Germany is in deep trouble and requires a major shift in policy strategy

The latest news I read from Germany was that the Rhine is now so low on water that its importance as a commercial waterway for transporting raw materials and finished products is being significantly compromised. The water level in places is now well below that required for navigation by the barges. It is the second time in the space of a few years that inland shipping in Europe has been thwarted by this sort of problem. The War in Ukraine is also causing bottlenecks in the inland transport routes as grain transports are being diverted as a consequence of the Black Sea blockades. Sure enough there are rail transports still capable of shifting the cargo but this problem is one of many now hitting Germany, which is finding out that its economic growth strategy is deeply flawed. It was only a matter of time before the ‘chickens came home to roost’. It was obvious for years that the Post-unification strategy the German government took as it entered the common currency could not deliver sustainable and stable growth. The reliance on suppressing domestic expenditure and wages growth in order to game its Eurozone partners so they recorded large external deficits in order to buy German exports was problematic given that the German insistence on austerity across the Eurozone resulted in stagnation and weaker export markets. Further, Germany relied heavily on diesel engines to underpin the strength of their dominant motor vehicle industry and not only did they lie about the quality of the products, but they failed to foresee the shifting sentiment away from polluting diesel. And, of course, they relied on imported energy from Russia to feed this industrial strength and supply their consumer markets, which assumed that Russia would remain reliable. At present they are also being impacted by the supply disruptions in China, given they have shifted their external sector towards an increased reliance on China. Some of these problems will ease but the reality is that the German model that they took into the Eurozone is now unsustainable. They must abandon their export led growth obsession, increase their reliance on domestic demand and improve the circumstances for their workers while dealing with the increasingly evident climate emergency.

I predicted this outcome some years ago – the tendency was inevitable – see these blog posts:

1. German external investment model a failure (August 19, 2019).

2. Germany is not a model for Europe – it fails abroad and at home (March 2, 2015).

3. The German model is not workable for the Eurozone (February 3, 2012).

Germany is now enduring the combination of stagnating growth and productivity and a major reduction in real per capita incomes as a result of the increasing prices of gas, food and petrol.

Its powerhouse manufacturing sector is in decline as a consequence of short-term factors relating to Covid and the War in Ukraine (supply disruptions) and longer-terms issues relating to poor investment choices (especially its failure to lead the shift away from diesel into EVs).

The bully of Europe is now approaching mendicant status as some of the states it lorded its austerity credentials over during the GFC, which caused massive socio-economic damage (entrenched unemployment and poverty, etc) have maintained growth as a result of the revival of tourism over the Northern Summer.

It is a case of the past hubris catching up with Germany.

In the early years of the Eurozone, Germany cut its domestic costs with hard labour market reforms that cut wages and job security (the mini-job boom) and allowed Germany to increase its international competitive vis-a-vis its common currency partners.

That caused a massive imbalance in the Eurozone, because Germany’s growth strategy relied on its partners running unsustainable external deficits as Germany suppressed its own domestic demand.

Now, without the tourist assets that Southern European states have and with its industrial production sectors faltering, Germany is reliant on domestic demand for growth.

And it killed that potential off years ago as it pursued austerity and export competitiveness.

On August 1, 2022, the German Statistical Office (De Statis) released the latest Retail Sales data and their press release – Retail turnover in June 2022 down 1.6% on the previous month – reported that in real terms (after adjusting for inflation) the:

… turnover of retail enterprises in Germany was 1.6% … lower, on a calendar and seasonally adjusted basis, in June 2022 compared with May 2022. Compared with June 2021, retail trade recorded an 8.8% decrease in turnover in real terms in June 2022. This was the largest year-on-year decrease since the beginning of the time series in 1994.

It was no surprise that German economic growth has fallen to zero in the June-quarter 2022 after recording a 0.8 per cent growth rate in the March-quarter.

And labour productivity growth stagnated in the June-quarter 2022.

Since February 2020, at the onset of the pandemic, manufacturing production has fallen by 6.2 points.

It was last at this level in 2013 during the GFC.

The graph shows Germany (blue) and Poland (orange) by way of comparison.

The German manufacturing model is faltering.

The next graph shows the industrial production index for the June-quarter 2022 (2015 = 100) for all the European nations for which comparable data from Eurostat is available.

The horizontal red line is there to make it easier to see where each nation is in relation to Germany.

It is clear that while Europe is in the front line of the energy crisis, that other nations are still seeing stronger manufacturing outcomes.

While Germany is now facing a deeper recession, one positive is that the German unemployment rate remains low – 2.8 per cent in June 2022, which is the third lowest in the European Union (above Czechia 2.4 per cent and Poland 2.7 per cent).

That is compared to Spain (12.6 per cent), Greece (12.3 per cent), Italy (8.1 per cent), Sweden (7.6 per cent), France (7.2 per cent), and the EU average of 6.2 per cent.

How long Germany can maintain that low rate of unemployment is the question.

Further, real earnings in the March-quarter 2022 fell by 1.8 per cent over the 12 months, which means that workers are facing declining purchasing power (Source).

On the positive side, the German Bundestag approved a 22 per cent increase in the legal minimum wage in June (to 12 euros an hour), which takes effect from October 1, 2022.

