Euro-area data have surprised on the upside in the opening weeks of 2012. This is particularly true in Germany, where there has been a strong bounce in key cyclical indicators and genuine signs of expansion. But could Germany be getting too much of a good thing?
As in many countries, German interest rates are at historic lows. Where Germany is different is that money is also in plentiful supply. The German banking system is currently awash with liquidity. Record amounts are being deposited at the European Central Bank (ECB), with more likely to come in the wake of the ECB’s recent longer-term refinancing operation.
The result is that the German monetary base is exploding. Unlike in other countries, this money is not dormant. Credit growth is on an upward trend and, crucially, there is no evidence of supply constraints. Recent surveys by the Bundesbank and Ifo, the German economic research group, show few signs of the credit tightening reported elsewhere in the euro area.
To cap it all, there are even signs of life in the construction and housing sectors. It’s likely that housing permits rose risen 19% last year, the third consecutive annual increase and by far the strongest since the early 1990s. Moreover, Bundesbank data show that house price inflation more than doubled to 5.5% last year, which is positively explosive by German standards.
There is little doubt that monetary and credit conditions are too loose in Germany. With the economy currently in a soft spot, this may not be a pressing issue right now. But if lose monetary and credit conditions are sustained, there is a risk that they will ultimately lead to economic overheating and inflation.
However, it is not obvious what Germany can do about this risk. Monetary policy is now set by the ECB on the basis of economic conditions in the euro area as a whole. With deflationary forces in the periphery likely to weigh on aggregate euro-area inflation for the foreseeable future, German interest rates are likely to remain too low. Moreover, the woes of the periphery are also likely to depress the euro, preventing it from rising as strongly as German fundamentals might warrant.
Germany could find itself in a similar position to the one that some of its euro-area partners faced before the crisis, when German “deflation” kept aggregate euro-area inflation and economic growth down. This led to overall monetary conditions that were far too slack for countries like Spain and Ireland, resulting in overheating and asset-price booms in both countries.
Increasingly, it appears that Germany’s membership in the euro leaves it with almost no way to prevent its own economy from overheating. In other words, the flip-side of deflation in the periphery might be inflation in Germany. If this analysis is borne out, it would (ultimately) mean a significant easing of the burden of the adjustment on the periphery. But it would also present a profound challenge to the German psyche.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.