Is There A Double Dip Risk In Germany?

This is not an idle question. Despite all those bullish headlines in the press, most informed observers - including Bundesbank head Axel Weber - are only to well aware of just how fragile the German recovery actually is. Indeed only last week the OECD warned that Germany’s economy, may only recover slowly next since investment “is lagging,”. The OECD now predict that German gross domestic product will expand 1.4 percent in 2010 and 1.9 percent in 2011 after shrinking 4.9 percent this year, which is in fact up on their earlier estimate, where the OECD predicted German growth of 0.2 percent next year. So whichever way you look at it, output at the end of 2010 will still be well down of 2008 levels. Worse, events like the recent upheaval in Dubai start to cast doubts on whether even the rather optimistic 1.4 percent growth level may now not be excessively optimistic for next year. The problem is that the recent rebound in Eurozone growth is extremely uneven as between countries, and, given its long standing export dependence, the German economy is hardly going to be leading the charge. As I said in my most recent post on the Eurozone :

"The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories......Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don’t have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports (largely to stock up on export oriented inventories, not items destined towards domestic consumption) and this part we more or less know, since we do have all the trade data in for the quarter. "

Well, now we have the detailed German third quarter breakdown, and interesting reading it makes. According to the federal statistics office "economic growth in the third quarter of 2009 was supported by capital formation" - since compared with the previous quarter capital formation was up 1.5% in construction and 0.8% in machinery and equipment. As they also note, however, all this really means is that following the slump in the first quarter of 2009 (–18.5% on the fourth quarter of 2008), capital formation in machinery and equipment has now "stabilised at a low level". In fact, this "support" from capital formation was quite marginal, offering only 0.2 percentage points to growth.

While a positive contribution to growth was made by goods exports, which were up 4.9% on the previous quarter, imports also rose , and by more than exports (up by 6.5%), and the resulting trade balance had a negative effect on growth of –0.5 percentage points. This was more or less the same as the contribution from household consumption (which was also negative by 0.5 percentage points). But what really, really mattered here - see the chart below - was the inventory build-up which added a staggering 1.5 percentage points to growth., while government final consumption expenditure only increased slightly (+0.1%) over the period and effectively had zero impact on the growth number. So, as I said, it is all about inventories in Q3.



And now we need to make an assessment of how much this can unwind in the final quarter, since the current position is very reminiscent of Q1 2008, when the German economy put in a record annualised growth rate (1.7% q-o-q, 7.2% annually) only then to slouch off into recession and four consecutive quarters of GDP contraction. One reason for that surge in GDP, then (as now), was the massive inventory pile-up (see chart for what happened next to GDP), a pile up which was precisely the result of an anticipated continuation in demand - demand which, as it happened, never materialised.

Now, the pile up in inventories in Q3 was not so spectacular as the one seen at the start of 2008, nor is the medium term growth outlook so gloomy as it was back then, but there are certain structural similarities in the situation, and these are worth exploring.

Basically a build up in inventories may be no bad thing, inventories need to be rebuilt after the massive rundown which followed the failure of Lehman Brothers, and a healthy build-up (and rise in capital investment) would be something we should look forward to. But there are grounds at this point for thinking that things are no so straightforward this time.

The Fourth Quarter Looks Weaker Than The Third One

We will now try and take a look at some of the information we have so far on the last quarter of 2009. Sources of information here are really of two kinds, the Purchasing Managers Indexes (PMIs) which are based on surveys, but do give us quite a reliable indication of the state of play well before the official data arrives, and sentiment indexes.

Let's start with the PMIs. In the first place consumer demand remains weak. The key points, as identified by Markit, are as follows:

- The Retail PMI was at its lowest level for five months.
- Actual sales short of targets by greatest degree for five-and-a-half years.
- Retail margins fell at fastest rate since January.

So the November data suggests that household expenditure in Germany remains relatively weak, with retailers indicating a further month-on-month reduction in sales. The seasonally adjusted Retail PMI fell from 48.8 in October to 46.0 in November, the lowest reading since June and below the neutral 50.0 mark for the eighteenth consecutive month. Anecdotal evidence from survey respondents suggests that a resistance among households to purchasing non-essential items contributed to the lower sales. The end of the scrap bonus was also commonly cited by retailers in the automobiles sector.

German retailers indicated that like-for-like sales were considerably lower than one year earlier, with the rate of reduction the sharpest since March. Survey respondents commented that short working hours and weak economic conditions meant that consumers’ purchasing power was much weaker than last November.

If we move over now to the relevant sentiment index, we find some confirmation for this weakening, since the GFK forward looking indicator for December fell back again for the second consecutive month, and now stands at 3.7.



As Gfk themselves say in their monthly report, even if experts are generally predicting an economic upswing for the coming months, consumers seem to be regarding such statements with caution, at least for the moment, and the economic expectations indicator indicator lost just under 8 points to currently stand at just 0.9 points. To put this in perspective though this is increase of 31 points over the level in November 2008.

However, it is apparent that after their continuous upward trend during the past seven months, German economic expectations dropped back again in November, primarily - according to Gfk - as a result of growing public fears of rising unemployment. In the wake of this, income expectations also fell, in particular, given the fact of the reduced effect of the low energy prices, which have been fuelling purchasing power.

In fact German unemployment unexpectedly fell in October, with the number of people out of work falling a seasonally adjusted 26,000 to 3.43 million. Frank-Juergen Weise, the head of the Federal Labour Agency attributed the good performance to government measures including the Kurzarbeit short-time work ones which offer incentives to hold on to staff. According to the latest comparable figures published by the Organization for Economic Cooperation and Development, Germany’s jobless rate was at 7.6 percent in September, up from a 2008 average of 7.3 percent. Nonetheless, in the absence of a strong recovery in global demand many German jobs are still at risk, and these are the worries which are reflected in the consumer confidence reading.



The picture of a divergent economy with fairly weak domestic consumption and a rather more robust export sector is further reinforced by the flash November PMI data, which while it showed a slight improvement in the level of German economic activity over October, revealed divergent trends between manufacturing and services. According to the Markit report the recovery in service sector activity remained relatively weak, with underlying client demand subdued and new business levels falling for the first time since July.



Thus while there was a fairly robust rise in new orders received by the manufacturing sector, with the rate of growth the strongest since August 2007, in the service sector, new work dropped moderately over the month as difficulties in securing new contracts continued. Job shedding remained evident in the German economy in November, with employment numbers falling for the fourteenth successive month. Reduced workforces were seen in both the manufacturing and service sectors, and it is thus not surprising to note in this context that the existing Kurtzarbeit (short time working) schemes were renewed last Wednesday, and will now remain in force until the end of 2010 (at least).



Backlogs data also pointed to divergent trends between the manufacturing and service sectors. Since while the latter saw the fastest drop for four months, partly as a result of lower volumes of new work, levels of unfinished business in the manufacturing sector rose at the sharpest pace since March 2008, suggesting further pressure on firms to increase capacity utilisation at their plants.

Interestingly all of this is being now reflected on the price level, since increased demand for raw materials continued to filter through to input prices in the manufacturing sector, with average purchasing costs close to stabilisation in November, and indeed the flash consumer price index for Germany .


This contrasted with the record declines in costs seen in the first quarter of 2009. In the service sector, input prices rose for the second month running, contributing to a fractional increase in average costs in the private sector as a whole. Consequently, firms were less able to discount their output prices, with the latest decline the slowest since December 2008.