Further, while the quality of work in Germany has declined over the last few decades with an increase in marginal employment, the minimum wage decision will also impact on the workers in the mini- and midi-jobs (marginal employment) which are outside the social security safety net. The new minimum wage will marginally push up wages in those precarious jobs.

Germany is also slow to respond the climate change imperatives for motor vehicle production.

Several years ago, it became obvious that the motor vehicle market was shifting against diesel car.

This Vox article from October 16, 2015 – Europe’s love affair with diesel cars has been a disaster – was responding to Volkswagen’s disgraceful cheating of emission data and concluded that:

Europe’s promotion of diesel vehicles as a green transportation option has been a disaster thus far — for reasons that go well beyond the Volkswagen scandal.

The European Commission started advocated diesel cars as a viable green alternative to petrol engine cars in the 1990s and nations offered tax incentives to shift consumption patterns.

The Volkswagen saga was just the tip of the iceberg with respect to how misguided that promotion was.

This 2013 article – Critical evaluation of the European diesel car boom – global comparison, environmental effects and various national strategies – published by Michel Carnes and Echard Helmers in the journal – Environmental Sciences Europe – provides detailed analysis of the problems of the European strategy.

The authors concluded that while climate change required a shift away from petrol driven cars:

… the path taken by European stakeholders – both politics and industry – has rather shifted Europe further away from the stated objective: the diesel path did not manage to reduce heating up the planet when accounting not only for those emissions laid down in the Kyoto protocol (CO2) but for black carbon as well. On top of that, it has persistently exacerbated local pollution with regard to noise, nitrogen oxide and particulate matter.

Moreover, the emphasis on diesel has prevented:

… the continent from exploring alternative and more sus- tainable pathways such as hybridization and electrifica- tion as yet

Once the Volkswagen scandal revealed that all the European car producers would no longer be able to cheat the emissions tests, the Vox article noted that:

Volkswagen, BMW, Daimler, Renault, Peugeot, and other manufacturers have been pleading with EU to relax the NOx limits by up to 30 percent.

While the German manufacturers (with their other European car makers) were still trying to hang on to their obsession with diesel cars, nations such as Japan saw the light and moved into hybrid and EV technologies.

The problem in Germany is that while new registrations of diesel cars has fallen significantly, the price of diesel fuel is very low relative to petrol, which has slowed the shift away.

Further, the shift away from an export reliance on the Eurozone (in part, the result of Germany’s obsession with imposing austerity on its European trading partners) to an increased reliance on China has come unstuck in the face of China’s Covid response.

The following Table traces German exports and imports (as proportion of respective totals) since 2005 (data available from DeStatis).

The shift away from intra-Eurozone trade to an increased reliance on the US and China is evident.

It is also notable the steady decline in trade with the United Kingdom, which was emerging well before the Brexit decision.

It is also evident that German was reducing its import exposure to Russia since 2015.

However, the dependency on Russian gas resources remains and is a major issue.

The most notable feature though is the increasing dependency on China for both exports and imports and in 2021 Germany ran a large external deficit against China and increasing relative to, say 2010.

It is clear that the German model, which marked the first two decades of the common currency and arguably caused the extended pain felt by its Eurozone partners during the GFC, is not sustainable into the future.

Its public infrastructure is crumbling (transport systems, bridges, roads, etc) from the extended period of domestic austerity.

Its workers are facing declines in material living standards.

It has to substantially shift its energy use and the places it gets its energy from.

It has to restructure its manufacturing sector especially in terms of motor vehicles.

It will have to stimulate domestic demand.

All of this means that its place as the bully of Europe is compromised and that, in turn, has implications for the way the European Commission deals with its stability framework in the next few years.

At present, the Stability and Growth Pact is under suspension – since Covid.

That has allowed more flexibility for nations to defend their domestic economies, although the degree to which individual nations have expanded their discretionary net public spending has not reflected that flexibility.

Greece, Spain and Italy, among others, should have much larger fiscal deficits given the unemployment situation there and the degradation of public infrastructure after years of austerity.

The system continues with the elevated fiscal deficits though because the European Central Bank has been effectively funding the Member State deficits under the various asset purchasing programs.

And while it has ceased the Pandemic Emergency Purchasing Program (PEPP) its new ‘anti fragmentation’ tool is just more of the same.

As long as the ECB continues to buy the public debt of the Member States (and it knows it cannot stop or else the system fails) the various governments will be able to continue to run deficits.

With Germany in decline, at least for the immediate period ahead, the pressure to return to the Excessive Deficit Mechanisms and start reimposing the SGP austerity is reduced.

There is no way the European Commission can return to that policy structure any time soon.

Which raises the question as to whether it will ever be able to return to it.

The most likely scenario – with the Ukraine War continuing on its borders and climate change creating havoc within its borders – is that the Eurozone will just continue to drag along the bottom with ECB support – a sort of nowhere state – not prosperity, not collapse – just nowhere anyone would want to be.

Conclusion

The inflationary pressures will ease.

But the dysfunctional architecture of the Eurozone will continue to plague the prosperity of the Member States.

Now with Germany in deep trouble and requiring a major shift in strategy, the future of the region in uncertain.

But a return to the export-led, domestic demand suppression model is not sustainable and the Germans should come to terms with that and make the appropriate strategic shift.

Their Eurozone partners will certainly benefit if they do.

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.