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Holger Schmieding – An unusual recession

3. November 2008

In market-based economies, recessions can be necessary, if painful, cleansing exercises to correct prior excesses. For Germany, however, we cannot find any such excesses that need to be flushed out. For Europe’s biggest economy, the last seven years had been a period of private and public austerity instead.

Having had its post-unification boom-bust before, there is no trace of any real estate boom, debt bonanza, excess consumption, profligate public spending or the like in Germany since 2001. The only economic indicator going up conspicuously in recent years has been employment, courtesy of wage restraint and some labour market reforms, noticeably the hugely successful part-deregulation of temporary employment.

For Germany, the recession comes solely as an external shock, more precisely, as a series of shocks that started with record oil prices and a surge in the euro and now extends to a collapse in export demand and a domestic credit crunch amid almost unprecedented financial turmoil. How could this unusual recession play out over time?

As a highly open economy with a focus on exports of top-notch cyclical goods such as reliable machinery and fast cars, Germany’s cyclical performance is usually a leveraged play on the fortunes of its trading partners. The severe downturn in the global investment cycle looks set to hit Germany hard. In response to a much bleaker export outlook, business investment will likely decline sharply in Germany. The credit crunch, which has finally come to Germany as well over the last few weeks according to some anecdotal evidence, looks set to exacerbate that. At the troughs of the 1993 and 2002 recessions, equipment investment (9.4% of GDP in 2007) fell at yoy rates of 17.3% and 11.3%, respectively. Whereas the 1993 plunge may be no guide as it came after the post-unification investment boom, the coming trough in equipment investment could easily be as bad as the 2002 example.

In 2003, exports had been largely stagnant for one year. We would not be surprised if exports actually fell modestly early next year.

While exports and business investment are more at risk than usual, residential construction (apart from some tax-induced distortions) and household consumption could be less affected than usual. On the negative side, the previous boom in (often temporary) employment suggests that firms can lay off workers earlier and more aggressively than in previous downturns. In addition, the credit crunch may also restrain household access to credit. However, German households don’t rely very much on borrowing in the first place. Against the international trend, they raised their savings rate from a trough of 9.2% in 2000 to 11.3% in 1H 2008. Although German households seem to take fright rather easily, their finances look in comparatively good shape.

More importantly, the oil driven decline in headline inflation from 3.1% in 3Q 2008 to a likely 1% next summer will probably fully offset the turnaround in the labour market. Rising transfer payments, especially the much higher pension increases next year echoing the strong wage growth in 2008 could largely compensate for some fall in entrepreneurial income. In other words, the real disposable income of households will probably suffer less in this recession than in previous ones. Also, German households tend to react only very mildly, if at all, to equity market wealth effects.

The recession is unusual and serious. We are still embroiled in a downward spiral of financial turbulence, shrinking export markets and slumping business confidence that looks set to trigger major declines in investment and employment. Amid the raging headwinds, however, key elements to underpin a major recovery are beginning to fall into place.

Start with monetary policy: Having adopted an unduly restrictive stance in mid-2008, the ECB now looks set to cut rates to no more than 2.5% by early 2008. As the ECB has also pulled out all stops to bring the actual funding costs of banks on term markets much closer to the policy rate, the decline in refinancing costs for banks could be more pronounced than the fall in the ECB refi rate from 4.25% to 2.5% may suggest. In effective terms, taking the money market dislocations into account, the ECB started well above 4.25%. However, the reluctance of banks to grant credit to households and corporates blocks the usual transmission mechanism of a monetary stimulus to the real economy. The credit crunch has to ease before policy can work. As a result, the lag between a monetary stimulus and a full real economy response, which is quite variable anyway, will probably be closer to twelve than the usual nine months.

Other forces beyond monetary policy are at work as well. The decline in oil prices helps comprehensively, although – for the business sector – the chances to export more to countries which benefit from lower oil prices will be offset somewhat by lower exports to oil producers. In addition, the trade weighted exchange rate of the euro has now fallen by 9% from the average of the six months to July 2008. While export markets are very weak, an enhanced price competitiveness makes little difference. The immediate issue for many German firms now is how many orders may  be cancelled, not how many orders they may win against their competitors in the future. But once the global economy revives, Germany could do quite well.

Ultimately, Germany cannot turn up again before its trading partners start to recover. But once this happens, Germany could outperform many of its peers in the next upturn. Benefiting from lower oil prices and a more realistically valued exchange rate, it has no negative wealth effect from slumping house prices to work off over time. We expect the German economy to stabilise in mid-2009 and to start growing rapidly again late next year. Unfortunately, the going could be quite rough until then. The risks to our forecast that GDP will contract merely by 0.3% in 2009 are very much to the downside.

Holger Schmieding ist Europa-Chefvolkswirt der Bank of America.

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