Three ways Germany can kickstart growth in Europe

Recently, a number of positive indicators suggest that the recession in the euro area is coming to an end. The European Commission’s economic sentiment indicator (ESI) rose from 91.3 to 92.5 and business climate also improved in July. Even in countries with still severe difficulties such as Portugal, business climate has improved in July. In Spain, GDP dropped by “only” 0.1% in Q2 while the ESI shows a slow but continuous improvement during the last 12 months reaching 93.5. For Italy, economic sentiment is at 89.5 almost 3 points over June measure and for France, sentiment indicators has been rather stable around 89 during the last year. Finally, in Germany the ESI stands at 100.5.

So does this suggest that the crisis is near to be over? Not at all, I would not declare victory and instead argue that more policy actions are needed.

Economic growth in the euro area as a whole is still weak with GDP growth for next year forecast to amount to 1.2% by the European Commission. While this would end the recession, growth would still be far too weak to lead to a significant increase in employment. Unemployment will thus remain unacceptably high across the euro area, in fact it is forecasted to decline only 0.1 percentage points to 12.1%.

In the pre-crisis years euro area growth was very much driven by the euro area periphery while German growth was below average. German growth benefitted from exports to the periphery countries. Now, economic growth in Spain but also in Ireland very much depends on exports. In Spain, exports have been the main positive contributors to GDP growth in the passing years but they are still not strong enough to bring the country into positive growth territory given the sluggish domestic demand. More structural reform in the euro area periphery will be needed to achieve the adjustment and increase exports. This includes labour markets but perhaps more importantly the numerous regulations at the firm level which hold back competition and increase rents while preventing prices from adjusting. But it would also help if German growth were more substantial.

I would see three central factors that would help increase German growth and thereby more decisively end the euro area recession:

First, German public investment is currently one of the lowest in the EU and in many areas the lack of public investment is becoming a bottle neck for growth. Germany would benefit from recycling some of its savings in domestic public investment, especially at a time when borrowing costs are so low. The return on public investment should also be higher than the return that Germany has made on its foreign investments. In fact, Germany as a whole made very substantial losses on its foreign investments, including in the US subprime market.

Second, conditions for immigration could be improved further. While some years ago, Germany was still a net emigrant country, in 2012 more people came to Germany than left the country. The booming labour market means that many corporations increasingly have to look for foreign specialized workers to help in production. But immigrants do not necessarily have the full skill-set needed. More specialized training, language courses and the like would be a useful investment for Germany and would also facilitate labour migration from countries with high unemployment rates.

Third, some parts of the service sector are still heavily regulated. Liberalizing this sector will help to increase activities in the sector. A liberalized service sector will be an important contributor to the efficiency of the German manufacturing sector and a source of new jobs, including for immigrants. Of course, this would also shift the structure of German industry towards more services. At the same time, German growth would increase. Such a shift would also be associated with rising wages in Germany that would further boost demand for foreign products.

Recent sentiment indicators of the euro area are encouraging but return to lasting health of the euro area economy will still require major further steps. Those include structural reforms in the euro area periphery but also in Germany as well as decisive steps to clean-up bank balance sheets and create a banking union. In their absence, unemployment will remain high for long.

Read the Re-emergence of Europe by Klaus Schwab.

This article first appeared in bruegel.org.

Author: Guntram Wolff is the Director of Bruegel.

Image: The European Union flag is seen outside the seat of Germany’s lower house of parliament in Berlin REUTERS/Thomas Peter.