Well with most commentators now assuming a 40% minimum probability that we will get a US recession in 2008 (I personally
really wouldn't want to quantify the risk here, and think,
along with MacroMan that the US may even surprise us on the upside), and With Morgan Stanley's Takehiro Sato (closely accompanied
by our very own Claus Vistesen) now calling some sort of recession for Japan in 2008 (and see
this morning's Tankan, and in this case I would not only go along with the consensus, but
even fear that the downside risks may exceed everyone's expectations) perhaps it is time to ask ourselves what the odds are for a recession in the Eurozone in 2008?
And what better vantage point to look at this from than that of the zone's largest economy, the German one.
ZEW PlummetsFirst off the sentiment indexes. These have been trawling negative territory for some time now (see
the IFO here and the
GFK consumer index here), and this week we learned that investor confidence in Germany reached its lowest level in almost 15 years, as rising credit costs dimmed the outlook for economic growth. The Mannheim-based ZEW Center for European Economic Research said its
index of investor and analyst expectations fell to minus 37.2, the lowest since January 1993, from minus 32.5 last month.
InterBank Rates
The cost to banks of borrowing euros over a three month period rose to its highest level since December 2000 this week as banks are hoarding cash to cover their commitments over year-end. The euro interbank offered rate, the amount banks charge each other for these loans, rose 3 base points to 4.93 percent, according to the European Banking Federation. That's 93 base points more than the European Central Bank's benchmark rate. If we look at the latest available data from the British Banking Association we will see that the three month euro Libor rate turned up once again in mid November, and has not stopped rising since.
It is important to realise here that this movement in the 3 month libor that have been seeing since the start of August has taken place without any change in interest rates at the ECB. But these rates will affect all those borrowers who are on variable interest rates tied to Euribor (or Mibor) and, for example, nearly 80% of mortgage holders in Spain fall into this category, so a sharp monetary tightening is now taking place, even as general economic conditions deteriorate.
Growth in Germany is expected by virtually everybody to slow next year, although no-one really knows by how much, and downside risks abound. A drop to a 2008 overall rate of 1.7 percent was forecast by the RWI economics group last week, but even this may be on the optimistic side.
German Exports
Meanwhile German exports unexpectedly rose in October, pushing the trade surplus to a record.
Still, the euro's 11 percent advance against the dollar this year is making German exports less competitive abroad, adding to concerns that this continued export strength may not be sustainable. Exports were the driving force behind last year's 2.9 percent economic expansion, which was the fastest in six years. And if we come to look at the evolution of the year on year growth rates in exports (which is the key data point I would argue), we can see that the trend is now definitely down, and indeed that the export component in this present expansion probably peaked sometime in the last quarter of last year.
So what can we expect from this. Well it may be worth reminding ourselves about what happened last time round, ie last time the acceleration in the Y-o-Y growth rates in German exports effectively stalled. That was back in early 2000, as we can see from the chart below. And what happened at that time? Well the fed was easing as the US entered recession, and the euro was to some extent rising, both of which put a strong break on German exports. So it isn't the rise in the currency alone that matters, you have to think about the whole environment which produces it. Why your currency is rising, while someone else's is falling. And of course, in German export terms, after the rise comes the fall. This is the cost of not being able to depend on your own internal demand, you have to depend on someone else's demand.
As we can see once the rate of increase in annual exports entered real decline, GDP was not far behind, and off Germany went into recession. So this time round the same thing may well happen, and domestic demand may well not offset any fall-off in foreign sales as oil-driven inflation and rising borrowing costs steadily sap German consumer and corporate spending power. Last month, consumer prices rose 3.3 percent from a year ago, the most since records began in 1996. The price of oil has gained 44 percent this year. At the same time German wages, as is well known have had only very weak increases in recent years.
Looking into the situation a bit more deeply, we can see that the construction and housing sectors are in long term decline in terms of their importance in the German economy. If we leave out the very exceptional quarters associated with the pre VAT rise construction boom (Q4 2006 and Q1 2007), housing simply hasn't turned back up since the end of the boom in 1995. As I keep saying I think the strongest explanation for this is the demographic one, and it is this element that those who keep hoping against hope to get a turnround in German domestic demand simply are not seeing.
If we now move on to look at the co-movement in German GDP and some of its key components - movements in GDP growth compared with growth in exports and growth in housing - we can see that every time the rate of increase in exports slows (the green line in the chart below), GDP (the red one) follows it down. And at the moment, of course, the rate of export increase is slowing. If we then add to this what is happening in housing and construction, where we have a very rapid decline from the VAT-rise-provoked-boom (houses also went up 3% on 1 January 2007), and the deteriorating external environment, it isn't at all clear to me at this point that we won't see a German recession in 2008, in fact I would put the odds on a German recession slighly higher than the 40% probability most people are attaching to a recession in the US (let's say 50-50).
Now, as I keep indicating, the backdrop to the whole situation in Germany is the vulnerability of domestic consumption, and quite how fragile all this is has been brought home by the boom-bust type dynamic produced by last January's VAT hike, which I think can be clearly seen in the data from the last quarter of of 2006 onwards. There is a huge spike, and then there are 3 quarters of negative growth.
