The German question

To grasp the dysfunctionality of any nation you must look into its past. For Germany, you take the 30 years, 1914-45. Everyone knows what you see – two world wars, for whose origins Germany bears the heaviest responsibility, and a spell of hyperinflation that wrecked Germany’s first attempt at democracy, the Weimar Republic.

It may be that the hyperinflation has had the greater effect on Germany’s collective consciousness, as we shall see shortly. However, the wars shaped the way Germany has seen its role in Europe since the early 1950s – to be a model citizen, constructive and committed but never pushy. The peak of Germany’s aspiration was to be a bigger version of Switzerland – economically successful, politically reticent and militarily nowhere.

From the perspective of seeking a country in which to put capital, those may be great criteria; and there is no question that investing in Germany still has much to commend it. Yet Germany’s ‘maxi-Swiss’ stance has been an increasingly tough act to follow since the demise of the Soviet empire and Germany’s reunification. The euro crisis – for whose duration Germany has prime responsibility – has seen to that. So let’s start with the basic problem that Germany faces – it is simply too big to be anything but Europe’s leader, yet it shows too many signs of being the wrong sort.

Europe’s leader

The hegemon, responsible or coercive?

Here’s a puzzle. Arguably, the crisis in the so-called sub-prime mortgage market of the US – the one that led to 2008’s global credit crunch – was far more serious than the local difficulty in Greece from which Europe’s euro crisis ensued. So why it is that the global crisis was sorted out in fairly short measure, while the euro crisis has dragged on for five years, still with no end in sight? The puzzle is all the more odd if you consider that the global financial crisis, by definition, involved lots of loosely-connected countries, while the euro crisis involves comparatively few countries that depend on each other and are closely tied by the institutions of the euro zone and the EU. So euro zone countries should have more incentives to work together and have more tools to do so.

For Matthias Mattijs, of Baltimore’s Johns Hopkins University, the explanation starts with ‘hegemonic stability theory’, an idea that was used to explain the Great Depression of the 1930s and which has been revived by events of recent years. The theory suggests that any international system is likely to work best when there is a single dominant nation that can impose its will. The absence of such a nation in the 1930s contributed to the policy errors that turned a recession into deep depression.

However, in a paper published last summer, Mr Mattijs takes the argument one step further by suggesting that the workings of an international system will heavily depend on the ideas and assumptions employed by the leaders of the dominant nations. In short, Mr Mattijs reckons that the global financial crisis was solved fairly quickly because the US – obviously the dominant player – acted as a “responsible hegemon”. Meanwhile, the euro crisis has persisted because of “Germany’s refusal to play an equivalent leadership role within Europe’s regional context, instead acting inadvertently as a ‘coercive’ hegemon”.

True, there was never any doubt that the sub-prime mortgage crisis was rooted in the US and therefore the US should shoulder the main burden of sorting it out. Yet the dangers to Germany stemming from Greece’s debt crisis may be worse. After all, Germany is far more integrated into Europe’s economy than the US is integrated into the global one.

Also, it is clear that Germany’s leaders are fully aware of their responsibilities. Mr Mattijs cites a 2010 speech by Wolfgang Schäuble, then and now Germany’s finance minister. Mr Schäuble told an audience in Paris: “A stable world economy does not materialise by itself. It is a public good that must be provided in the face of national self interest. For the world economy to be stable, it requires a leading nation, a benign hegemon or stabiliser.”

Almost certainly, however, Mr Schauble’s idea of how a benign hegemon should act – and, by extension, the idea held by most of Germany’s leaders – is at odds with the way that the US’s leaders acted in 2008-09.

Again, it comes down to history. Germany’s leaders – scarred by Germany’s hyperinflation of the 1920s and its consequences – feared the effects of moral hazard if they tackled the euro zone crisis by stimulating Germany’s domestic demand, relaxing the fiscal levers, even letting inflation perk up a little. Instead, the conventional explanation of the euro crisis was that “Club Med was having a party”, as Hans-Werner Sinn, a leading German economist of the ordoliberal school, has provokingly put it.

