Risks of Economic Overheating: German Boom Fuels Inflation Angst
The German economic boom is fuelling inflation, and prices are expected to keep rising because of Europe's one-size-fits-all monetary policy. The European Central Bank can't raise interest rates aggressively enough to curb German price pressures because that would hurt the weaker euro-zone economies.
In the last few days of his term, outgoing Bundesbank President Axel Weber appeared extremely satisfied with how effectively he had done his job. Looking back on seven years as head of the German central bank, he said, "we actually achieved quite a lot." Everywhere Weber goes, people rave about Germany's rapid economic recovery. In other words, things couldn't be better -- that is, if it weren't for a nagging problem that threatens to overshadow all the positive news.
The latest figures are indeed unsettling. Compared with the same month last year, consumer prices in Germany rose by 2.4 percent in April -- the biggest increase since the outbreak of the financial crisis in 2008.
This means that, for the fourth month in a row, the inflation rate in the euro zone's largest economy has been above the threshold of what the European Central Bank (ECB) considers compatible with general price stability, namely two percent.
Weber, who shares the central bankers' traditional aversion to inflation, already predicts difficult times ahead for the German economy: "We cannot rule out that over the coming months we may even see a three in front of the decimal point."
Others are even more pessimistic: "We will have to get used to the fact that Germany will have inflation rates of between three and four percent in the coming years," says Clemens Fuest, an economist at Oxford University and a member of the Scientific Advisory Board of the German Finance Ministry. Olivier Blanchard, the chief economist at the International Monetary Fund, has repeatedly told the Germans that they will have to come to terms with an annual inflation rate of around four percent.
Many German politicians would tend to agree: "I expect us to see higher inflation levels than previously in the coming years," says the chairman of the Finance Committee, Volker Wissing, of the business-friendly Free Democratic Party (FDP).
The last time statisticians recorded inflation rates of four percent in Germany was 20 years ago, when the boundless enthusiasm surrounding German reunification drove up prices. Once again, an economic boom is fuelling inflation. Germany's economy is moving ahead at full steam. The country seems to have made up for nearly all the losses incurred during the financial crisis, and many companies are working close to capacity.
Inflation Overshadowing Recovery
Normally known for its judicious reporting, the British business daily the Financial Times has already recognized the first signs of overheating. The paper writes that industrial production in Germany is growing at an annual rate of almost 15 percent, putting it in the same league as China. "The delight over robust growth and falling unemployment has turned sour," says the chief economist at Commerzbank, Jörg Krämer.
Soaring prices of natural resources are currently primarily responsible for the surge in inflation. A barrel of crude oil, for example, costs 35 percent more than it did a year ago, and motorists have to pay over 10 percent more at the pump than they did just twelve months ago. This is, of course, due to the recent unrest in North Africa and the Middle East, but also the so-called Easter effect, when filling stations sharply increased gasoline prices in the run-up to the holidays.
The ECB responded by cautiously raising its base lending rate in mid-April for the first time in nearly three years. But that won't be enough to ease inflationary pressures in Germany over the long term.
The ECB faces a dilemma. Its mandate is to pursue monetary policy for the entire euro zone, not just for one country, no matter how dominant that nation may be. The central bank must take into account the needs of all member countries -- and many of them, especially the peripheral southern nations like Greece, Portugal and Spain, are still mired in recession or struggling with stagnation.
There is no relief in sight for these stragglers -- quite the contrary. Figures released last week by Eurostat, the European Union's statistical office in Brussels, show that the 2010 Greek budget deficit was higher than expected at 10.5 percent of gross domestic product. At the same time, yields on Greek, Irish and Portuguese government bonds reached record highs last week -- a sign that investors expect these countries to undergo debt restructuring, despite all official statements to the contrary.
Out of consideration for Europe's most troubled economies, the ECB cannot raise the base lending rate nearly as much as would be necessary to contain price pressures in boom countries like Germany. If it did, their borrowing costs would rise even further, choking off what feeble growth the southern European countries are experiencing.
Germany Warrants Key Interest Rate of Three Percent
If the Bundesbank were still in charge of monetary policy for Germany, as it was before the introduction of the euro, it would have long since raised interest rates far more aggressively. "In the current economic situation, a base lending rate in the vicinity of three percent would be entirely appropriate," says Joachim Scheide, chief economic analyst at the Kiel Institute for the World Economy.
"Interest rates will remain too low for us," says Deutsche Bank's chief economist Thomas Mayer. The consequences are inevitable: Germany's already strong recovery is being further fueled by cheap money from the ECB. Turning up the temperature like this can cause the economy to overheat.
"A real estate bubble could develop, just as it did a few years ago in Spain and Ireland, because the ECB's monetary policy is too expansionary for the economic situation in Germany," says Kai Konrad, chairman of the Scientific Advisory Board of the German Finance Ministry and a professor at the Max Planck Institute for Tax Law in Munich.
In the early and middle part of the last decade, the euro zone had its first experience with the negative impact of a one-size-fits-all monetary policy, but with the reverse effect: Interest rates were too high for the ailing German economy, while dangerous real estate bubbles developed in the then-booming regions of Spain and Ireland. In fact, Germany is starting to show similarities with what happened in Spain at the time.
Anyone currently looking to buy a new apartment in the heart of Hamburg is in for a shock. Over the past twelve months, real estate prices at prime locations such as the trendy Hafencity have risen by one-third to 5,899 per square meter ($814 per square foot), and in other urban areas they are even higher.
