The End of the Upswing Bad News Keeps Coming for the European Economy

The bad news just keeps coming for Europe's economy. With oil prices still rising and job cuts growing, the German economy also looks like it may soon be in trouble. The country's dependence on exports has made its economy particularly vulnerable.

Before leaving for her summer holiday last week, German Chancellor Angela Merkel appeared to give her last public address of the season in a bordeaux-red blazer. Her message to the people: Everything will be okay, everything is under control. In terms of the economy, she conceded, "things haven't gotten any easier," but it has been "more independent and robust" than ever before. She also noted that the ideal of "full employment" had been achieved in some regions and that if the government continued to work together, a solution to the country's chronic unemployment could be in sight.

Less than 24 hours later, Germany's most important economic indicator, the Ifo Business Climate Index, released its latest report, which "dropped like a rock," as one Frankfurt banker put it. Analysts had forecast a decline to 100 points, but it's fall to 97.5 suggested the "economic upswing is coming to an end," Ifo President Hans-Werner Sinn said.

The raft of bad economic news for Germany continued into this week. After the Ifo report's release, Germany's second-largest industrial concern, Daimler AG, announced profits had drastically collapsed -- an announcement that caused its share price to take an 11.5 percent tumble. Finally, Deutsche Bank, Germany's biggest financial institution, announced that profits had fallen by 63 percent during the second quarter.

Increasing Risk of Recession

Meanwhile, this Thursday the euro zone reported 4.1 percent inflation for the month of July, up from 4 percent in June and representing the highest level of rising costs registered since the European Union began gathering such statistics for the euro-zone in 1997. The European Central Bank's preferred target for inflation is 2 percent.

Rising prices and a related shrinking of consumer demand are increasing the risk of a recession in the area where Europe's common currency, the euro, is used.

Back in Germany, Bert Rürup of Darmstadt University -- who chairs the German Council of Economic Advisors that advises Merkel's government -- said there had been a "clear economic cooling down" and that there was a danger that unemployment could start to mount again by year's end after months and months of job creation. Because of the industrial orders that have been booked, though, he said "a recession in Germany is unlikely." He still didn't rule out the possibility, though.

This is all bad news for Merkel's governing coalition, which is made up of her conservative Christian Democrats and the center-left Social Democrats. Up until now, the government has been able to rely on sunny economic prospects that have made governing between two parties that are traditionally in opposing camps a little bit easier. Instead of allocating the fruits of the upswing as Merkel has been able to do up until now, her cabinet may soon be forced to deal with an economic downswing.

Indeed, after three years of economic growth and job creation, the Germany economy is starting to upend. Although the industrial sector may still have orders to fill, there is a dearth of new orders coming in at the moment, turnover is declining and profits sinking.

Spending Program?

Last weekend, Germany Economics Minister Michael Glos let it be known that he wants to launch a €10 billion ($15.6 billion) spending program to help cushion the country from the effects of a slowing economy. "If the economic climate cools off, then we need to discuss measures this autumn that could reinforce growth," Walther Otremba, a deputy minister in the Economics Ministry told SPIEGEL.

The program would be aimed at increasing consumer spending. The measures would include tax cuts for private households and the reintroduction of a tax break for commuters.

However, Glos -- who is a member of the Christian Social Union party, the Bavarian sister party to Chancellor Angela Merkel's Christian Democratic Union -- faces formidable opposition to his plan from Finance Minister Peer Steinbrück, who has promised to balance the federal budget by 2011. Steinbrück has enjoyed the chancellor's support, and Merkel's spokesman told the Bild am Sonntag newspaper that the government had no plan to approve Glos' program. "Such considerations are not being discussed at this time," he told the paper, according to Reuters.

But the threat of Steinbrück rejecting his plan hasn't discouraged Glos. If the economy continues to plunge in the fall, he believes the Social Democrats will come to his side and call for state countermeasures.

The speed with which the economy is deteriorating is almost unprecedented -- with economists not having seen it go down this fast in years. During the second quarter, Germany had shrinkage of between 0.7 and 1.5 percent, government experts estimate. If the trend continues during the current quarter, then Germany will meet the technical definition for a recession.

Demands Will Not Be Modest

Soaring energy prices, high commodities prices, a strong euro, a persistent global credit crisis and a bursting real estate bubble in the United States, Britain and Spain have all hit the economies of these countries very hard; and the effects are starting to spill over to other countries across Europe, including Germany.

Here, the situation could become especially troublesome come fall when the country's labor unions come to the table to negotiate annual wage increases for most industry sectors. With inflation at 3 percent in Germany, their demands will not be modest.

For their part, companies have become extremely cautious in this environement. In the construction industry, the confidence seen in recent years has completely evaporated. New projects have been delayed, and the construction sector is suffering.

