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Joint Economic Forecast Autumn 2012

Euro Crisis Curbs Economic Activity – Risks to Stability Remain High

Oct 11, 2012

The euro crisis is putting a strain on the German economy. Economic growth will therefore remain weak for the moment and only looks set to recover again slightly over the course of next year. The institutes forecast a 0.8% increase in gross domestic product for 2012 and a 1.0% increase for 2013. The situation in the employment market will deteriorate further, with the number of unemployed set to rise slightly to 2.9 million in 2013. The German state budget will be almost balanced both this year and in 2013. The institutes are critical of the ECB’s programme to purchase the government bonds of crisis countries. This will increase the danger of inflation.

The world economy is going through a weak phase in autumn 2012. Economic activity has lost momentum nearly everywhere and the mood among companies and households has deteriorated further. A key factor stress factor since last year has been the debt and confidence crisis in the Eurozone. In addition, adjustment processes that have been taking place ever since the real-estate bubble burst in 2007 in the USA and in other advanced economies, have not yet been completed. The consequences of structural faults pre-dating the crisis are continuing to curb economic activity; and the longer it takes for a real recovery to occur, the more aware companies, households and governments become that the long-term growth and income perspectives are worse than previously imagined.

In late summer the central banks in the large, advanced economies reacted to the recent surge in pessimism in the financial markets and the deterioration in the economic outlook by announcing new government bond purchases, unlimited this time in the case of the ECB and the Fed. The mood in the financial markets initially brightened as a result. However, it is questionable whether monetary policy can succeed in reviving economic activity in this way. The ECB´s chances of sustainably improving the financing conditions for public and private debtors in the crisis countries will largely depend on whether economic policy can restore the confidence of financial investors, companies and households in the reform and consolidation efforts undertaken in the Eurozone. In this case fiscal policy will – as in almost all other advanced economies - have a strong dampening effect. However, it nevertheless offers the perspective that the uncertainty currently crippling economic activity in the crisis countries will subside.

Based on this assumption, economic activity in the Eurozone should gradually stabilise. After a downturn of 0.5% this year, gross domestic product will do little more than stagnate next year. In the USA demand will be curbed by highly restrictive fiscal policy next year. Macroeconomic output in advanced economies should therefore only increase very slightly and at a rate of 1.2%. In the emerging markets economic growth should accelerate somewhat next year. In the case of China in particular, it is safe to assume that the government will continue to follow its recent course and will upscale the expansionary character of its policy until economic activity clearly starts to pick up again. Overall, the world economy will grow relatively slowly up until the end of 2013; world output looks set to increase by 2.4% this year and 2.6% next year. World trade is expected to pick up only a little during this time. After growth of just 2.1% this year, it is also expected to increase at a long-term, moderate pace of 3.8% in the forthcoming year.

The euro crisis is also negatively impacting economic activity in Germany. In spring 2012 fresh problems in the crisis countries triggered turbulence in the financial markets, and uncertainty regarding the future of the Eurozone increased again. Combined with the deterioration in the world economy, this hit the confidence of companies in Germany. Business expectations have deteriorated from month to month since April 2012 accordingly and recently fell to their lowest level since the recession of 2008/2009. The unfavourable outlook had a particularly negative impact on corporate investment.

German exports, on the other hand, have been able to hold their ground very well given the deteriorating world economic climate. German exporters are obviously profiting from the fact that their price competitiveness improved significantly up lately due to the depreciation of the euro. Recently the euro was as cheap as it has ever been since the foundation of the European Monetary Union.

There are currently a large number of signs that overall economic expansion will weaken towards the end of the year. Order intake in manufacturing has followed a downward trend recently, and the unfavourable expectations of companies suggest that investments in equipment and commercial construction will continue to fall.  Investments in residential property, on the other hand, remain attractive. Overall, the institutes expect real gross domestic product to increase by 0.8% in 2012.

Over the course of the year ahead economic activity in Germany is expected to improve, since the situation in the Eurozone should gradually ease and the rest of the world economy should gain greater momentum. In this improved environment favourable financing conditions will have a greater impact. In the second half of next year the increase in gross domestic product once again looks set to be higher than the growth rate of potential output, which the institutes assess at slightly above 1%. They nevertheless expect an annual average increase in gross domestic product of just 1.0%

 

Key Forecast Figures for the Federal Republic of Germany

 
2008
2009
2010
2011
2012
2013
Gross domestic product (GDP)
(% change on previous year)
1,1
–5,1
4,2
3,0
0,8
1,0
Employment a) (1,000 persons)
40 348
40 370
40 603
41 164
41 627
41 775
Unemployment (1,000 persons)
3 258
3 415
3 238
2 976
2 892
2 903
Unemployment rate b) (in %)
7,8
8,1
7,7
7,1
6,8
6,8
Consumer prices c)
(% change versus previous year)
2,6
0,3
1,1
2,3
2,0
2,1
Unit labour costs d)
(% change versus previous year)
2,3
6,2
–1,5
1,2
2,8
1,8
General government financial balance e)
 
 
 
 
 
 
    in EUR billion
–1,8
–73,0
–103,6
–19,7
2,0
–0,2
    as % of GDP
–0,1
–3,1
–4,1
–0,8
0,1
0,0
Balance of Current Accounts
 
 
 
 
 
 
    in EUR billion
153,6
140,6
150,7
146,6
166,7
166,5
    as % of nominal GDP
6,2
5,9
6,0
5,7
6,3
6,1
a) Nationally. – b) Unemployed as % of civil working population (definition according to the Federal Employment Agency). – c) Consumer price index (2005 = 100). – d) National employed compensation per hour worked in relation to real domestic product per hour worked – e) compiled on a national accounts basis (ESA 1995).

