Down but not out

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The author is chief economist at German bank LBBW and former chief ratings officer at S&P

Germany has yet to be overtaken by capital markets in the sovereign rankings. Despite the country’s economic weakness, the Bund is still the undisputed euro debt benchmark. Its AAA-rating has a consistent outlook with all major rating agencies. But this will not last forever.

The simplistic view, still shared by many German politicians, is that higher creditworthiness is a direct function of lower debt. It isn’t. In fact, the public debt burden of highly rated advanced economies is significantly higher than that of lower rated emerging markets. Other factors such as growth, productivity and innovative capacity also play an important role. This is where Germany falls increasingly short.

The country’s economic data has been a drumbeat of disappointments. All high-frequency indicators, from order books and industrial production to retail sales and confidence indicators, are again pointing down. For two years, the economy has been in decline Abstract and out. However, the economy is not going anywhere.

Germany’s weakness led to confirmation of expectations for further rate cuts from the European Central Bank. The 10-year bond yield fell sharply to around 2.25 percent after briefly touching 2.6 percent in early July. This is a testament to the economic pessimism that forces the ECB’s hand. Other eurozone-countries, such as France or Italy, have their own deep challenges, making Germany relatively appreciative and its benchmark status unassailable.

The main causes of Germany’s structural stagnation partly reflect adverse megatrends beyond direct government control. The first factor is the end of globalization and the second is the threatening demographic profile. Added to that is the self-injury of persistent underinvestment.

Germany benefited like few other countries from China’s burst into the global economy. When China joined the World Trade Organization in 2001, the country needed products that German companies excelled in: capital goods, machinery, vehicles. Exports went through the roof. In 1999, a quarter of all goods produced in Germany were exported. By 2008, that stock was reached 46 percent of GDP.

But since the financial crisis, global trade and German exports have largely gone sideways. China has gradually become a competitor rather than a customer. Protectionist tendencies are creeping into the WTO. As external demand flattened, Germany’s economy stagnated.

German consumers are not picking up the slack. They have good reason to be frugal: a rapidly aging society with an underfunded public pension system. Big cohorts born in the 1960s are starting to retire. Germany will lose a net 1 percent of its workforce annually over the next half decade.

This trend is exacerbated by working fewer hours. No other OECD country has workers cost Less time at work. As labor input declines by 1 percent per year, labor productivity must rise by the same amount for the economy to remain stable. Unfortunately, productivity growth per hour has been less than 1 percent in recent years. The basic speed limit for the country’s growth may be below zero.

Sluggish productivity growth can be attributed to decades of underinvestment in education and infrastructure. When European soccer fans descended on Germany this summer, many positive preconceptions about the country’s transportation system were shattered. That should not be surprising.

Germany’s public sector has spent an average of 2.3 percent of GDP on investments since the turn of the millennium. In the euro area as a whole, it was almost 1 percentage point higher, even 2 percentage points higher in France. The gap between peers has recently become smaller. But it means that Germany continues to lag behind, at a slower pace.

If the AAA-crown is taken from Germany it will not be due to high debt. This is due to prolonged economic stagnation and lack of adequate measures to address it. As policymakers increasingly recognize the fundamental obstacles to growth, we can be confident that fixation with balanced budgets will overcome them all. Don’t count Germany out just yet!