Letter from Germany: Traffic lights and warning signs

Michael Burda on the effects of the Russian invasion on the German economy, 16 months later

Re-reading my missive of 2022, I was surprised at my despair that the Russian aggression against Ukraine would produce an economic catastrophe in Western Europe and in energy-intensive Germany in particular. While the horrors of the last century’s World Wars – trench warfare with high loss of human life, random violence against civilians, and recent reports of extreme brutality in Russian prisoner of war camps – are again a bitter reality, the economic situation has become less daunting. My faith in humanity has not recovered from its all-time low, but my faith in liberal economics and good macroeconomic policy has been buttressed by several interesting developments. And at the same time, my worries about the German economy in the middle of Europe have grown.

Let us review the facts as of June 2023. After decades of dormancy, inflation increased sharply across Europe in the aftermath of massive supply shocks to oil, natural gas, and grain prices; to shipping costs, and to just-in-time production and outsourcing (Figure 1), at the same time that demand was recovering from the pandemic and the attendant restrictions on human behaviour were being eliminated. In response, the ECB raised interest rates aggressively, by 350 basis points, the largest tightening in its history. Output growth here sputtered and even declined, a technical recession matched in other EU countries. Despite reductions in government outlays on Covid-19 measures and increasingly cautious consumer spending, unemployment remains extraordinarily low (standardized OECD rate in May: 2.9%). In the meantime, the price of oil has fallen to pre-war levels and the price of natural gas at the German border is a third of its high levels in February 2022.

Letter from Germany diagram

The textbook explanation gets it right. A surge of consumer price inflation resulting from the energy price shock should really only be a temporary affair, conditional on a credible target rate of inflation set by the central bank or a credibly fixed exchange rate regime. Like the donkey swallowed by the proverbial anaconda, this one-off jump in the price level will eventually be digested, unless the underlying expectations of inflation embedded in private contracts and supply behaviour rise as well. Oil and gas prices are down, but yet to fall to levels below those prevailing in 2019. As can be seen in Figure 1, inflation has not increased beyond the initial months. That inflation is more persistent in the UK proves the point, as the Bank of England struggles to maintain its credibility. It is also relatively persistent in France, Italy, and especially Germany, and less so in the periphery countries because the latter are small and open, and can do little to affect their loss in the terms of trade – and may have less to lose. At the same time, expectations of future inflation in the Euro area remain moderate, suggesting that the ECB’s target inflation rate of 2% is intact.

So what’s the problem? Last year I was worried about German competitiveness and remain so today. A battle of the markups has already begun, as workers attempt to claw back real wage losses stemming from unanticipated increases in energy and food prices. The extent to which they can is determined by fall-back positions of capital and labour in collective bargaining, because two-thirds of wages are determined by collectively bargained contracts. In small open economies, capital wins this battle rather quickly, as it must for the real wage to be consistent with intertemporal preferences and the international productivity of capital. Yet Germany faces severe labour shortages and worker bargaining power is on the rise. In many energy-intensive sectors, labour will price itself out of world markets. The Russian energy supply shock thus augurs a longer-run decrease in real wages, structural unemployment, or both.

A year or two of persistently higher inflation rates will damage Germany’s competitiveness. Germany has now ceased to import cheap gas and oil from Russia completely and struggles to diversify its energy sources while constrained on all fronts to meet its climate goals. Emergency reactivation of dirty old coal-fired plants is inevitable. At the same time, a “traffic light coalition” of SPD (red), Green and Liberal (yellow) parties should implement a green agenda with CO2 pricing and other incentives to reduce emissions while protecting workers. Instead, coalition members are following particular interests. The Greens – which control the economics ministry – have proposed ham-handed regulations on renewables, putting all their bets on the heat pump, an old-fashioned technology, while the Liberals insist on preferential treatment of cars and the Social Democrats lobby to subsidize energy-intensive industries. Rising to the challenge of climate change will complicate matters. Industry’s desire to get ahead of competition in developing decarbonized production and abatement strategies is driven by fears of a permanent loss of export prowess. Anguish is still felt at the loss of a competitive infant solar cell industry to Chinese competition in the 2000s. It will be tough going in a corporatist-oriented, interest-driven, and over-regulated Germany.

I wrote last year, rather desperately, of a silver lining. Curiously, a differential impact of the Ukrainian conflict on Germany could help correct the massive cumulative internal payments imbalances between Eurozone central banks – the so-called Target 2 balances – that have ballooned over the past 15 years and spurred populist claims and even agitation for Germany to exit the Euro. Initial data from the last twelve months confirm my suspicion; as the trade and current accounts dwindle, Germany’s Target 2 balances have declined by more than 11% over the past year, while the balances of southern countries have improved, and significantly so in the smaller periphery countries. Stronger economic growth in southern Europe, supported by a recovery of intra-Eurozone foreign direct investment, gives us hope that premia for those highly-indebted countries will continue to moderate – obviating my concerns expressed last June. All quiet on the Southern front?

Michael Burda, 26 June 2023