Today’s commentary
The latest quarterly figures for Germany have come out and they show an improving domestic demand trend in Germany. Net trade lowered economic growth because of weak export volume. These results and the institution of a minimum wage will quell much of the criticism of Germany’s large trade surplus.
Regarding the trade and current account imbalance, my contention all along has been that the Germans were willing to boost domestic demand but were constrained by the euro. The Germans are also concerned about an overheating housing market. My view in January was that the FDP were out because they were going to miss the 5% hurdle. German Chancellor Angela Merkel was already positioning herself to be able to govern with the SPD, and that there was going to be a leftward turn in German politics as a result. Germany has been actively moving its positions toward a pro-growth orientation on a number of issues: inflation, interest rates, and wage rates to name a few. The new minimum wage law that Angela Merkel has agreed to is a further sign that Germany is willing to allow wages to rise now. It doesn’t matter though because of the euro.
The problem is that the eurozone lacks flexibility. The institutional set up mandates a pro-cyclical fiscal policy to meet the stability and growth pact criteria and it prevents the ECB from monetizing government debt to lower bond yields to stop liquidity crises. Given these impediments, governments hands are tied. The Germans have been moving to address the crisis within that framework but there is only so far one can move without violating the legal framework. For example, the German Constitutional Court has yet to rule on ECB bond buying and still could rule it unconstitutional under German law. Moreover, the Germans are concerned about their own public finances as currency users who don’t have a central bank backstop, and therefore not willing to add a lot of fiscal measures. Europe will remain a growth laggard for all these reasons.
Where the Germans should take blame is in their desire to not only adhere to the Maastricht criteria but to enhance them, to make a super stability and growth pact that is more onerous than the present one. That is going to be exceedingly pro-cyclical and will almost surely cause problems in the next downturn if implemented. The Germans are angling for a balanced budget by 2015 (link in German) because they see balanced budgets as a virtue and deficits as a sign of profligacy. This is why they will push to beef up the stability and growth pact. They believe doing so will prevent a large build up in public debt that lessens fiscal space during a downturn and triggers a sovereign debt crisis. I certainly understand the reasoning, predicated as it is on the no-bailout clause of the ECB. However, this is a very pro-cyclical and anti-growth ideological position.
Having said all that, the German economy is doing better than the rest in the eurozone in part because Germany has benefitted from low interest rates. Domestic-led growth has finally started to take hold, with demand the main driver behind Q3 2013 GDP growth. The Germans are right to be concerned that this one size fits all interest rate policy is problematic for the German economy. There is a housing boom in Germany and a global equities boom as well. German savers are desperate for yield and return. If rates remain at zero and the economy expands due to domestic demand, this could end up in a bubble in Germany. That is a very real concern.
The deflation threat that ECB Chief Economist Peter Praet has warned of is mostly a phenomenon that is taking place in the periphery. And this should be expected since the periphery is in the midst of an internal devaluation wage and price reduction in order to regain export competitiveness because they cannot do so via a lower exchange rate with their major trading partners, since most of those trading partners are in the eurozone. The deflation is a logical consequence of the policy that the periphery is pursuing because of the lack of flexibility inherent in the eurozone’s institutional setup. And a common interest rate policy is only going to exacerbate tensions.
Before I close here, I want to flag the market froth issue again. If you look at the articles in today’s news links post, there were numerous articles pointing to froth. We saw the UK government’s deficit receding because of stamp duty collection from the buoyant British housing market. We saw record inflows into US equity markets as retail investors chased rising share prices. We saw pre-IPO technology companies getting rich valuations for their shares. We saw record convertible bond issuance because of the desire of bond funds to get upside. And all of this is coming on the back of record levels in shares in the US and hefty gains elsewhere.
I believe markets could go higher from here. And given Germany’s relative strength in Europe, this would benefit the Germans most. That is medium-term bullish, especially given the relative valuation of European shares is lower than it is in the US. Nonetheless, you have to watch the move upward in these asset markets with awe and fear. This is a liquidity driven market and the risk is that it is heading toward excess, something that will end badly – and not just in the US. If any country in the eurozone is in the hot seat riding this wave up, it is Germany.
