From a European perspective, the German coalition agreement is better that the status quo – but it does not contribute to the economic recovery of the eurozone, and it is disappointing when it comes to banking union.
One of the biggest stories in the European media over the past few days has been the coalition agreement between the German Christian Democrats (including its sister party, the CSU) and the Social Democrats. While politicians from across the eurozone welcomed the agreement, journalists have been busy trying to decipher the meaning of the 185-page document (only available in German).
Unfortunately, the authors of the document did not write it to facilitate a macroeconomic analysis. In fact, it seems that some sections actually intend to hide the real impact of the proposed policy measures to soothe criticism in both camps. After all, the Social Democrats still need to get a positive vote from their members.
The economic consequences of the coalition agreement in 30 seconds
So, what is really in the agreement? From a eurozone perspective, five points should be taken home:
- The proposed policies will slightly boost German economic growth over the coming four years to around 0.1 percent a year. This boost will come from an increase in consumption, not from investment.
- The proposed policies will do very little to solve Germany’s structural problem of permanent underinvestment in public infrastructure and education.
- The proposed policies will marginally contribute to rebalancing current account imbalances in the eurozone by potentially bringing down the German export surplus by maybe 0.5 percent to 1 percent of the GDP (maybe enough to bring Germany below the 6-percent-threshold in the macroeconomic imbalance procedure, but too little to really bring it to economically sustainable levels).
- The coalition agreement will further hinder the construction of a meaningful banking union for the eurozone.
- The coalition agreement does nothing to contribute to the growth and debt crisis in the euro periphery.
In order to understand these conclusions, one needs to take a detailed look at some of the measures.
Impact on German investment and consumption
To calculate how much the agreement impacts both economic growth and Germany’s current account position, we first need to understand its impact on investment and consumption in Germany. (Notes to the reader: unfortunately the analysis now becomes a bit technical. If you are more interested in the bigger picture, skip to the section on banking union. Please note, that these are back-of-the envelope calculations and should be treated with care.)
On the investment side, the media reports have focused on the proposed increase in public spending on infrastructure investment, research and development, and education of a total of €23 billion. While at first sight, this seems significant (almost 1 percent of the GDP), closer scrutiny shows that this proposed increase will not be able to bring up the public investment–to-GDP ratio in Germany. It will not reverse the trend of negative net public investment in Germany for two reasons: first, the numbers represent total additional spending over the coming four years. Dividing the headline figure by four leaves us with an annual surplus of only €6 billion (or about 0.2 percent of the GDP). Second, the relevant number in economic terms is the ratio of public investment-to-GDP. The numbers provided by the coalition are in nominal terms. Some of this extra spending is necessary to keep up with inflation and the growth of the economy. With public investment at €42 bn, an increase of annual spending by €5.25 billion annually until 2017 is necessary to keep the public investment-to-GDP ratio stable (assuming 2 percent inflation and 1 percent economic growth). So, the €23 billion might be an improvement against what the old government had planned, but it does not increase the German investment share.
That being said, there is a wild card in the agreement. The document states that municipalities will receive an additional €6 billion each year. German municipalities are of course responsible for the bulk of private investment, so some of this money might end up in additional an investment of maybe 0.2 percent of tGDP, but the exact reaction of the municipalities is unclear.
The agreement does much more on the consumption side, both through an increase of pensions for certain groups and the introduction of a legal minimum wage of €8.50.
The increase in pensions for mothers of children born before 1992 will cost around €6.5 billion annually. This money will go directly to these women, and one can expect that maybe three-quarters of this money will end up in additional consumption. (It is not the poorest who benefit from this change, but many middle income households with a second income, so it is reasonable to assume that at least part of the money will end up in additional savings.)
The next big item is the legal minimum wage. Assuming that it will directly and indirectly affect the wage level of about 20 percent of the employed population (as some of the wages just above the new minimum wage might also increase), that the hourly wage in this sector will increase by €1.5 on average, and that this sector of the population works on average 20 hours a week, the legal minimum wage will increase wage incomes by roughly €11.5 billion. However, even though this income goes mainly to households that usually do not save, this increase will not result in more consumption. As the money has to come from somewhere, it will either lead to a fall in profits or to an increase in the prices of certain services, reducing real incomes of other households. Moreover, there will be some taxes and social security contributions on this income. So, overall, it seems safe to assume that about half of the €11.5 billion end up in net additional consumption.