Construction Woes

On the other hand if we look at construction, the October construction PMI suggested there had been the sharpest decline in construction output for four months, with new orders and employment levels fell again, and the strongest rate of input cost inflation since September 2008. The PMI report spoke of October data pointing to "another difficult month" for the German construction sector. The headline seasonally adjusted Construction Purchasing Managers’ Index registered 43.4 in October, well below the neutral 50.0 mark and the lowest reading for four months. The latest overall decline in output reflected falling activity in all three broad areas of the construction sector. Commercial activity registered the steepest reduction over the month in October. Data also pointed to the fastest drop in civil engineering activity since February and a further marked fall in housing construction. Anecdotal evidence from survey respondents suggested that weak underlying market conditions and a corresponding lack of incoming new work contributed to falling levels of construction output. Levels of new business have now dropped for twenty consecutive months. So it is hard to anticipate any positive impact on GDP from the construction sector this time round.

Business and Investor Sentiment

On the business sentiment front we have two divergent trends, on the one hand German analyst and investor sentiment - as measured by the ZEW index - declined by more than most observers expected in November, falling to its lowest level in four months.The drop is hardly surprising, and suggests somewhat more realistic expectations are being adopted by financial analysts on the economic outlook. In this sense earlier excesses of enthusiasm are now gradually giving way to realism.



On the other hand German business confidence increased to a 15-month high in November, suggesting that many German managers expect the economic recovery to gather pace next year. The Ifo institute business climate index, based on a survey of 7,000 executives, rose to 93.9 from 92 in October, the highest reading since August last year. The index reached a 26-year low of 82.2 in March.



Which means that in Q4 it is all going to be about trade. Since if German exports hold up, then the run down in inventories need not be that strong, but if exports don't sustain momentum in December - and what just happened in Dubai is making me very nervous on that front - then German GDP will almost certainly fall back into negative territory in the fourth quarter. On the other hand, if I am jumping the gun slightly here, and German economic activity does manage to eke out some small increase at the end of the year, then I think a return to negative growth in the first quarter of 2010 is almost guaranteed. That is to say, we have a double dip on the horizon. At least, that is my call. Now it is over to you.

The French Rebound Continues In October While Germany Moves Sideways

Whoever would have thought that some people once called economics the most dismal of sciences? Certainly, as the current crisis goes on and on, those of us who consider ourselves to be economists scarcely are able to find the time to squeeze in a dull moment, even here and there. But even at a broader level, interest in that most dismal of dismal topics - the theory and practice of central banking - seems now to fire up levels of enthusiasm here in Spain that make even the appetising prospect of a forthcoming Real Madrid-Barça football match pale in intensity. Even if it is the case, I have to admit, that the everyday Johnny (or Jill) come lately sitting in the bar still - truth be told - prefers the sports columns of the daily newspapers, or the lacivious details of the latest romantic adventure of one of the rich and famous to a careful perusal of the detailed minutes of the last policy rate setting meeting over at the central bank.


The reason for the sudden and unexpected upsurge in interest should, I would have thought, be obvious - since with 85% of Spanish mortgages being variable (and thus determined by the ECB policy rate), and Spain's economy sinking into an ever deeper pit, the impact of the coming decisions (or even the hints at possible future decisions) have entered peoples lives like never before. And this is doubly the case in an environment where - as Bloomberg inform us this morning - central bankers from across the global, from Washington, to Sydney, to Oslo are likely to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade, culminating in the worst financial crisis since the Great Depression.

By way of illustration for their feature story the Blomberg reporters single out the prime example cases of Norway and Australia, countries whose recent stronger than average inflation and growth performance is now so well known to regular investors for the mention of their name in such reports to have become a mere commonplace, with the respective currencies being eagery purchased to the sound of hearty lipsmaking at the thought of all the juicy carry which lies ahead. Personally though, had I been doing the writing, I would have chosen a rather different example, one much nearer to the heart of Europe (and thus a little closer to my own) - France.

And why France you may ask? Well quite simply because the French economy is now plainly and evidently on the mend. That is the big, big news which can be gleaned from last Friday's Flash Markit PMI readings (see detailed breakdown below). Now those who regularly follow this blog will know that this seemingly unexpected leap into poll position hardly comes as a surprise to me, since I have long been arguing that the French economy would emerge as the strongest among the EU economies from the present deep recession, and some of the theoretical justification for this view can be found in this post here, while an earlier piece from Claus Vistesen in 2006 also gives an illustration of how we might conceptualise the problem.

So one epoch ends, and another begins, inauspicious as the beginnings may be. To summarise briefly the argument which will be presented below, there is both good and bad news here, since this early and isolated recovery in France is bound to create difficulties of the "exit thinking" kind for policymakers over at the ECB. The most pressing of the problems will concern what to do about containing French inflation if exit dependency in Germany means that a full recovery there remains out of reach, while Italy languishes where it has always languished and Spain's seemingly intractable difficulties only increase. In other words, what will happen if - as seems obvious - the eurozone economies are in fact diverging, and not converging, and the divergence far from reducing is in fact increasing.

As we will see in the charts which follow the long term decline in the GDP share of French manufacturing, which is closely associated with the steady opening of a trade deficit there, poses special threats and problems for ECB monetary policy. This long term manufacturing decline and growing external deficit are, in my opinion, the tell tale first signs of larger structural problems to come should inappropriate monetary policy be applied too hard for too long. That is to say France is well positioned to get a distortionary bubble next time round (of the exactly the kind the newly vigilant central banks should be at pains to avoid, and indeed precisely the bubble they successfully avoided last time round) unless the ECB and the French government are very clever and very agile indeed.

Above-par Inflation Looming Just Over The Horizon

In essence the return of growth in France will be welcomed with open arms across the euro area, since with it comes the prospect of opening up a larger French current account deficit and this will, of course, clearly help soak up all that newly found need to export which exists elsewhere in Europ (and especially in the South and the East). But if this should be the fate which befalls an unsuspecting French citizenry, and living in a Spain which has already been processed along this very same pipeline, then all I can say is "heaven help them" for what will then follow.

Again, all the early warning signs are there, including the prospect that France will begin to sustain above eurozone average inflation starting next year, and this will be the first time - as can be seen in the chart below - this has really happened on any sustained basis since the euro was introduced.


In fact, if we look at the second chart, which is only the above one with the reverse overlay, we can see that French inflation really only peaked its head above the average in late 2003/early 2004, and the overshoot was not that substantial.



This time things could well be very, very different, and the big change here is of course a direct result of what has just happened to Spain. Since given that Spain has now been catapulted from a high to a low growth (or even negative growth) mode, France has been ramped up the euro league table, moving from Mr Average to Monsieur Outperform, and this will have the consequence that the ECB policy rate - which will, remember, target eurozone average inflation -will be below the one which the French economy will, in reality, need. What this will mean in practice is that there is a real danger the French inflation rate will be above the policy rate - that is that negative interest rates will be applied. As we can see in the chart below, negative interest rates were applied to the Spanish economy between early 2002 and late 2006, and we all know what happened afterwards. With the return to growth French inflation is likely to rebound, and an annual rate of headline consumer price inflation of between 1.3% and 1.5% seems not unrealistic, which means, should the ECB not start to raise its refi rate early next year then France will be rebounding strongly under the twin tailwind effect of significant fiscal stimulus AND negative interest rates.



So France is about to become the ECB's stellar pupil, but looking at what actually happened to the previous prize students (Ireland and Spain) somehow I doubt that those responsible for running things at La Banque de France and the Elysee Palace will be jumping up and down with joy at the prospect. The bottom line then is that lots of difficult decisions are now looming for European policymakers - assuming they are sharp enough to spot them at this point.

Note - the next section is essentially a detailed breakdown of this month's Flash PMI data (the flash historically bears a reasonably good resemblance to the final data). If you are not especially interested in such detail you may be well advised to glance at the charts and skip to the section - France, Not Spain, Is Different!.


Eurozone Composite PMI

Summary:

Flash Eurozone Composite Output Index(1) at 53.0 (51.1 in September). 22-month high.