German domestic demand is improving
Today’s commentary
The latest quarterly figures for Germany have come out and they show an improving domestic demand trend in Germany. Net trade lowered economic growth because of weak export volume. These results and the institution of a minimum wage will quell much of the criticism of Germany’s large trade surplus.
Regarding the trade and current account imbalance, my contention all along has been that the Germans were willing to boost domestic demand but were constrained by the euro. The Germans are also concerned about an overheating housing market. My view in January was that the FDP were out because they were going to miss the 5% hurdle. German Chancellor Angela Merkel was already positioning herself to be able to govern with the SPD, and that there was going to be a leftward turn in German politics as a result. Germany has been actively moving its positions toward a pro-growth orientation on a number of issues: inflation, interest rates, and wage rates to name a few. The new minimum wage law that Angela Merkel has agreed to is a further sign that Germany is willing to allow wages to rise now. It doesn’t matter though because of the euro.
The problem is that the eurozone lacks flexibility. The institutional set up mandates a pro-cyclical fiscal policy to meet the stability and growth pact criteria and it prevents the ECB from monetizing government debt to lower bond yields to stop liquidity crises. Given these impediments, governments hands are tied. The Germans have been moving to address the crisis within that framework but there is only so far one can move without violating the legal framework. For example, the German Constitutional Court has yet to rule on ECB bond buying and still could rule it unconstitutional under German law. Moreover, the Germans are concerned about their own public finances as currency users who don’t have a central bank backstop, and therefore not willing to add a lot of fiscal measures. Europe will remain a growth laggard for all these reasons.
Where the Germans should take blame is in their desire to not only adhere to the Maastricht criteria but to enhance them, to make a super stability and growth pact that is more onerous than the present one. That is going to be exceedingly pro-cyclical and will almost surely cause problems in the next downturn if implemented. The Germans are angling for a balanced budget by 2015 (link in German) because they see balanced budgets as a virtue and deficits as a sign of profligacy. This is why they will push to beef up the stability and growth pact. They believe doing so will prevent a large build up in public debt that lessens fiscal space during a downturn and triggers a sovereign debt crisis. I certainly understand the reasoning, predicated as it is on the no-bailout clause of the ECB. However, this is a very pro-cyclical and anti-growth ideological position.
Having said all that, the German economy is doing better than the rest in the eurozone in part because Germany has benefitted from low interest rates. Domestic-led growth has finally started to take hold, with demand the main driver behind Q3 2013 GDP growth. The Germans are right to be concerned that this one size fits all interest rate policy is problematic for the German economy. There is a housing boom in Germany and a global equities boom as well. German savers are desperate for yield and return. If rates remain at zero and the economy expands due to domestic demand, this could end up in a bubble in Germany. That is a very real concern.
The deflation threat that ECB Chief Economist Peter Praet has warned of is mostly a phenomenon that is taking place in the periphery. And this should be expected since the periphery is in the midst of an internal devaluation wage and price reduction in order to regain export competitiveness because they cannot do so via a lower exchange rate with their major trading partners, since most of those trading partners are in the eurozone. The deflation is a logical consequence of the policy that the periphery is pursuing because of the lack of flexibility inherent in the eurozone’s institutional setup. And a common interest rate policy is only going to exacerbate tensions.
Before I close here, I want to flag the market froth issue again. If you look at the articles in today’s news links post, there were numerous articles pointing to froth. We saw the UK government’s deficit receding because of stamp duty collection from the buoyant British housing market. We saw record inflows into US equity markets as retail investors chased rising share prices. We saw pre-IPO technology companies getting rich valuations for their shares. We saw record convertible bond issuance because of the desire of bond funds to get upside. And all of this is coming on the back of record levels in shares in the US and hefty gains elsewhere.
I believe markets could go higher from here. And given Germany’s relative strength in Europe, this would benefit the Germans most. That is medium-term bullish, especially given the relative valuation of European shares is lower than it is in the US. Nonetheless, you have to watch the move upward in these asset markets with awe and fear. This is a liquidity driven market and the risk is that it is heading toward excess, something that will end badly – and not just in the US. If any country in the eurozone is in the hot seat riding this wave up, it is Germany.