Business Cycles, Growth, Economic Structure Europe Foreign Trade and International Economic Relations Public Finances and Financial Economics

The German locomotive has become Europe’s liability

This article was first published on on 27 August 2014.

The news that German output declined in the second quarter has dented the country’s economic euphoria, but only a little.

Many blame the Ukraine crisis and transient factors such as the mild winter, and believe that Europe’s largest economy remains fundamentally strong. They are wrong. Germany’s disappointing performance mostly reflects structural weaknesses, both at home and in the eurozone. Policy makers should act quickly, before the problems become further entrenched.

The country’s attitude towards the eurozone is increasingly one of disengagement. It hopes the openness of its own economy, and its strong position in export markets, will spare it from being pulled down by its neighbours’ misfortune. The past few months have shattered this hope.

France is sinking ever deeper into economic stagnation and political deadlock over the urgency of structural reforms, reflected in yet another cabinet reshuffle. Italy’s economy is in its third recession in six years. The collapse of Portugal’s Banco Espirito Santo shows that Europe’s financial system still poses huge risks to stability. Public and private debt is still rising in most eurozone countries. And the looming threat of deflation in the eurozone – including even Germany – makes it ever harder to generate demand and growth. All this contributes to a highly uncertain economic environment for German companies.

It is true German exports to Russia and Eastern Europe have declined since the beginning of the year. But, given that they never accounted for more than 4 per cent of total exports, this does little to explain the country’s lacklustre performance.

The main problem is not weak export demand or the reluctance of consumers to spend money but the fact that companies are unwilling to invest in new productive assets. Investment now accounts for a smaller portion of output in Germany than in most other industrialised countries. Company managers have long blamed the high uncertainty in the business environment as the main reason for low investment.

The conflict with Russia has certainly contributed to this uncertainty. But there are much bigger clouds on the horizon.

One is the possibility of renewed financial instability, as questions continue to surface about the health of the banking system and the dearth of credit for small and medium-sized enterprises. Rising energy costs are a further worry. Then there are threats to free trade, concerns about possible tax rises and more stringent regulation, political instability in countries such as France and Italy, and fears in some quarters that European integration may soon go into reverse.

The most urgent challenge for German and European policy makers is to generate more investment – which would create jobs and enhance productivity, leading the way to permanent increases in household incomes. Governments should also use whatever fiscal leeway they have to boost employment, for example by cutting payroll taxes. And Europe should create a financing vehicle to give smaller companies better access to credit.

Germany is in a position of strength. It should be leading these reforms in Europe. Almost uniquely, it need not wait for skittish managers to resume their investment programs; its balanced budget and its low level of public debt gives the government scope to invest using its own balance sheet.

Germany’s public investment in transport infrastructure and education has long been among the lowest in Europe. This needs to change. The country should also use its political clout to convince its partners and Brussels to implement a European reform agenda that targets investment and growth.

This month’s output figures should be a wake-up call for German policy makers. They need to realise that their country cannot succeed without Europe. A healthy and dynamic eurozone economy is an essential precondition for German growth and prosperity.

Equally, the country’s economy has been an anchor of stability, and a recession there would be a significant setback for Europe. It is high time for Europe’s policy makers to address the structural weaknesses of their economies and create an impulse for more demand and investment.

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