Is Germany’s business model kaput and should we care?

In an otherwise quiet few days for Australian data, the main domestic focus this week was the release of the October 2024 Monthly Consumer Price Index (CPI) Indicator. The headline number showed the annual rate of increase unchanged from September 2024 at just 2.1 per cent. That result beat market expectations for a 2.3 per cent outcome.

But the good news here was offset by more mixed results on underlying inflation. While one measure (the CPI excluding volatile items and holiday travel) reported a slowdown in the annual rate of increase from 2.7 per cent in September to 2.4 per cent last month, the other (annual trimmed mean) reported an increase from 3.2 per cent to 3.5 per cent.

Given that the RBA anyway places much more weight on the quarterly CPI numbers, plus the fact that the headline rate continues to be influenced by a mix of government policy interventions (electricity rebates and rent assistance) and the state of the global oil market via automotive fuel prices, this week’s numbers will likely have little impact on the RBA’s musings, ahead of the 9-10 December monetary policy meeting. The overwhelming consensus is that Martin Place will leave the cash rate target unchanged for a ninth consecutive meeting.

In the absence of more domestic data and after a deeper dive into the CPI numbers, this week we look at the recent debate in the financial press over strains on the German economy and then provide a quick update on the outcome of COP29. The German story is interesting, not just because the travails of the world’s third largest economy (at market exchange rates) are worth a look, but also because of what it tells us about how some key trends are reshaping the broader global economy and relative comparative advantage. (Ranging from ageing populations to geoeconomic fragmentation and rising protectionism and new technologies). All that, plus a summary of the rest of the week’s data and our regular reading and listening round up below. For those who would like more, this week’s Dismal Science podcast digs further into the CPI numbers and the German economic story.

Inflation unchanged in October

The Monthly CPI Indicator rose 2.1 per cent over the year to October 2024. That was unchanged from September’s result and below the market consensus forecast of a 2.3 per cent print. It also meant that the headline rate remained at its lowest level since July 2021.

According to the ABS, the main features of October’s release included:

• A 35.6 per cent fall in electricity prices over the year to October, following a 24.1 per cent annual drop in the previous month. October’s decline set a record for the largest annual fall in the series. It reflected the combined impact of Commonwealth Energy Bill Relief Fund (EBRF) rebates, plus State government rebates in Queensland and Western Australia that together saw prices drop 12.3 per cent over the month. The Bureau noted that including all government electricity rebates, electricity costs for households have now fallen by more than 30 per cent since June 2023. Excluding these rebates, electricity costs would instead have increased by a little more than 16 per cent over the same period.
• An 11.5 per cent fall in automotive fuel prices over the year to October, after a 14 per cent decline in September. Fuel prices fell 0.1 per cent over the month and have now fallen for five of the past six months.
• An annual increase of 3.3 per cent in the price of food and non-alcoholic beverages. That rate was unchanged from September’s result and partly reflected the impact of supply shortages for some fruit and vegetables.
• A year-on-year increase of 4.2 per cent for new dwelling prices, down from 4.3 per cent in September and 5.1 per cent in August. Prices were up just 0.1 per cent over the month.
• An increase in rental prices of 6.7 per cent over the year to October. That was up from a 6.6 per cent gain in September, but down slightly from August’s 6.8 per cent annual increase. The rise in rental costs was partly offset by an increase in Commonwealth Rent Assistance (CRA). Without the change to CRA support, the ABS estimates rents would have risen by 8.1 per cent. In monthly terms, rents fell 0.3 per cent in October, although absent the CRA changes they would have risen by 0.5 per cent.
• An eight per cent annual increase in holiday travel and accommodation prices, reflecting the base effects created by a large seven per cent fall in October 2023. In monthly terms, holiday travel and accommodation prices dropped 7.8 per cent.

The ABS also reported it had corrected its previous estimate of out-of-pocket childcare costs in October. This reduced the Childcare index by 5.8 per cent and reduced the Preschool and primary education index by 0.4 per cent. These corrections meant the rise in annual CPI inflation was 0.05 percentage points lower than it otherwise would have been.