So over the coming years consumption will go up by almost €11 billion. Together with the increase in investment, this means that we can expect an increase in domestic demand of a little more than 0.5 percent of the GDP or an annual growth boost of a little more than 0.1 percentage points over the coming four years.
Note, however, that the coalition agreement does very little to increase Germany’s medium- or long-term growth potential. For this, a real, measurable increase in public spending and spending on education would have been necessary.
Impact on Germany’s large current account surplus
From these elements, there will be two consequences for the current account surplus. First, additional domestic demand means more imports. Second, the introduction of a minimum wage will reduce German international price competitiveness somewhat, leading to slightly fewer exports and more imports.
On the cost side, one can easily see that the impact is measurable, but not overly significant. Taking the figure of additional income of €11.5 billion, this will increase German gross wage sum by almost 1 percent. Taken at face value, this would increase German unit labour cost by 1 percent. How much of this actually ends up in a net deterioration of German competitiveness depends on a number of factors, among others, the development of productivity in Germany and the development of productivity and prices in the partner countries. Some of the increase in the wages in the low-wage sector can be seen as a compensation for inflation (€8.50 at the final date of implementation in 2017 is only €7.85 in today’s prices).
Taking the above calculation and assuming that half of the additional investment and consumption ends up in more imports – and if we assume that there will be some limited impact from the increase in price competitiveness, this might lower Germany's current account surplus by maybe 0.5 percent of the GDP. Given the persistently large current account surplus in Germany of more than 6 percent of the GDP, this might be enough to bring Germany below this threshold (which has lately caused tensions with the European Commission), but this will not be enough to safely move Germany into the more moderate magnitudes of maybe 2-3 percent of GDP.
Also, from a European perspective, this might contribute to a rebalancing within the eurozone, but not by a decisive amount. The German current account surplus will remain dangerously large.
A further blow to banking union
The coalition agreement has two interesting elements on banking union. First, it is spelled out once more that local and regional banks should be excluded from central supervision by the European Central Bank, and second, that European Stability Mechanism money can only be used for direct bank recapitalisation after bailing in bondholders, shareholders, and unprotected borrowers – and after using national resources to the point where debt sustainability of the country needs to be questioned. Moreover, it explicitly excludes a common European deposit insurance.
If all these plans are put in place, it is a recipe for a dysfunctional banking union. First, regional and local institutions can become a systemic problem (just look at Cajas in Spain). Excluding them from common oversight might plant the seeds for the next crisis. Second, excluding direct European recapitalisation except in cases where a country is threatened with insolvency will not stop the toxic vicious cycle we have observed that links a country’s banking crisis and its sovereign debt.
No end of austerity and the debt crisis
Interestingly, the agreement does not contain anything substantial that would solve the European debt crisis, re-ignite growth in the euro periphery, or even dampen the disastrous impact of austerity. Instead, the agreement contains a strong commitment to all of the deficit and debt rules in its current form. There is also nothing about a debt restructuring fund and an outright exclusion of common debt (read: eurobonds). While the Social Democrats have often criticised Angela Merkel’s approach to fighting the eurocrisis, this obviously has not been important enough for them to really push for any substantial change in the coalition negotiations.
So, how should European partners read this agreement as a whole? With its impact on the rebalancing of current account imbalances, the agreement is better than the status quo for the eurozone. However, it does not substantially improve the economic ailing of the continent, and it is disappointing on banking union.
Maybe the best thing to say about the “Grand Coalition” from the perspective of the eurozone is that the coalition will have a very decisive majority in the Bundestag and probably will be able to mobilise a large majority in Germany’s second chamber, the Bundesrat. In case the euro crisis flares up again (or the German constitutional court torpedos the ECB’s actions), this majority would be enough to change Germany’s constitution to allow for much bolder steps. For the time being, the message from Berlin to its euro partners is: the euro crisis is just not our priority. The economic problems you are experiencing are not our problems and we will not move until it becomes absolutely necessary.
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