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The world economy at the crossroads – the German perspective

The G20 summit in Osaka will be marked by a decelerating world economy, increasing protectionism and trade conflicts. For Germany, Europe's largest and highly export-oriented economy, it is essential to set the right course for economic policy, together with its European partners.

Nikkei vom 24.06.2019

1. Dampened prospects for the global economy

After it had experienced extraordinarily fast growth in 2017, the pace of expansion of the global economy decelerated sharply in 2018. To a considerable extent, this development reflects a cyclical normalization, as in many economies the upturn is already well advanced and real growth of gross domestic product (GDP) exceeds potential output. In addition, the ongoing trade conflicts and the turbulent road towards Brexit have created considerable uncertainty. In consequence, many advanced economies experienced an economic slowdown in the second half of 2018.

Against this backdrop, in its most recent update the German Council of Economic Experts (GCEE) expects global economic growth of 2.7 % and 2.8 % in real terms for 2019 and 2020, respectively, after 3.2 % in 2018. Correspondingly, the volume of world trade is expected to increase only by 1.5 % and 2.7 %, respectively, after 3.3 % in 2018. Individual stories behind the rather synchronized modest economic expansion are, however, quite heterogeneous.

For the United States (US), the deceleration rather constituted a normalization of economic activity towards potential growth, after a comprehensive tax reform had contributed to an exceptionally strong expansion in the first half of 2018. This reform is likely to have increased US potential output and the pace of its growth. By contrast, while the newly introduced import duties might give some US companies advantages in their domestic markets, the US risks weaker economic development as a result of retaliatory measures by its trade partners.

In Japan and in the euro area, it were instead temporary one-off factors which apparently made the slowdown in growth particularly sharp. For example, the strong, albeit temporary growth slowdown in Germany reflected serious and protracted production problems in the German automotive industry. Instead in Italy the persistent uncertainty surrounding the intransigent fiscal policy of the Italian government was a contributing factor, investment almost stagnated, and the economy even entered a technical recession in the second half of 2018.

2. Major trouble spots in Europe and China

In addition to these internal factors, weaker demand for exports generates a particular burden for the economy of the euro area. This is even more disconcerting as exports are a strong component of euro area growth. Nevertheless, unemployment in the euro area continues to decrease, while employment and wages are increasing. Together with a low oil price, the strong labor market is likely to boost private consumption. Moreover, the European Central Bank already responded to decelerated growth with a further relaxation of monetary policy.

The GCEE expects real GDP growth in the euro area to stabilize again, with real annual growth rates of 1.2 % in 2019 and 1.4 % in 2020. These rates thus approach the level of potential growth of presumably slightly more than 1.5 %. A major risk would be additional tariffs imposed by the US on automobile imports, on the quite flimsy argument of protecting national security. This would hurt the European automotive industry, which could trigger a spiral of tit-for-tat protectionist measures.

Developments in the United Kingdom (UK) continue to be dictated by Brexit. Only optimistic scenarios such as that of an orderly Brexit support the expectation of moderately positive growth rates. Far more negative developments cannot be ruled out in the event of a hard, disorderly Brexit. This would likely have a severely negative impact on the UK economy and, to a lesser extent, on the economies of other EU member states, depending on the intensity of their trade integration with the UK.

Among emerging economies, the Chinese economy is affected particularly strongly by the uncertainty stemming from the escalating trade conflict with the US and by the tariffs already put into place. Its future development hinges primarily on whether the US continue to carry out their threats to levy extensive additional tariffs on Chinese products, and the conflict escalates further. It will also be important whether the measures introduced to support growth avoid increasing risks to financial stability.

3. Setting the right course for German economic policy

Despite its recent slowdown the German economy is maintaining one of its longest upswings in the post-war period. Yet, its long-term growth prospects are under serious threat. One of the major challenges to German economic prosperity is the worldwide trend towards a departure from the multilateral global economic order. An important factor in this development has been US international policy, which focuses particularly on the recent trade deficits which the US have with China and Germany. The US has had a permanent current account deficit since the 1980s, though.

The German economy relies considerably on international trade for ascertaining its prosperity, as it is the most open among the major economies (Figure). The German current account surplus has been declining since its peak in 2015 and there are numerous reasons why its reduction will be inexorable anyway. But the impending further escalation of the trade conflict seriously threatens German prosperity by reducing the international division of labor. Around half of the growth in real income per capita in Germany in the past two decades is estimated to be attributable to trade.

The top priority of German and European policymakers should be to strengthen the multilateral, rule-based trading system and to step up international efforts to reduce tariffs within the WTO. The EU could also conclude new free trade agreements, especially with the US, but also with other regions, to take advantage of the opportunity of further increasing welfare by means of liberalizing trade. Germany should not take own protectionist measures, but rather improve the country’s appeal as a location for business and attempt to attract international investors.

Nikkei_G20_world economy

In addition, an internal challenge, severe demographic change, also raises the question of the German economy's future viability. Germany will be one of the countries most heavily exposed to demographic change, and among the major economies already holds one of the highest old-age dependency ratios (Figure). The German labor force will decline and a shortage of skilled labor is looming. Thus, to ensure prosperity Germany will have to depend heavily on dynamic productivity growth. This, however, requires comprehensive structural change towards a digitized economy.

In light of this, it seems even more disconcerting that current political decisions made by the German government threaten to adversely affect the sustainability of public finances. Instead, it would be well-advised to pursue growth-friendly tax reforms, a sustainable structure for the pension, healthcare and transfer systems and an economically efficient energy transition. To turn structural change into a beneficial force, workers should be empowered to embrace the opportunities inherent in change on their own initiative.

Finally, Germany is affected heavily by the severe blow to the efforts for global climate protection delivered by the decision of the US to withdraw from the Paris climate agreement. But a global solution towards effective carbon pricing is ultimately indispensable: Setting a uniform global carbon price as the major instrument of a global energy transition would be more effective than the sum of uncoordinated national turnarounds in energy policy. Germany, for instance, is already achieving a high carbon efficiency, leaving little leeway for further national improvement (Figure).

EU member states should back an enhanced European Emissions Trading System (EU ETS) to facilitate implementation of a common international carbon price. While during the last years the price of EU ETS emission allowances was relatively low, more recently measures which removed non-allocated allowances from the market contributed to an increasing price. It would be highly advisable to also include the transport sector and private households into the system at last. Only then the EU will be able to contribute effectively and efficiently to the reduction of greenhouse gases.

Der Gastbeitrag erschien im Original auf Japanisch in der japanischen Tageszeitung Nikkei.