Germany Will Lead the Global Downturn

by Matthew Lynn
Wednesday, August 17, 2011

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With German growth stumbling, Europe has little margin for error

There has been no shortage of shocks for the market in the past few weeks. The U.S. has lost its triple-A rating. Italy is struggling to stay in the euro. The French banks are running into trouble because of the loans they have made to the continent's peripheral countries.

But in fact none of those should have surprised anyone much. The U.S. had been running up too much debt for a couple of decades and the dollar was already on the way out as a reserve currency. The Italians struggled to stay in the lira — no one expected them to survive in the euro without a few problems. And it would hardly qualify as a financial crisis if the French banks weren't losing money. Each of those events was about as unexpected as Andy Murray getting knocked out of Wimbledon in the semi-finals.

In truth, the really worrying news is coming out of Germany.

The signs right now are that the motor of the European economy is starting to slow down significantly. That was confirmed with the release of second-quarter figures that showed gross domestic product growth of a mere 0.1% at a quarterly rate in the second quarter of the year, significantly lower than the 0.5% most economists had been predicting. Read our full story: German growth nearly grinds to a halt.

What happens to the mighty German economy matters hugely to the rest of the world right now. Germany will have to bail out the rest of the euro zone, and it won't want to do that if its own economy is struggling.

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Germany is one of the few viable sources of global growth. And because it is a huge exporter, Germany is a good leading indicator for what is happening to the rest of global demand. If the world economy is going to run into serious trouble this autumn, then it is Germany that will be pointing the way over the cliff.

The signs right now are hardly encouraging.

Tuesday's GDP figures merely confirmed a trend that has been evident for the last few weeks. In June, German exports, adjusted for work days and seasonal changes, fell by 1.2%, compared with a rise of 4.4% in May, according to the country's statistical office. The IFO business climate index for July fell sharply to its lowest level in nine months, and analysts predict it is likely to keep dropping. The ZEW investor sentiment index recorded its weakest results since back in January 2009.

And the Markit/BME purchasing managers' index for the German manufacturing sector fell 2.6 points in July to 52 points, its lowest level since October 2009. German engineering orders — one of the most crucial sectors of an engineering-based economy — rose in June by just 1% year-on-year, after recording a 21% rise in May, according to the VDMA engineering industry association.

It all adds to the same picture. The German economy is still growing, but it is not booming the way it was for most of last year. It may still expand by 3% this year as the Bundesbank currently forecasts — first-quarter growth was very strong 1.3% — but it looks unlikely it will be able to sustain that into 2012.

There is no great mystery about why that is. The country's big export markets are slowing down. China is unlikely to import as much high-quality German stuff as it has in the past two years. The Eastern European countries, which are huge customers for German industry, are cutting back: Czech and Hungarian growth is also slowing down. So of course are the countries in the euro. The Greek economy is currently contracting by almost 7% year — a 1930s-style depression. German firms can't expect to win much new business there.

A German slowdown, however, is going to knock the world economy. Here's why.

First, Germany is going to have to bail out the rest of the euro zone. It was hard enough to persuade German voters to do that when the economy was booming. The Germans believe in low inflation and balanced budgets, and if they can live within their means they don't understand why other countries shouldn't do so as well. When their economy was booming, it just might have been possible for the political class to persuade the voters it was worth digging into their pockets to salvage the currency (EURUSD - News). We all feel a bit more generous towards our neighbors when we are doing well. But if ordinary people are feeling squeezed and losing their jobs, it is going to be impossible. If the country slows significantly, the euro will fall apart a lot faster and with a lot more recriminations.

Next, Germany was one of the few potential sources of global growth. It was growing fast, and even if the Germans don't import that much, they do take a lot of holidays — and that helps the countries they visit. German consumer spending has only risen very slowly even as the economy has been booming. If all those prosperous Germans could have been persuaded to start spending a bit more of their money, they could have boosted the world economy. That's not going to happen now.

Lastly, the German economy is an export economy. Not only that, it is also a world leader in capital goods. It makes many of the machine tools that power factories around the world. It is good leading indicator of both global demand and investment, particularly in the emerging markets. If it is slowing down, it is a good bet that the rest of the world economy probably is as well.

Everything else that has happened in the markets in the last couple of weeks should have already been priced into the markets. None of it was a big surprise. But a slowing German economy is genuinely bad news — and a good reason for investors to start to sell off equities.

Matthew Lynn is a financial journalist based in London. He is the author of "Bust: Greece, the Euro and the Sovereign Debt Crisis," and he writes adventure thrillers under the name Matt Lynn.