Considering past business cycles such as the late seventies when late eighties and adjusting accordingly, a figure of i.5% appears a conservative and reasonable figure for 2011 growth.

Poor performances in the services sector and education contrast to the rapidly expanded, industry driven, export sector. Over the past decade exports have enjoyed a 50% increase in potential export markets. The emergence of the BRIC nations and in particular China has been a factor, supplementing declines in poorer performing economies such as the UK and USA, but 80% of exports remain to developed OECD nations. China accounted for 4% of total 2010 exports, a figure that has steadily increased with the exception of the crisis years and is considered a huge growth area. Exports performance is impressive when considering the emergence of nations offering low cost alternatives. Low growth in nominal wages, an increase in offshoring, and a weaker Euro have all effectively reduced costs and increased international competitiveness. Again, the

pace of recovery in exports has been notably stronger than locally dragging total output figures up to 2007 levels and highlighting importance to economy. The past decade sees largely positive performances across the main sectors of industry with losses in 2007 2009 periods being quickly retraced. One of the most significant of these industries is the automotive industry which accounts for one in six jobs in Germany and was provided 5bn in stimulus by again stimulating the demand side of the economy and offering 2,500 towards a new car to those wishing to exchange a nine year old or older car. Further reform was noted in motor vehicle tax, easing costs relative to CO2 emissions. Surprisingly, machinery and equipment, which makes up 40% of exports is struggling relative to smaller sectors of electronics and capital goods. All industrial components have an exposure to the increasing price of oil. Declining inventories during a severe winter of December 2010 and continued unrest in some Middle Eastern oil producing nations have seen oil prices rise $20 a barrel past the $100 mark. These conditions will weigh on the bottom line of industries into 2011. While domestic consumption has proved strong over the past decade, phasing out of austerity measures, budget consolidation over the coming four years and rising interest rates will take money out of the economy hampering demand. The future for industrial production is largely linked to its exports sector which is a function of the world economy. Post crisis two very different worlds are evident. Firstly those that have been hard hit by deflating real estate bubbles and government debt crises (USA and Europe) who are struggling to close the output gap created in the past few years. Recovery in Europe has been very uneven with German growth roaring ahead of other members with Ireland, Spain, Portugal and Greece continuing to hold back the Eurozone. Inability to devalue a sovereign currency will protract these individual recoveries. Modest recoveries have also been noted in France and Italy while QE2 in the USA has seen significant growth in equities with credit flowing albeit at the expense of a $14.2 trillion government debt. The pace of USA private deleveraging has decreased to having an effect comparable to an increase in credit growth suggesting some positives going into 2011 but this would not address the low inflation environment the USA currently finds itself in [5]. With financial markets stabilizing the capacity of OECD members to recover and sustain demand in Germany increases. As time passes a sovereign default in

Europe looks less likely with restructuring negotiations for embattled Euro nations become more than a possibility, the extent of haircuts on sovereign debt remains to be seen. The second group of countries are those affected by a global downturn in demand but have resumed the trend of the early part of the decade. These consist of BRIC nations and other emerging markets (mostly Asian) including Latin America. Many of these economies have pegged their currency to the dollar absorbing the Feds monetary policy with it which is massively expansionary. Expansion at this rate for these nations such as China may lead to overheating to the detriment of Germanys exports. In stark contrast to the first group, here economic slowdowns are being engineered by governments keen on reducing inflation pressures. Overall growth predictions of 4% in global recovery at inflation rates of c.3% appear enough to sustain exports in the absence of a sovereign default or similar event [7].

Inflation and Consumer Confidence

Energy costs and austerity measures introduced have addressed the economic issues and increased inflation levels with higher disposable incomes stimulating general demand. Policy targeting low inflation growth is not being met. Energy and food commodities have played a significant role also with prices paid by importers for energy products increasing by 5.1% in Q4 2010 pushing on an industrial products price increase of 10% from the prior year (8). Petrol and heating costs also noted increases in Q4 as a cold snap in many parts of the world drove up prices; this is on the back of sustained energy price increases since 2004. Food commodities such as wheat have noted similar increases. Month on month inflation rates to January 2011 have increased by 0.6% indicating an above average rate of growth. January 2011 inflation rate has been reported over 2%. With ECB mandate requiring a sub 2% annual level to be maintained and Germany being its biggest economy the money markets are now pricing in policy rate increase as soon as April. The imposition of these rates on struggling Eurozone members could crystalize further losses on their banking systems and maybe increase contributions required from Germany to keep the Euro dream alive. Compared to international counterparts, 2010 inflation levels appear quite high but, trends suggest, rising. As mentioned, the distinction between country groupings will determine policy rates globally with the USA pricing in rate increases further down the line than Europe and China looking to immediately rapidly rising inflation issues. These rates will in turn

