FT.com / Columnists / Wolfgang Munchau - Germany must import some fresh thinking

FT.com / Columnists / Wolfgang Munchau - Germany must import some fresh thinking

The eurozone had an extraordinarily good performance in the second half of 2006. But how well is it going to perform at a time of financial turbulence, of the kind we saw last week?

Let me try to answer this question for Germany, which is currently popular among global investors. The general story is that Germany has overcome its unification shock, improved cost competitiveness and undertaken politically difficult reforms that are finally paying off in terms of higher economic growth and lower unemployment.

I would treat this fashionable analysis with caution. It is true that the internal dynamic of Germany’s economy is strong, much stronger than most forecasters, including myself, had predicted. It is also true that German companies have cut jobs and improved cost competitiveness, a strategy from which they are now benefiting. If the global economic environment remains calm, Germany will experience another good year. So one should enjoy this Goldilocks scenario while it lasts, except that it may not last very long. The problem is not the strength of the recovery as such but Germany’s feeble resistance to external shocks.

Germany is the world’s third largest economy, but the largest exporter. Germans take pride in their status as export world champion, a curious title that erroneously suggests that an export surplus is a measure of economic success. Germany’s export strength also makes it export-dependent and vulnerable to a downturn in global demand. While Germany is good at producing highly specialised niche products for its export markets, its structural weaknesses have not changed: an underdeveloped financial sector with a relatively low degree of financial innovation; and poor services.

Economic theory suggests that a country faced with a fall in demand for its export goods should seek to shift economic activity from the external sector to the domestic sector. The reason why Germany is not good at this has been the one-sided focus of economic reform: labour market reforms with a view to the competitiveness of the export sector. While they have achieved their goal, they have not increased flexibility and thus left the domestic sector as weak as ever. Now, it is true that a competitiveness-based strategy is better than no strategy at all. You may euphemistically call it a second-best strategy. It surely contributed to the present recovery. But it is the lack of flexibility that will end it prematurely.

Eric Chaney, chief economist for Europe at Morgan Stanley, has done some interesting calculations on the effects of a cocktail of external shocks on the eurozone as a whole: a credit crunch in the US, a contraction in Chinese exports and a further sell-off in equity markets. While each one of those would not hurt the eurozone particularly badly, all three together could shave off between 0.5 and 0.9 per cent of gross domestic product.

I have heard some economists argue that Germany would be in a better position than France to withstand any global shocks, given Germany’s recent improvements in competitiveness. I disagree. Germany’s economic strategy is far more dependent on a friendly global economic macroeconomic and financial environment – precisely the kind of environment that was called into question last week. France may be suffering from a deteriorating export performance, but at least France still manages to generate a decent rate of domestic demand.

The Morgan Stanley calculation is, in fact, not even a worst-case scenario. For that you would need to add a big rise in the trade-weighted exchange rate of the euro.

So how real are these alarmist scenarios? Last week, we saw a taste of how quickly the markets’ euphoria can turn. While Alan Greenspan, former chairman of the Federal Reserve, did not forecast a recession, the mere fact that he used the word is remarkable. As I predicted in my New Year outlook on the global economy, there is a non-trivial, though incalculable risk of a recession in the US and a fairly significant probability of a hard landing. I am aware that the Fed’s forecasting model strongly favours a soft landing. I just cannot see how such a sharp and persistent downturn in housing, combined with the present carnage in the subprime mortgage market, will have only a minimal effect on economic growth – especially in a year when the global credit bubble is relatively likely to burst at some point.

Nor do I share the view that the world could decouple from the US, for the simple reason that any distress in the US will transmit to the rest of the world economy via the financial markets. Direct trade has long ceased to be the main transmission mechanism of transatlantic shocks, at least for the UK and the eurozone.

A global economic downturn, possibly accompanied by falling equity prices, a reappraisal of credit risk and a shift in the euro/dollar exchange rate, would leave the export-dependent economies in the eurozone, Germany and Italy in particular, in a tight spot. In the short run, monetary policy can help the eurozone to alleviate those problems. In the long run, its governments may have to confront an uncomfortable category of economic reforms that they have been able to avoid with some success: the reform of their corporatist systems, the ultimate cause of their economic inflexibility. This is an environment in which cutting costs is not going to cut it any longer.

Copyright The Financial Times Limited 2007