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Prolonged German downturn could prompt stimulus rethink

But a bout of German weakness may be precisely what is required to convince Angela Merkel to loosen the fiscal reins at home and provide Europe with a dose of stimulus that struggling states like France and Italy have long been seeking - PHOTO: REUTERS

[BERLIN] The last thing the faltering European economy would appear to need right now is a sudden downturn in Germany, hitherto the bloc's pillar of strength.

But a bout of German weakness may be precisely what is required to convince Angela Merkel to loosen the fiscal reins at home and provide Europe with a dose of stimulus that struggling states like France and Italy have long been seeking.

For now, the top economic priority of Merkel's government is to deliver on its promise of a "schwarze Null" - a federal budget that is in the black, or fully balanced - in 2015.

That goal, spelled out in the coalition agreement struck last year between Merkel's conservatives and the centre-left Social Democrats (SPD), is described by officials in Berlin as a political "holy grail" - an historic achievement that would carry huge benefits for both ruling partners if reached.

It is largely due to the constraints of this budget target that Merkel has repeatedly rebuffed calls at home and abroad for Berlin to splash out more public money on infrastructure.

But if the German economy, which contracted by 0.2 per cent in the second quarter and may flatline in the third, continues to weaken into next year, Merkel could be forced to reverse course and step up public investment, as the European Central Bank (ECB) and International Monetary Fund (IMF) have urged. "If the only way to achieve the balanced budget goal is to make cuts that would deepen a recession, it will be abandoned and we will see more spending," said one senior German official, who requested anonymity due to the sensitivity of the issue.

Another official close to the chancellor said: "If the German economy weakens substantially, that would be a game changer."

For now, the "schwarze Null" - or black zero - looks comfortably within reach.

With unemployment still hovering near post-reunification lows under 7 per cent, tax revenues continue to flow into federal coffers at record rates.

Rock-bottom interest rates have sharply reduced the cost of borrowing in Germany, providing additional budget support. The Bundesbank estimates the German state saved 120 billion euros over the past seven years - including 37 billion euros last year - thanks to the drop in rates. "Of course there is a risk for the balanced budget goal if the economy weakens considerably," said Eckart Tuchtfeld, an economist at Commerzbank who focuses on budget issues. "But we don't see this as likely. Our base case is for a temporary period of economic weakness, not a prolonged recession." Still, recent German data has been unusually poor. This week industrial orders and output for the month of August posted their steepest falls since the height of the global financial crisis in 2009.

The Ifo institute's closely-watched gauge of business sentiment has fallen for five straight months. And a recent survey of purchasing managers showed activity in the German manufacturing sector shrinking in September for the first time in 15 months.

On Tuesday, the IMF slashed its 2014 growth forecast for Germany to 1.4 per cent from 1.9 per cent, and its 2015 forecast to 1.5 per cent from 1.7. "The risks to the German economic outlook are high," said Marcel Fratzscher of the DIW economic institute in Berlin, citing weakness in the euro area, political risks in France and Italy, looming stress tests that could expose troubles at European banks, and geopolitical threats from Ukraine and the Middle East. "My expectation is that if the economy deteriorates further there will be a fundamental rethink of the German government's policy," said Fratzscher, a former ECB official who leads a panel of experts set up by Economy Minister Sigmar Gabriel to study ways to boost investment. "You could see this shift very quickly," Fratzscher said.

The DIW estimates that Germany is suffering from an annual investment gap of 80 billion euros after decades of declining public and private spending on domestic infrastructure and equipment.

At the start of the 1990s, investment represented 23 per cent of German gross domestic product (GDP). Now it is hovering around 17 per cent - compared to an OECD average of 20 per cent.

Because of this, Fratzscher and other economists like Peter Bofinger, who sits on the "wisemen" council of economic advisers to the German government, believe it was a mistake for the government to set itself a balanced budget goal in the first place.

It is difficult to find anyone in the government who agrees with that now.

Finance Minister Wolfgang Schaeuble has consistently rejected calls from euro zone and G20 peers to increase public spending and has instead called for measures to boost private sector investment.

But there are signs of cracks in Berlin's united front.

Last month, Deputy Labour Minister Joerg Asmussen penned an article with European Central Bank policymaker Benoit Coeure calling on Berlin to promote investment and cut payroll taxes in order to bolster growth in the euro zone.

Asmussen returned from a spell on the ECB's Executive Board to join the coalition government last year and remains a powerful voice.

Members of Gabriel's ministry are also sympathetic to the idea of more public investment and admit that the economic landscape has changed since the coalition agreed to the black zero nearly a year ago. "The commitment to a balanced budget was not a mistake given the economic circumstances at the time it was made - on the contrary it was good economics and politics," said the senior German official, who is close to Gabriel. "But the situation has changed. We now realise that we have big needs in terms of infrastructure investment and the economic environment has deteriorated." - Reuters