Joint Economic Forecast Autumn 2011

Members of the Project Group Joint Economic Forecast are:

Institut für Wirtschaftsforschung Halle
in cooperation with:
Kiel Economics

ifo Institut für Wirtschaftsforschung an der Universität München
in cooperation with:
KOF Konjunkturforschungsstelle der ETH Zürich

Institut für Weltwirtschaft an der Universität Kiel
for the medium term economic forecast in cooperation with:
Zentrum für Europäische Wirtschaftsforschung (ZEW) Mannheim

Rheinisch-Westfälisches Institut für Wirtschaftsforschung
in cooperation with:
Institut für Höhere Studien Wien

Summary

In summer 2011, the outlook for the global economy deteriorated markedly. In Europe in particular, the sovereign debt crisis threatens to escalate into a banking crisis. This is having increasingly adverse effects on the German economy. The greatly heightened uncertainty will dampen domestic demand, and foreign trade will no longer contribute to expansion because of the difficult situation of major trading partners. The Institutes expect the gross domestic product to increase by 2.9% this year and by only 0.8% next year. The unemployment rate will decline only slightly from 7.0% to 6.7% in 2012. The expected inflation rate of 2.3% in 2011 and 1.8% in 2012 will be determined more and more by domestic price increases. The government’s budget deficit will decline to 0.9% of GDP this year and 0.6% next year. The greatest risk is an escalation of the European debt and confidence crisis, because of which the financing conditions for businesses could deteriorate noticeably. Economic policy in the EU has been heavily focused on using all possible means to prevent the insolvency of a euro country. Instead of this course, it should create a workable insolvency mechanism for states and a European procedure for the recapitalization and, where necessary, an ordered insolvency of banks.

The outlook for the global economy deteriorated markedly in summer 2011. Businesses and households in the US and Europe regard the future with increased pessimism, and in financial markets, indicators such as a slump in share prices point to a downturn. In Europe, the sovereign debt crisis threatens to escalate into a banking crisis, since many banks hold a large amount of debt of the countries affected by the crisis.

The worldwide collapse in confidence began in July, when simultaneously the US was struggling to expand the public-debt ceiling and a new aid package for Greece and a reform of the rescue fund were being negotiated in the European Union. The results that were reached on both sides of the Atlantic were not perceived by the markets as a solution to debt problems and they were not able to stop the loss of confidence. However, economic concerns were not limited to the worsening debt crisis. Already in the months before, the worldwide confidence indicators weakened slightly when supply chains were interrupted as a result of the natural and nuclear catastrophes in Japan. Another stress factor was the very sharp rise in energy and commodity prices.

Compared to the more advanced economies, demand in most emerging countries remained buoyant. Although there was also an economic slowdown in these countries, it has been moderate so far. In addition, this was often the intention of economic policy-makers: in many countries, including China, India and Brazil, the reins of monetary and fiscal policy have been tightened because of high inflation, and aggregate demand has been dampened.

The growing insecurity in the European Union and in the United States will not only have a dampening effect on the demand for goods because of deteriorating financing conditions. Many investors and consumers will initially postpone spending decisions in the second half of 2011. Also for this reason, aggregate output will do little more than stagnate in the winter half year in the US and will even decline temporarily in the euro area. Even if the debt and confidence crisis remains manageable, as assumed by this forecast, it will prevent a strong recovery in the euro area next year. The factor that will support business activity in the advanced economies in the second half of 2011 and next year is the continued expansionary monetary policy as well as the high, although weaker growth momentum in the emerging countries of Asia, but also in Latin America and Central and Eastern Europe. All in all, total economic output in the advanced economies is likely to expand slightly this year and next year by 1.4% and 1.3%. Total world output is expected to grow by 2.6% in 2011 and by 2.5% in 2012.

The debt and confidence crisis in the euro area is having increasingly adverse effects on the German economy. The greatly increased uncertainty will dampen domestic demand, and foreign trade will no longer contribute to expansion because of the difficult situation of some major trading partners. If in this situation to a further escalation of the debt crisis in Europe were to occur, this would have considerably negative effects on economic activity in the euro area and in Germany. The Institutes do not expect this to happen. Although they assume that the restructuring of the Greek government debt will continue, leading to losses among creditors, they do not regard a contagion of the same extent as after the Lehman Brothers bankruptcy as very likely. The losses would neither be unexpected nor would doubts arise as to the liquidity of the banking system, since the ECB, with its newly created instruments, can ensure liquidity. Under these assumptions, unlike 2008–09, a severe recession is not likely.

In the third quarter of 2011, GDP will expand by 0.6%. This is indicated by the favourable development of output and turnover and by the further increase in employment. For the winter half year 2011/12, the Institutes expect that the increased uncertainty and the deteriorating global conditions will lead to a stagnation in output. Unlike the rest of the euro area, Germany will probably not experience a recession. This is not least because German fiscal policy is significantly less restrictive than elsewhere in the euro area, and the financing conditions in Germany are considerably more favourable than in countries with high debt.

Assuming that the uncertainty in the euro area will slowly subside as the debt and confidence crisis gradually loses its sharpness and as the world economy overcomes its weakness, economic activity in Germany should pick up as of the second quarter of 2012. In addition, the monetary policy of the ECB will continue to have a relatively expansionary effect in Germany. For 2012, the Institutes expect an increase in GDP of 0.8% after 2.9% in 2011.