While the headline number suggested that inflationary pressures in the Australian economy remained subdued last month, the two monthly measures of underlying inflation sent contradictory messages. Consistent with the decline in the headline rate, the annual rate of increase in the CPI, excluding volatile items (automotive fuel and fruit and vegetables) and holiday travel slowed from 2.7 per cent in September to 2.4 per cent in October. At the same time, however, the monthly annual trimmed mean (which excluded the large falls in automotive fuel and electricity prices in October, along with other outsized price changes) increased from 3.2 per cent to 3.5 per cent over the same period.

Is the German model kaput?

Earlier this month, the FT ran a Big Read asking, Is Germany’s business model broken? This week’s Economist magazine includes a piece with the heading, Once dominant, Germany is now desperate. And the current edition of the Literary Review includes a review of Wolfgang Munchau’s new book, Kaput: The end of the German Miracle, which also came out this month. Meanwhile, Germany’s unpopular ‘traffic light’ governing coalition has just collapsed – the latest on a growing list of failing incumbent administrations.

So, what’s going wrong with the country that last year became the world’s third largest economy  (measured on a market exchange rate basis)?

Like much of the advanced world, Germany has suffered from the post-pandemic inflation surge and the monetary response that followed. But its relative economic performance has also been poor. Real GDP has been stagnant since the pandemic and last year, the country’s Council of Economic Experts put potential growth over the coming decade at just 0.4 per cent. The economy shrank by 0.3 per cent in 2023 and according to the Economy Ministry is likely to contract again this year, this time by 0.2 per cent. If it does, that would mark the first back-to-back declines in GDP since the early 2000s.

There are a range of – often overlapping – diagnoses of the country’s problems:

• One theory is that the German economic model became over-reliant on cheap Russian gas imports to power its industrial export machine. In 2022, the war in Ukraine saw the price of imports of natural gas surge to around 10 times their 2021 levels, inflicting damage on the energy intensive parts of German manufacturing – the chemical, metal production and paper industries in particular. This produced falling output and employment, which some commentators see as triggering a wave of deindustrialisation.

• Another theory emphasises the changing relationship with China. For two decades before the pandemic, German exporters found a ready market for their cars, chemicals and engineering equipment. But in recent years, China has switched from customer to competitor, not only squeezing German sales in China but also competing in third markets. By this account, Germany’s export-led model is particularly vulnerable to China Shock 2.0.

• Related, there are the specific challenges facing Germany’s auto sector. As the IMF points out in the latest World Economic Outlook (see Chapter 1, Box 1.1), the global auto sector is undergoing a fundamental period of transformation that is producing shifts in global patterns of investment, production, trade and employment. The drivers of this change include the rise of China as a leading car exporter (on some counts it became the world’s largest vehicle exporter last year) and the growing importance of EVs, where Chinese producers are now technology leaders. The auto sector is viewed as strategically important by many governments – it is capital intensive, employs skilled labour, pays high wages and with its close relationship with global value chains and multinational production is seen as emblematic of modern business in the age of globalisation. The news that Volkswagen is considering the unprecedented move of closing three German factories and cutting thousands of jobs has been seen as symbolic of a crisis in German business. Some commentators have also pointed to the (relative) failure on EVs as symptomatic of a broader failure on the part of German industry to keep up with new technology, from the digital revolution to AI.

• More generally, there are concerns that being an export-dependent economy in a time of deglobalisation and geoeconomic fragmentation – not to mention the prospect of a looming tariffs and potential trade war under a Trump presidency – makes for an increasingly challenging position. Germany’s trade to GDP ratio is a relatively high 90 per cent (for Australia the same ratio is around 48 per cent), making it more vulnerable to a deteriorating global trade environment.

• Another theory focuses on demographics, ageing and the so-called ‘Japanification’ of the German economy. Over the past decade, Germany’s working age population was supported by a large influx of migrants. But as the migrant wave recedes and as older Germans move into retirement, the country is on track to experience a decline in the rate of growth of its working age population. According to Eurostat, it will shrink by 0.5 per cent per annum between 2024 and 2030 under baseline immigration assumptions. The IMF reckons this demographic headwind, plus sluggish productivity growth, means the economy’s medium-term potential growth rate will be just 0.7 per cent per annum, down 0.7 percentage points from the pre-pandemic average.