These figures are listed in the new so-called real estate market atlas published recently by public mortgage bank LBS Schleswig-Holstein-Hamburg. "There are no longer any areas where prices remain stable," says LBS head Peter Magel, who has noticed a "remarkably dynamic" market environment.
Property Boom in Top German Cities
The German real estate market is booming in Hamburg, Munich, Düsseldorf and Berlin. Large brokerage firms such as Engel & Völkers have reported record sales. "A lot of people are currently withdrawing their money from the bank and investing it in residential real estate," says Jürgen Michael Schick from the German real estate industry association IVD, "and this trend will continue throughout the year."
Investors are not merely interested in buildings and residential properties, but also farmland and forests. Some property dealers are currently reaping enormous profits. "We've seen a massive increase in land value," says real estate agent Dirk Meier Westhoff, "especially in eastern Germany."
For many years, no one was interested in the fields and forests in northeastern Germany's Uckermark region, or anything east of Magdeburg for that matter. But now prices have soared by as much as 20 to 30 percent in recent months. "This is a tremendous development in our market," says Meier Westhoff.
The buying frenzy has also surprised experts in other sectors -- such as philately. Dieter Michelson, managing director of the Köhler auction house in Wiesbaden, was "extremely surprised" that his 1920 20-mark Bavarian stamp overprinted with 'Sarre' sold for 107,100 last March. It was a record price. "Prices of high-quality items are going through the roof," says Michelson.
Other German auction houses report similar sharp price increases. "Fear of inflation influences people's buying behavior. That's something we notice," says Robert van den Valentyn, a staff member at Cologne-based auction house Van Ham.
He says that art is an internationally tradable commodity that has a transparent market -- and although it may be difficult to predict whether investing in works by young or newly discovered artists will pay off financially, van den Valentyn says that it's a very different story for big stars: "The recent spate of record auction house sales is certainly no coincidence. People want to buy tangible assets."
Late last year, Van Ham auctioned Andy Warhol's "Holstentor," a painting of the historic city gate in the northern German town of Lübeck, for over 600,000.
Moving assets into tangible materials is an international phenomenon, as can be clearly seen with the rise in precious metal prices. While gold now sells for over $1,500 dollars per troy ounce, setting a new all-time record high, silver is worth $49 dollars per troy ounce, which is just shy of the 1980 record.
Inflation Poses Threat to Economy
The recent bout of inflation in Germany is by no means harmless. It carries the seeds of future decline. When prices rise like this, everyone wants a piece of the action.
Trade unions will try to compensate for the loss of purchasing power by negotiating better wage settlements -- and they have a good chance of pushing through their demands after years of wage restraint. They also enjoy a better bargaining position as skilled workers become increasingly scarce during the economic upswing. Politicians such as Michael Meister, a finance policy expert of Chancellor Angela Merkel's conservative Christian Democratic Union (CDU) party, are already warning of such "second round effects."
Higher wage agreements drive prices up even further. Many people use this newly acquired prosperity to buy a new car or go out to restaurants more often. This rise in consumer demand doesn't just boost economic growth, it also makes things more expensive.
The downside of the boom is that higher prices and wages undermine the competitiveness of German companies. Their products become more expensive than those made by rivals in other euro zone countries, and find fewer buyers as a result. Higher wages also make Germany less attractive as a business location.
In the past, the Bundesbank played the role of currency watchdog, and would swiftly intervene to slow such a spiral of rising prices and wages, with all its adverse consequences. This is no longer possible in a monetary union.
Its members have to accept that a centrally managed monetary policy is not appropriate at all times and in all places. Instead, it is normal for interest rates to be too high for some, yet too low for others.
Since monetary policy applies equally to everyone, each individual country has a limited array of countermeasures. "In a monetary union, governments facing burgeoning inflation can only resort to fiscal policy as a countermeasure," says Lars Feld, a professor of economics in Freiburg and a member of the German Council of Economic Experts, which advises the government and parliament on economic policy issues. The government in Berlin has a choice: It can either raise taxes or reduce its expenditures.
Fighting Inflation With Taxes
Some time ago, Swedish economics professor Lars Calmfors was commissioned by his government to give some thought to what options a country in a monetary union has at its disposal to prevent economic fluctuations. He recommended an independent fiscal stability council, which would raise or lower value-added tax, depending on the economic situation. If the economy requires stimulation, consumers would receive a discount, but if it's more appropriate to slow things down, they have to pay more VAT.
Oxford economist Fuest sees VAT as an inadequate stabilizing tool, however. He says that it could exacerbate a crisis. If a stability council were to announce an imminent increase in VAT, consumers would rush out to make last-minute purchases, which would further fuel inflation. Fuest would rather impose a surcharge on income tax -- an alternative that is scarcely feasible from a political point of view.
Feld, from the Council of Economic Experts, advocates an alternative: "The government should primarily cut back on its spending, to reduce demand." Deutsche Bank economist Mayer makes a similar recommendation: "The robust economy allows the government to reduce the deficit more quickly -- ideally, by saving on expenditures." Mayer would focus on trimming costly and inefficient labor market programs.
It's quite possible that German Finance Minister Wolfgang Schäuble (CDU) would take an entirely different approach to the rising inflation rate -- and opt to do nothing at all. Indeed, this could give the treasury a distinct advantage. The spiral of rising prices and wages would bolster tax revenues -- while inflation would reduce government debts. Both of these together constitute a relatively painless way of restructuring the country's finances -- at least its public ones.
Translated from the German by Paul Cohen
© SPIEGEL ONLINE 2011
All Rights Reserved
Reproduction only allowed with the permission of SPIEGELnet GmbH