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What a German recession means for the rest of Europe

This article originally appeared in the 4 November 2019 edition of Investment Europe. Click Here to view the original article.

The German economy grew at its slowest annual rate between August 2018 and July 2019 since the depth of the 2011 euro crisis. The September PMI numbers dropped to 49. It is the first time since April 2013 that Germany’s PMI, which tracks manufacturing and services sectors, fell below 50. What is worse, its August manufacturing PMI dropped to 43.5, well below the 50 mark indicating recession. Around 22% of Germany’s GDP comes from manufacturing, and the automotive sector, one of its most significant components, is down 18% since its peak in August 2017.

Germany’s reliance on the rest of the world to buy its products and the lack of political will to develop domestic sources of consumption are set to turn into a significant issue. So how did Germany get itself into this situation?

In the 1990s, Germany took a politically difficult decision: to cap workers’ pay and unemployment benefits to ensure the economy can compete with emerging Asia and Eastern Europe. Wage growth of German workers dropped from 3% in 1990 to just over 1% in the following decade. Subsequently, Germany’s current account surplus rose from 1.7% to over 7% over the same period, while Greece, Portugal and Spain saw their current account deficits adjusted upwards by a similar magnitude.

Recent economic data highlight the problem with Germany’s economic model. However, it could lead to a very much needed rebalancing, which would be better for the eurozone in the long term. Can a German recession be good for the rest of Europe?

Our initial thoughts tell us that a German recession could have a significant negative impact across European supply chain interconnections, and one would expect German woes to spill over to Southern and Eastern Europe due to a slowdown in investments. However, this does not tell the real story.

As Germany has historically been running current account surplus with other eurozone economies, it is the deficit economies that fuelled the demand for German products and recycled excess German savings, driving asset-price bubbles and capital misallocation in the likes of Spain and Portugal. When imports collapsed due to austerity in Southern Europe, Germany turned to China. After the global financial crisis in 2008, China started rebalancing its economy which resulted in a significant reduction of its current account surplus. In other words, China has been focusing on developing domestic demand. Germany could have also addressed its overreliance on the external demand but chose not to do so. Instead, it has increased its current account surplus with China, US and the UK.

Recently, the German economy has been a victim of the ongoing China-US trade war. The recent re-emergence of protectionism and populism, which is destroying global demand, means that Germany will find it difficult to sustain its “economic miracle” without re-building its domestic demand. Germany is running out of economies willing or able to absorb its production. Stronger German consumption is also needed for the rest of Europe to rebalance away from recycling German savings, allowing for a fair competition of capital.

Being locked in the currency union with Germany means that countries such as Portugal and Spain can do little but to absorb its excess savings. If these economies decide to address this issue without Germany lowering its surplus or running a corresponding deficit, they would have to find other economies outside the eurozone willing to do so.

A German recession, induced by the recent global slowdown, might force the country to start addressing its weak domestic consumer market with higher wages and new fiscal measures. This should be positive for the eurozone as it will address the imbalance created by the monetary union. Higher earning power for German consumers would mean a lower share of income for German corporates – a painful pill but potentially a necessary one to swallow considering weak global demand. Whatever the solution Germany chooses, history tells us that things need to get really bad before the momentum swings the other way.

Artur Baluszynski is director and head of research at Henderson Rowe.

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