Stephen King: German Chancellor must push for reform to sustain export-led recovery

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At the time of writing, a lot of this talk is likely to continue. With neither Merkel nor Schröder able to offer a convincing lead following the vote, the next few days are likely to be full of meetings in smoke-filled and Schnapps-lubricated rooms as attempts are made to piece together a viable coalition, of whatever political hue.

Recent economic developments, however, might suggest either that reform is not necessary or, instead, that earlier reforms have finally started to kick in. Business surveys were already pointing to greater optimism in the early summer months. That brighter tone now seems to have been well-justified: manufacturing orders have been rising rapidly, as has manufacturing production. Suddenly, the German economy, once the sick man of Europe, appears to be motoring ahead. Does this mean that Germany, freed from its reunification shackles, might finally be regaining its old dynamism? And, if it is, might this mean that other countries in Europe will soon be benefiting from Germany's rediscovered vigour?

It's worth taking a closer look at the orders and production data before rushing to conclusions. Manufacturing orders rose by a staggering 3.7 per cent in the month to July, taking the year-on-year growth rate up to a very impressive 7.6 per cent. Of the overall monthly increase, more than all of it was accounted for by a surge in foreign orders: businesses in other countries increased their demand for German manufacturing products by 7.7 per cent in July alone. Orders from within Germany, however, were less impressive, down 0.1 per cent after a rather more encouraging gain of 3.8 per cent in June. The gains in production were more subdued - up 1.2 per cent on the month and 3.0 per cent on the year - but, nevertheless, production also seems to be heading in the right direction.

How much should we read into this sudden, and rather unexpected, potency? There are some obvious problems. The chart, for example, shows that we've seen upward spikes in manufacturing orders before, and they've never really indicated a sustainable improvement in German economic activity. At the height of the dot.com boom, for example, orders twice threatened to head off into the stratosphere yet any upward revisions to growth projections at the time would, in hindsight, have been a serious mistake.

Similarly, at the end of 1994 and the beginning of 1995, there was a sudden surge in optimism, to be followed shortly afterwards by a return to the miserly growth rates that have become so characteristic of Germany's economic progress in recent years (I remember that episode well. I published a piece at the time entitled "The German Locomotive Returns": sadly for Germany, and for my reputation as an economist, the locomotive was shunted back to the sidings all too quickly).

Germany's Economics Ministry has been quick to point out that foreign orders benefited in July from some lumpy requests for "big-ticket" items - within the aeronautics, shipbuilding and machine-building areas. These tend to be one-offs, flattering the orders figures for a month or so before reality returns. And, even if foreign orders are rising rapidly, there's the hardly trivial matter of an ongoing absence of domestic demand. Domestic orders are certainly improving - they were up by 3.3 per cent in the year to July - but the pace of improvement is not hugely impressive. Moreover, there is not a great deal of evidence to suggest that domestic demand is recovering: admittedly, consumers are suggesting, when asked, that now is a good time to be splashing out on consumer durables but that's hardly surprising when most of them have been fearing a substantial VAT increase next year as part of a CDU-inspired reform package.

Germany's success thus far is, therefore, mostly confined to exports. Control over labour costs has doubtless helped. German companies, once at the mercy of demanding unions, can simply point east and threaten workers with outsourcing: all of a sudden, it no longer seems sensible for a German worker to demand compensation for, for example, higher oil prices. As a result, inflation has remained quiescent, Germany's labour costs have fallen relative to many of its competitors and German industry has maintained its share of world trade (a remarkable result given that most Western countries have seen their trade shares battered into submission though the rise of China).

Germany's export success is, of course, partly a reflection of Germany's own unique position. As Robert Prior-Wandesforde, my colleague at HSBC, often points out, German exporters are the only ones that don't have to export to Germany: it's only other countries' exporters - including those based in the UK - who have to contend with Germany's weak domestic economy. More broadly, Germany's export success may not be a guarantee that the economy as a whole can flourish. After all, the US economy has expanded at a much faster rate than Germany's in recent years, but America's share of world trade has been in seemingly relentless decline.

So when might export success not be universally good news? One possibility is that companies are forced to export because there simply isn't enough domestic demand: in this case, Germany has had exactly the opposite experience to the United States in recent years. Another is that world trade success might come about only through a deterioration in the terms of trade. In other words, it's easy enough getting more and more export orders, but if export prices are under persistent downward pressure, then domestic incomes are not going to do so well. Fortunately for Germany, the evidence here is not so convincing: the terms of trade improved between 2000 and 2004. More recently, though, the trend has looked a little less encouraging, suggesting that this is an area that needs to be monitored.

The biggest difficulty with Germany's export gains, though, is that success has come at other countries' expense. Germany's cost control has been unusually good in recent years. Italy's cost control has been unusually bad. And, through the introduction of the 35-hour week, it may be that France has also lost momentum. Germany might want to celebrate its apparent industrial renaissance but other eurozone countries - and, for that matter, the UK - are not in the same position. French manufacturing production is in decline, UK manufacturing production is barely rising and the Italian economy seems to be always on the brink of recession.

It would be nice to think that Germany really is about to embark on a sustained period of healthy economic growth. But if reform is needed - and almost all German politicians agree that there's a lot of hard work ahead - it's difficult to believe that Germany's summer surge will amount to very much. Meanwhile, if Germany's apparent improvement depends mainly on a decline in unit labour costs relative to its near-neighbours, this is no more than the eurozone equivalent of an old-fashioned exchange rate devaluation: good news for Germany, perhaps, but hardly good news for the eurozone as a whole.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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