The European Central Bank (ECB) could face a thorny problem in the coming quarters. On one hand, German economic performance is robust. On the other hand, economic fundamentals in the other euro area countries are weaker. Germany is the euro area’s largest economy with a very low unemployment rate of 3.7%. Meanwhile the unemployment rates in France, Italy and Spain are 9.8%, 11.3% and 17.1%, respectively. Due to this weakness, the ECB maintains a ‐0.40% interest rate on bank deposits and a base lending rate of 0%. As further economic stimulus, the ECB is also pursuing aggressive “Quantitative Easing” policies similar to the Fed’s bond purchases in the U.S. after the financial crisis.
While the ECB’s easy money policies averted the euro’s collapse and reinvigorated modest economic growth, they threaten to ignite inflation in Germany. At present the German inflation rate is a manageable 1.8%, but substantially higher than the 0.37% average inflation rate recorded in 2015 and 2016. From Germany’s perspective, easy money keeps the euro weaker than it should be. The weak euro boosts German exports, but it also raises concerns about economic overheating.
Germany’s surprising economic dynamism and flexibility are the result of policies enacted more than a decade ago. Known commonly as the “Hartz Reforms” (named for the legislative committee chairman), Germany slashed generous early retirement benefits and granted employers greater freedom to fire workers. Without burdensome red tape, employers hired more aggressively, and older workers stayed in the labor force longer. The dramatic decline in the German unemployment rate from 11.2% in 2005 to 3.7% at present (Chart 1) understates German job creation in recent years. Even as unemployment declined, millions of workforce dropouts found employment. Germany’s labor force participation rate – the percentage of the population either employed or looking for work ‐ now exceeds the United States (Chart 2).
German labor laws prior to Hartz were more rigid and expensive like the current laws in Italy and France. By expanding the labor force, the Hartz Reforms averted German wage inflation giving the ECB room to save the euro with aggressive monetary policies. With more rigid labor markets, the ECB’s stimulus could have stoked inflation in Germany. Hyperinflation doomed democracy in Germany prior to World War II and aided the Nazi’s rise to power. Ever since World War II, Germans have been fearful of accelerating inflation. If the ECB advanced inflationary policies, Germany would likely abandon the euro. Rather than collapse as many predicted, the euro survived, and Germany’s Hartz Reforms provide a successful model for other countries to emulate (the newly elected French government is about to enact labor reforms reminiscent of Hartz).
Although the Hartz Reforms paid big dividends for Germany and Europe, its benefits are reaching their limits. German unemployment cannot fall much further, nor can labor force participation rise indefinitely. Therefore, the ECB’s monetary stimulus could end well before other euro area economies are fully recovered.
In the United States, the Federal Reserve was able to delay unwinding its policies until the American economy was clearly growing without financial life support. The ECB will not have the same luxury. Since its unemployment is very low, Germany could experience accelerating inflation. This despite muted inflation in the remainder of the Eurozone, where unemployment is still quite high (albeit declining). Since they all share the same currency, the ECB might need to remove monetary stimulus to accommodate Germany, despite the ongoing need for it elsewhere. When viewed as a whole, unemployment in the euro area is high and inflation is low. In the United States, where labor and capital move more freely, the Federal Reserve can often disregard regional economic differences when setting monetary policy. Europe is quite different. Despite the common currency, labor and capital are less mobile across country borders within the Eurozone. Rising inflation in Germany could dictate ECB policy well before economic conditions warrant such a shift in the remainder of the Eurozone. Meanwhile, with money flowing out of low yielding European bonds, interest rates in the U.S. and around the world are probably lower than they would be otherwise. A shift toward higher interest rates in Germany could reduce European demand for dollar denominated bonds, pushing American interest rates higher.
Germany proved that flexible labor markets create jobs. This very American sounding idea often receives a skeptical audience in Europe (including Germany), but other countries are slowly moving in this direction. Spain liberalized its labor laws after its unemployment rate spiked to 28% during the Euro Crisis and France is about to do so now. This will allow the Spanish and French economies to grow even as monetary stimulus is removed. Ultimately German economic strength could force a shift away from ultra‐low global interest rates faster than many investors currently predict.
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