As such, the best antidote was what the Swabian housewife would recommend – a good dose of austerity, fiscal rectitude and domestic restraint. This south German figure was first introduced to the world by Germany’s chancellor, Angela Merkel, in 2008 to explain the US sub-prime crisis. The bosses of US banks, according to Ms Merkel, should have asked the Swabian hausfrau how to manage their lending. The epitome of thrift and frugality, she would have kept them on the straight and narrow, suggested Ms Merkel. True, such Swabian virtues are perfect for managing a household, perhaps even right for getting a single exporting nation out of a hole (a bit like Germany in the early 2000s). But they are of little use – possibly even harmful – when they are applied to a multinational context.

In short, the ideas and assumptions that underpin the policies and prescriptions of Germany’s leaders are the wrong ones to deal with an international crisis such as the threat to the euro. Still, perhaps it’s not too surprising that the assumptions are flawed. Arguably, there has been something harmful at the heart of Germany’s economy policy for decades.

The economy 1

The inflexible model

“The self image of Germany,” says Hans-Michael Trautwein, the director of ZenTra, an economics think-thank at the universities of Bremen and Oldenburg, is of “an export nation that traditionally celebrates its top-three positions in global exports like victories in world championships”.

Historically, such export orientation may have been born of necessity. When the German federation was being established, and in the inter-War years, domestic demand was consistently weak so it made sense for industry to focus on export markets. Thus, whether as cause or effect, Germany’s leaders built up an economic model that fostered its leading industries – engineering, vehicles manufacture, chemicals – and re-enforced the country’s exporting success.

The building blocks of this model are well known. They include:

■ universal banking, which supplies long-term capital to its corporate customers;

■ vocational training in an apprentice system geared to the needs of industry;

■ a co-ordinated approach to wage bargaining;

■ regulated competition that aims to prevent abuse of market power;

■ an independent central bank working to a rigid monetary policy

All very organised; all very co-operative; all very German. It powered West Germany’s wirtschaftwunder, the economic miracle of the 1950s and ’60s that established the country as Europe’s economic power house. It did the same in the 1970s and ’80s as West Germany overcame stagflation and, in the process, acquired the label Modell-Deutschland. And it repeated the trick after the creation of European monetary union in the early 2000s in the process known as ‘Germany goes global’.

There is, however, a fault in the machine. According to Professor Trautwein, “the export orientation of the German economy seems to be conducive to disruptions in the international monetary order time and again”. One effect of the wirtschaftwunder of the 1960s was a German trade surplus that contributed greatly to the breakdown in 1971 of the post-War Bretton Woods system of fixed exchange rates; a system that greatly favoured Germany’s exports by setting the exchange rate for the Deutschemark too low.

In the 1990s, Modell-Deutschland benefited from the European Monetary System (EMS) of loosely-pegged exchange rates in much the same way – and its effect on the system was the same, too. The EMS was soon caricatured as the ‘DM Club’ – and that was the core problem. Because of Germany’s massive trade surpluses, Germany’s central bank, the Bundesbank, dominated. And whenever domestic inflation was rising, the Bundesbank’s response was to raise interest rates even though weaker countries in the EMS were likely to tip into recession. The ultimate moment came on Black Wednesday – 16 September 1992 – when John Major’s UK government pulled sterling out of the EMS to prevent further losses. But the root cause was that Germany needed higher interest rates because its economy was overheating in the reunification boom while the rest of Europe needed lower rates.

Germany got its way; the UK quit; France suffered a savage recession. The flaws of exchange-rate mechanisms were exposed (again) then the European Union marched merrily on to full monetary union.

And – would you know it? – that’s when it happened again. It is conventional wisdom – disputed mostly in Germany – that the country’s trade surpluses were a key part of the imbalances that turned the Greek debt problem into an existential crisis for the euro. Through a combination of domestic restraint, buoyant export markets and, in effect, a cheap currency, Germany’s trade surpluses have climbed to the extent that the country now runs the world’s biggest current-account surplus.