• Finally, there are issues around Germany’s fiscal position and spending rules. The argument here is that Germany has underspent on public infrastructure in areas such as transport, energy and communications, with the economy now ranking near the bottom of advanced economies in terms of gross public investment. At the same time, future fiscal needs are set to grow as an ageing population will require increased public spending on health care and pensions, while a commitment to meet NATO targets requires increased expenditure on defence. Yet at the same time, Germany’s so-called debt brake (which caps the federal structural budget deficit at just 0.35 per cent of GDP) constrains the government’s ability to meet these demands.

One of the reasons that all this is of interest beyond the obvious implications for German and European economic prospects is that several of the items on the previous list – from demographic headwinds and fiscal challenges through to the China Shock 2.0 and geoeconomic fragmentation – apply not just to other European economies (compare some of the arguments advanced by Mario Draghi in his September 2024 report on EU competitiveness to the European Commission), but also to (non-US) advanced economies more generally. Granted, the parallels between national economic experiences are rarely exact, reflecting as they do country-specific economic structures, institutions and histories. Even so, just as commentators have previously pointed to the Japanese experience as offering broader lessons for what demographic change might have in store for the rest of us, so too could the current German experience have wider implications for advanced economies.

COP Out?

Last week’s note covered COP29 (see Good COP, bad COP) and noted that previously, observers had identified the key test for the so-called ‘Climate Finance COP’ as agreement on a ‘New Collective Quantified Goal’ (NCQG) on financing. The problem was that developing economies were looking for a major upgrade on the previous commitment of US$100 billion per annum to something more than US$1 trillion (subsequently scaled back to a bid of around US$500 billion by the G77 group of developing countries), while cash strapped developed economies were hoping to wind back dollar expectations, while also roping in new donors from the ranks of increasingly affluent emerging markets. In the end a compromise deal was struck that saw rich countries agreeing to take the lead in delivering at least US$300 billion a year by 2035 for developing nations via a mix of public finance, bilateral agreements and other odds and sods. That stopped the summit ending in failure. But the agreement has left many developing countries unhappy with the lack of ambition and observers questioning both the size of the funding and the likelihood of even the US$300 billion target being achieved on schedule.

What else happened on the Australian data front this week?

The ABS said total construction work done in the September quarter 2024 was up 1.6 per cent over the quarter (seasonally adjusted) and 3.2 per cent over the year at $73.3 billion. Building work done rose 0.7 per cent over the quarter and 0.8 per cent over the year to $38.6 billion, of which residential ($23.4 billion) was up 1.8 per cent quarter-on-quarter and 0.1 per cent year-on-year. Non-residential construction ($15.3 billion) fell one per cent over the quarter but was still 1.7 per cent higher in annual terms. Engineering work done ($73.3 billion) rose 2.6 per cent in quarterly terms and six per cent on an annual basis.

The ANZ-Roy Morgan Consumer Confidence index fell 1.1 points to 85.7 in the week ending 24 November 2024, but nevertheless remained above an index reading of 85 for a sixth consecutive week. Four of the five subindices fell over the week, with consumers feeling less confident about current and future economic and financial conditions. The only exception was the ‘time to buy a major household item’ subindex, which increased 2.5 points to its strongest reading since late 2022, likely in response to the start of Black Friday-related sales events. Weekly inflation expectations rose by 0.3 percentage points to five per cent.

The ABS published experimental estimates for the National Land Account, covering the period between 2015-16 and 2020-21. According to the Bureau, in 2020-21, 43.6 per cent of total land was grazing native vegetation, 19.4 per cent comprised managed resource protection, 10.8 per cent was classified as other minimal use, and 9.4 per cent was nature conservation. Between 2015-16 and 2020-21, total land value increased 48.4 per cent to $7.7 trillion.

