Luke Bartholomew, Senior Economist, talks to Felix Feather, European Economic Analyst, about why the Eurozone economy is stagnating, and how the German economy in particular is facing significant cyclical and structural headwinds.

Our economists discuss the impact of higher energy prices and shifting geopolitics on Germany’s growth model, how fiscal policy is being shaped by new rules and court rulings, and what the European Central Bank needs to see before it is ready to start cutting interest rates.

Podcast

Luke Bartholomew

Hello and welcome to Macro Bytes, the Economics and Politics podcast from abrdn. My name is Luke Bartholomew, Senior Economist at abrdn. And today we are talking about the European economy and in particular the German economy. And that's because the European economy has been notably sluggish recently and within that Germany has been especially weak, so much so that some people are calling Germany the new sick man of Europe.

Now, I have to say at this point it feels like quite a few countries over the years have been called the new sick man of Europe. So, it's perhaps more like the new, new, new or something like that sick man that Germany is. But either way, I think it is clear that there are a lot of interesting things happening in Europe that are important to the global macro economy and markets, including around growth, inflation, monetary policy, industrial policy, fiscal policy.

So, I am delighted to say joining us today to discuss all of that is Felix Feather, European Economic Analyst at abrdn. Welcome, Felix.

 

Felix Feather

Thanks for having me on.

 

Luke Bartholomew

So, Felix, as I said, the European economy has been very weak recently, so much so that the Eurozone only narrowly avoided a technical recession that is two consecutive quarters of contraction at the back end of last year.

And to put that in perspective, at the same time that Europe was stagnating, the US economy grew by over 4% annualised. So, the European economy notably weaker than many other developed market economies. So perhaps, Felix, we can start off with you just telling us why European growth has been so weak recently.

 

Felix Feather

So, I guess you could start the discussion with the Russian invasion of Ukraine and the subsequent drop to energy prices, which triggered a very large hiking cycle from the ECB.  So back at the beginning of 2022, you had negative interest rates. That was the ECB deposit rate was sat at -0.5%. Now they've gone all the way up to 4%. That's tightened financial conditions quite a lot and obviously weighed on growth, which is what you should expect. Unlike in some other DMs, especially the U.S., where that's been paired with quite a strong supply side response, response to the hiking cycle has been perhaps a bit more conventional in Europe and that you've had a very slow period of growth not just last year, but you would call it the end of 2022 going into 2023 we're at a very similar juncture with the economy just avoiding recession.

 

Luke Bartholomew

And I suppose another big headwind that could be facing the European economy right now is being the big increase in shipping rates related to issues in the Middle East and the Red Sea and in particular the Rotterdam to Shanghai route has been particularly badly hit and that is, of course key for European trade.

So, much like the big increase in energy prices related to the invasion of Ukraine, this represents a large negative supply shock to the European economy. So, whilst the US has been benefiting from positive supply environment over the last year, Europe perhaps continuing to be hit by these negative supply shocks that push growth down and inflation up. At the same time, indeed, I think our modelling suggests that if we see shipping rates sustained at these kind of levels, we could be adding something like 0.7 percentage points to inflation.

It's worth saying that that's not nothing, but it is pretty small in the context of the big run-up in inflation shipping rates that occurred during the pandemic. So, I don't think we're talking about that kind of shock. But still, it is another thing that could be weighing on European growth and in particular trade routes out of Europe, which perhaps turns is quite nicely to Germany, which is very much an export-driven economy, or at least has been in the past.

And as I say, it's economic growth within the eurozone has been especially weak recently. So, what are the cyclical and structural headwinds that Germany is facing to its growth model?

 

Felix Feather

So, the primary cyclical drivers is the same one that's been affecting the Euro and you've had a very big monetary tightening, that's what's going to weigh on growth. And particularly in Germany, where you've got a very large industrial sector which is interest rate sensitive, that weighs on production quite strongly.

The structural drivers might be more interesting here and definitely most strongly felt in the industrial parts of the economy. The first I'd say is climate transition and another is increased geopolitical competitiveness. And if we want to get into the weeds of this a bit, we can understand what's going on here by looking into the auto industry a bit where you've seen exports in particular really struggle over the last five years or so.

This is partly related to the fact that a lot of big competitors for Germany have been implementing industrial policy, which has made the export markets more competitive. China has put a lot of subsidies into the production of electric vehicles. You had the Inflation Reduction Act a couple years ago in the US, which has similarly prioritised domestic production there.

And this means that in a key industry, Germany is squeezed out in a way that it hasn't previously been and exports are slowing quite a lot. And within this auto space is also that little climate transition factor that's there playing an important role. Germany's got a long-established comparative advantage in the production of combustion-powered vehicles, traditionally powered vehicles, but not so much in the electric vehicle space.

These sorts of industrial transitions require a lot of innovation and investment, and it is a key challenge for the German economy going forward to meet these meet these hurdles in order to retain its leading position as a global manufacturer of high-end goods.