As Table 2 shows, Germany’s current-account surplus is much more than the euro zone’s total surplus (in other words, in aggregate, the other 18 countries run a €68bn deficit). Sure, the debtor nations are not directly in hock to Germany, but the effect is much the same. Germany, effectively the net lender, wants – or rather its leaders want – the net borrowers to do what its citizens did in the early 2000s and it does not want the borrowers – most especially Greece – to pursue policies that could maximise moral hazard even if they also minimised austerity.

You can see where they’re coming from. The countries of southern Europe don’t exactly have a great track record in so many aspects of pursuing sound policies. Still, it may be that Germany’s leaders are conveniently ignoring the non-recurring factors that make their country seem stronger than it really is.

The economy 2

Weaker than it looks

Oldenburg University’s Professor Trautwein is in no doubt that a brace of one-off factors have helped Germany’s economy look more powerful than it is. The first was the enormous rise in demand during the 1990s and – especially – the early 2000s for the manufactured goods for which the country is best known, machinery, vehicles and chemicals. His concern is that much of this demand was a spike as China especially, but also emerging markets in east Europe and Southeast Asia, made a dash for growth. True, the EU remains Germany’s main export market – France accounts for nearly 10 per cent of exports and the UK over 7 per cent. But China came from nowhere to be Germany’s sixth biggest customer, buying over 5 per cent of its exports. Yet in future markets outside the EU – far from being Germany’s future, as many of its business leaders seem to assume – may be static at best and quite likely shrink.

Second – and closely related to Germany’s export success – Germany has benefited hugely from giving up the D-mark and adopting the euro. Professor Trautwein puts it bluntly: “The export boom of the 2000s would have been hardly sustainable if Germany had still had a national currency.” In addition, with its own currency, Germany would have suffered badly after the global financial crisis of 2008. The currency’s ‘safe-haven’ status would have meant that German goods were priced out of world markets; whereas the effect of trade deficits among other euro zone countries and then their debt crises meant that the weakening euro “worked like a protective blanket for the German economy”.

Yet within Germany there is little appreciation of the euro’s beneficial effect. On the contrary, according to Marcel Fratzscher, the head of the German Institute of Economic Research, “euro illusion” is one of three myths that, he reckons, lies behind “many Germans’ failure to understand that Germany has the most to lose from the euro’s collapse”. Specifically, says Mr Fratzscher, euro illusion is the notion that Europe’s financial crisis is about the limitations of forcing a single currency on to 19 very different sovereign states and that, therefore, Germany would be better off outside the euro zone.

The second – and linked – myth “that blinkers many Germans is that other European governments are after their money”. Mr Fratzscher thinks that’s why Germany’s leaders have been reluctant to engage in the discussion about a proper banking union among the euro countries.

But third – and perhaps most important – is the illusion that the German economy is doing really well. That’s partly because, as mentioned earlier, Germany’s economic success is measured by the size of the country’s current-account surplus. Also it’s because Germany’s unemployment rate – at 6.4 per cent – remains far lower than in the years immediately after reunification and the federal government is once again in fiscal surplus (see table 1).

The truth of Germany’s economic performance, says Mr Fratzscher, is less comforting. The improvement in productivity since 2000 (see Table 1) looks good largely because real wages (adjusted for inflation) have hardly risen since 1999. That has left two-thirds of German workers actually worse off since reunification. Meanwhile, the country’s employment success – much like the US and UK – is based on creating lots of part-time jobs. As a result, total hours worked have barely increased. And Germany’s investment rate – though better than many advanced economies (see Table 3) – is nothing special. Indeed, given the rate at which Germans save, it is poor. As a proportion of economic output (GDP) Germans save 26 per cent, which compares with 19 per cent for the average of all EU countries and just 11 per cent in the UK. Yet rather than constructing productivity-enhancing assets at home, too much German saving goes abroad. Germany now has the world’s second biggest stock of foreign investment at $2.1 trillion behind the US. Once abroad – due largely to the ineptitude of Germany’s banks – it earns poor returns. “Germany saves much, but saves badly,” says Mr Fratzscher.

That’s bad. Germany needs to make its work force as productive as possible because, as we will discuss shortly, it’s a dwindling resource. But Germany also needs to tackle the costs of an energy policy that almost defies belief.

