Recently, however, euro zone activity has softened. Germany’s economy, which constitutes one-quarter of the euro zone GDP, experienced flat growth in the second quarter. The Kiel Institute recently revised its forecast for this year to minus 0.5 percent, mainly reflecting a decline in industrial output, construction activity, and soft consumer spending. According to the IMF, Germany will be the only major economy to shrink this year.
Euro's Decline & Monetary Policy Challenges
Germany’s problems are weighing on the euro, which has fallen to a nine-month low against the dollar after strengthening in the first half (see chart). Even the ECB’s increase in its deposit rate in September to 4 percent – the highest rate in the euro’s history – has failed to bolster the currency, which is approaching its lows for this year.
U.S. Dollars to Euro Spot Exchange Rate FRED
Is Germany's Weakness Cyclical or Structural?
Economists at UBS argue that Germany’s problems are more structural than cyclical in their September 8 commentary. They point out that Germany’s economy has lagged behind peers such as France and Italy since 2019, a full year before the Covid-19 pandemic. On the demand side, the main culprit has been under-investment, estimated to have detracted 0.4 percent from annualized growth. While on the supply side, Germany’s performance has been particularly weak in in-service sectors.
The Impact on Germany's Economy
1. Energy Transition Challenges
Several fronts are impacting Germany’s economy. First, it has been forced to reduce its reliance on Russian natural gas and shift to alternative sources of energy that are more expensive. The challenge is most apparent in energy-intensive industries such as metals, glass, cars, and fertilizer. A Financial Times article documents sacrifices that Germany and other European countries are making to limit the fallout of Russia’s squeeze, including conserving energy consumption and substituting for other energy sources, including increased use of coal in Germany.
2. China's Economic Slowdown
Second, Germany’s export capability has been hampered by the weakening of China’s economy since the beginning of the coronavirus pandemic, apparent in the share of Germany’s exports to China, which have fallen to the lowest level since 2016. Moreover, as China builds its own capabilities in auto production — especially electric vehicles — it could begin to penetrate markets in Europe and elsewhere.
In the Bundesbank’s September monthly report, the central bank took the unusual step of warning that Germany’s excessive dependence on trade with China is one of the main reasons its “business model is in danger.” It advised German firms to “rethink” their supply links and direct investment abroad.
3. Construction Industry Crisis
Third, according to The Economist, the construction industry, which makes up 12 percent of German GDP, has been hurt by a confluence of factors that threaten to leave builders on the brink of collapse. These factors include higher interest rates stemming from the ECB’s actions to combat inflation, higher prices for materials and energy, and bureaucratic red tape that has left the construction of flats well below the government’s targets.
Amid this, comparisons have been made to what happened in the late 1990s, when Germany struggled with high labor costs and lack of international competitiveness after unification and was called “the sick man of Europe.” Subsequently, a series of labor market reforms in 2003-2005 undertaken by Chancellor Gerhard Schroeder successfully improved labor market flexibility. They helped to revive economic growth and restore Germany’s role as an export powerhouse that sold industrial machinery and high-quality automobiles to the rest of the world.
The Economist’s assessment is that current conditions are not as alarming as the 1990s because unemployment is much lower now at about 3 percent. Nonetheless, structural reforms are required to bolster the economy with factors such as an aging population and chronic underinvestment in technology and public infrastructure weighing on it.
Regarding technology, Wolfgang Munchau of Eurointelligence observes that Germany has excellent scientists and engineers, but it overspecialized in pre-digital technologies. He contends Germany and other European countries missed out on the digital revolution.
Challenges & Complexities in Implementing Economic Reforms
Faced with this myriad of issues, it will not be easy for German policymakers to develop a quick fix, especially with a three-party coalition in government. A structural transformation of the economy will require a combination of public and private investment, including streamlining regulation and bureaucracy.
The process would also necessitate a sizable financial commitment. However, this would only be possible if Germany changed its own fiscal rules, and the European Union extended the relaxation of its rules invoked during the pandemic. For his part, Chancellor Olaf Scholz opposes increased spending on the basis it could fuel a resurgence of inflation.
Meanwhile, the ECB is committed to maintaining a restrictive monetary policy even if the euro zone slips into recession. Christine Lagarde reaffirmed at Jackson Hole that “the fight against inflation is not yet won,” she indicated that EU interest rates will need to stay high “as long as necessary.”
Despite this, pressures on the euro could persist if investors conclude that Wolfgang Munchau is correct that “the trophy of the sick man of Europe is therefore safe in Berlin for the foreseeable future.”
A version of this article was posted to Forbes.com on October 2, 2023.
This publication has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Opinions expressed in this commentary reflect subjective judgments of the author based on the current market conditions at the time of writing and are subject to change without notice. Information and statistics contained herein have been obtained from sources believed to reliable but are not guaranteed to be accurate or complete. Past performance is not indicative of future results.
© 2023 Fort Washington Investment Advisors, Inc.