Luke Bartholomew

And I suppose one contrast that brings out quite nicely how important the economic composition of Germany is in terms of why it's facing this kind of weakness is to compare it with the likes of Spain or Portugal in the EU, which, unlike Germany, are much more services and tourism-driven.

And they've been some of the bright spots of growth within the eurozone. So, it is very much a reflection of the kind of economic structure that Germany has and the difficulty of being in energy-intensive industrial production, exporting space at the moment. And as you say in particular with a long-standing comparative advantage in internal combustion engine production, which is a difficult place to be as China, the US, adopt their industrial policy in a way to to move into producing more electric vehicles.

The regulatory and consumption environment becoming less friendly as well. But another factor that might well weigh on the German economy this year outside of its economic structure is one of fiscal policy. So that is government spending and taxation policy. And in this regard, we've seen interesting ruling by the German Constitutional Court late last year that seems to require the government to push through quite significant fiscal tightening.

So, can you tell us about this ruling and why it matters?

 

Felix Feather

Yeah, without getting too much into the details of German fiscal rules, the upshot is that in Germany, your fiscal deficit, your government deficit is capped at 0.35% GDP every year. And you can't go over this except if explicitly legislated for some sort of emergency. The German government wanted to use emergency funds related to climate transition, pandemic support to implement some of their high-cost programs.

However, the Constitutional Court ruled that at least some of these funds would not be available for the purposes which they were earmarked for. Therefore, the government had to find a lot savings from its original intended budget. This means that you get a lot less government spending. Some of the some of the tax breaks which were introduced that are planning to be introduced for the industrial sector won't be going ahead.

And all in all, you get a much less strong impulse from the government deficit next year than you did last year. It's worth noting that this would have been the case anyway, as some emergency spending was due to roll off and come to an end in 2024. But this has caused the German government to find an extra €200 billion or so from the off-balance sheet spending.

This for inflation could be a hit to GDP of about 0.3, 0.4%. It's not always entirely clear when these cuts are going to land. And indeed, that could be mean that you get a less than anticipated spending going forward in 2025, 26, 27 as well, which could weigh on growth on the medium term as well.  It's a very short term as a result of this judgment.

 

Luke Bartholomew

Yeah, and it's worth saying that 0.3, 0.4 percentage points may not sound especially large, but when growth is basically zero or at best only modestly positive, that kind of hit is the kind of thing that could tip you into a recession very easily. As potential growth gets lower, these kind of hits as a percentage of total growth obviously become much bigger.

And it's worth saying that fiscal rules are not just a feature of Germany, but of the Eurozone as a whole. And indeed, the European fiscal rules, sometimes referred to as the Maastricht conditions, most famously that government debt to GDP shouldn't exceed 60% and year on year, government deficits shouldn't exceed 3% of GDP. These rules are coming back after having been suspended during the pandemic.

But interestingly, unlike Germany, where the Constitutional Court ruling does seem to be quite binding, that isn't the case in Europe in the sense that it doesn't seem to be directly affecting fiscal policy over the next year or so. Felix In fact, you've referred to them as coming back without a bang. So, so why, why is that and why do they not especially matter for policy over the next couple of years?

 

Felix Feather

Well, I think you can see if you look at the detail of the rules, that these rules which were agreed, as always, by negotiation between the member states of the European Union, that they were designed with accommodating national budget plans without requiring governments to make cutbacks from those plans. So, that means you get a lot of carve-outs, you get a lot of leeway, you get bespoke debt reduction plans.

And as a result, we don't expect any governments to be going away looking at their budgets and saying, okay, we need to make cuts here, here and here. Rather, it's a case of, as you were, this is despite the fact that a lot of countries are in breach of the old rules which stipulate it. As you said, you got that 3% deficit rule, loads of countries running deficits and planning to run deficits quite a lot higher than that.

Obviously, lots of countries in breach of the 60% debt rule.  Previously, you are going to be reducing that debt differential between 60 and your current level of debt by one-twentieth per year. Those rules are quite a lot less restrictive now, there is sort of an irony here, I guess, that one of your countries where you've had historic quite strong compliance with those rules and relatively low debt and deficit ratios are having to make adjustments because of fiscal rules in Germany, whereas other countries where that's money running in excess of 100% in deficits around 5%, as you've got in places like France and Spain, not having to make adjustments in the near term at least. 

There is a broad requirement to bring these ratios back in line with the limits defined in the treaty over time. But that could mean that once if the governments aren’t back in line with those ratios by, say, I think 2028 is the deadline for when the carve-outs expire, then you end up in the same situation that we were in last year where a load of countries cannot comply with the debt rules and maybe they need to be changed or made more lenient again to retain the rules is credibility.

Obviously, if you do end up in this situation where rules have to be changed on a rolling basis, they do lose some credibility and that could be a concern.

 

 

 

Luke Bartholomew

So, as you say, Felix, I mean, the rules seem to have been very carefully negotiated and written in such a way that they won’t necessitate any short-term significant adjustments in fiscal policy.