Bayer is Germany's biggest company by market cap

Energy policy

Running on empty

Tackling climate change is doing some strange things to energy policy in various European countries, but nothing so strange as what’s happening in Germany. The country is witnessing the unintended consequences of an energy policy that, according to an energy-industry boss, is “a weird mix of idealism and greed”. As a result, Germany’s electricity-generating capacity – especially via renewables – is expanding hugely yet, despite this, the retail price of electricity is the world’s highest, the risk of blackouts is growing and Germany’s carbon footprint is rising as more power is generated by coal-fired plant. Perverse or what?

The money costs of this mess are also huge. To accommodate the rising share of electricity generated by renewable sources – mostly wind and solar power – Germany must add about 2,500 miles of new transmission lines at a cost of maybe €50bn (£35bn) and upgrade as much again. So far – due mainly to nimby protests – about 500 miles of new lines have been built. Meanwhile, the ability of Germany’s leading utilities to fund such an upgrade has been deeply undermined by the fall in their stock market value. Combined, the two biggest – RWE (DB:RWE) and E.ON (DB:EOAN) – have lost €121bn in market value from their peak in early 2008. And to pay for the guaranteed subsidy to renewables suppliers – the so-called ‘feed-in tariff’ – residential prices are now running at about €0.32 per kilowatt hour. According to shrinkthatfootprint.com, a website run by energy consultant Lindsay Wilson, only Denmark, whose energy-industry dynamics are much like Germany’s, has more expensive electricity. However, adjust for Germany’s lower cost of living and its electricity becomes the world’s most expensive.

The German government's energy target is having perverse effects

The roots of this mess lie in Germany’s Energiewende, or ‘energy transformation’, the government target – set in 2000 – that by 2020 Germany should have cut its emissions of greenhouse gases by 40 per cent from its 1990 level and that renewable sources should provide 35 per cent of electricity generated. Stimulated by generous government subsidies – the cost of which is €16bn a year and rising – renewables capacity has soared and will easily beat the 2020 target for market share. This has happened at a time when German utilities added lots of gas-fired generating capacity. The result is that Germany has far more generating capacity than it needs, but heavily-subsidised renewable-generated energy gets so-called grid priority. And that’s where the trouble really starts.

In effect, grid priority creates four perverse outcomes that are mashing Germany’s energy industry:

■ Solar and wind power, whose marginal costs of energy generation are minimal, undermine the profitability of conventional ‘base load’ providers, such as nuclear and coal-fired plant which also provide power at minimal marginal cost but don’t have grid priority.

■ However, unlike nuclear and coal-fired power, electricity from solar and wind technology is intermittent. It comes with sunny, windy weather and vanishes on dull, calm days. So the base load provided by renewables is unreliable. That drives prices up, which could be good for conventional utilities, except that . . .

■ The sun is most likely to shine in the middle of the day. So solar-sourced power often surges into the grid during the midday hours. But that means Germany’s utilities no longer enjoy the profits to be taken from the midday spike in demand; in particular, the profitability of their new, clean and relatively flexible gas-fired plant has been undermined, so much of this plant has been mothballed.

■ In response to this – and encouraged by the falling price of European coal, which no longer has a ready market in the US since production of shale gas soared – utilities have turned to coal-fired plant to supply base-load power when solar and wind fail to show. As a result, coal-fired power now accounts for 45 per cent of Germany’s electricity supply and the country’s carbon emissions are rising. Rather than tackle that problem and offend big commercial energy users, Germany’s government was content to nudge Europe’s carbon-trading scheme into oblivion in 2013.

Meanwhile, the number of energy-intensive companies getting an exemption from paying the levy that funds the feed-in tariff has risen from 59 in 2003 to over 2,000 today. This means that increasingly the burden falls on households.

To cap it all, the huge rise in Germany’s generating capacity means there can be far more supply than demand. So when the sun shines and excess power surges into the grid, the system struggle to cope. The grid’s managers respond by shutting off supply – for example, by charging utilities for the electricity they generate – or by dumping the excess on neighbouring countries. But ultimately the grid could fail, leading to blackouts. That would be the ultimate irony of Germany’s energiewende, a transformation indeed.

