From black to red zero in Germany? Don’t bank on it

From black to red zero in Germany? Don’t bank on it

Berlin has tightened deficit discipline as ‘bond vigilantes’ return

Germany has the means to fire up its ailing economy, but will it use it? Berlin’s fiscal strength gives it an option most other countries can only dream of to revive growth: a deficit-funded investment plan.

This option would see Germany abandon its attachment to a “black zero” balanced budget and dip into the red to fund a fiscal stimulus programme to retool the economy. Such is Berlin’s aversion to debt, however, that not only is it refusing to take the deficit-coated medicine, it is actually looking to tighten its fiscal constraint — even as the economy risks falling into recession for the second time within a year.

After loosening the national purse strings during the pandemic, Germany’s policymakers are reverting to type. They are also keenly aware that “bond vigilantes” appear to be back, ready to impose discipline on policymakers and press them to keep inflation expectations under control through higher government bond yields.

Where does this leave investors? The reappearance of bond vigilantes suggests central banks could keep interest rates “higher for longer” to tackle structurally higher inflation, which is being buoyed by tight labour markets and increased demand for the materials and investments needed for the energy transition.

In this context, US and eurozone investment-grade corporate bonds of up to five-year duration offer enticing yields and should remain attractive as long as inflation is brought under control and the coming economic downturn is moderate. It is worth noting that any prospect of the European Central Bank riding to Germany’s rescue is far-fetched. Just as Berlin prioritises fiscal discipline over growth, so the ECB puts price stability first. We do not expect the ECB to cut rates until at least the second half of 2024.

Berlin is actually looking to tighten its fiscal constraint — even as the economy risks falling into recession for the second time within a year.

Structurally higher inflation is being reinforced by the “reshoring” trend, which is a direct result of heightened strategic rivalry. This trend will put pressure on labour markets, which are already tight. The increasingly fraught geopolitical environment is also starting to eclipse the significance for the global economy of central banks. In short, we are moving from an era of monetary dominance to one of geopolitical dominance.

This new normal challenges the multilateralist German model. Put crudely, Germany relied for decades on cheap Russian gas to produce goods that it exported to China, while enjoying the safety of a US defence shield. Now the Russian gas has gone, China has become the world’s biggest exporter of cars, and Berlin is having to increase its military spending to bolster national security after Russia’s invasion of Ukraine.

To be sure, Germany is not in the same state as in the 1990s, when, after reunification, it was dubbed “the sick man of Europe”. But the competitiveness Germany won with reforms in the early 2000s is waning now, and structural problems are being exposed by the changing dynamics in the global economy on which the German export engine depends for growth.

Indeed, a decade after the eurozone crisis, the relative position of countries in the south of the currency bloc and Germany has reversed. Greece is now leading a robust post-pandemic recovery in the economies of the euro area’s south. We expect German gross domestic product to contract 0.3 per cent this year and the wider eurozone to expand 0.5 per cent.

The reappearance of bond vigilantes suggests central banks could keep interest rates 'higher for longer' to tackle structurally higher inflation.

There is scope for Berlin to take action:

German public investment stands at 2.7 per cent of GDP, behind 3.4 per cent for the US. However, Germany is planning to trim spending and to stick with its debt brake rule, which it suspended between 2020 and 2022 to help deal with costs associated with the Covid-19 pandemic.

There is no political consensus in Berlin to drop this rule, which was inserted into the constitution in 2009 to limit the central government’s structural budget deficit to 0.35 per cent of GDP. While there could be some “off balance sheet” creativity at the edges, as with Germany’s €100bn special fund for military spending, Berlin wants to keep debt issuance tight, in keeping with the national instinct that is a legacy of hyperinflation in the 1920s.

The Bundesbank has urged German companies to reduce their China exposure. Efforts at a corporate level to improve productive capacity as part of reshoring mean increased capital expenditure, from which a number of industrial sector firms should benefit. German corporates could yet be part of this retooling drive, but the structural problems facing their national economy will make it harder without a fiscal fillip.

The article was published in the Financial Times.
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