affect the ability of domestic enterprise to buy German products. The rate increases proposed for April (and beyond) and continued budget consolidation will take money out of the economy, reducing consumption and with it inflation. This will be in contrast to potentially persistent high oil costs as Middle East as troubles look set to continue. A cold winter has reduced oil stocks and food commodities note increases as supply cannot keep up with demand. The duration of the Middle Eastern troubles could determine the trajectory of inflation into 2011. Consumer confidence is at an all-time high having successfully come through the downturn. Individuals expectations of future income and employment are optimistic with spending habits reflected in private consumption GDP. Similar optimism is evident in the PMI Index with scores of 60.3 and 58.6 in January and February comfortably above the 50 score indicating economic expansion and optimism amongst purchasing managers. Surprisingly this is also the case for the rest of the Eurozone many of whom have experienced a more difficult path to recovery, some who are still struggling.

Public Finances and Banking

Measures taken to stimulate the demand side of the economy have had an adverse effect on the public finances with a significant increase in public debt. Between 2003 and 2007 the government were in the process of consolidation which saw expenditure reduced by 4% of GDP, this reduction was partly due to GDP growth but also public sector wage restraint and public investment restraint. Buoyant economic conditions reduced social welfare expenditure bringing a reduction in the structural deficit also. This process was reversed by the economic crisis which saw the economy contract by 6.5% during the nine months from April 2008. The package was introduced in two parts, firstly November 2008 which introduced reform of depreciation charges by companies (6.3bn), increased spending (2bn) and a raft of smaller tax reforms aimed at increasing consumption. The January 2009 package earmarked 15bn for infrastructure expenditure, increasing tax allowances and reducing income tax (9bn), increased benefits and reduced social security contributions for employers and labor programs (5bn), car scrappage scheme (5bn) and other similar minor adjustments which put the total pledged and spent to c.65bn, increasing the government deficit to 3.3% of GDP in 2009. Their effects were almost immediately obvious with the multiplier effect estimated to have boosted 2009 GDP by .5% and 2010 GDP by .2% [5]. As the stimulus is phased out and consolidation is again on the table, its implementation comes with an aging population, steep pension increases, lower

tax take and increasing healthcare costs. During 2007 it was estimated that the implicit debt embedded in the social insurance system was 185% of then GDP [9], something the economy was bracing itself for during the 2003-2007 consolidation. Addressing this has led to new fiscal policy whereby the cyclically adjusted federal (individual state) budget deficit cannot exceed .35% of GDP. This will ensure Germanys fiscal position remains close to structural balance [5]. Further measures introducing transparency and clarity will be taken as moves to fall in line with the European Stability and Growth Pact are taken. Cuts alone will not balance the books and a proposed broadening of the tax base and phasing out of concessions, such as the housing tax concession of 2006 which raised 2bn. The Kiel Institute for the World Economy estimates such measures as having the potential to raise 41bn in 2012 if all concessions were removed which would prove politically unpopular but the removal of five of the large concessions could generate 4.8bn in further revenues and may prove tempting [5]. The roots of the banking crisis in Germany primarily include; the overexposure of Landesbanks (state owned banks), inadequate capital base of banks and regulation and governance issues. Landesbanks exposure came about following a prolonged period of phasing out of government guarantees during which time the banks build up significant liquidity which was quickly used to purchase US originated structured debt products. German banking accounts for 7% (c. 230bn) of the global write down of assets with at least one third of these belonging to the state-owned Landesbanken, a huge figure considering they hold 20% of the German banking sector. Fears of another bout of write-downs valued between 10-15bn remain with 2010 banking stress tests; while positive with one German bank requiring nationalization, now appear inconclusive as Irish banks that previously passed the testing have required nationalization. Reform of the banking sector began with the establishment of two separate bad bank types, one aimed at public and private banks (consolidation model where each bank could apply to set up an individual bank) with another specifically at public sector banks. The former bought toxic assets from the banks for a 10% discount, with money supplied by the state. Mark to market losses on the date of transfer are calculated with repayment coming over the following 20 years from profits. Losses other than those initially calculated at the date of transfer are borne by the state. As repayments are contingent on profits, it becomes an indirect liability ensuring a healthier balance sheet. A mixture of accounting uncertainty and reputational damage has caused limited participation in the schemes which is worrying as uncertainty remains. While the worst of the economic downturn appears to be over, and those US citizens at the root of the cashflows to these structured debt products have weathered the storm to date, there remains significant uncertainty about the American economy and with that the cashflows