Flash Eurozone Services Business Activity Index(2) at 52.3 (50.9 in September). 20-month high.

Flash Eurozone Manufacturing PMI(3) at 50.7 (49.3 in September). 18-month high.

Flash Eurozone Manufacturing Output Index(4) at 54.1 (51.7 in September). 23-month high.

The Markit Flash Eurozone Composite Output Index, based on around 85% of normal monthly survey replies, rose from 51.1 in September to 53.0 in October, registering an increase in private sector output for the third successive month and the strongest monthly gain since December 2007.

Commenting on the flash PMI data, Chris Williamson, Chief Economist at Markit said:

“The flash PMIs indicate that the Eurozone economy has entered Q4 on a strong note, with growth accelerating in both manufacturing and services. The data are consistent with GDP rising at a quarterly rate of around 0.4% in October. Reassuringly, job losses also slowed, and forward-looking indicators such as service sector confidence and manufacturing order-to-inventory ratios suggest that the labour market could stabilise early next year.”

Employment in the Eurozone fell for the sixteenth successive month, even if the rate of job loss eased compared to September. The rate of decline is much slower than that seen in the spring but remains high by historical standards. Both manufacturing and services saw reduced rates of job losses, though the former continued to see the sharper rate of job shedding, despite seeing the smallest cut in headcounts for a year.

Growth was driven primarily by manufacturing, where output rose for the third month running and new orders showed the strongest gain since August 2007. Despite the recent strength of the euro, new export orders showed the largest rise since January 2008, but the rate of growth remained very subdued.



Activity in the Eurozone services sector meanwhile rose for the second month, expanding at the sharpest rate since February of last year, though the rate of increase remained modest and continued to trail that of manufacturing.




German PMIs Dissapoint

Key points:

Flash Germany Composite Output Index(1) at 52.6 (52.4 in September), 2-month high.

Flash Germany Services Activity Index(2) at 50.9 (52.1 in September), 3-month low.

Flash Germany Manufacturing PMI(3) at 51.1 (49.6 in September), 16-month high.

Flash Germany Manufacturing Output Index(4) at 54.9 (52.8 in September), 17-month high.

Output levels in the German private sector economy continued to expand in October, led by the strongest rise in manufacturing production for seventeen months. Service sector business activity also increased again, but at the slowest rate in the current three-month period of growth. The seasonally adjusted Markit Flash Germany Composite Output Index, which is based on around 85% of normal monthly survey replies, rose fractionally from 52.4 in September to 52.6. The index has now registered above the 50.0 no-change mark for three consecutive months, yet the rate of expansion has remained extremely modest.



Commenting on the Markit Flash Germany PMI survey data, Tim Moore, economist at Markit said:

“The German economy started the final quarter of the year in growth territory, with the manufacturing sector the main driver of expansion. Manufacturing firms posted the fastest rise in new orders since August 2007 while employment fell more slowly, contributing to an above-50 Manufacturing PMI reading for the first time in 15 months. Meanwhile, service providers saw only a modest improvement in activity as demand continued to recover only gradually in the sector.”

Signs of excess capacity in the German economy persisted in October, despite solid rises in output and new business. Latest data indicated a further drop in backlogs of work and continued job shedding among private sector companies. Reduced staffing numbers were recorded in both the manufacturing and service sectors, primarily reflecting workforce restructuring following sharp declines in new work at the start of the year. Some firms also commented on the need to cut costs as margins remained under pressure in October.

Average prices charged by private sector firms in Germany were reduced for a twelfth month running and again at a faster pace than input costs. Manufactures and service providers both signalled marked declines in average output charges. Panellists generally attributed this to strong market competition and a resultant lack of pricing power. Meanwhile, input costs dropped only marginally in October and at the slowest rate in the current twelve-month period of decline. Data indicated that lower costs were largely confined to the manufacturing sector. Those reporting a reduction in purchasing costs frequently commented that subdued demand for raw materials had contributed to successful price negotiations with suppliers.

In the manufacturing sector, higher levels of private sector business activity were driven by a further solid expansion of incoming new work. The latest increase in new business was the strongest for a year-and-a-half. The manufacturing sector continued to lead the way, as new order volumes rose at the fastest pace since August 2007. This was supported by a robust increase in new export orders, with a number of firms pointing to stronger demand from China and Eastern Europe.



Meanwhile, service providers recorded only a modest improvement in new business levels in October. Anecdotal evidence suggested that clients remained hesitant to commit to new expenditure, leading to only a gradual recovery in demand. Nonetheless, service sector companies were confident regarding the twelve-month outlook for activity at their units, with 32% expecting a rise against just 18% thatforecast a decline.



French PMI - Robust Growth Registered


What stands out in this months data, however, is the performance of the French economy. The output Index, which is based on around 85% of normal monthly survey replies, indicated that growth of the French private sector was sustained into a third successive month – and at an accelerated rate. Climbing to 58.4, from 54.8 in September, the headline index indicated that growth accelerated markedly to reach its steepest in nearly three years.



Commenting on the Markit/CDAF Flash France PMI data, Paul Smith, Senior Economist at Markit, said:

“Expansion of the French private sector continued to gather pace in October, reaching its highest in just shy of three years. Output was sustained through higher gains in new business, particularly from the domestic market, although in part this was driven by continued discounting amid strong competitive pressures. While employment continues to fall, emerging signs of capacity pressures and optimism in the strength of the upturn raise hopes that job losses will dwindle over the coming months.”

Higher output was again broad-based, with both manufacturing and service sectors registering strong growth. Manufacturing output increased for a fourth successive month and at the steepest pace since May 2006. Outstanding business in the French private sector rose in October for a second successive month. In a sign of emerging capacity pressures – particularly in manufacturing – overall growth was the steepest in 19 months.

Despite rising backlogs, French private sector companies continued to reduce employment in October. The rate of contraction remained historically marked, with job losses most acute in services (job losses in manufacturing were the slowest for 14 months). Cost cutting and restructuring were noted by panellists. Input prices continued to fall in October, extending the current period of deflation to 12 months.

However, the rate at which costs declined was only modest, with manufacturing registering a net rise in their purchase prices. Inflation here was linked to higher steel and oil-related product prices. Strong competitive pressures led to another reduction in output prices during October, with the rate of decline remaining sharp. Output charges have now fallen throughout the past year.

Services activity rose at a slower pace than manufacturing output, but still - at a level of 57.8 - registered a strong gain, indeed the rate of expansion was the best since February 2008.

This Time France, Not Spain, Is Different, But Is It Really A Case Of Vive La Difference?

So French industrial production has been steadily recovering in recent months and the latest business surveys show this should continue, even if activity is still significantly (12%, much less than many other euro area countries) below its pre-crisis level. Consumer confidence has been steadily rising for over a year - even if, again, it continues to be weak by historic standards. Household consumption has also been rising, and in fact remained positive on an annual basis throughout the crisis (see chart below), and even if the potential for substantial further acceleration seems limited, this is still the key difference between France - where there is sufficient autonomous domestic demand left for the stimulus package to work - and the other euro area economies.

Why should this resilience be? Well in the first place I would single out France's rather favouralable demographics. But this alone cannot explain the situation. In addition I would add France also probably has had:

i) much better lending regulation than some of the bubble economies in the key years.
ii) no housing BUBBLE (as opposed to boom)
iii) a large population on fixed as opposed to variable interest rates for mortgages

France was also the only eurozone country who really had a more or less approriate interest rate applied by the ECB during the critical years from 2001 to 2007, so there are less structural distortions in the economy (not NONE, but less). On the other hand, as far as France's fiscal budget trajectory goes there are both long term structural and short term fine-tuning deficit issues to think about. The deficit has nearly doubled during the first eight months of this year (widening from EUR 67.6bn in 2008 to EUR 127.6bn in 2009), and although the French budget normally has a surplus in the last four months of the year, this is unlikely to be the case this year, so the deficit will undoubtedly widen further possibly reaching 7.3% of GDP (or 8.2% including social security).

