Leading the way

When Germany entered recession in the first quarter of this year there seemed little hope of recovery as demand for exports – the country’s economic lifeblood – slowed to a trickle. But rapid government intervention and multibillion-euro stimulus packages have brought the German economy back to life and out of recession. CXO reports on the bounce back and asks whether its recovery is sustainable.

“The German consumer is one of the most inflation sensitive”
-Timo Klein

"We will do everything possible to make sure Germany not only gets through this crisis but emerges stronger." These were the words of German Chancellor Angela Merkel in January this year, as the country entered its worst recession since the Second World War. At that time all the odds were stacked against a recovery by Europe's biggest economy, which relies heavily for its economic stability on the global export market. The effects of the downturn on global commerce, set to plummet a further 10 percent this year, saw orders for goods produced in Germany fall by eight percent between August and September last year. In the first quarter of this year the economy contracted by 6.7 percent - the biggest slump in 40 years. Meanwhile the government slashed its full year economic forecast, predicting the economy would shrink by six percent, led by the fall in global exports. Describing the seriousness of the situation, Professor Iain Begg an expert on EU economic and social policy at the London School of Economics (LSE), says: "The German economy had an extremely sharp fall in the first quarter of the year and that's because as an export-orientated country it was being hit badly by the fact that other countries were clamping down on their demand. So they simply weren't buying from Germany."

However, five months on from the German government's dire predictions, and against all expectations, it emerged triumphant from recession, posting a 0.7 percent growth in GDP. Its recovery has been attributed in no small part to the intervention of Merkel who, in January of this year, unveiled an economic stimulus package worth around €50 billion, including investments in railways, roads and schools as well as a number of tax relief initiatives.  Timo Klein, Senior Economist at IHS Global Insight, says: "The most important role the government played in the beginning stages of the acute crisis was to stabilise matters.  Then followed a couple of stimulus packages. If you take these two together they have roughly the magnitude of stimulating the economy to the tune of 1.5 to two percent of GDP by 2010."

Dr Robert Hancké of the Economic's European Institute of LSE agrees, adding that the effects of the stimulus packages coincided with a lift in conditions across the world economy to pull Germany out of recession: "It really is because of the interplay between the fact that the world economy is slowly picking up, which since Germany is such a large exporter of GDP has massive effects, and the fact that the government made sure that the bottom didn't fall out of the labour market, and thereby the economy as a whole. I don't think you can really say one is more important than the other. You really need both factors feeding off each other rather than the government just providing passive support."

Cash for clunkers

Among the most high profile stimulus measures was Germany's car scrappage initiative launched in January. Under the terms of the scheme buyers of new fuel-efficient cars were given a €2500 discount in exchange for scrapping a vehicle over nine years old. Although greeted with scepticism, the scheme attracted over 1.2 million applications, resulting in the purchase of over 600,000 cars. In March, just two months after the launch of the initiative, new car sales soared 40 percent compared to the previous year to 401,000 - the highest level since 1992.  Meanwhile sales were up by 18 percent over the previous quarter. This success prompted the government to extend the funding from the scheme from €1.5 billion to around €4.5 billion. Klein says he does not believe that the effects of the car scrappage scheme will have any long-term affect on Germany's troubled auto industry; however, he does believe it made a significant contribution to the country's economic recovery. "This was never intended to be a long-term boost. Because, of course, the car industry in Germany, and worldwide, has certain structural problems, such as overcapacity. The idea of it was always to serve as a bridge between the relatively healthy economy of mid-2008 and the hope for the recovery in the second half of 2009. The question is, of course, how far does this bridge carry? I would personally argue that it has been relatively successful, if you look at how GDP has developed between the middle of 2008 and the middle of 2009. The car scrappage scheme was one element that helped to enable the German economy to get above the zero line in the second quarter."

Hancké agrees that the initiative provided a much needed short-term boost to the German economy but he too is sceptical about its long-term value as a solution: "It's been successful in terms of the number of people who've bought into this. But I don't think it makes any difference in the long term for the macro economy. It's not entirely clear in Europe at the moment what the structural over capacity is in the car industry, but everybody, including me, agrees that it's at least 20 to 25 percent of the existing capacity. So either we need to increase demand by 25 percent over the next 25 years or we reduce the supply of cars by 25 percent over the next 10 years or so."

Consumer confidence

As well temporarily stimulating the auto industry, the success of Germany's car scrappage scheme also went a long way to restoring consumer confidence in the country - therefore stimulating other areas of the economy, as Begg explains: "If the side effect of the car scrappage scheme was to restore confidence in the German economy, then other sectors of activity might well take up the running, in particular the service sector." The restoration of consumer confidence in Germany is a crucial part of the government's recession-busting plan and a means of using domestic spending to counteract the effects of the fall in exports. Analysts agree that the German consumer is typically sensitive to economic conditions and will stop spending in times of economic instability. "In Germany you're up against the fact that the German consumer, traditionally, has been a lot more cautious than the British consumer," Begg says. "The kind of workforce you have in Germany is one that doesn't like spending when there's a lot of uncertainty around the corner. So they begin to save and the government begins to save and the effect of that is that you have low aggregate demand. That's the sort of structural condition the German economy has been in for the last 10 years.

According to the GfK Group's monthly Consumer Confidence Index, confidence rose for five months running up until this October when it dropped for the first time in more than a year, from a score of 4.2 to four. According to Gfk, a key reason for the drop was the expiry of the scrappage bonus scheme as well as the rise in the oil price.  A report on the results stated, however, that domestic spending would continue to be crucial to Germany's continued recovery: "Despite the slight setback, private consumption remains a major source of support for the German economy this year, since investments and exports will record large decreases at the close of 2009. It remains to be seen whether private consumption can also fulfil this supportive function in the coming year."