Some companies are already responding with plans to cut jobs. Carmaker BMW is eliminating 8,000 positions, engineering and electronics giant Siemens wants to shave 5,250 by 2010, chipmaker Infineon is slashing 2,000 employees and Deutsche Telekom is threatening to make 4,000 of its workers redundant. The country may still be seeking high-skilled IT workers, but the general labor market looks set to suffer. The finance sector is likely to get hit the quickest. Lender Hypovereinsbank plans to cut 2,500 employees, and WestLB plans to eliminate 1,500 jobs.

The decrease in consumer demand is hitting Germany's 38,500 car dealers and mechanics especially hard. In an attempt to shore up sales, dealers are offering steep discounts and low-interest financing. But with gas prices soaring, even when people do buy, they are purchasing smaller models. Sales on the upper segment of middle-size vehicles are down 10.6 percent over last year.

Falling sales have left the important automobile industry as well as its suppliers flagging. Parts supplier Bosch is already reducing production as a "cautionary measure," according to CEO Franz Fehrenbach. And major parts supplier ZF Friedrichshafen has painfully experienced how costs for raw materials can put downward pressure on profits, especially steel prices. Within the past year, the price of steel has risen to about $1,200, almost double last year's cost.

Dire Warnings

With rising costs and sinking demand, German companies are getting caught in the pincers. Jürgen Riebel, for example, is the CEO of Florimex, a large flower importer located just minutes away from the Frankfurt International Airport. His company buys roses, carnations, lilies and other flowers from more than 50 different countries and supplies flower shops all across Germany.

Business conditions for Florimex have deteriorated rapidly in recent months as a result of exploding energy prices -- which have led to a soaring of costs for his company's refrigerated containers, shippers and green houses. His buyers are finding it difficult to pass these costs on to consumers, fearing they will stop shopping at florists altogether.

"Cut flowers are probably the most useless product there is," the wholesaler concedes. Flowers may look great in a vase in the living room, but for most consumers its a guilty pleasure they can easily dispense with.

The economic situation could get a lot worse, too; and gasoline prices could continue to climb. Those developments would likely further curb consumer demand. "Inflation has a stranglehold on consumer demand," a analysis from economists and Germany's DekaBank warned, direly.

Indeed, German industry could be facing a maelstrom of trouble. For a long time, German companies hoped that they could remain untouched by the global downward economic trend created by the US credit and real estate crisis. Instead, the crisis is threatening to hit Germany where it hurts the most: its exports on the global market.

Germany's $1.5 Trillion Export Market at Risk

Since the start of the decade, German exports have increased by 62 percent to a total annual value to €969 billion ($1.5 trillion). The percentage exports comprise of Germany gross domestic product has also risen rapidly in the past 15 years, from 24 to 47 percent. At no point in German history has the country's economy been as dependent on exports as it is today. When globalization is working to Germany's advantage as it did in recent years, it helps the economy. But if global markets are paralyzed by financial crises, then Germany's economy because disproportionately vulnerable.

Emerging economies like China and Russia prefer German companies when ordering major heavy machinery -- like power plants or petro-chemical equipment. Indeed, German exports to Russia increased by 25 percent during the first quarter and by 19 percent to China. But in absolute numbers, these new economic powers do not play a prominent role in German exports. And they're not nearly enough to offset the possible shortfall in exports in Germany's own backyard in Europe.

During the first quarter of this year, Germany exported €7.5 billion worth of goods to Russia, but it exported three times that much to France (€25.1 billion). And the €7.9 billion worth of goods it exported to China is modest compared to the close to €17 billion in goods it sold to neighboring Holland.

'Very Volitile'

Indeed, Germany's partners in the European Union remain its most important trading partners, with close to two-thirds of all its exports going to member states. But now Germany is facing difficulties in its most-important market. The last time the purchasing managers index (PMI) -- a reliable barometer of the current economic mood in the euro zone -- was as low as it is now was back in November 2001. Expectations for the service industry have fallen the most.

Great Britain has already fallen into a recession, and German exports to the country are already dropping. Exports to Italy, which has lost competitiveness because of high labor costs, have also dropped. Economic prospects in France are also growing cloudy, and businesses there haven't been as pessimistic as they are now in a decade. Meanwhile, in Spain, the real estate crisis is threatening to pull the entire economy down with it. The economies of Germany's neighbors in Europe are losing their umph and German export firms are sharing their pain.

Much suggests that when Germany's parliament returns from its summer break, it will be returning to a completely different reality. And the threat of an economic downturn is likely to have a widespread impact on the government -- both on the budget and the campaign for 2009 elections. The troubled economy is also likely to fuel a debate in Merkel's conservative Christian Democrats to move quickly to cut taxes.

The chancellor also know this. Just before leaving on vacation last week, she said she would do some fresh thinking about the state of the global economy during her holiday. After all, she said, political developments these days are "very volatile."

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