What's Bad for Germany Could Be Good for Europe

Europe works in mysterious ways.

Even those familiar with Europe's plight will find the latest economic forecasts grim reading. You thought the outlook for the euro area was bad already. It's getting worse, says the European Commission.

That said, Europe works in mysterious ways. In this deepening pessimism, there might just be grounds for optimism. The projections make plain the true character of Europe's economic malaise. It's no longer (if it ever was) a question of a debt-burdened periphery dragging down an otherwise healthy core of modern, well-run economies. The forecasts confirm that the rot has spread not just to the core but also to the core of the core: Germany. Europe's largest economy now has more incentive than ever to help revive the larger European economy.

Germany's economy has been slowing for a while, but the new forecasts are still pretty shocking. In May, the commission predicted growth in German gross domestic product of just 2 percent next year. This has been halved, to a little more than 1 percent -- the same dismal rate that the forecasters now expect for the euro area as a whole. Underlining the point, as the center of Europe deteriorates, growth in the U.S. and the U.K. continues to improve.

The commission has cut its inflation forecasts for the euro area as well. It now expects prices to rise by 0.5 percent this year and 0.8 percent next -- compared with its previous forecasts of 0.8 percent and 1.2 percent. The European Central Bank's inflation target of "below, but close to, 2 percent" is slipping further out of sight.

This combination of slow growth and persistently low inflation is dangerously self-reinforcing, because it keeps debt-to-GDP ratios high across the whole euro area. This depresses confidence even further, which puts additional downward pressure on demand. Investment spending in Europe has been especially hard hit -- including, again, in Germany.

For the moment, at least, fears of a debt-induced breakup of the euro area have receded. They have been replaced by an equally dismal prospect -- lasting and widespread stagnation, with no exemptions for the region's most powerful economies.

If there's hope, it lies in that last point. It's one thing for Germany to lecture Greece, Italy, Portugal and Spain on the need for more responsible economic policies from a position of economic strength. It's quite another to issue instructions when the German economy is failing, too. In addition, Germany has the fiscal capacity to spur demand with tax cuts and higher public spending. The best policy for the whole euro area has long been obvious, and it's now increasingly clear that it makes sense for Germany itself.

QuickTake Europe's QE Quandary

With luck, Germany's worsening economy may also soften its resistance to a much more aggressive monetary easing by the European Central Bank. The ECB is acting already, within the scope allowed by its rules. But those rules need to be relaxed, so that the central bank can adopt full-bore, Fed-style quantitative easing.

Efforts to support demand in the euro area are long overdue. Maybe, just maybe, Germany's stalling economy will help its leaders see the urgency.

--Editors: Clive Crook, Michael Newman.

To contact the editor on this story:
David Shipley at davidshipley@bloomberg.net