The threat of an overheated German economy

The Eurozone economy is doing really well. Some data points to 3% growth. The German economy is doing even better – with some data pointing to 5% annualized growth. But there’s a downside – overheating. And with the ECB at negative rates and engaged in 60 billion Euros of QE to boot, overheating in Germany is a reasonable fear. Some thoughts below

First, let’s look at the data.

This morning the Eurozone Composite PMI came out at a robust 56.8. This is the best we’ve seen out of Europe since April 2011, before the sovereign debt crisis took its toll – and consistent with a 3% annualized growth rate.

At the same time, in Germany, the second estimate for first quarter growth confirmed the initial 0.6% number. And private consumption is the underlying driver, as it has been since 2014, contributing about one half of GDP growth in that three year period. On the back of these results, business confidence in Germany is so high now that it corresponds to an annualized 5% GDP growth print.

But beneath the statistics lie weaknesses. One problem is Italy. Holding purchasing power constant, the country’s economy is no bigger today than it was twenty years ago before the euro was introduced.

And that has the ECB at negative rates and expanding its balance sheet – even as the German economy is booming. After all, if the ECB were not engaged in QE, the solvency of the Italian government would again become a question, raising the spectre of rising interest rates and government bond losses that would enfeeble the already problematic Italian banking system.

This is a big problem.

See, the Germans have been railing for years at the ECB because of its monetary policy. Just yesterday, German Chancellor Angela Merkel blamed the ECB for making the euro too weak (and allowing the German economy to post a current account surplus of 270 billion Euros in 2016). The German view is that Germany has made its economy ultra competitive and others in the eurozone are playing catch-up. And so, the ECB’s ‘loose’ monetary policy makes this dichotomy even more stark.

The threat is overheating in Germany. We saw this last decade when the eurozone core was less robust, but periphery countries like Ireland and Spain were benefitting from free capital movement in the single currency zone and low interest rates. Spain and Ireland overheated with massive property bubbles ending in tears, transforming the countries from fiscal paragons to bailout basket cases. The German central bank is warning that the same thing could be happening right now in Germany.

But, of course, if the massive German economy overheats, there will be no one to pick up the pieces; it is too big and too many of the other Eurozone economies have their own problems. And so the Germans have to be concerned that they don’t contribute to the euphoria in the private sector with fiscal stimulus, even while German infrastructure spending lags France and needs to increase. It’s not like the Germans can spend to boost the moribund Italian economy because there really isn’t a way to do that in the eurozone. And that would be a ‘transfer union’ anyway, something derided in Germany right now, and a concept fuelling the AfD party whose popularity Angela Merkel’s party is still trying to dampen in order to win re-election this fall.

Bottom line: The Germans are desperate to get their government debt load below 60% of GDP to fulfill the Maastricht Treaty’s government debt hurdles. And meeting Maastricht’s 3% deficit hurdle is why Germany passed the debt brake balanced budget law in 2009. Combine this with German concern about overheating and it makes the Germans very cautious about adding any fiscal stimulus to their domestic economy.

At the same time, German politics – especially during this election period – are such that the EU reform toward greater fiscal union and transfers that French President Emmanuel Macron espouses will not be rushed. Therefore, the Goldilocks scenario would be a long enough period of eurozone growth without German overheating to make the necessary changes to the EU before a recession hits. Time will tell if this is even possible.

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