Released last Friday, the S&P Global Flash Australia PMI Composite Index fell from 50.2 in October 2024 to 49.4 this month, dropping to a 10-month low and indicating a slight decline in private sector activity for the second time in the past three months. That reflected a similar fall in the Flash Australia Services PMI Business Activity Index, which slid from 51 in October to 49.6 last month, also a 10-month low and the first fall in services activity for 10 months. The Flash Australia Manufacturing Output Index remained in negative territory again this month at 47.9. The series has been signalling contraction in the manufacturing sector for two full years now, although the index was up from October’s 44.7 and has climbed to a six-month high. Employment growth also fell further below its long-term average in November. Finally, the survey results reported a decline in price pressures this month. Average input prices rose at their lowest rate in just over four years, while the rate of output price inflation was the joint lowest in nearly four years.

Other things to note . . .

• The November 2024 edition of the Deloitte Access Economics Budget Monitor previews this year’s upcoming Mid-Year Economic and Fiscal Outlook (MYEFO). The Monitor is predicting a deterioration of more than $49.3 billion in the budget bottom line, translating into a deficit of $33.5 billion. If realised, that would represent the largest deterioration in the underlying cash balance on record, excluding the pandemic-hit budget of 2019-20.
• Mark Crosby considers recent proposals to use the Future Fund for housing, energy and infrastructure.
• In the AFR, Saul Eslake explains how Victoria became a poor state. State Treasurer Tim Pallas demurs, arguing that Victoria is an economic powerhouse.
• The e61 Institute with a long-term perspective on Australia’s love of gambling.
• On housing mismatch and the welfare effects of stamp duty. And a Tax and Transfer Policy Institute Policy Brief on negative gearing.
• Productivity Commission Chair Danielle Wood gave a speech on the role of economics in contemporary policy challenges, noting that while ‘economists still wield a lot of power in key debates…there is a greater contestability and also a greater degree of scepticism of economic prescriptions’. Wood still reckons that despite the latter, a range of ‘wicked problems’ from housing affordability to the green energy transition will benefit from ‘the expertise and tools that economics provides’.
• Somewhat related, how economic research has shifted towards civil society themes.
• The IMF says for most G20 economies, growth is poised to weaken over the next five years and remain below pre-pandemic performance. In response, the Fund argues that they should target reforms to lift their medium-term growth prospects.
• An FT Big Read asks, Can Europe defend itself without America?
• The OECD’s Revenue Statistics 2024 reports that the average tax to GDP ratio for OECD countries was 33.9 per cent last year. That was down 0.1 percentage points (ppts) from 2021 and 2022 but above 2019’s pre-pandemic ratio of 33.4 per cent. Tax ratios ranged from a low of 17.7 per cent in Mexico to a high of 43.8 per cent in France. That gap of 26.1 ppts is the smallest since at least 2000, with the gap having narrowed by 5.2 ppt since 2019. The report doesn’t present comparable Australian data for 2023, but in 2022 our tax to GDP ratio was 29.4 per cent – below the OECD average of 34 per cent that year and the OECD average of 33.9 per cent in 2023.
• Related and also from the OECD, Consumption Tax Trends 2024.
• The Economist magazine ponders why AI has had only a muted economic impact to date, drawing on lessons from the computer age to argue that while AI may yet produce extraordinary productivity growth, it currently appears to be some distance from reaching economic take-off.
• The WSJ on Scott Bessent, Donald Trump’s pick for US Treasury Secretary.
• Michael Pettis discusses whether more US tariffs might shift China towards a greater reliance on domestic demand.
• Goldman Sachs 2025 Outlooks.
• Wired magazine on the race to create the perfect EV tire.
• The Australia in the World podcast is Thinking through Trump 2.0.
• The FT’s unhedged podcast looks ahead to 2025.
• The These Times podcast considers The threat of World War Three.
• Tyler Cowen (from Conversations with Tyler) and Russ Roberts (from Econtalk) discuss Vasily Grossman and his novel Life and Fate. The same episode is available from both podcasts.