It might be funny if it wasn’t so expensive – especially as Germany faces a costly demographic challenge.

Germany’s population

Where have all the people gone?

To grow, a country needs people. It needs their numbers to rise; it needs them to be young and – within limits – to be well qualified; like it or not, young people work harder, longer and with more innovation than the old. If all that is true, Germany is set to struggle.

For starters, Germany’s population is already declining. In the country’s unified form, its population peaked at 82.5m in 2004 and now stands at 81.2m (though the good news is that’s above the low point of 80.2m in 2011). Consistent with a falling population, Germany’s is also old. The proportion of the population who are over 65 is 21.3 per cent, whereas that ratio was 13.2 per cent in 1970. Sure those figures aren’t half as bleak as Japan’s, where the proportion of over 65s rose from just 7 per cent in 1970 to 25.1 per cent today. But Germany must carry a far greater coterie of pensioners even than the UK, which increasingly struggles and where the ratios rose from to 13 per cent in 1970 to 17 per cent today.

Similarly, Germany’s median age – ie, the level where there is an equal number both older and younger – is old at 46.1 years. The only state in the world – if you can call it a state – that exceeds that age is Monaco (51.1 years) and not even Japan’s ageing population is older (it’s also 46.1).

That won’t change in a hurry. Countries with comparatively few young adults produce similarly small numbers of children. This is reflected in both Germany’s birth rate, which demographers define as the number of births per 1,000 people in a year, and its fertility rate, which is the number of children expected to be born to a woman over her reproductive life. At 8.4 births per 1,000 in 2014, Germany’s birth rate is the world’s lowest (tying with Japan) Its fertility rate is equally dismal. At 1.42 in 2012, according to United Nations data, it is fractionally higher than Japan’s plus a clutch of eastern European countries.

Demographics such as these will have far-reaching consequences. For example, Germany’s working-age population is set to fall by 6.5m between now and 2025. That’s the equivalent of losing the entire working population of Bavaria, a federal state that, if it were a standalone country, would have almost the same output as Switzerland. And some sectors will be especially badly affected. For example, half of all Germany’s teachers are already over 50. So, by 2030, just to keep the number of teachers stable, one new teacher will be needed for every teacher still in the job. Given that Germany’s rigid secondary educational system of hauptschulen, realschulen and gymnasien struggles to cope with the demands of a 21st century economy anyway, then the dearth of teachers will only compound difficulties.

Such effects can be offset in three ways. First, by getting older people to defer retirement. This is happening in a small way. The government is raising Germany’s state pensionable age, but at a snail’s pace and an odd effect of reforms agreed last year is that pensionable age is reduced to 63 for those few workers who have been in the system for 45 years. Meanwhile, the participation rate in the work force of those over 55 is encouragingly high at almost 66 per cent. In comparison, the UK’s equivalent rate is 61 per cent and the average for all countries in the OECD, a club of wealthier nations, is 57.5 per cent.

Second, by getting to people to work more hours. Chiefly this means getting more women to work longer. The participation rate of women in the workforce – at 72 per cent – is high, But, at least in what was West Germany, the old norms linger and, in a nation that still labels mothers who work full time as rabenmutter (raven mother), on average women only put in just 18.5 hours a week. As a result, on average each German worker clocks up just 1,363 hours a year, which is the lowest rate in the OECD and compares with, for example, 1,669 hours in the UK. Not just that, but Germany – as its labour force ages and part-time work becomes increasingly favoured – is on a steady downward trend. In 1990, the earliest year for which the OECD has data, the German average was 1,553 hours a year.

The third way to offset the ‘greying’ of the economy is to import more workers – and Germany is trying. Go to the website, make-it-in-germany.com, and you will find an upbeat portal in 10 languages that encourages professionals who are interested in immigrating to Germany. According to the federal economics ministry, which runs the site, it is “the expression of a whole culture of welcome”. That especially applies to those with in-demand qualifications such as doctors – Germany could do with another 5,000, says the site – engineers – especially with mechanical or automotive skills – and IT specialists.

