Thursday, January 04, 2007

German Economy Stronger Than Expected

It increasingly looks as though the German economy will handle the VAT hike that went into effect on January 1st better than expected. First of all because the momentum in the economy is seemingly gathering in strength. Latest sign of this was the sharp drop in unemployment in November and the fact that both manufacturing and non-manufacturing
purchasing manager indexes rose further in December (while falling in France and Italy).

Moreover, as The Economist point out, the effects of the VAT hike will be limited by the fact that first of all only half of all goods and services is affected by it and secondly because payroll taxes (aka "social security contributions") will be reduced, making the effect more limited than I previously estimated in my article on the subject.

Meanwhile, because Germany unlike some other euro-zone countries, like Spain, Ireland and France have not experienced rising house prices and therefore rising household debt, Germany will be hurt a lot less by ECB rate hikes than those countries where house prices have soared.

This means that the short-term outlook for Germany looks a lot brighter than before. First quarter growth will still probably be significantly lowered by the VAT hike, but there is a good chance the economy could recover. Exports could of course be hurt if the euro continues to rise and the American economy falls into a recession, but because of the limited free market reforms of recent years and because Germany is in the early stage of the business cycle, growth will probably stay fairly strong (by German standards).

However, in a longer perspective, growth prospects are weaker because reforms haven't been radical enough and because of demographics (Germany's working age population is shrinking at a rate of roughly 0.5% per year).


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