Germany on the verge of recession: Why are politicians so far behind the curve again?

Today’s data releases have shown that the state of the German economy is worse than even the pessimists have thought so far. Details from Q2 GDP data revealed that there were fundamental rather than merely technical factors behind the siginificant drop of GDP in the second quarter (0.5 percent quarter-on-quarter or 2.0 percent in annualized terms). Even taking out the drop in construction activity (which was a technical reaction to an extremely strong increase in Q1) and the inventory correction, economic growth basically came to a standstill this spring. Private consumption has now been contracting three quarters in a row and investment in equipment and software contracted sharply (possibly as a side effect of the corporate tax reform which was enacted on January 1 as has been criticised on Eurozone watch for its contractionary effects before – see here and here).

To make things worse, the outlook has further clouded: The German ifo index for the business climate for August recorded another whopping 2.7 points after already experiencing the largest monthly drop since September 11, 2001 in July. If one looks at the graph of the index, one does not need any econometric tools to see that this now is the most violent and fastest deterioration in German business climate for more than a decade (see below).

kt_08_08_climate_dtl.gif

Given the leading indicators, it would be very surprising if the German economy would grow again strongly in Q3. Instead, a further contraction of GDP now looks likely. With such a development, Germany would fulfill the standard definition of a recession.

What is more worrying, though, is that there is not a single indicator which points at a quick recovery. While gas prices at the pump are declining, so far it is only plain hope that consumers will react with a consumption binge. The risk is significant that instead the labour market will start deteriorating this fall and thus again eating into the Germans’ disposable income, just counteracting any positive effect from falling energy prices.

While thus a GDP growth rate of around 1.7 percent for the current year still seems plausible given the statistical overhang from 2007 and the first quarter of 2008, for 2009 it will be now very hard to even achieve a GDP growth rate of 1.0 percent (even only figuring in a very mild recession and a recovery around the end of the year, I now only come to an estimate of 0.6 percent for next year). At that kind of growth, unemployment will clearly rise again.

What is puzzling given the bleak data, however, is that in Germany, politicians and large parts of the mainstream media continue their business as if Germany was still in the middle of an upswing.

The government even managed the impressive stunt to sell the 2 percent annualized GDP drop in Q2 as a good economic figure: Roughly ten days before publication of the figure (and before even the data on exports or production were available), some government source leaked to the Süddeutsche Zeitung that the government expected GDP to contract by as much as 4 percent in annualized terms. When the final number came out, large parts of the media (with the notable exception of the Financial Times Deutschland) judged the drop relative to the figures published prior and hence came to the conclusion that economic conditions in Germany are not that bad after all.

The two most important daily newspapers, Süddeutsche Zeitung und Frankfurter Allgemeine Zeitung continue to claim that there are no clear signs of a significant downturn. Especially, they underline, there is no need for government action or fiscal stimulus. In the government, the Social Democrats and chancellor Angela Merkel also follow this line: They claim that budget consolidation needs to remain the highest priority even though the government sector as a whole already ran a balanced budget last year and is forecast to run only a modest deficit this year.

They get support from economic think tanks: Only about a week ago, ifo-president Hans-Werner Sinn said that while Germany is facing tougher economic times, it does not need a stimulus program at the moment and does not have the fiscal scope to enact one (http://www.cesifo-group.de/portal/page/portal/ifoHome/B-politik/10echomitarb/_echomitarb?item_link=ifostimme-wiwo-18-08-08.htm)

The only major party (except the Left party) talking of economic stimulus are now the Christian Socialists which – while being part of the grand coalition – face a state election in their home state Bavaria in September. Unfortunately, they do not make any useful proposals but basically want to cut taxes after the next federal election in 2009 – which certainly does little to help the short term economic problems of the German economy.

One can only speculate where this overall complacency of the political elite comes from. One reason seems to be that in the German public debate, economic cycles have never featured very high and both a large number of German journalists as well as German economists have a very poor understanding of forces shaping the economic cycle.

When Germany fell into recession after 2001, most economists and journalists claimed that this was not a cyclical, but a structural problem of the German economy. The general reading now is that the structural problems have been tackled with Gerhard Schröder’s labour market reform and years of wage restraint. In fact, most mainstream economist explain the strong economic recovery since 2005 at least partly with the effects from this reform. Against this mental frame, it is only logical to argue that a downturn is not a danger for the German economy as long as structural impediments are not increased.

Unfortunately, the economy is influenced by more than these structural issues. For an economy as dependend on exports as the German economy, the appreciation of the euro and the global economic slowdown will be enough to end an upswing even if the underlying structure of labour markets have improved. With the government sitting on its hands, Germans will learn this the hard way in the months to come.

This post has been co-posted at Eurozone Watch.