Inflation too has a major impact on German consumer confidence, and the fact that this fell sharply in the second quarter meant consumer spending received a much needed boost, according to Klein. "The German consumer is one of the most inflation sensitive. Private consumption actually fell in the second half of 2007 and in the first half of 2008, despite the economy having a boom overall, and that was because the oil price went up and inflation in general went up strongly so people felt to be worse off. So when suddenly inflation fell very sharply, which means we've had the biggest real wage increase in 10 years or so, that really encouraged German consumer spending."

A workable solution

A key element of the government's work to prevent slumps in consumer confidence and domestic spending has been the Kurzarbeitergeld - the German government's reduced hours compensation scheme - under which companies can radically cut the working hours of their staff, who then receive compensation of up to 60 percent of their net salary from the government. According to figures released by the International Monetary Fund, Kurzarbeitergeld has meant that despite a sharp contraction in industrial output in Germany, there has only been a rise of three quarters of a point in joblessness. Meanwhile in the UK, where trade unions are lobbying the government to introduce a similar scheme, the IMF predicts unemployment will reach 7.6 percent this year and 9.3 percent in 2010.  Klein explains the benefit of the scheme, which was first introduced in Germany in the 1920s: "In the overall scheme of things it has made a huge difference to the labour statistics. Germany is the one country where we've seen very little increase in unemployment and the main reason for that is the short time work scheme. Something like 1.5 million people were on the scheme at its peak in 2009. That's out of a total workforce of about 40 million. Interestingly, during the crisis, in late 2008 and the first half of 2009, we've had slightly stronger private consumption than in years past. One of the main reasons for that is the stability of the labour market."

Begg goes on to say that the prevention of mass unemployment across Germany will prevent future problems for when the upturn in the economy creates greater demand for employees: "There's an argument that if you push too many people out of work they then lose attachment to the labour market. If you're outside employment you're less employable and that means that the aggregate labour supply is diminished because the people willing to take jobs are fewer and that means that if there is an upturn in the economy, employers are less willing to take on those that have been detached from the labour markets. This means that they will build up wage rates for those that are employable and so you get a combination of inflation and unemployment at the same time."

A sustainable recovery?

But while the German government may be hard at work to restore consumer confidence and consumer spending, another key aim is to cut its own spending in order to reduce its hefty debts. The county's deficit is expected to reach 3.7 percent worth of GDP by the end of this year and around six percent in 2010, which is double the EU limit of three percent. The Paris-based EU think tank, the Organisation for Economic Co-operation and Development, told the Reuters news agency that the German government would need to cut spending or raise taxes in the coming years in order to reduce the deficit. Meanwhile Germany is under pressure from the EU Commission to reduce the deficit and it has agreed with an EU decision that member countries should begin budget consolidation measures by 2011. 

Analysts warn that the government's determination to reduce its budget deficit over increasing spending could potentially have a depressive effect on the economy in the long term. This impetus to cut debt is drive by the government's pledge to have balanced its books by 2016,  a move which Begg says could lead to a stagnant economy in the long term: "One concern the Germans will have is that they do plan to clamp down on their economy to ensure that their fiscal deficit is back on track. And they've passed this constitutional amendment that will, by 2016, mean they have a balanced budget. This could tend towards a depressing effect over a number of years until it's fully worked out because it means that the state will no longer be spending, or at least spending less than it otherwise would." He goes on to say that this could counteract the effects of the government's €50 billion worth of stimulus packages: "That impetus, that injection of momentum to the economy, will be lost. In the short term, if you clamp down on public expenditure, in other words do exactly the opposite of a stimulus package, this would have an anti-stimulant effect."

Klein says there could be conflict too between the government's wish to cut taxes and its aim to reduce its deficit: "Cutting spending is what sensible economists would tell the government to do because it is piling up very large deficits at the moment. But it is very hard to see how it would be possible to reconcile income tax cuts with the need to bring down deficits. The burden for the individual wage earner is going to become larger. So all of these problems suggest that one should not expect much at all in the medium to long term from the German consumer."

Cautious optimism

The state of the German economy, when compared to that of the UK and Spain, is relatively buoyant with government stimulus packages having injected much needed consumer confidence and provided labour opportunities. But analysts warn that under normal global conditions the state of the German economy would be considered weak and say they believe that in the absence of long-term solutions to the slump in the country's manufacturing sector, its recovery remains fragile.  "It's very slightly above zero which is a long way behind what you'd expect under normal circumstances," says Begg. "They are not doing well, they're just doing less badly than others. That is an important distinction to make. Everybody expects German unemployment to continue rising and that's something that would damage consumer confidence. It's only slightly offset by the fact that it looks as though they might have turned the corner. We're in a very delicate position where things could go either way."

Timo Klein goes on to say that he believes the country remains close to the brink of another collapse into recession: "I'd say there is now a reasonable degree of stability, due not least to major monetary and fiscal policy measures. But the whole thing is still relatively fragile because it relies on world trade and the stimulus that has come from both government and the Central Bank. If that were to be withdrawn within the next few months that would most likely lead to a collapse into recessionary conditions." He predicts that proper sustained recovery will not begin until late 2010 when wider global economic recovery will provide long-term opportunities for the German export market.

"We at Global Insight expect there will be something of a setback in the first half of 2010, so that a more sustained and more underlying broader based recovery will only start in late 2010. Probably it will mean weaker growth rates in quarter on quarter terms than during the second half of 2009."