The German Economy - Batting on a Sticky Dog.
For those not familiar with cricket, the terminology can seem impenetrable, with its short legs, silly points and googlies. One bit of lingo that has largely been discarded is the ‘sticky dog’, the rare phenomenon of a hot sun beating down on a rain-soaked pitch which makes batting almost impossible. While England legends of yesteryear Jack Hobbes and Herbert Sutcliffe earned cricketing immortality by scoring heavily on sticky dogs in Ashes series against Australia in the 1920s, the advent of covered pitches has meant such rain-affected batting treachery has largely been consigned to history.
Due to its geographic position and geopolitical alignment, Europe finds itself in 2022 in the economic equivalent of a sticky dog, where ‘staying in’ is a much of a task as scoring runs. Nowhere is this more true of Germany, Europe’s bulwark during the Eurozone crisis of 2009-2012, which now finds its diplomatic and moral obligations strongly at odds with its economic wellbeing.
In an age of big data, apps and salad-as-a-service, the conflict in the Ukraine has come as a salutary reminder of the importance of energy to the global economy. Europe’s problem is that it has very limited stocks of its own oil and gas. While coal drove the industrial revolution of the nineteenth century, the twentieth century saw the rise of oil, and with it Europe’s dependence on external sources of it.
The story of Europe’s energy problem has a familiar tone. In World War I, Imperial Germany’s interest in the emerging oil sources of Persia (now Iran) and Ottoman-controlled Mesopotamia (now Iraq) underpinned the country’s Middle-Eastern strategy. Hitler’s disastrous invasion of Russia in 1941 was in parted motivated by a desire to secure Soviet Russia’s oil fields in the Caucasus.
Yet it was the largely-forgotten Suez crisis of 1956 that saw Europe pivot east for energy sources even in the midst of the Cold War. When the US refusal to release oil from its strategic reserve forced a humiliating exit from the conflict by Britain, German Chancellor Adenauer pushed for the formation of the European Economic Community (The EEC, later the EC) and the European Atomic Agency (EURATOM) as a means of addressing Europe’s economic and energy interests.
In the years that followed Suez, Soviet Russia started to build the Druzhba (Friendship) pipeline which would move gas from central then to western Europe. Given Europe’s previous reliance on energy from the Western hemisphere, the strategic threat to the US was obvious, so much so that during the Cuban missile crisis, President Kennedy banned the export of pipeline materials to the Soviet Union. With the problem of NATO unity in the background, the issue of Europe’s energy security became even more of a problem for America’s sphere of influence. Understanding this backdrop is key when considering for example how vociferous the US has been in opposition to the now-defunct Nordstream 2 pipeline.
Countries get into trouble when their political obligations and economic interests come into conflict with one another. The emerging issue of Chinese influence in the Solomon Islands and the US and Australia’s opposition to it has made plain yet again that Australia’s diplomatic alliance to the US as part of the five-eyes security group stands in stark opposition to its economy’s reliance on commodity exports to China.
Likewise, it seems increasingly clear that Germany has a similar problem. Its economic advantages in industrial production are reliant on cheap energy and commodities from Russia as well as an export market to China. Russia is definitely on the other side, while China increasingly appears to be so.
From a purely-economic perspective, Germany could be said to be on the wrong side, and the close links that some members of Germany’s political class have to the Putin regime (notably former chancellor Gerhard Schroder) is only adding to the angst that is currently consuming the country’s political elite. It seems the moral and political imperative to take a strong stance against Russia will involve paying a heavy price economically. Germany still seems to be dragging its heals on the provision of military aid to Ukraine, and that certainly isn’t a good look right now.
At the same time as German industry is starting to talk about an impending economic catastrophe if the country is cut off from its Russian gas supplies, consumer confidence is plummeting, as can be seen from the GfK data below.
With the rise in energy prices, German inflation is accelerating sharply. The German purchasing price index (PPI) is now at 31%, while headline inflation for April was above 7% (see graph below). All the while, the ECB has kept its deposit rate negative, and while there may be a rate hike in July, it is unclear whether the central bank will be able to raise rates to the 85 basis points or so that the market is currently pricing for 2022.
With respect to Russia’s demand that gas is to be paid for in rubles, the EU seems to suggest that this would a breach of sanctions, although it appears a number of European energy suppliers have already opened ruble accounts with GazpromBank. This week’s news that Bulgaria and Poland have been cut off from Russian gas shows that a showdown is imminent with respect to Europe (and Germany) walking the talk on ruble payments. To top things off, in the background is a Chinese lockdown-induced economic slowdown which will likely have a knock-on effect on German industry and GDP.
These really are tough times. While Germany announced this week it would be borrowing an additional 40b euros to offset the effect of the Ukrainian conflict on the domestic economy, the sliding euro and spiking gas prices resulting from the news of Poland and Bulgaria being cut off from Russian gas increases the odds of recession in the short-term and stagflation in the medium term.
While German borrowing costs remain low (10yr bunds currently yield around 0.90%), the risk of a supply shock from energy supply disruption is growing. Germany has just agreed to go along with the EU’s proposed ban on Russian oil imports, but the prospect of gas supplies being cut if Germany refuses to pay Russia in rubles raises another unpleasant spectre from Germany’s distant past.
It was the French occupation of the Ruhr (Germany’s old coal- and steel-producing heartland) and the subsequent general strike in 1922 while the German government ran central-bank financed deficits to pay workers that finally pushed Weimar inflation into hyperinflation territory. While hyperinflation is not currently on the cards, the propensity for governments to think they can print their way out of supply-side shocks does not have good historical precedents.
Japan is heading down that road, and the yen is falling against the dollar as a result. The recent lurch lower in the euro ought to offer Europe’s politicians and central bankers a salutary reminder of what is at stake. German economic strength as well as the dominant political personality of Angela Merkel anchored the eurozone in the last crisis a decade ago. With the German economy already in trouble and with the political class divided, the end of the day’s play and the haven of the pavilion seems a long way away right now.