The main reason for the increasing deficit is evident - the collapse on the revenue side. VAT income, for example, fell by EUR 10.4bn, or 12.0%, over the first eight months of the year. Overall total income fell 23.1% during the first eight months of the fiscal year, and although the pace of decline may slow over the whole year the government still expect the 2009 deficit to reach EUR 141bn for the central government and EUR 158bn (or 8.2% of GDP) for the government spending in general (including social security).

Since the various French stimulus packages only amount to an estimated 1.2% of GDP this means that the so called automatic stabilisers (i.e. the “natural” drift of the deficit on a no policy change assumption) account for 3.6 percentage points of the 4.8% of GDP increase in the general government deficit from 2008.

Looking forward, France's 2010 budget is based on a reasonably cautious economic forecast of 0.75% growth, following something like a 2.5% - 2.25% contraction in 2009. Despite this cautious approach there is still a considerable degree of uncertainty about the behaviour of tax income in the wake of the recession, and this is why the budget deficit is also expected to grow. On the inflation side the government forecasts an inflation rate of 1.2% in 2010, following 0.4% in 2009, but since the growth forecast is conservative the inflation outlook will be subject to upside risk, which is why I think 1.3% to 1.5% is a much more likely band.

Part of the deficit will naturally disappear as tax revenues recover. However, due to structural biases in the cost components of the budget there is still plenty of upside potential in debt to GDP moving forward - the latest forecast is for around 91% in 2013/14 - and substantial action will still be needed to lower the deficit in the years ahead. The public deficit is currently expected to fall in 2011 (from 8.5% in 2010 to 7.0%), but the numbers involved are still very large, and France is one of the best case scenarios, so this really begin to give us a picture of the severity of the downturn we have just been through. And of course we are by no means out of the woods yet.


French GDP On The Rebound, And Looking Onwards And Upwards

French GDP surprised positively with a 0.3% quarterly gain in the second quarter. Given the data we are seeing, a forecast of 0.2% quarterly growth for both the third and final quarters would not seem to be an unreasonable expectation at this point, which would mean the French economy would shrink by something under 2.5% in 2009, well below the average Eurozone contraction rate.

All the data we have seen for August and September confirm the view that the French economic environment is improving considerably, although the presence of continuing weak spots (especially on the employment front) mean real GDP growth will probably remain modest during the rest of this year.
The monthly survey of business sentiment was up sharply in September (at 92 against 89 in July). This indicator has moved even further away from its all-time low (68 in February and March), while remaining far below its long-run average.



Order books are also picking up -59 showing in September versus -68 in July. Export order books are also looking better too at -65 versus -66 in July. The consumer goods component in industrial goods orders improved markedly in September (-32 versus -37 for total orders, and -39 versus -33 for export orders), which indicates that domestic consumption spending is likely to be less depressed than it was in July and August. Likewise "capital goods" orders showed a slight improvement in September ( -68 for total and -70 for export orders versus -69 and -73 in July). If this improvement continues in October the ongoing deterioration in investment spending (see chart below) might be drawing to a close.


This improvement is also corroborated by the surge in the October manufacturing PMI. Activity in services also picked up again sharply in October as did activity in the construction sector - hence the interannual drop in GDP should be significantly under the Q2 level of 2.6% by the time we reach the end of the year.

It is also worth remembering that long term growth in French GDP has really been remarkably constant in recent times (see ten year moving everage chart below), at just a little over 2%. Previously this might have been considered rather low by many commentators, but in the light of what we have just seen happen to the "out-performers" the French result looks reasonably solid and sustainable, which means we could expect a pretty solid "V" shaped rebound in 2010 (especially during the second half) and the big danger is that excessively loose monetary conditions for the Eurozone as a whole and ongoing fiscal stimulus could send the French economy shooting upwards above its long term sustainable trend.




Industrial Output


French industrial output rose more than expected in August, rising 1.8 per cent from the previous month on the back of a surge in car production, according to new data. The monthly rise contrasted with a forecast rise of 0.5 per cent from economists and was fuelled by an 11 per cent rise in production of transport equipment, including an 18.2 per cent rise in the car component. Nonetheless French industrial output remains down around 12% in comparison with a year earlier, even though - as I keep stressing - this is considerably less than the drop in most other Eurozone economies.




Although the industrial output collapse has been a little less dramatic than in other eurozone countries, the rebound in France seems to remain largely in line with its peers. Industrial production in fact outpaced the GDP collapse in late 2008, so that it may now also be overstating the rebound.




French retail sales have been falling, but not to anything like the extent we have seen elsewhere in Europe. They were down 3.75% year on year in July.





France's construction sector also seems to be on the long road to recovery, thanks to a correction in the housing sector. A combination of lower prices and very low interest rates have boosted new home sales. Housing investment dropped over the last five quarters, losing an annual 8.7%, making for the worst recession in the sector in the last thirty years. Housing affordability has now rebounded sharply thanks to the interest rate component and a sharp fall in existing home prices (down about 10% year on year) which has allowed a rebound in new home sales and a decline in the stock of new homes for sale. To get some sort of comparison France had approximately 100,000 unsold new housing units at the end of 2008, compared with over a million in Spain. This inventory has now fallen to around 80,000.

According to the latest provisional INSEE data French household spending decreased slightly in Q3 (-0.2% q/q), despite the end of quarter rebound recorded in September (up a monthly 2.3%). Real spending was up a monthly 2.3% in September, after following a 1.1% fall in July and a 1.0% drop in August - so the long march upwards in consumption is not yet that robust. In fact the stats office data show that this September rise was mainly due to a surge in car sales. In line with a sharp rebound of new vehicles registrations (up 7.3% on the month), car sales were up by 10.2% in September over August, offsetting the falls recorded from the beginning of the quarter. Consequently, car sales were roughly flat in Q3 (down 0.1% over Q2), following a 5.7% quarterly rise in Q2.

On the other hand, general sales were down by a quarterly 2.5% in Q3, while "other manufactured products" sales, that represent more than 40% of the consumption, remain sluggish, rising by a quarterly 0.1% in Q3 following a drop of 0.1% in Q2. So at the end of the day the data tend to confirm the idea that the evolution of total spending has been largely dependant on car sales and government incentive scheme since the beginning of the year. Despite the rebound recorded in September, the stabilisation of car sales in Q3 resulted in a slight decrease of overall spending, that was down by 0.2% in Q3 when compared with Q2, following a 0.7% rise in Q2. As can be seen in the chart below (which was prepared by Dominique Barbet and Martine Borde for PNB Paribas) even while headline GDP shot down at the end of 2008 Private Consumption Expenditure (PCE) recovered rapidly due to the impact of the stimulus programme.

And as we can see in the following chart, while consumption in France has proved quite robust over the years, the manufacturing share in GDP has been declining steadily. This is, of course, quite a worrying trend. We can also see quite a clear indication of why France doesn't have the kind of problems Ireland and Spain have when we look at the construction share, since while this rose slightly between 2004 and 2007, at around 6% of GDP it was a far cry from the Irish and Spanish levels (which were twice as big at around 12%), and hence the French economy now has far less difficulty sweating down the capacity and inventory overhang.

And lastly (in this set of charts) we can see that while the trade share in French GDP has been growing steadily since the early 1990s, this increase in trade openness has also been accompanied by an increase in import penetration, and a steady widening of the trade deficit. It is this problem which could well turn critical during the next upturn if corrective measures are not taken in time.