Of course, demographic ageing is not only about rising median age, it is also about continuous changes in the population structure, and in particular the proportion of the population in the key 25-49 age group rises to a peak and then starts to fall. Let's look at this chart for Germany:
As can be seen this crucial age group touched its highpoint in 1997/98, precisely around the time that the mid 1990s boom in construction came to an end.This could be imagined as the moment of maximum capacity for the German economy as a whole. In closing I would wish to point out that I am not trying to draw all this to people's attention in order to criticise, or in some way have a go at Germany. Au contraire. It is because I am concerned that I am going to all this trouble. The first step to getting to grips with and fixing a problem has to be recognising that it exists. That drop in fertility that happened deep in the past, may now seem like a long forgotten event, but its presence is forever with us. Something obviously needs to be done, and better late than never. Putting all your eggs in one basket is never the best of ideas.
The Great VAT Rise Scandal
I think the chart I have just presented showing the recent evolution of German private consumption really speaks for itself. I created it as I was going through the detailed data for German Q3 2007 GDP. So some of the things you were taught in Econ 101 do turn out to be more or less valid, despite what a whole battery of people who should have known better (from the FT to the Economist among many others) were telling you not so long ago. You can't raise prices without having some effect on underlying demand. And when you tell people you are going to raise them in advance, then you should expect them to stock up as best they can. So we get a big spike in private consumption at the end of 2006, and then 3 quarters of year on year negative consumption growth. I'm not sure after this experience people will be piling ageing society costs onto already fragile domestic consumption again. (NB, I do hope they are looking at this data in Japan, where, of course they are currently discussing the advisability of introducing a consumption tax to try to reduce the scale of the accumulated government debt they have - around 150% of GDP).
But the problem with this VAT rise isn't only the impact it is now having on German internal consumption, it is also making its effect felt in the legacy it is leaving policymakers to get to grips with. In particular we can, of course, notice the impact of the rise on Germany's short term inflation dynamics (with many observers suggesting it has contributed around 1.3% points to Germany's current inflation spike - to which we will now turn) and in this way the earlier VAT decision has considerably constrained the ECB's room for manouevre in the face of the sub-prime housing shock.
Inflation on the Rise
So, and just to make things really complicated for the ECB, German inflation accelerated in November to the fastest pace in 12 years, led by surging oil and food costs, and the knock-on VAT effect.
German consumer prices - as measured by the harmonized European Union index, rose 3.3 percent from a year earlier in November, following a 2.7 percent increase in October, according to this weeks data from the Federal Statistics Bureau. That's the fastest monthly rate to be recorded since harmonized data for Germany started being collated in January 1996. In the month of November prices rose by 0.5 percent.
While the wage response to the price pressure is likely to be moderate, the inflation squeeze following on the back of the VAT hike is likely to weaken an already weak domestic consumption even further, and in the absence of some strong monetary easing I think the result is not too hard to predict.
If we now take a look at the breakdown in Q3 German GDP growth in terms of the component contributions, it isn't hard to see that the heavy lifting was carried out by exports, and these were followed in importance by machinery and equipment investment (which to some extent is related to export needs). So if external conditions deteriorate, even slightly - which all the forecasts suggest they will for 2008 - then Germany will have increasing difficulty maintaining the pace of the export expansion. Remember, for Germany to fall into recession we don't need to see negative export growth, just a substantial reduction in the rate of increase.
Conclusions
To end up more or less where we started, below is the chart for the percentage point contributions of private domestic consumption to GDP growth in Germany in recent quarters. As can be seen, during the three last quarters (following the VAT anticipation spurt) consumption has acted as a drag on growth. With inflation now biting into consumers pockets, and monetary conditions effectively tightening, this position is more than likely going to deteriorate.
All of this has, as I am saying, put the ECB in something of a double-bind straightjacket. It is difficult for them to raise rates in the short term. In which case the Fed is likely to continue easing, and the relative yield offered by European rates will rise, and with them, in all possibility, the euro. So one of the factors in the mechanism has to be the different response rates of the two central banks involved. The Fed tends to respond more rapidly and more aggressively when iit sees problems coming. So it we look at the chart below for the movements in interest rates by the 2 insitutions since the second half of 2000 we can see that the fed started resacting last time tround a full six months before the ECB. as a result by mid 2001 Federal reserve rates were below ECB ones. So what happened then?
Well, if you look at the chart below you will see, the euro started to rise against the dollar (the yield differential factor). The rise really got going at the start of 2002 and lasted till the spring of 2005. And what was happening at this point, well the Federal Reserve rate was once more back above the ECB one, and the differential was rising, that's what happened. And what happened to German GDP during 2002, 2003, and 2004? GDP growth was at a very low, near recessionary level, that's what happened. Go back and look at the export growth GDP chart, the fit isn't perfect, but there is obviously a very strong relationship.
Now I am obviously not suggesting that what happened to German GDP after 2002 is an entirely relative interest rates story, the slump in world growth following the internet bust is also a very important part of the picture (as are the cosequences of the sub-prime generated credit crunch this time round), but interest rates and relative exchange rates do form part of the picture, and provide an interesting part of the narrative. So basically we have a cyclical sub-mechanism at work based on the ECBs ability to get things wrong (or work itself into a corner), where by the delayed reaction from the ECB leads the euro to rise to unrealistic levels, and this rise eventually pinches German export growth (German enterprises may be a lot better at reacting than the ECB, but their elasticity is not infinite, there is a limit). And when the limit is hit, then off goes Germany into recession, and usually these days this means something more than just two quarters of negative growth.
And why is Germany structurally condemned to depend on exports, well the principal reason is the rising median age. And what drives the rising median age? Well a number of factors are involved, but the most important of them is fertility. And so I present you with what is possibly the most preoccupying graph of all, the one thats shows the stubborn resistance of the German TFR to any upward movement.
Basically then I rest my case. The danger of recession in Germany as we enter 2008 is at greater than 50%.
