A Double Blow to Germany's Economy

Rising inflation and plummeting consumer buying power feed fears the German Central Bank may be forced to raise interest rates

German Chancellor Angela Merkel attempted to put Germans in the holiday mood last Wednesday with a veritable fireworks of good news. The country has "regained its economic strength," the chancellor announced triumphantly in her report on the government budget at Berlin's Reichstag, the seat of the German parliament, the Bundestag. Germany's "international competitiveness" is on the rise once again, she said, and fewer and fewer people should be "worried about their jobs."

As could be expected of a speech from the chancellor only a few weeks before important state parliamentary elections, Merkel rounded off her sunny assessment of Germany's economy with a statement clearly intended to generate optimism among delegates to the upcoming convention of her party, the Christian Democratic Union (CDU), in Hanover. "The recovery," she concluded, "is making itself felt among ordinary citizens."

Unfortunately for the chancellor, her rosy message was quickly dispelled by the headlines in newspapers that very morning, headlines that described a less than comforting reality. According to information recently issued by the Federal Office of Statistics, inflation has reached the 3 percent threshold -- for the first time in 14 years. The figure is well above the level considered acceptable by the European Central Bank.

What the chancellor studiously ignored in her speech is the fact that German citizens have been seeing inflation rising for months now. The increase in consumer prices had been so moderate for years that experts were predicting the "death of inflation."

But now prices are shooting up, and in places where it hurts Germans the most. Homeowners and renters are being hit with price hikes, some in the double digits, for heating oil, natural gas and electricity. Businesses face hefty surcharges for leasing additional trucks to transport their products. Drivers have seen so many repeated price increases at the pump that the German automobile club ADAC is calling for a "gasoline summit" with the chancellor.

Late last week, it was announced that more than 300 German electric utilities plan yet another price hike next year, this time by up to 34 percent.

Most of all, prices are rising for those ordinary goods that have been becoming less costly for years, so much so that consumers were taking sinking prices for granted. On everything from vegetables to fruit juice, and flour to cheese, consumers in recent months are suddenly faced with prices significantly higher than they were in the past.

The supermarket price of a liter of milk, €0.55 ($0.80) a year ago, is now €0.75. In the same time period, the price of grapes has increased by 20 percent and that of cauliflower by 33 percent. Butter is 46 percent more expensive than it was a year ago, and for other dairy products like curds, retailers in some regions are reporting "supply bottlenecks" and "stockpiling."

Germans react quickly when they perceive a threat to the value of their money. The experiences of the early 1920s, when a pound of butter cost 4 trillion marks, has firmly imprinted the fear of inflation into the German genetic code. Since then, maintaining stable prices has been a central tenet of German economic policy. Those who sought to violate this unwritten rule quickly felt the wrath of the central bank and of voters -- like the Social Democratic government of former Chancellor Helmut Schmidt, whose administration saw inflation rise above 7 percent in 1981.

Seven percent inflation is still a long way off, but the rate at which prices are currently rising has surprised all experts. Only a few weeks ago, economists were convinced that, for the first time in years, German workers could finally look forward to rising real income. But it is now becoming clear that price inflation will outpace wage growth once again this year, a combination that is especially tough on low-income workers and retirees. Axel Weber, the chairman of the Bundesbank, Germany's central bank, warns of an "unsettling rise in prices across the board."

The government is also worried. Although experts at the ministries of finance and economics are not overly concerned about the rising inflation rate alone, they are worried that the combination of inflation, an international financial crisis and the strong euro will weigh heavily on the German economy. "Each factor alone is not very dangerous," says Simon Johnson, chief economist with the International Monetary Fund, "but together they produce a menacing mix that could put a significant damper on the outlook for growth throughout Europe."

If the pessimists are right, the government could already face daunting challenges by next year. Instead of enjoying a solid upturn, Germany's grand coalition government of left-leaning Social Democrats and conservative Christian Democrats would have to make adjustments for less growth, higher interest rates and shrinking tax revenues.

Their concerns are justified. A troubling combination of causes is behind the price increases of recent months. The price of oil, for example, has risen by close to 40 percent since the beginning of the year, with oil now at close to €60 a barrel.

Higher crude oil prices have serious repercussions on the overall price structure of the economy. The retail costs of petroleum-based products, like gasoline, diesel fuel and heating oil, rise virtually in tandem with prices on the spot markets. The price of natural gas, traditionally tied to that of oil, also rises when crude oil becomes more expensive.

Growing demand in the European Union's new member states and Asia's emerging economies also leads to higher prices in German supermarkets. Eastern Europeans, in particular, are taking advantage of their newfound wealth, and are buying large quantities of dairy products from Germany. Nowadays, German cheese is as much a fixture on supermarket shelves in Prague as Czech beer is in Germany. But Eastern Europe's growing demand for German food and dairy products translates into shortages in German refrigerators.

The consequences are inevitable. The high demand for German products abroad and short supply at home invariably lead to higher prices for German consumers.

Part 2: A Turn in the Tide of Globalization

The phenomenon shows that Germans are not only competing for jobs and high-tech products, but also for their share of such ordinary products as cheese.

This development is indicative of a turn in the tide of globalization. Until now, economic activity in the world's emerging economies tended to depress prices, at least in industrialized nations. They flooded global markets with their cheap, mass-produced products -- from toys to textiles to tools. Heightened competition with traditional, Western manufacturers ensured that prices were kept under control.

This effect is beginning to wane, though. On the one hand, India and China are beginning to sell more expensive products. On the other hand, the increasingly affluent middle class in these countries creates demand on global markets, driving up prices.