Evidently French exports remain weak, and can in no way explain the recent recovery in industrial pooduction. The export rebound which took place in July was short-lived, and the narrowing of the deficit we have seen between 2008 and 2009 has primarily been due to lower crude oil prices. On the other hand euro appreciation is not the main reason for the poor export performance, as the deficit is wider with eurozone trading partners than with others. The drop in imports is adequately explained by the fall in domestic demand, and is not a sign of improved domestic competitiveness. At the same time the non-goods surplus has narrowed significantly, because of smaller surplus on services and the decline of the surplus on the income account. Thus while the current account deficit has narrowed somewhat, and is expected to stay contained over the next twelve months, the risk of a sharp widening in the years to come is clear enough.


A Tale Of Two Population Pyramids

Basically, a large part of the differential performance between France and Germany can be explained by comparing the two population pyramids. France has an annual population growth rate of around 0.5% while Germany has a population SHRINKAGE rate of around 0.1%. France has a total fertility rate of around 2.0, while the German one is around 1.35.

Thus the French population pyramid (above) is evidently far more stable than the German one (following), and this means that:

a) French domestic consumption is far more stable and dynamic (I would say that this by now should have attained the status of being a "self evident truth").

b) the French government debt to GDP problem, while being important, can be corrected over a longer period than the German one, since France is not ageing so rapidly. This does NOT mean that France should not be doing anything to put its house in order, clearly the underlying structural problems in the public deficit situation - health and pensions - need addressing, but France has more margin of manoeuvre to do this. The important thing is that the French administration do not put this off and off until they reach the same state of mess that the Germans are now in. France should, nonetheless be given credit for having done her homework on fertility.



Basically one look at the unstable shape of this pyramid should give us plenty of course for concern about Germany's future.



Frankly this differential situation, and its implications, has still failed to sink in in many quarers. The Economist Intelligence Unit, for example, in their recent piece - France Easy Does It (20th October 2009) - says the following:

"However, after several years of budgetary vigour Germany's public finances are now in far better shape than those of France, while the German government has secured approval of a law establishing the principle of a balanced budget in the German constitution. A persistent, large-scale asymmetry in the fiscal policies of the euro area's two largest member states could become a significant source of tension in the period ahead."

This is simply nonesense. German finances (despite the sacrifices which ordinary Germans have evidently made) are NOT in better longer term shape than French finances, and this for the reason that:

a) German trend growth (under 1%) is now significantly below French trend growth (around 2%).

b) German structural deficits related to ageing are going to be much more serious in the coming decade.

And signs of the problems this is creating are to be found all over the place. Only last week the two parties in the new German government coalition were toying with the idea of setting up a €60bn fund whose explicit objective was to cover expected welfare-system deficits over the next four years. That would have raised new government borrowing for 2009 from just under €50bn to over €90bn – but would have had the advantage that it would have made it easier for the government to fulfil a constitutional amendment passed this year, which obliges the federal and state governments to reduce their deficits year by year starting in 2011. Basically, what is the value of having a constitutional ammendment to limit the deficit, if the very next minute you start to look for ways to get around it in order to meet the needs of short term expediency?

Clemens Fuest, head of the finance ministry’s council of economic advisers, accused the incoming government of “false labelling” in claiming the special fund was just to cover welfare cost overruns. “The real reason is tax cuts,” he told the Financial Times. “The coalition has manoeuvred itself into a kind of cul-de-sac by saying on the one hand we’re going to have broad income-tax cuts, but on the other, we won’t do that by borrowing more. Of course that’s impossible.”

Rainer Brüderle, one of the FDP’s economics experts, on the other hand denied the plan was mere "trickery” and noted that special funds had been used before to finance the extraordinary burdens of German unification and the recent bank bail-out fund. The point here is not to get bogged down in the ins and outs of fiscal rectitude, but to see the stark and evident fact that the German government far from having, as the EIU puts it, secured a law which means their fiscal position is in better shape than that of French faces stark and difficult choices in carrying through what will remain a knife edged balancing act over the years to come.

The background here is that in June 2009, Germany introduced ammended its constitution by passing a law that will only allow federal deficits of up to 0.35% of GDP during normal times starting in 2016. After 2020, regional state deficits are to be abolished, while parliament can only suspend the rule in the event of “natural catastrophes or other unusual emergency situations."

The very presence of this law should give us an indication of just how critical German public finances may become. In order to comply with the law, Germany will have to implement spending cuts or raise taxes starting in 2011 regardless of whether they have weaker tax revenue, rising welfare bills, or need more stimulus measures and spending for bank bailouts.

On October 8, 2009, the German newspaper Handelsblatt reported that till 2013 Germany will have to raise taxes or cut spending equivalent to 34.3 billion euros in order to comply with the debt brake. Even if growth should be a full percentage point above the current forecasts the hole in German government finances will still stand at 29 billion euros. Therefore even if the economy improves more than expected the coalition will not enjoy ample scope with regards to public finances. (Handelsblatt; October 8, 2009)

In the end the proposal to borrow extra money this year was ditched even though a 24 billion- euro tax cut programme aimed at low and mid-level earners was adopted. Basically the "creative accounting" proposal might well have satisfied the needs of the new constitutional law, but they would not have helped with the excess deficit criteria applied by Eurostat and the EU Commission, since when the German social security system (which - remember - forms part of the government sector according to the Eurostat rules) spent the money and actually ran the deficits in 2011 or 2012, this would have been recorded as a deficit for the German public sector according to the Eurostat rules no matter when the money was borrowed. So the new government now adding tax cuts to the earlier deficits is very likely to put it in breach of the EU's Stability and Growth Pact concept of a 3-percent limit and will in all likelihood put Berlin in conflict with Brussels.


According to the most recent government forecast Germany GDP will now contract by 5% in 2009 (as compared to around minus 2.5% in France) and will the grow by about 1.2% next year. As a result net new borrowing is forecast by the latest government budget calculations to almost double next year to 86.1 billion euros from a record 47.6 billion euros this year. In an interview with Financial Times Deutschland, Jurgen von Hagen from the Institute for International Economics put it like this "Germany’s fiscal policy has been totally misguided, as it persistently ignored the inter-relationship between deficits and growth. Debt ceilings, such as the recently agreed constitutional change, do not work as they are too mechanistic, and lead to policy mistakes."

Germany's debt to GDP is estimated at 79% for 2009 and 87% for 2010, up from 67% in 2008, according to the IMF (World Economic Outlook) and on October 7, 2009, the European Commission issued a formal warning about Germany's large deficit - normally the initial step before opening an excessive deficit procedure.

To return German public debt to a sustainable path, UniCredit have calculated that the primary balance (budget balance minus debt interest payments on debt) would have to be increased by close to a full percentage point. This is equivalent to savings or additional revenues of almost EUR25 billion. To bring the debt ratio back below 60% in the next 20 years, the primary balance would have to be increased by 2 percentage points, and of course stay there (Unicredit research note, 25 June 2009)

Keeping Credit Growth In France Under Control

In this post we have covered a lot of ground. We have:

a) suggested that the whole covergence idea (that all eurozone economies where converging to a common profile) did not offer an adequate description of the actually economic processes we can see on the ground, and that, in fact, the economic profile varies widely from one country to another. It is more a question of "vive la difference"

b) examined how, in terms of the Eurozone's two largest economies - France and Germany - the paths are very divergent. Germany has an export dependent economy, which has been severely savaged by the present deep recession, and recovery is fragile (Axel Weber's expression) and will remain so until other economies recover and export growth can resume.

c) seen that while both countries suffer from important structural problems in the public finances, with debt to GDP in both cases being around 90% of GDP in 2011, in fact the country which is likely to face the more extreme difficulties over the coming decade is likely to be Germany due to the more rapid population ageing which is taking place there and the excessive dependency on exports which this produces.

d) spelt out how the ECB may well now be facing its "finest hour", as it has to rise to the challenge of adapting a one size fits all interest rate policy to a world where one size evidently doesn't fit all, and where the danger of fuelling an excessive consumer boom in one country (France) will have to be set against the risk of sending the banking system of into meltdown in another (Spain). This is clearly the banking equivalent of being stuck between a rock and a hard place new tools and new thinking will need to be developed if we are to finally steer that path between the insatiable appetite of Scylla and the never ending thirst of Charybdis.