And indeed, there's a possibility that as and when they come up for renewal, the same dynamic comes into play again. That being said, and without the aid of these rules, fiscal policy in the eurozone over the next couple of years is turning restrictive, or at the very least, the impulse of it that it imparts on growth should be negative. So, could you explain why that would be the case and how much of an impact that's likely to have on the European economy as a whole?

 

Felix Feather

Yeah, that's right. The fiscal impulse is going to be quite negative over the next year at least. So, the reason for this is similar to what we already mentioned with regard to Germany. A lot of EU countries have continued to operate pandemic and energy shock inflates pull over 2023 with that expiring in 2024, which means some of that deficit spending comes off the books, which is a negative fiscal impulse, which is bad for growth.

Some good examples of this are VAT exemptions on energy bills, which we’ve got rolling off in Italy and Germany, France's publicly funded electricity price cap that's due to roll off and these measures are being phased out as we speak. And this means that you're going to end up with less consumption spending from the government side in the economy weighing on overall GDP.

So, we've had a look at the budget proposals from national governments and compared the level of net spending this year to last year and seeing what the overall impulse comes to for each country in terms of its impact on GDP as a percentage for the bloc as a whole, this is about 0.6% drag. So that's quite, quite a fair chunk of growth to be losing when growth last year was only 0.4, 0.5%.  The bright side of zero.

And there's quite importantly some significant variation across the bloc. So, this fiscal impulse will be more strongly negative in some southern European economies where deficits are larger. It's going to be quite strongly negative in Germany, where the domestic fiscal rules are biting. But for some that this won’t really play a role at all.

For example, the Netherlands, quite an important northern economy, you're actually getting the opposite effect. You're getting an expansion of deficit spending. So important variation across economies is going to be key here.

 

Luke Bartholomew

And so then finally, on monetary policy, given this weak environment, we've been discussing and also the fact that inflation has moderated quite sharply over the last year, in part because of the weakness in growth.

There has been a lot of speculation amongst investors, market participants about the European Central Bank cutting interest rates very soon. But there was a little bit of pushback from key European policymakers, President Lagarde and others at both the European Central Bank's meeting and in other forums, suggesting that there are a few things that the ECB needs to see before it is prepared to start cutting rates.

So, what do you think is necessary for the European Central Bank to become comfortable about the fact that now is the time to start easing policy? And when do we think those conditions will be met?

 

Felix Feather

Well, let me start by saying what I don't think is sufficient for you to get a cut. And that's just the simple continuation and the disinflation that we've seen so far.

What the Governing Council really wants to see to be able to cut rates is data that changed its view that medium term inflation refreshes. Underlying inflationary pressures are going to be a little bit softer than they think. So, the key thing here is going to be wage growth. The ECB thinks the current ongoing wage negotiations, which you get a lot of in Q1 in the Eurozone, that they're going to come out pretty strong.

And this would be a concern because they're concerned about second round effects on consumer prices from strong wage growth. Whether or not you agree that this is the correct way to be thinking about things, it means that you shouldn't expect cuts to come immediately unless you do see strong a strong slowdown in wage growth. A key problem here is the wage data is actually very backward looking. It's published only quarterly. And so, we won't know, for example, what the official measures of Q1 wage growth in the Eurozone were by the time the ECB meets in April.

So, what you need to do here and what the ECB have confirmed they are doing is keep an eye on some high-frequency, timely labour market data, which gives us an idea of where wage growth might be right now.

For example, you've got the Indeed posted wage growth. That's Indeed the job market site, publishing that on a monthly basis, which you can from which we can take an idea of where wage growth is sitting by the time the April meeting comes about. If these more timely measures do show a slowdown in wage growth, I think it's quite likely that the there would be a strong argument in favour of a cut at that meeting.

Certainly, there's some doves on the board who I think would be pushing for that quite hard. Certainly, Q2 at some point a cut looks quite likely given the strength of disinflation and the weakness in the economy. Right now, market pricing suggests that you've got about 60% chance of a cut in April, which looks to me pretty sensible. Either way, when rate cuts do start, we expect a relatively deep cutting cycle because of the strength of disinflation as past monetary tightening continues to weigh on prices.

 

Luke Bartholomew

Yeah, perhaps it's worth saying that whilst the strength of the wage growth might be staying the hand of the ECB at the moment it is something that could provide some upside impetus for the European economy. Perhaps that is what ultimately drags Europe out of this very weak environment that we've been in the last 18 months or so and that we've been discussing today.

So as the year progresses, perhaps you get stronger wage growth, interest rates coming down, and that's ultimately what sees the European economy turning round. But I think that is all we have time for this week. So as ever, please do forgive me if I asked you once again to like and subscribe on your preferred podcast provider and then all that remains is for me to thank Felix for joining us today.

 

Felix Feather

Thank you.

 

Luke Bartholomew

And to thank you all for listening. So, thanks very much and speak again soon.

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