It is less clear whether the effort is bringing success. Germany has Europe’s biggest immigrant population anyway – 10.9m of its 81m inhabitants (13.5 per cent) were born outside the country and net immigration means that the population is creeping upwards – in 1994 11 per cent of the population (including German nationals) were born abroad. Simultaneously, however, Germany faces problems with the immigration that it cannot control and with the offspring of the so-called gastarbeiter (guest workers) who stayed. Those – mostly – young people have below average qualifications and suffer above average rates of unemployment.

So there is a demographic problem – not on the scale of Japan’s – but a problem nonetheless. Yet if there is a silver lining to be spotted, it is this: a shortage of workers should push up wages. If so, that would shift more of Germany’s economic growth on to domestic consumption and away from export-driven manufacturing. And that would be a step in the right direction.

And in conclusion . . .

Okay, let’s sum up. Germany’s economy is weaker than it looks because it lacks flexibility – too many resources are concentrated in too few export-orientated manufacturing sectors. Those sectors got a huge boost from a one-off factor – the industrialisation of China – and from the comparative weakness of the euro. Meanwhile, Germany’s economy remains lopsided, focused too much on exporting and too little on domestic consumption. Added to that, the country has an energy policy that both defies belief and is ridiculously costly. Last – and maybe most ominous – Germany’s demographics are lousy. The country is old and, whether Germans understand it or not, old countries struggle to grow.

So is this country a good place to put capital into? No, for the reasons just outlined. They suggest that there won’t be enough growth to lift share values much. It’s also difficult to see how the euro crisis will be sorted out to Germany’s advantage. By far the best outcome is a proper resolution of the imbalances between ‘Club Med’ Europe and the rest. The quantifiable price that Germany would pay wouldn’t be much more than losses on the loans that its banks have made to Greece – tiny in the scheme of things. The bigger – though unquantifiable – price would be loss of credibility for the Germanic model of doing things. The worst outcome would be for the euro to become a currency club for north Europeans. Then – as the currency’s value surged – German exports would pay a heavy price. True, Germans would adapt. It’s what they did before when currency pacts collapsed. But the transition would be painful, especially for a nation with a shrinking workforce.

Most likely however – and at least for the foreseeable future – the euro issue won’t be resolved. In the best traditions of the EU, the can will continue to be kicked down the road. So where does that leave the proposition to invest in Germany or not? Let’s not forget we are talking about Europe’s biggest economy by far and – among the continent’s five biggest developed economies – easily the most successful. With a fully-functional democracy, sound property rights and world-class companies to choose from, there is much to like.

The choice of investing options is fine, too. Apart from exchange-traded funds (see Table 4) there are 41 unit trusts that specialise in Germany and investing in single companies is perfectly feasible. It helps that shares in all of Germany’s 10 biggest companies (see Table 5) are traded on London’s European Quoting Service.

True, the superior performance of German equities, especially compared with the UK (see Table 6) these past 10 years suggests that mean reversion may drag down their future performance. However, Table 6 also implies that German shares are cheap compared with the UK’s. Possibly that’s reconciled by the point that UK indices are dominated by companies in banking, oil and commodities, whose profits are depressed (temporarily, in the case of oil and commodities; semi-permanently in the case of banks). That has the effect of pushing up PE ratios. Meanwhile, Germany’s indices lean towards manufacturing companies whose profits are around optimum levels. Then again, Germany’s bias towards solid-but-dull manufacturers means that its rating never gets that high. In a way, Germany’s stock market might be likened to a giant value index – serially underrated, which is why it tends to generate superior returns (performance often exceeds expectations).

If this seems like sitting on a fence, well – yes – take the proposition to invest in any major market and the response will be nuanced. How many times, for instance, has the US been written off only to defy its critics? Germany may do something similar; after all, it’s not as if the country is about to disappear into the Rhine. Yet there are trends, and the trends in the developed world are towards more debt and less growth; in effect, rising debt cloaks the absence of growth. Germany has its idiosyncrasies – Germans eschew debt more than Americans and British, and are more productive; but they are older, poorer and run a less flexible economy – but it’s in that boat, too. So put capital into the country’s stocks by all means. But don’t expect long-term returns to be any better than the rest of the developed world.