Finally, just to make all of this very concrete, lets take a look at the different rates of new credit creation as between French and Spanish households - courtesy again of one of those very useful charts prepared by Dominique Barbet and Martine Borde for PNB Paribas). As we can see in the following chart, annual growth in total household credit in France never went about around 11% to 12% during the boom, and has now not fallen much below 3% during the slump.

In Spain in contrast, the annual rate of new household credit creation was more like 20% during the boom years, and this has steadily dropped since the start of 2007, and finally went negative in August (latest data). It is of course still falling. And this is the danger, that consumer borrowing in Spain remains weak (even as exports are lacklustre), while in France the excessively loose monetary conditions send consumers off to the banks to borrow and then on to the shops to spend.

Germany - The Bitter-Sweet Tears Of Angela von Merkel

German voters gave Chancellor Angela Merkel the green light for a second term on Sunday, along with a clear mandate to form a new government with the liberal Free Democrat Party (FDP). But just what exactly is the new government likely to do? Merlek has been quick to pour cold water on any idea of early tax cuts, “I expect we’ll agree very quickly on tax policy, especially when you look at the leeway we have with the budget," she is quoted as saying.

Angela Merkel's room for maneuver is limited by the fact that Germany has been steadily racking up debt to tackle the crisis. Only today the Federal Statistical Office have said that the deficit in the overall public budget increased to euro 57.2 billion in the first six months of this year from euro 6.9 billion a year earlier as spending rose sharply (8.1%) and revenue declined (1.7%). No figure was given as a proportion of gross domestic product, but it seems to be around 4.89% of the GDP registered in the first six months (unadjusted GDP was reported by the Federal Statistics Office as €1,168 billion over the same period).

So, while the mood in Merkel's Berlin headquarters was naturally jubilant, the euphoria will not last too long, especially since things are not going to be anything like as simple as they may seem at first sight. The problem, of course, is an economic and not a political one. Simply put, Germany’s apparent recovery from recession may have come "just in time" to see Angela re- elected, but the good economic news may not last much longer than today.

Europe's Economies Buoyant But Not Ebullient?

While talk of a Eurozone recovery continues unabated following a recent heavy slew of data, including the business surveys for September and the summer consumer spending numbers from France, which tend to suggest upside momentum. The data continue to support the idea of continuing recovery in the third quarter of 2009 but a more careful examination suggests that the German economy is not building up as much underlying momentum as was prviously hoped, and that sustaining this timid growth into 2010, especially as government stimulus programmes are pulled back, may prove to be hard work.

In France, the latest household consumer data pointed to 1% monthly falls in spending in both July and August as a rebound in inflation and further job losses continued to weigh on consumption. The untick in French inflation while price index numbers remain lodged in negative territory in Spain, Ireland, Finland and even Germany, constitutes just one of the rapidly looming headaches for the ECB.

The weaker French consumption trend was, however, offset by a fairly solid performance in both the industrial and service sectors, with the PMIs powering above the critical 50 level. Similar improvements were not, however, matched in Germany, where both the IFO survey, the Retail PMI and the Manufacruring and Serivices PMIs came in below expectations. So France, far from being a harbinger of things to come, may well turn out to be an exception in a region characterised by stagnation (at best) or continuing sharp contraction (Ireland, Finland, Spain).

Just this cautiousness about the fagility of the recent stabilisation in the Eurozone was underlined by Bundesbank President, Axel Weber in an interview with Market News. Mr Weber was at pains to stress that he still considers the current level of interest rates to be appropriate and that it is still far too early “to exit the currently extremely loose monetary policy.” He also warned that the recovery will be “very sluggish”. Mr Weber placed considerable emphaisis on the behaviour of bank credit, stating he did not expect any turnround in the present decline before mid-2010. Clearly this is likely to be the decisive indicator for the ECB to begin withdrawing liquidity. “As we come out of this crisis and as the economy recovers and as the credit cycle turns, I think we do have an obligation to decisively counter long term inflation risks,” he said.


Germans Get Ready To Tighten Your Seatbelts


If we come to examine the German situation in more detail, then we can see that M. Merkel's room for manoeuvre is going to be extremely limited indeed. Economic growth managed to scrape together a 0.3% increase in the second quarter, but this was driven by exceptional measures of 85 billion euros to lift spending and subsidize jobs, measures which surely helped keep unemployment below levels in many other OECD economies, even while the economy suffered the hammer blows of its worst post-World War II recession. However, the positive feedback impact from so much government spending can't continue like this, and Angela Merkel knows it, and she she also knows that it is either pain now or pain later, then my bet is she will use the political capital accruing from the first post election year to put the German house in order, in the hope of being able to offer some tax-cut based upside in the second half of her mandate.

That is to say, if you are hoping for some more German consumer expansion tow to help pull your own local economy out of the mire, then I suggest you forget about it right now.

Q2 GDP Growth A Statistical Quirk?

First off, the 0.3% growth obtained in the second quarter was actually the outcome of quite a complicated statistical balancing act. As is illustrated in the chart below the small final balance is actually obtained after cancelling out two much larger elements, the inventory run down (which subtracted 1.9 percentage points from the final total) and net exports which (which added 1.6 percentage points, where the positive balance was produced by a much larger drop in imports than the drop in exports).

So while it may not be absolutely correct to talk about a statistical "quirk", and while it is obviously true that there was some real growth, there was so much noise going on in the background that it is hard to know what importance to put on the headline numbers. As should be obvious it is very hard to attach too much importance to the ideat that houshold consumption added 0.4 percentage points when there are such large percentage swings impacting other items, and the fact that the trade impact was achieved by having exports down 1.2% on the quarter while imports were down 5.1% only adds to the lack of conviction which can be attached to the idea that "Germany has now returned to growth", even though this headline perhaps has sold more papers in recent weeks than virtually any other.

In fact as should also be abundantly clear from the two charts below, the sharp fall in exports was largely halted in the second quarter, while the fall in imports continued, but again, it really is stretching the point a bit to call this a solid return to growth.

So with the stimulus programme now steadily set to come off from this point on, and unemployment looking certain to jump and consumer spending to drop as we enter 2010, and with many companies continuing to warn of a credit crunch, while debt remains at very high levels, policy makers would seem to be left with few options to counter any eventual double dip should there be no sharp upturn in world trade. In fact the German economy will never recover on the back of domestic demand, which is weak, and tends to lag behind movements in exports and in GDP. So really a full fledged German recovery must await recovery elsewhere, and in the meantime we are left with simply marking time.

Germany's Economy "Returns To Growth" in the Second Quarter

German second-quarter real gross domestic product rose 0.3% from the first quarter, when it fell back 3.5% from the previous one.



Year on year the economy was down 5.9% in the second quarter. Exceptional stimulus measures amounting to some 85 billion euros have so far helped spending hold up and made it possible to keep people on short time working, but this situation obviously cannot continue much longer and even Germany’s 5 billion-euro “cash-for- clunkers” program has now come to an end. The premium led to a 23 percent increase on spending on vehicles during the first six months of 2009, spending which evidently had a lot to do with the second-quarter rebound. The unemployment rate is set to jump to 10.3 percent in 2010 from 8.1 percent this year, according to the latest IWH institute forecast. The also predict that consumer spending will drop 0.7 percent in 2010 after growing 0.5 percent this year.

