Outlook for Germany and the Eurozone

Adam Posen

To sum up, recovery is coming to the eurozone, but Germany will be a drag on this process.

In the second quarter of 2003, only three eurozone countries grew.  Germany, which represents 32 percent of the GDP of the eurozone and is the recipient of a large share of members’ exports (between 15-25 percent), has had three consecutive quarters of negative growth.  Germany has been the slowest growing eurozone economy for the last five years.  Unemployment is at 10.4 percent (this translates to over 4.3 million workers).    Recent retail sales and IP numbers were much weaker.  As a result, the markets do not expect the output gap to close.

The government of Gerhard Schroeder has embarked on an ambitious "Agenda 2010" effort to reform the German economy.  Among other things, it seeks to reduce work disincentives by cutting the amount of time a person can claim unemployment benefits.  Tax reform, as well as a plan to bring the date forward for implementing income and corporate tax cuts, is in the works.  In the area of health care, the government hopes to staunch rising costs by increasing the amount of co-payments Germans make for services.  Finally, the plan hopes to make the pension system more sustainable by raising the retirement age from 65 to 67.

Yet, financial fragility remains an issue.  Germany’s over-banking, with limited use of alternatives by savers, over-lending to small and medium enterprises on real estate, the continuing existence of government subsidized banks, and partial liberalization could combine with near-deflation for difficulties in this sector.

However, a renewed commitment to privatization of the Landesbanken and promotion of the “True Sale” initiative to pool and securitize loans are steps in the right direction.  Still, there are too many banks with too little profit and, therefore, too little capital.  The resulting adverse selection and ever-greening of dubious loans remain a problem.

In addition, Eurozone macro policy has been insufficiently countercyclical and has hit Germany hardest.  The Stability and Growth Pact, though increasingly ignored, has constrained fiscal policy.     Dreams of expansionary consolidations (i.e., budget contractions that increase growth) are not relevant for large, low debt countries borrowing in their own currency, such as France and Germany.     The rise in the euro against the dollar has been an additional drag, but, to date, the manufacturing recession probably had a much greater effect.  Real interest rates in the eurozone have declined far less than in the United States, and, given inflation differentials, have been especially high in Germany.

Thus, the current German recession cannot be ascribed to euro appreciation—so far.  Germany is heavily dependent upon capital goods demand, but nearly 50 percent of its export markets are in the eurozone.

What can we say about Germany's relationship with other members of the eurozone?  For several years, reform and (with a lag) growth in the smaller economies has outpaced growth in the "core" EU states.  In the last few years, France has engaged in stealth reform, and the recent pension battle shows willingness to carry it through.  Spain has continued to improve its competitiveness as well. Eastern enlargement will bring in higher growth economies and some competitive pressure, but these remain very small.  A lot of investment has already occurred, since integration is taken for granted.  The eurozone “outs” (Denmark, Sweden, and the UK) are likely to remain out.  They do not have a common economic agenda (e.g., on the Stability and Growth Pact), however and have little leverage beyond bargaining to come into the eurozone.  As a result, Germany’s domestic will to liberalize will be a key determinant of the EU’s economic agenda.

In conclusion, if the Agenda 2010 reforms are implemented, Germany will have a significantly improved labor supply and tax code.  It will also have made some progress on health care and pension sustainability.  Financial fragility is being addressed as well, but only partially at this time.  These reforms may be somewhat contractionary over the next few quarters on net.  As a result, recovery in Germany will be weak (with growth of less than 1.3 percent in CY2004).  Moreover, if the European Central Bank and the conditions imposed by the Stability and Growth Pact continue to bind Germany excessively, the net drag from implementing reform will increase, and likelihood of full implementation will decrease.  This will be a further demonstration that macro tightness impedes reform.   Overall, the eurozone will come back, despite Germany, but weakness in Germany will suppress the strength of recovery.

Adam S. Posen is a Senior Fellow at the Institute for International Economics.  This essay is adapted from his presentation at the Institute on September 9, 2003 (http://www.iie.com).  He published a major article on the German economy, "Frog in the Pot: Germany's Path to the Japan Syndrome," in the Spring 2003 issue of The National Interest.  (An archived version is available at http://www.nationalinterest.org.)