Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Fourth-Quarter Forecast. These assessments are designed to provide more context and in-depth analysis on key developments over the next quarter.
Europe's largest economy seems headed for its first recession in a decade. Recent data suggests that the German economy could contract again in the third quarter of 2019, after already contracting by 0.1 percent in the second quarter. According to the Munich-based Ifo institute, business sentiment in the country also reached a nearly seven-year low in August. And likewise, IHS Markit found that sentiment among Germany's manufacturing and service sectors, in particular, fell to its lowest level since 2013.
Germany's dimming economic outlook is the result of several factors. Growing uncertainty fueled by the U.S.-China trade war and a potentially hard Brexit in October, for one, has taken a toll on the country's export-dependent economy. Meanwhile, at home, Berlin is grappling with lackluster economic activity, along with a troubled automotive industry that has struggled to adapt to changing consumer demands for more electric and self-driving technologies. But while the German government has the funds to react to the economic downturn, it lacks the political unity to confidently jump-start growth with an all-in-one stimulus package. And this, combined with an influx of global uncertainty, will limit the country's room for a quick recovery.
Germany is the largest economy in the European Union, which means that political and economic developments in the country have reverberations across Europe. In the coming months, economic risk and, to a much lesser extent, political risk in Germany will contribute to a generalized slowing down of EU economies. This will force Berlin, as well as other national governments and EU institutions, to introduce measures to minimize the impact.
A Slow and Steady Stimulus
In Germany, the prospect of a recession has reopened an old debate on whether the government should introduce stimulus measures to kickstart the economy. When the international financial crisis hit Europe a decade ago, the European Union, International Monetary Fund and U.S. officials criticized Germany for dragging its feet on a stimulus package (which it eventually implemented, but only after an intense political debate in Berlin). And this criticism is slowly coming back, with Germany's allies and trade partners pushing Berlin to cut taxes, introduce measures to boost domestic consumption, and increase public spending on sectors such as infrastructure.
Money shouldn't be a problem for Germany. After all, the state has had four consecutive years of a fiscal surplus, and has already saved some 45 billion euros (roughly $49 billion) in the first half of 2019 alone. The problem is instead more ideological, as Berlin's policy of having no fiscal deficit — which, in Germany, is known as the "black zero" — is extremely popular among a large sector of the electorate. In recent weeks, discussions about how to address the slowing economy have spurred some tension within Germany's coalition government, which includes the center-left Social Democratic Party (SPD) and Chancellor Angela Merkel's conservative Christian Democratic Union (CDU). Broadly speaking, the CDU tends to be supportive of the strict black zero policy, while the SPD is more open to increasing public spending, even if it means creating a tiny deficit.
To make things more complicated, the CDU, and particularly the SPD, are performing poorly in opinion polls, which has increased discontent within both ruling parties. Some factions of the CDU believe that Merkel has moved too much to the political center and should return to the right, while sectors of the SPD think that the party should take more left-leaning positions to improve its popularity. Merkel's decision not to seek reelection has also opened a debate within both parties over where to take the country after her term ends in 2021.
The far-right Alternative for Germany party's strong performance in recent regional elections has since only added to this general uneasiness within the German government, with the CDU and the SPD increasingly believing that they should distance themselves from each other after having governed together for the better half of the last two decades. Certain members of the SDP have even argued that the party should leave the coalition entirely, and spend a few years in the opposition to rejuvenate itself. The government's complete collapse, however, remains highly unlikely, as the CDU and SPD's coalition is unlikely to end at a time when neither of its members would benefit from an early general election.
But this more anxious political context likely means Berlin will move with caution to stimulate the country's economy — opting for a step-by-step approach where measures are incrementally introduced in tandem with economic data, in lieu of a single, large stimulus package. On Aug. 29, Economy Minister Peter Altmaier suggested cutting corporate taxes for small- and medium-sized companies, which serve as the backbone of the German economy. Then on Aug. 11, German Finance Minister Olaf Scholz also recently announced plans to cut the "solidarity tax" that German households pay to promote economic development in eastern Germany.