And the most recent data results are only likely to add to policymakers’ concerns about the sustainability of Germany’s recovery. The country’s economy is still expected to shrink by about 5 per cent this year, with the under-utilisation of capacity bound to feed through into higher unemployment – which in turn will act as a further constraint on growth.

And as if to offer yet more evidence that the crisis is far over, the VDMA industry group said this week that orders for German machinery and factory equipment were down 43 percent on the year in August.

Export Dependent For Growth

Domestic demand is congenitally weak, and lags behind export and headline GDP gowth. As a result it is not especially surprising to find that retail sales fell for a the third consecutive month in July. Sales, adjusted for inflation and seasonal factors, decreased 0.8 percent from June when they fell 1.8 percent from May. From a year earlier, sales fell 0.7 percent, but this number is not especially significant, since, as can be seen in the chart, German retail sales have now been in decline since 2006.

Spain's retail sales fell again in September, according to the Markit Retail PMI which came in at 47.9, disappointingly weaker that the 49.5 reading registered in August. The index has been below the neutral 50.0 value during every month since June 2008, and the latest reading pointed to the sharpest rate of contraction for three months. Anecdotal evidence attributed the drop in like-for-like sales to weak economic conditions and subdued willingness to spend among consumers. There were also a number of reports in the autos sector that the end of the government’s ‘cash for clunkers’ scheme had contributed to lower sales compared with the previous month.

Despite some slight uptick in houshold consumption, overall domestic demand, which includes both final consumption expenditure and gross capital formation (including changes in inventories), was down by 2.5% in Q2 over the same period in 2008. A large part of this decrease was due to the performance of gross capital formation, which was down by 16.0% year on year. The massive slump in real capital formation in machinery and equipment therefore continued and even accelerated in Q2, with German enterprises reducing their capital formation in machinery, equipment and vehicles by 23.4% compared with the second quarter of 2008. And the trend looks set to continue, if the latest report from the Frankfurt-based VDMA machine makers associationis anything to go by. VDMA said German plant and machinery orders declined 43 percent in August from a year earlier. Export orders slumped 41 percent and domestic orders dropped 45 percent.



Looking into the third quarter German exports rose for a third month in July as global trade picked up generally. German sales abroad, adjusted for working days and seasonal changes, increased 2.3 percent from June, when they jumped 6.1 percent. Exports were still down 18.7 percent from a year earlier.



Imports remained unchanged from June, when they increased 5.9 percent. As a result the trade surplus increased to 13.9 billion euros from 12.1 billion euros in June. The surplus in the current account, the measure of all trade including services, was 11 billion euros, down from 13.5 billion euros in June. But all in all, the balance during the first moth of the third quarter was positive, even if only marginally so.



On the other hand, industrial production output numbers for Junly tempered hopes for a further rebound, since they fell back a seasonally asjusted 0.76 per cent compared with June’s figures, according to Eurostat. According to the German Technology Ministry the strongest performing sectors in recent months have been those producing investment goods and “intermediate” products, shipped for completion elsewhere.




PMIs Suggest Germany Pulled Back In September

Eurozone Flash PMIs generally showed a continued improvement in operating conditions in September, although the rate of improvement slowed somewhat, and indeed the German private sector slipped back even if it continue to maintain a general expansion. France did generally rather better. However, this does start to suggest that the easy part - stopping the slide - may now be over. We have stopped the fall, but restoring growth may well prove to be a very tough nut to crack indeed.

The Markit Flash Eurozone Composite Output Index - based on a sample of around 85% of the normal monthly survey - edged up from 50.4 in August to 50.8 in September, signalling a marginal increase in private sector output for the second successive month. The flash German Composite Output Index stood at 52.2 ( following 54.0 in August), a 2-month low.



Manufacturing new export orders weakened slightly in September, but growth on average in the third was the most pronounced since the first quarter of 2008. Anecdotal evidence suggested that overall demand had improved as a result of more favourable economic conditions and a corresponding rise in confidence among clients. Moreover, a number of investment goods producers pointed to increased exports to emerging markets in Asia.

The German flash Manufacturing PMI came in at 49.6 (49.2 in August), a 13-month high, but still just shy of the critical frontier separating overall expansion from contraction.



Commenting on the Markit Flash Germany PMI survey data, Tim Moore, economist at Markit said:

“The German economy ended the third quarter with output levels still moving in the right direction, supported by the fastest rise in new business since June 2008 and a rebound in business sentiment. PMI data suggest that the economy continued to expand in Q3, but the latest figures point to below-trend growth and only a gradual recovery. Job shedding and cost cutting measures were prevalent in September, while firms were forced to reduce their charges further, suggesting that the outlook for private sector demand remains subdued.”

The German Flash Services Activity Index came in at 52.2 (53.8 in August), again a 2-month low. And the weakening in German activity seems to have been concentrated in the services sector. Service providers were again upbeat about the outlook for the next twelve months. The balance of firms expecting a rise in business activity was the highest since January 2006, largely reflecting optimism that economic conditions will gradually improve in the year ahead.



Nonetheless, private sector companies remained cautious in their staff hiring decisions in September. Overall employment levels fell for the twelfth successive month, largely reflecting a marked decline in the manufacturing sector. Job cuts were linked to output and demand remaining at relatively low levels, with the recent change of direction not yet sufficient to prevent staff restructuring. Furthermore, backlogs of work decreased for the seventeenth month running, suggesting that firms had adequate staffing levels for existing workloads.

Plenty Of Confidence Around Though

German investor confidence jumped again in September,to hit yet another three year high as stocks surged and election day approached. The ZEW Center for European Economic Research said its index of investor and analyst expectations rose to 57.7 from 56.1 in August. The benchmark DAX index has now rebounded 52 percent from its March trough and reached the highest level in almost a year last week. At roughly the same moment the survey result was released the European Commission forecast that the German economy woul barely grow in the fourth quarter after expanding an anticipated 0.7 percent in the third one. My feeling is the Q3 estimate is too high, but the fourth quarter prognosis seems very realistic.



German consumer confidence rose to a 16-month high as the economic recovery boosted households’ income expectations and willingness to spend. GfK AG’s sentiment index for October, based on a survey of about 2,000 people, increased to 4.3 from a revised 3.8 in September, the Nuremberg-based market-research company said in a statement today. That’s the highest reading since June 2008. GfK’s measure of economic expectations turned positive for the first time since June 2008 and jumped to 3.4 from minus 7.5. A gauge of income expectations rose to 16 from 8.8 and an index of consumers’ propensity to spend increased to 36.5 from 31.1.



However it is possible to detect signals thatGermany’s economic recovery is losing momentum to some extent since business confidence rose less than expected in September, and this on the back of the weaker than expected PMI readings certainly serves to highlight the fragility of the growth recovery in Europe’s largest economy.

The Munich-based Ifo institute reported its business climate index rose from 90.5 in August to 91.3 in September. That was the highest reading since September last year, when Lehman Brothers collapsed in the US. But it fell short of many economists’ expectations, suggesting that at least some of the recent optimism about Europe’s largest economy may have been overdone.



The rate of increase in the Ifo index certainly slowed markedly in September. Hans Werner Sinn, Ifo president, pointed out that most companies still regarded current business conditions as poor, and that the rise in the index had been driven largely by the component covering businesses’ expectations for the next six months – which has risen for nine consecutive months to the highest level since May 2008.


Employment Falling As Unemployment Slowly Ticks Up

German unemployment declined in September, but the fall was due to a seasonal upturn and statistical effects rather than any fundamental economic improvement.

The unadjusted jobless rate was 8 percent, down from 8.3 percent in August.

A total of 3.346 million people were registered as unemployed — 125,000 fewer than the previous month but 266,000 more than in September 2008.

