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With the state parliamentary elections in Lower Saxony, one of the largest federal states in Germany, the election cycle in the country has come to an end, allowing for negotiations on a new national ruling coalition to begin. The stakes at the bargaining table include the future of not just Germany but also the euro area. The new German government will be confronted with pressure from international institutions urging to reorganise the country’s model of economic development, whereas the domestic policy course chosen by those in power will impact growth and the distribution of prosperity across the whole continent. The mood in Germany will also be decisive for the implementation of the most ambitious euro area reforms proposed by the French President. The particular reforms that will be eventually agreed on would undoubtedly affect macroeconomic developments in Lithuania, alongside other countries.

Comment by Simonas Algirdas Spurga, Senior Economist at the Economic Policy Analysis Division of the Bank of Lithuania

The cost of German economic miracle

Germany will most likely be heading towards the so-called Jamaica coalition, dubbed this way since the official colours of the three parties that may be involved mirror the flag of the Caribbean country. These include the Christian Democratic Union/Christian Social Union (CDU/CSU) led by Chancellor Angela Merkel, the Free Democratic Party (FDP) and the Green Party.

The participation of the fiscally conservative FDP – a liberal party exhibiting sceptical attitudes towards euro area reforms – in the ruling coalition will in practice mean that the positions of hardliners in the CDU/CSU union, led by the former Finance Minister Wolfgang Schäuble, the President of Bundestag since 24 October, will be maintained. It can, therefore, be expected that such a political landscape in Germany will imply maintenance of the current status quo both in Germany and the euro area, especially in case the finance portfolio is handed to the Liberals.

In such a scenario, Germany’s economic policy will remain under fire from critics, including the International Monetary Fund (IMF), the European Commission (EC) and the Organisation for Economic Cooperation and Development (OECD). The international community has been expressing discontent with Germany’s current account surplus, which is the largest in the world and will stand at 8.1 per cent of GDP in 2017. This indicator shows that the volume of goods and services that are produced in Germany and sold to foreign countries is considerably higher than the volume of goods and services imported by the country itself.

As a result, Germany’s trade partners are unhappy that Germany, despite its successful trade in foreign markets, maintains a relatively low level of spending and appears sluggish in promoting domestic investment. This is evidenced by high savings rates of the country’s private sector and the government budget surplus. As a result of the low investment levels, consumption (and, accordingly, import) by the Germans is insufficient to fuel the growth of export volumes of the outside countries and put the scales in balance. Consumption in Germany has also been constrained by slow wage growth.

As assessed by major international institutions, Germany’s current account surplus has put the brakes on the growth of domestic demand across the euro area and made it more difficult to tackle debt problems in peripheral euro area countries like Greece, Spain or Italy. In the view of the EC, stronger import demand in Germany fuelled by additional public investment would boost the real GDP growth of the euro area as early as in two or three years. This could give a positive impetus to the stubbornly low euro area inflation that persistently fails to reach its 2 per cent target. As a result, many external voices keep reminding that Germany’s government has to promote private sector investment and spend much more in areas such as public infrastructure or education.

German population might be the first in line to benefit from changes

In some respects, the current policy of fiscal discipline has worked against Germany itself. On the one hand, the reserve accumulation can be justified by population ageing, which will put pressure on public finances in the future. Moreover, Germany’s unwillingness to shift the course of its economic policy has been underpinned by the public satisfaction with the country’s economic performance –  according to the May Eurobarometer poll, 90 per cent of respondents in Germany believe that the situation of their national economy is good (as compared to the EU average of a meagre 46%).

On the other hand, more decisive actions taken by the state in order to kick-start public or private investment might contribute to addressing the problems of deteriorating domestic infrastructure. According to the data made available by the World Economic Forum, Germany has displayed a double-digit decline in the rankings of road, rail and airport infrastructure quality over the past decade. Meanwhile, the OECD estimates that the country ranks close to the bottom among the developed economies in terms of deployment of fibre-optic network, lagging behind Chile, Poland and Mexico.

Tax cuts will not offset the lack of investment

The electoral loss of the Social Democrats (SDP), who vowed to boost annual public investment by as much as EUR 30 billion (approx. 1% of GDP), has simultaneously shut the window of opportunity for significantly increased public expenditure. The Jamaica coalition is more likely to implement fiscal expansion through tax rate reductions.

Before the elections, the CDU/CSU pledged to ease the tax burden on households by EUR 24 billion per year by implementing income tax cuts worth more than EUR 15 billion and granting additional tax reliefs to families with children. The FDP was even more ambitious, as the party leaders discussed a EUR 30 billion tax cut for the middle class. Both the Greens and the Liberals have also emphasised that the country needs tax incentives promoting greater investment.

As tax reductions will fuel domestic consumption and private investment, such a move may accelerate the growth of demand in the euro area and the decrease in Germany’s current account surplus. However, both the EC and the IMF warn that a fiscal expansion implemented through tax cuts instead of higher budgetary expenditure would have a limited effect on external economies as the increased volume of Germany’s imports in this case would be offset by improvements in the country’s competitiveness fuelled by decreases in labour costs.

The Liberals may thwart Macron’s vision

One of the ways to start dealing with the problem of imbalances in Europe could be to undertake governance reforms all across the euro area, which is something that France’s President Emmanuel Macron has recently been talking about, in addition to other political leaders. If the German government fails to implement more radical changes in domestic economic policy, the issue concerning the future of the euro area is bound to become even more pressing, with Germany’s stance on Europe’s reforms being the decisive element. In this case, however, Merkel will have to manoeuvre between the Green Party and the FDP, which has drawn a red line on many initiatives to reform the euro area. The Alternative for Germany (AfD), a parliamentary newcomer, will also oppose ambitious euro area programmes in the Bundestag.

The CDU/CSU and the FDP, however, agree on one main point, i.e. the necessity to ensure stricter compliance with the common EU economic governance rules setting the government deficit and debt limits. It is, therefore, likely that the mix of parties in the Germany’s new ruling coalition will complicate the implementation of Macron’s vision for euro area reforms. Concessions to the French President will most likely be merely symbolic in their nature, whereas a single euro area finance minister or other new institutions, if eventually established, will be primarily responsible for more stringent monitoring of compliance with the respective rules and regulations.

For the euro area, compliance with the common rules is vitally important. However, the EU has restrictions in place not just on the fiscal policy but also the current account balance, whereas the existing trade surplus in Germany exceeds the 6 per cent of GDP threshold laid down in the bloc’s regulations.

Before the elections, Christian Lindner, the leader of the FDP, stated that the current account surplus in Germany “is not a problem”. Hence the Jamaica coalition will most likely continue to support the asymmetrical nature of applying EU rules and regulations, focusing on cases of excessive deficit instead of excessive surplus. In this context and as far as trade imbalances are concerned, the levelling of the scales in the euro area can hardly be expected as Europe is more likely to be in for a status quo scenario.