Germany: the eurozone laggard

Germany is clearly the eurozone's worst participant, with its nascent recovery possibly over almost before it began. GDP rose just 0.3% in the second quarter, matching the Q1 gain. And with recent data overwhelmingly bad, Q3 growth prospects are not encouraging. Most worryingly, business sentiment is deteriorating, with Germany's Ifo index of business sentiment down for five straight months. This type of economic disappointment is nothing new for Germany, and while external factors have been at play they have hit its economy especially hard, suggesting the problem is largely homegrown. Lacklustre growth in domestic demand, reflecting a poor labour market performance, has hobbled the economy, making it particularly susceptible to external shocks.

One-off factors, such as a contentious wage-round, floods in East Germany, and slumping equities, have taken their toll this year, and it would be tempting to attribute the economy's poor performance to these factors. But we think Germany's problems are more deeply rooted. Construction activity continues to decline following a post-unification boom, the Stability Pact offers little room for fiscal manoeuvre, and European Central Bank (ECB) interest rates have probably been too high for Germany's liking for at least the past year. But more than anything, Germany's troubles reflect a dismal job performance: incredibly, employment today is about 0.5% lower than in 1991 and the lack of job gains has held back growth in household incomes and spending.

Nonexistent job growth reflects an inefficient labour market. Over the last decade, vacancies and unemployment have both risen as a percentage of the labour force, indicating an increasing structural mismatch between labour demand and labour supply. The labour market's key shortcomings include issues such as: wage differentiation by skill level and region is low; it is hard to hire and fire (with restrictive conditions for permanent workers, including procedural requirements, notice and severance pay), and unemployment benefit levels are generous, which acts as a disincentive to search for work.

We expect the economy to stagnate this year, with just 0.1% GDP growth, and a still dismal 0.7% increase in 2003. With Germany amounting to a third of the eurozone economy, that will limit its recovery and, more than that, growth is also slowing elsewhere in the region. For the eurozone as a whole, we expect 0.6% GDP growth in 2002, improving to 1.4% in 2003 -- still well below trend.

Consumer price index (CPI) inflation is currently trending just above 2%, and elevated oil prices suggest it will remain there in coming months. Core CPI inflation, meanwhile, has remained stubbornly persistent, at around 2.5% since the beginning of this year. And the monetary pillar of the ECB's policy strategy is not exactly flashing an easing signal either. M3 money supply growth has slowed in recent months, but remains above 7% year-on-year, and well above the ECB reference value of 4.5%. The ECB is edging slowly towards a rate cut, but we don't expect any easing until the 'Iraq premium' has been removed from oil prices and inflation has begun to recede. That may not happen until early 2003, by when it may be a case of too little, too late, in terms of helping euro-zone recovery.

With the eurozone economy sputtering along, deteriorating budget balances have come back into focus across the region, leading even EU policymakers to question the value of strictly enforcing the Stability and Growth pact. Bowing to the inevitable, the EU has delayed the deadline for achieving broad budget balance from 2004 to 2006. That will help at the margin, but will hardly boost growth, with the EU still keeping one eye on the 3% of GDP deficit ceiling. The German government has admitted its budget deficit for 2002 will exceed that 3% limit, but hopes to bring it back below that level in 2003.

For the likes of Germany, France and Italy, the 2006 balanced budget deadline still implies a hefty fiscal consolidation.

Even when the euro was rising strongly, few looked for European reasons to buy it. Rather, its key market role remains as the 'un-dollar'. But given geo-politics and an uninspiring economy, euro gains in 2003 will be more moderate than we expected back in June. The muted eurozone recovery has had a cyclical impact, leaving interest rates and expected investment returns below where they would have been in a more normal upswing. And this economic disappointment goes beyond the cyclical, bringing the eurozonestructural problems into harsh relief. Still, we think the euro should gain versus the dollar, particularly later in 2003, when cyclical factors may swing in the its favour. And -- a negative positive -- financial risks seem lower in Europe than in the US or Japan, which may matter when interest rates begin to rise. Finally, lower oil prices could be a euro-positive in 2003.

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