Nevertheless, a significant share of the current wave of price increases is homegrown. Those responsible are sitting, in full view of the public, on the government bench in the Bundestag, especially Chancellor Merkel and Finance Minister Peer Steinbrück. At the beginning of the year, the grand coalition enacted the biggest increase in the value-added tax (VAT) in postwar German history. This reduces the purchasing power of the euro, because merchants have raised their prices to offset the tax increase. "One percentage point of the current inflation rate is attributable to the increase in the VAT," says Joachim Scheide, an economic expert with the Kiel Institute for the Global Economy. "Without it, inflation would be at only 2 percent."

In a highly favorable economic environment, it made sense to impose a higher tax on consumers. The German economy had already recovered in 2006. Unemployment was down and the employed were less concerned about losing their jobs. But if people feel secure and begin earning more, consumption goes up, even when prices are rising. This, in turn, encourages merchants to raise their prices even beyond a level that would have been justified by the VAT increase.

The economic recovery, higher commodity prices and the tax increases are all reasons for inflation, and yet they do not tell the full story. For inflation to pervade the entire economy, more money must be in circulation than the economy needs to complete its transactions. The European Central Bank (ECB) made sure that this was the case by keeping interest rates at historically low levels for years in an effort to stimulate the economy.

The ECB pumps money into the economic cycle so that its price -- interest rates -- remains relatively low. The flipside of this cheap money policy is that it provides the economy with an abundance of cash. In recent years the volume of money in circulation was periodically growing at double-digit rates. With its policies, the ECB essentially laid the foundation for the current and future price increases.

The effects of inflation are not always damaging. Inflation can even be beneficial in the short term. For instance, German companies currently enjoy a competitive advantage over their Dutch competitors, because real interest rates -- interest rates adjusted for inflation -- are now lower in Germany than they are in the Netherlands. Although the same prime rate set by the ECB applies in both economies, prices are rising at a faster rate in Germany, reducing the cost of borrowing.

On the other hand, price increases also create serious drawbacks for businesses. The higher wages they are paying their employees, who are also potential customers, are being completely consumed by inflation. Furthermore, consumers who are forced to spend more on gasoline and heating oil than they did last year end up cutting back on discretionary spending -- for things like restaurants and Christmas presents. Retailers are already complaining about a drop in consumption.

This declining consumption could throw off the predictions of economists, who base their still relatively optimistic forecasts on the assumption of growing domestic demand. But if rising prices put a damper on demand, the outlook for the economy as a whole will worsen.

An intervention by the central bank poses the greatest threat to the economy. If it believes that prices are spinning out of control, it must intervene. Despite the smoldering crisis in the financial markets and the rising exchange rate of the euro, the ECB could very well raise interest rates.

The consequences could be fatal. Higher interest rates make it more difficult to run businesses. Production facilities that are less profitable than monetary investments are closed and capital investments are cancelled. This could ultimately lead to job losses, economic slowdown and, in a worst-case scenario, the economy sliding into recession.

The central bank is "in a tough spot," says economic guru Beatrice Weder di Mauro, who belongs to the government's economic advisory panel. By leaving interest rates untouched, central bankers further encourage inflation. If they raise interest rates they could very well send the entire European economy into a tailspin.

Experts are worried that the ECB could ultimately take both approaches. This could lead to what economists call stagflation, a disastrous combination of rising prices and declining growth rates. European nations last suffered from stagflation in the 1970s and 80s.

At the cost of ever-rising inflation, governments and central bankers at the time tried to stimulate growth, only to look on as their economies plunged into recession when they were abruptly forced to stop printing money.

The situation is unlikely to spin that far out of control this time. On the one hand, the pressure on prices in Germany is decreasing because the effects of the VAT increase will expire next year. On the other hand, emerging economies like China and India are taking noticeable steps to cool down their overheated economies.

Nevertheless, experts agree that the recent price increases will contribute to a slowing down of the German economy. The question is: by how much?

While Hans-Werner Sinn, the president of the renowned Ifo Institute for Economic Research, believes that the economic slowdown will be brief, Martin Hüfner, the former chief economist at HypoVereinsbank, warns of a "significant impact on the economy." Hüfner fears that the extent to which current higher prices will reduce consumer purchasing power has "not even been reflected in the financial markets yet," and that markets could soon face "the next rude awakening."

This could happen if companies and trade unions are forced to make adjustments for rising inflation. Once they embark on a cycle of competing wage and price demands, an "inflation mentality" could return, warns Kiel-based economic expert Joachim Scheide. The effects of this upward spiral would be fatal, as the fear of inflation stimulates inflation.

According to Scheide, the ECB, under its current chairman, Jean-Claude Trichet, has only one choice: raise interest rates to wipe out expectations of inflation before they can take hold. This would deal a double blow to the economy, as it would cause the euro to continue to rise, putting even more of a strain on the economy.

Frank Bsirske, the president of Germany's service sector union Ver.di, recently showed why such concerns are justified. In recent years, Bsirske told a group of hospital employees in Stuttgart that the effects of wage increases have repeatedly been obliterated by hefty price increases. This, he told his audience, is why employees must achieve "significant real pay increases" during the upcoming public sector wage negotiations.

Bsirske also revealed how he expects workers in the service sector to achieve their goals. A major public sector strike, the head of Ver.di predicted, is "very likely" in the coming year.

Translated from the German by Christopher Sultan

Before it's here, it's on the Bloomberg Terminal.