Germany's Potential to Surprise
By Dr. Sebastian Dullien

Germany's economic data continues to surprise most economists positively: As the statistical office Destatis announced this week, the German economy grew with a speed of annualized 3.5 percent in the fourth quarter of 2006. Moreover, the statisticians have revised earlier estimates for the first three quarters of the past year, putting growth for the whole year 2006 at 2.9 percent in calendar-adjusted terms. This is an impressive increase over the forecasts from the start of the year. In December 2005, the consensus among professional forecasters saw a growth rate of only 1.5 percent, with the highest forecast at 1.8 percent.

Moreover, details of German growth are even more impressive than the headline figure: Talking to American economists here in Washington, DC, I often hear the argument that the 2.9 percent annual GDP growth Germany is experiencing is not that impressive - after all, the U.S. has grown with rates of more than 3 percent over the past three years. However, when comparing growth rates, one often forgets to keep demographic developments in mind. While the German population is basically stagnating, the U.S. population is growing by roughly 1 percent annually.

Updating the data from the EU commission's fall forecast with the recent revisions from the statistical office puts German per-capita-GDP-growth for 2006 at 2.9 percent, roughly half a percentage point more than U.S. per-capita-GDP-growth. Furthermore, even the U.S. economy, arguably one of the most efficient economies in the world when it comes to generating stable growth over extended periods, only reached such a pace in per-capita-GDP growth once this decade, in 2004. Per-capita-GDP is a much better indicator than headline growth in determining whether an economy is able to provide increasing prosperity for its citizens. And on this account, the German economic model, often chastised as sclerotic and doomed to stagnation, is at the moment not doing so badly after all.

In addition, there are a number of indications that Germany might again surprise in 2007. While the strong growth in the fourth quarter might, to a certain extent, be a result of advanced purchases just prior to the VAT hike and thus might increase the chance of a payback in the first quarter of this year, the statistical overhang and the overall dynamic of the economy expressed in most recent business surveys have already forced a number of bank analysts to increase their 2007 growth forecast for Germany once more, many of them now again exceeding two percent.

Two reasons are behind the new strength of the German economy: First, a number of problems have disappeared which have dragged German growth down for the past years. Second, the business cycle has by now reached a stage in which it has at least partly become self-sustaining.

Germany had lost its price competitiveness to a significant degree during the years immediately following German reunification. A strong increase in domestic wage costs was followed by a nominal depreciation of the currencies of many European trading partners in the European Monetary System (EMS) crisis of 1992. The loss of competitiveness created downward pressure on employment and wages in Germany. A number of years of sub-trend wage increases followed, which improved the firms' situation in the world market, but also dampened disposable income and thus consumption. Now the problems with price competitiveness have been solved. Germany is gaining shares in the world market and employment is growing briskly again. The hiring rate is currently so strong that wages will most likely rise again from their low rate of less than 2 percent year-on-year (in nominal terms) observed during the past years, providing an additional boost to consumption. At the same time, even though IG Metall, Germany's metal workers' union, has demanded a 6.5 percent increase in wages, past experience predict that an economy-wide wage increase at the end of the negotiations will not amount to more than maybe 2.5 to 3 percent, not damaging German competitiveness.

Moreover, there are signs that the decade-long correction of the construction sector has come to an end. While the current mini-boom in construction has been boosted by the imminent rise in VAT (for housing construction, the VAT has to be paid by the house owners), there is an independent upswing in business construction as businesses are VAT-exempt.

Combined with the export boom, the improvement in competitiveness has led to a boom in German investments in equipment and software. In the third quarter of 2006, domestic machinery orders were 11.5 percent higher than a year ago. According to first indications by the statistical office, the trend has strongly continued into the final quarter of 2006. This investment boom is now the driving force of the German upswing, not the continuously strong export boom or purchases just before the VAT increase.

So, chances are good that five years of extremely weak growth and investment will now be followed by several years of good growth and strong investment. In 2001, German fixed capital formation fell significantly below EMU average, probably due to earlier over-investment, but possibly also because of problems in the German banking sector, depriving some companies of liquidity for their investment plans. As there is no a priori reason why, over the long run, German companies should invest a lower share of GDP than their counterparts in France, Italy or the Netherlands, there is hope that Germany is beginning to close the gap with the rest of the EMU. This could result in a number of years with high investment growth. Given that investment growth is often followed by employment growth, which also boosts incomes and consumption, this bodes well for domestic demand.

Some commentators might now argue that growth potential in Germany is too low to allow for several years of growth rates of 2 percent or more (incidentally, only two years ago the Kiel Institute even explained its low German growth forecast with their estimate on potential growth - a notion which they happily omitted when they doubled their growth forecast for 2007 to more than 2 percent in December).

This notion is misguided. Potential growth estimates are little more than a sophisticated extrapolation of past trends. This is true not only for the crude HP-filter, but also for more complicated methods. Even if one uses a structural model in which the capital stock enters explicitly, the computations are distorted to the downside if there is a prolonged period of sub-par demand growth (which of course leads to lower investment growth) as Germany has experienced over the past years: In this case, the filter will forecast an excessively low growth of the capital stock, resulting in an excessively low potential growth estimate. As soon as capital expenditure in Germany has finished its normalization process, these methods for computing the growth potential will also result in higher estimates of potential growth rates. Because the German labor force is not shrinking yet and a productivity increase of roughly 2 percent annually is not overly ambitious, an overall potential growth rate of roughly the same magnitude seems plausible.

Dr. Sebastian Dullien was a DAAD/AICGS Fellow in January-February 2007.

This essay appeared in the February 16, 2007 AICGS Advisor.

The views expressed in this article are those of the author(s) alone. They do not necessarily reflect the views of the American Institute for Contemporary German Studies.