One of the interim leaders of the SPD, Thorsten Schaefer-Guembel, recently proposed introducing a wealth tax as well, though this hasn't sat well with the CDU and large segments of Germany's business sector. Other measures under consideration include taking advantage of historically low borrowing costs to take on new debt to invest in infrastructure projects. The German government is also working on a plan to reduce the country's greenhouse gas emissions by 55 percent by 2030, which opens the door to higher public spending to fund the transition to a greener economy.
A Future in Flux
However, a series of challenges in the months ahead risk dampening the effectiveness of such measures, beginning first with the potential for a no-deal Brexit in late October. The United Kingdom is Germany's fifth-largest export destination overall, and the third-largest destination for German car exports in particular (after the United States and China). While there is still room for an orderly Brexit, the chances of a hard exit have increased in recent months, which means that German exports to the United Kingdom may soon start facing higher tariffs. Indeed, Brexit-fueled uncertainty and a weaker pound have already reduced German shipments to the United Kingdom by roughly 21 percent in the second quarter of 2019.
The United Kingdom, however, isn't the only country creating headaches for Germany. The United States has threatened to introduce higher tariffs on EU cars as early as November, which risks further hurting Germany's already troubled automotive industry. This threat could be significantly reduced, should the European Union and the United States make progress in their current negotiations over a free trade agreement. But alas, the two sides have yet to even agree on what products their deal should cover. Brussels has pushed back against U.S. demands to include agricultural shipments, due largely to pressure from countries like France and Ireland that fear opening their markets to competitive U.S. agri-food products. And the European Union will likely continue to be reluctant on this front, given the recent appointment of Phil Hogan, a protectionist Irish national, as the bloc's new trade commissioner.
Should Washington decide to tack on higher auto tariffs, however, the European Union would be compelled to retaliate by raising its own tariffs for some American imports. This would risk further souring already tense relations between Brussels and the White House, which are also battling out bitter disputes over aircraft subsidies and the construction of the Nord Stream 2 project between Russia and Germany. That said, there's a chance Washington could decide to postpone imposing higher tariffs on European cars so that it can focus its attention on Washington's escalating trade disputes with China. But this, of course, would only delay (and not defuse) the looming threat to German automakers.
Brussels Braces for Impact
The continued cooling of Europe's largest economy will no doubt be felt well beyond the country's borders. Germany's many trade partners, for example, will start to feel the weight of Berlin's lagging economic growth, should it yield overall weaker demand for foreign goods — especially Italy, France, Austria and Poland, where Germany serves as the main export destination. This also comes at a time when most EU member states are already facing economic slowdowns of their own, due to a combination of domestic issues and generalized uncertainty about the future of the global economy.
Countries in Southern Europe will likely use the generalized European slowdown — exacerbated by Germany's own worsening economic situation — as a justification to ask the European Union for more flexibility in implementing deficit and debt targets for the bloc. This will be one of the most immediate challenges for the new European Commission, which takes office in November. The commission's new president, Ursula von der Leyen, and her team will have to decide between strictly adhering to current EU financial policies, which could alienate some governments like Italy; or accepting some flexibility, which could also weaken its credibility right from the start.
Given the political constraints Germany faces at home and the mounting uncertainty it faces abroad, Europe's largest economy will likely continue to cool in the months ahead.
Slower economic growth and low inflation in the eurozone, however, have already forced the European Central Bank (ECB) to introduce some stimulus measures on Sept. 12, including leaving its benchmark interest rate at 0 percent and taking its deposit rate (the one it charges to commercial bank deposits at the ECB) to an all-time low of -0.5 percent. Such lower interest rates have a mixed impact on Germany. On one hand, they keep the country's borrowing costs low, which would allow Berlin to take on new loans without threatening its fiscal stability. But lower rates also risk reducing the value of Germans' savings and deposits, while exacerbating the profitability problems many German banks are already facing.
So far, German politicians have been relatively quiet in their criticism of ECB policies. But Berlin's pressure for a change of direction in the institution's policies could grow louder if it's motivated by electoral pressure at home. That said, considering the political constraints Germany faces at home, as well as the many headwinds it faces abroad, there's a good chance the country's economy will continue to cool in the months ahead — fueling more political dilemmas in both Berlin and Brussels, while adding to Europe's greater economic woes in the process.