In seasonally adjusted terms, the unemployment rate dipped to 8.2 percent from 8.3 percent, with 12,000 fewer people out of work than in August. Economists had forecast an increase of 20,000. The labor agency drew attention to the fact that the number would have risen by 10,000 but for a change made earlier this year under which those being trained by private job agencies were removed from the jobless figures.



At the same time the number of those employed is falling, and there were 40.01 million people in employment in Germany in August 2009. Compared with the previous year, this was a decrease of 216,000, or 0.5%. In fact the German job machine ran out of steam last autumn, and since that time has been adding jobs at an ever slower pace. Now it has turned negative, and less Germans are employed every month than they were a year earlier.



Jobs have been subsidized by the Federal Labor Agency, which pays 60 percent of the net wage that’s lost due to reduced working hours. The program, extended to 24 months in May from 18 months, supported about 1.4 million employees at some 50,000 companies as of June.

As compared with July 2009, there was hardly any change, with the number in employment even rising slightly - by 11,000 (0.0%). But after seasonal adjustment the number in employment dropped by 57,000 (–0.1%) from July to August 2009. In July 2009, the seasonally adjusted number of persons in employment declined by 30,000 (–0.1%) on June.

Given the scale of the current economic crisis, the decline in the employment observed in Germany over the last year has been quite moderate. As the statistics office point out the fact that many employees were placed on short-time working significantly reduced the negative effects of the fall in output on employment.

So far, unemployment has been kept in check because many employers have used government-supported short-time working arrangements - Kurzarbeit - rather than laying off workers. However, this is now widely expected to be gradually wound down and hence the number of unemployed will rise significantly over the next year.






So How Long Can Kurzarbeit Continue To Run?

Well the good news, at least according to analysts at Societe Generale is a good deal longer than many seem to think. The analysts examined the working of the German employment protection programme, and show clearly that while official unemployment in Germany has in fact only risen moderately in the current recession the underlying real effective rate is much higher. The unemployment rate (using the ILO measure) has risen by just 0.6ppt - to 7.7% from its 7.1% low in Q4 2008, while in the euro area as a whole, the rate is up by 2.4ppt to 9.6% from its March 2008 low of 7.2%. As they say, it is also quite clear that this relative stability owes much to the widely-used practice of so called short-time working (Kurzarbeit).



As the SocGen analysts point out, this relatively benign situation could easily turn nasty if company employment intentions deteriorate significantly and growth expectations get revised down. However they are not that convinced by this line of argument, since they think that since German legislation has already extended the period for which companies can run short-time working from 18 to 24 months the programme is pretty firmly supported.

Examining in detail the evolution of the numbers on short-time working they find that the vast majority of companies only resorted to the programme in the spring, so that the 24 month limit will not bite until late-2010. Until the turn of the year 2008/09, the recourse to short-time working was very small indeed. Aside from the seasonal increases in the first quarters of 2007 and 2008, the numbers were small at around 50,000. To put the number in context, they point out that this represents 0.1% of the labour force and is equivalent to the monthly gains in unemployment that were recorded this year. Since then, the numbers resorting to the programme have indeed exploded and by March of this year (the latest available data), there were 1.3 million workers with shortened hours, and this number has probably now risen to around 1.4 million. These are clearly big numbers, amounting to about 3% of the labour force. If they were added to unemployment figures, total unemployment would rise to the previous historic peaks of around 5 million.




Deflationary Winds Blowing?

The German consumer price index declined by 0.4% in September 2009 over september 2008, maintaining pressure on existing deflation concerns. Germany as a whole has never seen such a low inflation rate since German reunification.

The harmonised consumer price index for Germany, which is calculated for European purposes, is expected to decrease by 0.4% in September 2009 on September 2008 (August 2009 on August 2008: –0.1%). Compared with the Augus the index is expected to be down by 0.4% in September.



And producer prices are also falling, with the index of producer prices for industrial products falling by 6.9% in August from August 2008. In July 2009, the annual rate of change was –7.8%. Compared with the preceding month, the index rose by 0.5% (as compared with –1.5% in July 2009).




Meantime the ECB continues to try to offer abundant liquidity to get credit and economic activity moving again, though there seem to be few takers.

The European Central Bank is lending banks less money than economists forecast in its second 12-month auction of unlimited funds, held on September 30, suggesting banks’ need for cash has eased for now.

Banks bid for 75.2 billion euros at the current benchmark interest rate of 1 percent. The ECB loaned a record 442 billion euros at the first auction in June and economists had forecast demand for 137.5 billion euros this month.

The ECB, which will offer banks 12-month loans for a third time on Dec. 15, is trying to flood the system with money in the hope it will be lent on to companies and households. Liquidity, liquidity everywhere, but not a drop of inflation in sight.

In A Tight, And Embarassing Corner?

Angela Merkel did not mince words at last weekends G20, warning fellow world leaders not to make the fight against global imbalances the central issue of the meeting. With Sunday's election looming she came close to accusing the US and Britain of backtracking on the issues of financial market regulation and global limits on bonuses for bankers by shining the spotlight on the export-oriented economic policies of Germany and China.


“We should not start looking for ersatz issues and forget the topic of financial market regulation,” she said in one of her speeches, “We cannot afford to neglect this issue now....Imbalances are an issue, but we must look at all the factors . . . We must talk about imbalances and name the reasons why they came into being.”

“We should also look at imbalances between currency regions and not pick on specific countries within the eurozone,” she added, referring to criticism from the US that Germany is not doing enough to support its domestic demand.”

"In terms of handling the aftermath effects of the financial crisis, the biggest problems and the deepest pitfalls are yet to materialize," according to Munich-based Unicredit economists Alexander Koch and Andreas Rees "It is very likely that typical lagging indicators like the labor market and the public deficit will still deteriorate markedly next year," and "big question marks" remain over the sustainability of the recent upswing.

A fiscal "exit strategy" is needed to avoid ballooning public debt, set to pass 5% of GDP this year, and even more during 2010. At the same time Merkel want to create a growth-friendly environment for consumers and companies by lowering the tax and social security burden. This balancing act is going to be hard, very hard, in a worl dwhich may just not allow Germany to run up the sort of trade surpluses she has been living from.

The German deficit is forecast to rise to 6% of gross domestic product next year, double the amount allowed under normal circumstances under European Union rules. Germany is still expected to see full-year gross domestic product shrink by around 5% in 2009.

One of the main acts of the outgoing government was the introduction of a debt ceiling, under which the German constitution now limits federal government borrowing to 0.35% of GDP by the time we reach 2016. What this means is that the new government will really have its work cut out if it wants to reduce the budget deficit and cut taxes at the same time. The only way will likely be via serious spending cuts. Some of these cuts may well come in the area of social benefits, possibly in health care, where the FDP is proposing a basic private insurance, with subsidies for those who cannot meet the costs. On the other hand, the CDU/CSU is essentially committed to maintaining the status quo, having already abandoned its more radical health care reform ideas. This more or less guarantess that a sizeable chunk in savings will have to come in the area of pension benefits, where the CDU/CSU is committed to the planned gradual increase in the pension age to 67.

Angela Merkel faces no easy task. She has to manage the exit from the massive fiscal stimulus and financial rescue packages,she has to ensure that the post-crisis economy is a more resilient and more balanced one, she has to address the long-standing issue of an ageing German society where generational inequality is on the rise and where younger generations are now burdened with an even higher debt level. And she has to do all this while keeping alive a coalition with a Free Democrat Party whose proposals on pension reform while certainly far reaching, still raise serious doubts about whether they will be sufficient to address the pension time bomb that is ticking away under an elderly export dependent society whose generous entitlements to pension benefits, healthcare and long-term care are becoming harder and harder to square with the long run growth performance of the German economy.