Because of the greater economic dynamism, the core inflation rate will probably be higher in Germany than in many other countries in the euro area. This will be boosted by a strong increase in wages. Currently, however, inflation is marked by price increases for raw materials, energy and food, which is not expected to continue on the same scale. In contrast, domestic price pressure will increase. On balance, consumer prices in Germany will rise by 2.3% in 2011 and by 1.8% in 2012.

Set-backs are not expected for the labour market as a result of the brief stagnation. To bridge the economic slowdown, the companies will initially resort to flexible working time arrangements. The expected decrease in the labour force will also be a contributing factor. The unemployment rate is therefore likely to fall slightly to 7.0% in 2011 and to 6.7% in 2012. The fiscal position of the government will improve further. The budget deficit will decline to 0.9% of GDP this year and to 0.6% next year. The decline in 2011 is largely due to greater cyclically induced decreases in expenditures and increases in revenue.

The biggest risk to the forecast is a further escalation of the debt and confidence crisis that could again shake the European financial system. The Institutes expect a further restructuring of the Greek public debt during the forecast period. Even if this does not lead to a collapse of the banking system, there is still the danger of contagion effects in portions of the financial system, especially in the less transparent derivatives markets. This could increase the stress in the financial sector and lead to less favourable financing conditions for non-financial companies. The German economy would then be dampened to a greater extent that assumed in this forecast, and a recession would result.

However, there is also a chance for more positive economic developments in the coming months. So far it is primarily the sentiment indicators and financial market data that point to a significant slowdown in the economy. The data for the real economy, however, have been largely positive. If policy-makers were able to find a way out of the debt crisis in the near future, the mood could quickly improve and the economic outlook would brighten.

In the current difficult situation, economic policy needs to prevent a further aggravation of the crisis. For the debt crisis in the euro area, a solution is not yet in sight despite the numerous measures by European governments and the ECB. The rescue attempts undertaken in the past two years have been able to contribute at most to short-term relief, because the basic problem of unsustainable debt, particularly that of Greece, has been denied by governments for too long.

In particular, two key European reform elements have not been addressed. Firstly, no insolvency mechanism for the member countries of the euro area has been created that would be both effective and would provide the proper incentives. However, a default of states could lead to major disruptions in financial markets, especially since commercial banks could lose equity and their existence could be threatened. Therefore, secondly, a reorganisation of financial market regulation and a European procedure for recapitalisation and, if necessary, orderly insolvency procedure for banks is desperately needed. It is positive in principle that the new regulation for the EFSF includes this possibility.

An economic policy that seeks to prevent government default by any means contains risks. An implicit bailout guarantee leads to the financial markets not adequately assessing the macroeconomic risks and therefore building up too high exposures. Moreover, the events since spring 2010 have shown that the liability sums may continue to increase. There is thus the danger that the guarantor states will overextend themselves and that their debt will increase to more and more critical levels. If this happens, the rescue efforts would yield no benefit in the short term – quite the contrary: the guarantor states would no longer be able to help the problem countries, and in the euro area as a whole the debt problem would be even greater.

Governments are now trying to limit the debt problems in the medium term by making the Stability and Growth Pact stricter and by having the countries adopt national debt rules, which some have already done or intend to do. Such steps are to be welcomed. However, they cannot be expected to lead to a rapid easing of the situation. Since in the past many countries have not kept to the agreed rules like the Stability and Growth Pact or to their own stability programmes, the real test of how seriously the rules are taken is still pending.

Since the measures taken by European governments have not yet led to a solution of the debt crisis, the ECB has come under pressure to act. As early as May of last year, it purchased government bonds; in August this year it surprisingly took up this action again and bought bonds, mainly of Spain and Italy. The Institutes have given varying assessments of the actions of the ECB during the debt crisis. The majority of Institutes believe that the ECB overextended its mandate and thus put its independence at risk. In addition, the purchase of government bonds has had adverse incentive effects. It reduced the pressure on member countries and the European Commission to quickly implement procedures for solving the debt crisis and reduced the pressure on the countries concerned to consolidate their budgets. The consortium of IWH and Kiel Economics does not share this view but feels that the government bond purchases by the ECB are justified because of the acute threat to the stability of the banking and financial system and since the ordo-policy solutions recommended by all the consortia cannot be realised in the short term. In the view of all the Institutes, however, it is not a sustainable situation when the responsibility for economic-policy goals is blurred. The key goal is that the ECB return to acting independently of fiscal policy and to ensuring price stability.

Against this background, German fiscal policy should maintain its consolidation course. On the one hand, the state budget remains structurally under-funded: in the current year, with a positive output gap of around 1%, the structural deficit in relation to nominal GDP will be nearly 1.5%. On the other hand, the debt ratio surged from 74.2% to 84.0% in the past year, and even in the best case – if the European sovereign debt crisis can be solved without cost to the German budget – the debt ratio will lie above the Maastricht Treaty limit of 60%.

Long version as pdf-file (only in German)

For further information, please contact:
Prof. Dr. Roland Döhrn, Tel.: +49 201 81 49-262, email
Sabine Weiler (press office), Tel.: +49 201 81 49-213, email

Key Data of the Forecast for Germany

^a)In Germany. -^b)Unemployed as % of domestic labor force (definition according to Federal Employment Agency). - ^c)Consumer price index (2005 = 100). - ^d)Compensation of employees per employee created in the domestic economy as % of real GDP per employed person. - ^e)National accounting definitions (ESNA 95). - Sources: Federal Statistical Office; Federal Employment Agency; States' Working Group for Public-economy Accounting; German Bundesbank; 2011 and 2012: Institutes' forecast.