Europe: as strong as its weakest link, Germany, says Western Asset’s Michael Story
Michael Story, economist at Legg Mason subsidiary Western Asset, explains why he sees dangers in the current German status quo.
Germany stands out among its G7 colleagues for having had the strongest economic rebound after the financial crisis of 2008 with only Canada performing better.
As investors continue to look to Germany as the pillar of strength for the euro area, the observers seem to express a wish that other European peripheries were more like Germany.
However, Germany’s latest GDP release – a meek 0.1% expansion during the 2nd quarter of 2011 – suggests that this narrative, where Germany plays the role of growth engine, and, if it so chooses, saviour of the system, is actually quite flimsy.
Granted, the German balance sheet is envious, but its strengths end there. Germany is as much a cause of the European crisis as are its peripheral peers. It must engage in deep structural reform alongside that already underway in the periphery and finally live up to its leadership responsibilities. Yet, German officials refuse to admit to any weakness, instead promoting the false narrative in which Germany is victim-by-association with other, irresponsible euro area members.
German unification in 1990, nothing short of a seismic transformation, created a deep disequilibrium in its economy. By the mid-1990s, the post-unification boom in construction and domestic spending-supported by strong wage growth and even stronger productivity gains-began to decelerate. By the beginning of the 2000s, these trends had reversed completely. Domestic demand became anaemic, wages stagnated and national savings soared. Germany’s current account swung from modest deficit into the second largest surplus in the world behind only China, reaching $253 billion just before the onset of the global financial crisis in 2007.
Germany had transformed itself into an export-dependent economy just in time for the launch of the euro, which consolidated Germany’s competitive advantage vis-à-vis its trading partners. Net exports have accounted for more than half of its meagre 1.1% average GDP growth since then. Moreover, 28% of Germany’s trade surplus was derived from the periphery (36% of the periphery’s trade deficit was derived from Germany). This translated into $100 billion of purchasing power channelled away from the periphery and into Germany in 2007 alone.
In a self-perpetuating feedback loop, Germany recycled its new-found purchasing power back into the periphery in the form of cheap credit, helping to inflate the housing bubbles and perpetuate the consumption booms there. Through this process, Germany’s household balance sheet improved, while at the same time its banking system, the intermediary of these flows, became gorged on what later turned out to be high-risk assets. Despite the absence of a domestic housing bubble, German banks lead Europe in their level of non-performing loans, and hold close to $600 billion of peripheral European sovereign debt.
Even the impressive trajectory of Germany’s unit labour costs relative to the periphery, routinely offered as evidence of its dynamism and competitiveness, is not what it seems. German unit labour costs have only been impressive because of stagnant wage growth, not because of strong productivity gains. Living standards have barely improved in the past decade. Consider that per capita GDP growth, a measure closely associated with labour productivity and which corrects for Germany’s shrinking workforce, has been the second slowest in the euro area.