What will it take to get the German government to spend?

By Zac Tate, Hottinger Investment Management

A week after the UK posted negative Q2 economic growth figures, it was Germany’s turn for disappointing news. According to the Federal Statistical Office (FSO), Germany’s gross domestic product (GDP) was 0.1% lower at the end of June than it was at the start of April. Persistent weakness over the last twelve months means that the German economy is only 0.4% larger today than it was a year ago.

Softness in the country’s macroeconomy has been reflected within export-facing industries that are highly exposed to the global economy. Data from the Verband der Automobilindustrie reveal that annual production of passenger cars has fallen by more than a million units (from 5.8 million cars in mid-2017 to fewer than 4.8 million cars today).

The slowdown in China and the adverse development of the politics of international trade have hit German car-makers hard. According to ING, one quarter of all cars sold in China were German – with BMW, Daimler and Volkswagen relying on Chinese demand as the source of over one third of their total car revenues. Daimler has issued four profit warnings in recent times and Continental expects a 5% drop in global car production.

But it is not just car makers who are feeling downbeat; some of the country’s largest industrial firms have released warnings of some description. Chemical producer BASF has cut profit expectations by 30%, Henkel announced that it missed its Q2 revenue target, and Lufthansa announced that H1 2019 profits were €800m lower than the corresponding period a year earlier.

Even though Germany’s service sector is showing more resilience, the poor performance of industrials (down over 5% over the last 12 months according to the Federal Statistical Office, FSO) is a major issue for the country because this sector is a significant driver of German exports, which itself account for 47% of GDP according to the World Bank (considering imports, the excess of exports over imports amounts to around 7% of GDP). As global demand is a major determinant of a country’s export demand, and small economies such as Germany have little influence over global factors, the country must be willing to boost domestic demand if it wants to stabilise its overall GDP.

Fiscal policy is the best understood method of boosting a struggling economy. It involves deficit spending, where the government spends more than it takes in through taxes, usually by borrowing funds from investors in the bond markets. This should create additional demand that, in theory, percolates through the economy and reduces the effects of a slowdown on employment and wages. The problem is that the German political class has developed an almost allergic stance to deficit spending in recent years, exposing the economy to the vicissitudes of global trade.

In recent weeks, the situation moved into absurd territory with investors now willing to pay the German government to borrow for a period of a generation (or thirty years). It is worth putting this into context. The negative yield in 30-year German government bonds implies that the state could destroy resources and still make good on its debts, even before inflation is taken into account. At one-point last week, the 30-year yield fell to as low as -0.27% (See figure 1); this means that at this yield a €100, 30-year zero-coupon bond would generate funds of about €108.45 from the markets. With the government due to return only the €100 in thirty years’ time, markets are basically saying that the state can waste about 8% of the nominal funds that investors lend to it and ensure that the rest is only preserved – in nominal terms – over the holding period.

It is even more striking once one considers the effects of inflation. If the rate of German inflation averages 2% over the next thirty years, the government would in real terms have to return only half of what investors lend to it today.  It is an extraordinary situation,  yet the German government is still not taking advantage of it. Why?

Figure 1 shows the yield on 2-year, 10-year and 30-year German government bonds.

The key factor is the law. In response to the rise in public borrowing after the global financial crisis, the then German government amended its constitution to introduce the Schuldenbremse (or debt brake), limiting structural deficits at 0.35% of GDP for the federal government and 0% for German states (Länder) after 2020. Article 109, Paragraph 3 of the Basic Law essentially forbids meaningful deficit spending unless it is caused by ‘cyclical’ factors, such as an economic downturn that pushes down tax revenues and raises payments on items such as unemployment insurance. As a result, public indebtedness in Germany has been falling rapidly over recent years (see figure 2).

The €50bn stimulus package that Finance Minister Olaf Scholz floated as a suggestion last week is therefore very much dependent on the economy first falling into recession and is in any case constrained by the 60% debt-to-GDP ceiling imposed by the European Union’s Maastricht Treaty and protected by the Schuldenbremse law. In other words, the spending pledge risks being too little, too late.

Figure 2 shows the debt-to-GDP ratio of Germany and the Eurozone (including Germany). Since 2014, Germany has run balanced budgets (colloquially known as the schwarze Null). This, combined with strong GDP growth, has pushed down the country’s indebtedness towards levels approved by the Maastricht Treaty.

But this only shifts the question as to why the government won’t change the law to allow for structural deficits. There would be plenty of uses for deficit spending, whether it’s repairing roads and bridges, installing digital infrastructure, investing in schools, or getting the country retrained and retooled for the green energy transition whose first casualty could be Germany’s car manufacturers if it continues to rely on the internal combustion engine. The longer the country neglects areas in serious need of investment, the harder it will become for it to overcome the problems that such underinvestment will inevitably cause.

There is something else too. Structural deficits can be inflationary, and inflation is anathema to the key players in Germany’s political economy. Earlier in the year, Martin Höpner, a scholar at the Max-Planck-Institut in Cologne, published a paper on the history of what he calls Germany’s “undervaluation regime”. He describes how this regime started not with the euro but in 1944 with the Bretton Woods system of fixed global exchange rates, allowing Germany to run trade surpluses by keeping inflation low and its real effective exchange rate weak and thus competitive. A combination of German industry looking to expand into new markets, trade unions hoping to protect job security and the Bundesbank burnishing its low inflation credentials created conditions for the country’s strong position in global trade markets. Expansive fiscal policy, however, disturbs this equilibrium by generating upward pressure on wages via the public sector that can push corresponding wages in exports firms up too, thus reducing the export competitiveness in what is a very well-protected business sector.

Figure 3 shows the relationship between nominal GDP growth (g) and the 10-year German bond yield (r). Where the former exceeds the latter, the government can run a budget deficit of a limited size without increasing the debt-to-GDP ratio. The larger the excess of g over r, the greater the deficit can be without raising the public debt-to-GDP ratio.

A more challenging global environment may change this calculation. It appears that a slowing China, which is looking to source more of the capital goods that it has recently imported from Germany domestically, combined with political tensions that are negatively impacting global trade, could create serious problems for Germany’s export-driven accumulation model.

If these trends were to continue, Germany would have to start looking closer to home for sustained economic growth. That would mean deficit spending, which could have benefits for both Germany and the wider European region. Government spending would make up for years of under-investment and could provide conditions for the German economy to better face structural changes in the global economy – as it faces the rise of digital technologies and the transition to a low-carbon production model. If it raises Germany’s nominal GDP growth rate while keeping bond yields low, the deficit could effectively more than pay for itself (see figure 3). For Europe, higher domestic demand in Germany should raise demand for imports from other euro area states, and any higher German inflation that results could improve the competitiveness of those states.

The German government is starting to talk about stimulus and that is good. But the fear is that when it comes, it will be too little and too late.