Germany: Stuck in the Slow Lane

Germany's federal elections, set for Sept. 22, are too close to call, but one thing is certain: The next government will inherit a sluggish economy set to lag behind its euro zone neighbors for the rest of the year.

Real gross domestic product grew at an annual rate of 1.1% in the second quarter, with first-quarter growth revised up to a similar 1.1% pace. Growth through the second half is expected to continue near this tepid pace, resulting in GDP growth for 2002 averaging about 1.4%, compared to just under 2% for the entire euro zone.

Inventories provided one of the few boosts. They declined at a much slower pace--a sign of strengthening demand--contributing 3.1 percentage points to second-quarter GDP.

And household spending rose for the first time in a year. Many consumers are benefiting from union wage gains and tame inflation. Early August data showed consumer prices up just 1% from a year ago. Inflation should remain subdued, although the recent floods could lead to a temporary spike in food prices, while oil, now at $30 per barrel, could get pushed up by worries that the U.S. is gearing up to attack Iraq. But a strong recovery in consumer spending won't happen until the labor market begins to turn around.

Businesses remain the linchpin to the recovery. Capital investment fell over 10% in the second quarter, exacerbated by strikes in May, and a quick turnaround isn't likely. The August IFO Institute for Economic Research index of business confidence fell for the third month in a row. Firms are less optimistic about both current conditions and future prospects. So businesses probably won't start hiring again anytime soon.

The impact of recent floods remains a wild card. Rebuilding will bolster a weak construction sector and give a lift to GDP in the coming quarters. However, the current government's proposal to fund flood relief projects by freezing $6.7 billion in income-tax cuts scheduled for 2003 would keep much-needed broader stimulus from reaching all consumers.

By James Mehring in New York

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