It may sound a little strange with Germany leading the way on positive economic data surprises in recent months but the biggest risk to Europe’s nascent recovery remains Chancellor Angela Merkel’s government.
Why, you might well ask?
Well while the pace of growth in Germany is to be welcomed, and particularly the fact that it is appears to be finally feeding into wage gains for German workers, the country’s history of chronic inflation phobia could yet scupper hopes of a sustainable recovery in the region.
The problem is as follows: Since the onset of the euro crisis the economies of member states have been diverging. This was initially reflected in bond spreads between the so-called core countries (think Germany, France, Austria, the Netherlands etc.) and peripheral states (Greece, Italy, Spain, Portugal and Ireland):
However, it is currently best illustrated by comparing the spread between unemployment rates:
The key point to note is that high unemployment is generally considered a good reason to think that an economy has room to grow at a relatively rapid pace without causing inflation to rise to worrying levels. Low unemployment suggests that an economy is operating close to its potential, meaning that an increase in the rate of growth would likely mean that prices would start being pushed up.
And that’s a problem for Europe. In Germany and Austria, unemployment is hovering around levels that economists tend to consider the “natural rate”, where further drops would likely imply higher wage growth (as employers have to offer more money to entice workers) and rising prices. By stark contrast, unemployment in Spain and Greece remains above 20% — an extraordinarily high level that implies an uptick in growth would have very little impact on average wages.
Such large differences between countries would normally result in very different central bank interest rates. Within the monetary union, however, they are all reliant on rates set by the European Central Bank, which means that during periods of economic divergence (as we have now) policy is likely to be too tight for the weakest economies and too loose for the strongest.
So what does all that actually mean in practice?
So far, economic theory seems to be playing out much as expected. Stronger growth in Germany has seen n
egotiated salaries are now rising at the fastest pace in two decades as workers appear to be shrugging off their reputation for wage restraint. These gains now also seem to be feeding through to expectations for the future as well with German consumer confidence hitting a 14-year high on Thursday.
Higher wages are good news for German consumers, but they will be equally welcomed by struggling states in Europe’s periphery as stronger German demand could provide a boost to exports and reduce the competitive advantage that lower labour costs have given to German products and services. Yet to realise these benefits, Merkel’s government will have to allow inflation in the country to rise — potentially even above the ECB’s target of “close to but below 2%”.
That still looks like an extremely unlikely scenario.
For evidence of this, you need only look at the government’s ultra-conservative response to the collapse in its borrowing costs over recent months. Last year the German government ran a budget surplus equivalent to 0.4% of GDP despite being able to borrow at interest rates below 1% for 30-year bonds.
Last month the German government sold 5-year bonds with a negative nominal yield — meaning that in effect people are paying the government to borrow — for the first time in its history. Markets are practically begging Germany to issue debt but it seems that the need to appear prudent is getting in the way of sensible policy.
Bringing on a housing bubble?
And there are serious risks to this strategy. Between 1998 and 2001 the Clinton administration also decided to run a budget surplus in the face of very strong investor demand for safe government bonds. Some academics argue that by doing so and shrinking the outstanding stock of government debt the US government played a part in inflating a housing bubble as investors began channelling funds that would have gone to government bonds into mortgage securities.
The bubble ultimately burst in 2008 with devastating consequences.
While we are unlikely to see exactly the same scenario play out in Europe, extremely low yields on safe government debt could well start to channel investment into other higher-yielding (and at least notionally “safe”) assets such as property in core countries.
Already Germany’s central bank president Jens Weidmann has been warning that property prices in the country are showing signs of being overvalued, although he stopped short of calling it a bubble. He told an audience in Munich, according to The Wall Street Journal:
“Bundesbank calculations suggest that by now in cities there are clear overvaluations [in residential real estate]. We reckon that prices are between 10% and 20% above the levels that are fundamentally justified. In the hip neighbourhoods of big cities, the overvaluation may be more.”
Worrying times ahead…
With the ECB undertaking asset purchase programmes, the cost of credit in large, growing economies like Germany is only likely to fall from here. That in turn suggests that, in the absence of direct government intervention, the prices of a range of assets (including property) could well continue to rise.
This is clearly a concern for Weidmann.
So what can the government do about it? In theory it could decide to increase taxes, for example on property transactions, in order to drain money from the economy and prevent it from overheating. However, it would have to manage the results very carefully.
If the state chose to use the tax windfall to swell its coffers even more it might help to cool domestic demand somewhat. However, it would also be likely to exacerbate the contraction of government debt supply as demand for it fails to drop at the same rate as it is being paid down. At least some of this money could be driven into the very asset classes that the state is trying to cool worsening the problem rather than resolving it.
Moreover, even if it were to succeed in cooling German economic growth and inflation it would mean that the gap between the core and the periphery would last for longer. If growth is fails to pick up elsewhere in the region the ECB could be compelled to continue or even increase its QE programme to bring inflation back towards target causing the cycle to start all over again.
A more positive alternative scenario is that the government could try to soak up the additional investment demand through issuing bonds. If it used even a portion of those funds to invest in struggling peripheral European economies (either directly or through increasing funding of supranational investment funds) it could help increase growth across the region, helping to bring those economies back into line with Germany and reducing the pressure on itself to take the burden of adjustment.
Unfortunately, there is precious little evidence that German policymakers are even willing to consider such a strategy. Without it, however, Merkel and her government remain the biggest risk to the prospects of a European recovery.
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