Sources: Federal Statistical Office, Federal Employment Agency, German Bundesbank; 2012 and 2013: forecast of the Institutes.

JF Autumn 2012

 

In view of the overall economic development forecast, the situation in the employment market is expected to recover very little for the moment. The rise in employment has already slowed down considerably in the course of this year. There has even been a slightly upward trend in unemployment since the spring, not least due to the fact that the size of the potential workforce is increasing more quickly due to greater immigration. Factors like the falling number of jobs vacant since the beginning of year suggest that labour demand is hardly expected to increase in the forecasting period. The unemployment rate is expected to be 6.8% in both years of the period.

Despite weakening economic activity, the increase in consumer prices over the course of 2012 slowed only slightly. Inflation has even accelerated slightly again recently due to rising crude oil prices. The institutes expect domestic price inflation to grow during the forecasting period. The rise in unit labour costs in particular is expected to accelerate. Overall, an inflation of rate of 2.0% is forecast for this year and a rate of 2.1% for next year.

For public finances it is significant that the structure of economic expansion is currently yield-ing high revenues, since gross wages and salaries and nominal private consumer spending are increasing considerably. This has strongly boosted state income until recently. Moreover fiscal policy is restrictively–oriented this year. Against this background the institutes expect the budget for 2012 to be balanced. There should not be any further improvements in the budget situation next year, especially since consolidation is expected to be interrupted.

This assessment of the German economy is based on the assumption that the situation in the Eurozone gradually stabilises over the forecasting period and that confidence, especially on the part of investors, is restored. Should the situation in the Eurozone continue to deteriorate, this will also impact the German economy. Over the forecasting period as a whole the downside risks prevail and there is a great danger that Germany will fall into a recession.

The euro crisis will continue to determine economic policy. At the beginning of September the ECB Council decided to purchase government bonds in the secondary market under certain conditions and on an unlimited basis in principle. There are nevertheless no signs of a long-term economic policy solution to the crisis; on the contrary, risks to stability remain high.

To overcome the government debt crisis it is necessary to guarantee the sustainability of public finances in the crisis countries. Should this sustainability be endangered, then a state has four possibilities in principle. The first is to consolidate its budget and enable higher growth through structural reform. Should this fail, a state is left with three options: its public debt can be carried by others through transfers, it can be reduced through insolvency or restructuring, or it can be devalued via inflation. Ultimately, Europe’s economic policy-making bodies are also now confronted with this choice.

According to the institutes, the strategy of reforms promoting growth linked with the credible consolidation of public budgets remains the best way of restoring confidence in the sustainability of public finances in the crisis countries.  Moreover, in recent months there has been growing doubt as to whether this strategy alone will produce the desired result. At the same time, domestic political debates in countries like Finland and Germany have shown that the readiness to increase assistance loans or make transfers is evaporating. This makes a transfer solution less likely.

The option of a state declaring insolvency is categorically excluded by politicians. This means that there is no ordered, fiscal policy alternative should the growth and consolidation strategy should fail. Yet insolvency would be an appropriate way of making creditors share the costs of the crisis. This should take place in the framework of an insolvency mechanism for states, which has been called for by the institutes on several occasions in previous expert reports.

In the absence of another politically acceptable solution, the ECB has now intervened once again to limit the risk premiums for the government bonds of crisis countries. The ECB’s decision could shake the main pillar of the currency union, namely the goal of price stability. Due to these conditions the ECB is no longer independent of fiscal policy, blurring the responsibilities for individual policy areas. Yet a central bank’s independence is a key requisite for a long-term, stability-oriented monetary policy.

Against this background the institutes are also critical of the Outright Monetary Transactions (OMT) programme. They see the risk of a mid-term rise in inflation. This process could be triggered by the ECB effectively providing monetary financing for states. Europe’s citizens and players in the markets may lose trust in the ECB’s ability to ensure long-term price stability as a result. Sooner or later inflation expectations will then be cut loose. In the longer-term there is a great danger that the ECB will continue to purchase bonds and provide excessive monetary policy stimulation even if states deviate from the adjustment programmes, which could drive up prices and lead to an increase in inflation expectations. Since rebuilding a monetary-policy reputation can be a lengthy process in such cases and is accompanied by restrictive impulses, guaranteeing price stability would have high social costs.

Independent of the central bank’s current course, a lasting expansive monetary policy may have major implications for economic development in Germany in the mid-term. Although there is no overheating at the moment, a shortage of capacity can nevertheless be expected in the mid-term. This creates the risk of excesses in, for example, the real-estate sector. However, debt-financed excesses on the scale witnessed in some of the crisis countries in the Eurozone seem unlikely at the moment in Germany. Moreover, banks in Germany traditionally have relatively strict requirements for granting credit. However, this does not rule out the possibility of excesses in the mid-term, especially in the real-estate sector. Economic policy should follow this closely and can use a series of indicators analysed in the expert report as a point of orientation. Since economic excesses follow similar patterns, but are never absolutely identical, a broad spectrum of indicators should be used. 

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Harald Schultz

Ifo Institute
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