of these products. Taking mark to market losses on these assets rather than an annual impairment charge would introduce more uncertainty in the banking sector bringing further confidence. While they remain on bank balance sheets the requirement for strict capital supervision and stringent stress testing remain.

Determined to set an example to other countries, the German ministry has begun implementing cuts to reign in its national debt which is approaching 80% of GDP. Federal responsibility for budget deficit reduction will embrace both spending cuts and revenue increases. This will introduce savings 80bn by the end of 2014, a significant reduction in the spending GDP component along with the potential growth element GDP being held back by huge demographic imbalances. Doubt is casted over workforce suitability with the working age population to decrease by 1% annually from 2020. Ensuring at least todays output levels can be sustained by future generations is fundamental to growth. Policy regarding beginning age of working life, retirement age, yearly working hours and immigration could decide how growth progresses over the coming decades. This, resulting declines in government spending and private consumption, a flattening of the stock cycle in larger markets and the phasing out of stimuli in major European countries will see a deceleration of the growth rate into 2011 and 2012. The phasing out of government investment and labour subsidies should see increases in unemployment as the economy adjusts further reducing consumption. Reform and heightened regulation in the banking sector is in process, the rejection of Basle III by Germany was unexpected but it is likely a compromise will be made [10]. This will see total capital requirements of between 10.5% and 13.5% introduced, coming into effect in 2015 it will reduce annual GDP by an estimated .1% [11]. During 2011, with stability restored it is expected that a reduction in government guarantees will be noted. The start of 2011 saw German CDS spreads again widen as the extent of Irelands woes became clear. Germanys commitment to the Euro project led to 119.4bn in relief being pledged (c. 4.8% of 2010 GDP). Political pressure is building as German taxpayers voice their resentment at paying for the mismanagement of other member economies. A case is currently being taken against the provision of these loans in a German constitutional court; a successful hearing would see financial market turmoil return as the likelihood of sovereign default would increase [12]. This and a string of other fundamental finance problems across Europe alongside weak growth prospects imply a weaker Euro over 2011 and 2012 which will ultimately support German exports. Exports will continue to grow in line with the world economy (c.4% next year) and growth in Asian markets will increase as their boom continues. ECB interest rate increases priced into yield curves between now and the end of 2012 will supress price levels with rate levels depending largely on energy and food commodity prices.

In summary, assuming no sovereign debt bubble bursts, the factors outlined above will see Germany grow at a stable but sluggish pace with mild increases in unemployment and sweeping policy changes to address the demographic imbalance.

From the key economic indicators outlined above it appears the course of actions taken to address the economic downturn were appropriate, while noting the convenient timing to the end of global de-stocking. The decline in growth was brought around by an overexposure to the exports sector as the world economy shrank. Measures should be taken to grow other sectors, in particular a poorly performing services sector, while maintaining current export levels and ensure exposures such as this are minimized. Barriers remain to achieving this and a relaxing of current overregulation would stimulate competition encouraging innovation and entrepreneurship. Demographics are not in the economies favor and immigration policy needs to lend itself further to welcoming high-skilled workers thus preventing a shortage over the coming decade when the working age population will start to decline. Promptly addressing current structural changes in the labour market can also ensure an adequate supply of appropriately skilled workers. The short-time subsidies should cease as soon as possible as in the long run they delay structural change. A charge of some sort to employers for participation in this scheme would ensure only jobs that have long term viability are maintained while others become part of the structural change process. In the new two tier economic world, Germany has secured its place as one of the countries moderately affected by the global downturn. The European sovereign crisis continues with what was popular support in Germany for the project now waning. Continued participation in the project will depend on the ability of current government to persuade its people it is in fact in their best interest to support the project.


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