Germany: Better Hedge That Optimism


By David Fairlamb After two recessions in three years, Germany seems poised for a recovery. Retail sales surged in May and June and capital-goods orders leapt 2.3% in June, surprising economists and businesses alike. Then there is the string of companies, including electronics giant Siemens (SI) and sportswear maker Puma (PMMAY), which have just reported stronger than expected second-quarter earnings. Plus, for the first time in almost a year, the number of Germans who think the economy will improve over the next year is greater than the number who think it will get worse, 36% vs. 33%. Says Dirk Schumacher, an economist at Goldman Sachs & Co. in Frankfurt: "Germany is turning the corner."

The government has been quick to claim credit. Economy Minister Wolfgang Clement predicts that economic growth will be % this year and 2% next. That's short of the 3% to 4% upswing expected in the U.S., "but it shows we are heading in the right direction," Clement says. "Our policies are working."

Sounds good. But is it too good to be true? Fact is, the German economy's prospects are iffy at best. And that's bad news for the entire European Union. Germany is easily the Continent's largest economy, and sluggish performance there acts as a brake on growth elsewhere.

FUNDAMENTAL UNCERTAINTY? Many leading German research organizations are far more downbeat than Schumacher. Ullrich Heilemann, a forecaster at the Rhine-Westphalia Institute for Economic Research in Essen, predicts that the coming recovery will be weaker and shorter than previous upswings, predicting that growth will be lucky to reach 0.2% this year and 1.8% in 2004.

Optimists like Schumacher tend to emphasize the recent improvement in German business confidence, which strengthened in July for the third month in succession. If past experience is anything to go by, Schumacher contends, an economic recovery will follow the upsurge in business confidence in three months to six months

Fair enough. Trouble is, there doesn't seem to be any real basis for the improvement in business confidence, which has been buoyed by the government's determination to push ahead with a number of structural reforms that will reduce labor costs and promote labor-market flexibility. The problem is the reforms aren't radical enough to encourage most companies to invest more and hire more.

CARS STALL. Moreover, German recoveries traditionally have been led by stronger exports, which did in fact increase more than expected in June. But German companies' sales abroad have been disappointing for most of this year. And with the euro about 15% stronger against the dollar than it was a year ago, German products are now significantly less competitive in foreign markets.

Worse, currency experts see the euro, which has weakened slightly in recent weeks, to recommence its upward climb against the dollar in the second half of the year, as investors react negatively to the burgeoning U.S. current account and budget deficits. "The U.S. has crossed the threshold of where it can take funding the current-account deficit for granted," says David Gilmore, a currency specialist at Foreign Exchange Analytics in Essex, Conn. "Just look at the bond market. Are foreign investors lining up to buy U.S. Treasuries? Far from it."

Worrisome signs abound. Up to 40,000 German companies -- a record -- are expected to go bust this year. And the auto industry, Germany's biggest employer and the country's most important economic bellwether, is still in the economic doldrums. Sales at home and abroad are running around 2% below last year's levels. Germans are keeping their cars longer, and they increasingly buy second-hand models when do they upgrade. That means carmakers aren't acting as an engine for the economy, as they usually do in upswings.

WORKFORCE WOES. Germany's 10.6% unemployment rate also shows little sign of falling significantly. Admittedly, June saw the number of people registered as being out of work declined slightly for the third month in a row. But in July, the total number of people out of work edged up again, showing that the underlying trend appears to be toward higher joblessness.

The dip in unemployment was the result of technical factors, say labor experts. The main reason for the decline, they say, is that the government is putting more pressure on jobless people to seek work. So some people who had previously registered for unemployment benefits have stopped doing so. They aren't back in the workforce. They simply don't want to work.

The recent uptick in retail spending won't give the economy much of a kick, either. According to economists, consumers are enthused by government plans to bring forward $18 billion of tax cuts initially scheduled for January, 2005, to the beginning of next year. But the tax reductions have already been partly neutralized by increases in social-security and health-insurance contributions.

THE DEFICIT TRAP. The tax cuts also could backfire. They may cause Germany's budget deficit to breach the European Union's 3%-of-national GDP limit for the third year in a row. The European Central Bank, meanwhile, has warned that it's disinclined to cut interest rates further to stimulate growth unless Germany and other European nations put their finances in order.

The upshot: As Germans head for their summer holidays their mood is clearly better than it was. But the odds are that the euphoria will be short-lived. Fairlamb follows German economic trends from BusinessWeek's Frankfurt bureau


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