Europe's growth engine risks going off the rails

David Crossland: The rest of the euro zone has taken a back seat as the Germany economy powers ahead relentlessly. But rising prices and wage increases are among the danger signs ahead.

Germany is being hailed as the locomotive of Europe's economic recovery, leaving euro-zone strugglers such as Greece, Spain and Portugal back at the station. Europe's biggest economy is enjoying runaway growth thanks to booming demand for its goods in emerging markets, especially China, but any positive impact on the rest of Europe has so far largely been on paper.

Without Germany, euro-zone economic growth in the second quarter would have been about only half the 1 per cent recorded. Germany's dramatic recovery is not having a significant knock-on effect on its European neighbours because it continues to run trade surpluses with most of them. Its reinvigorated companies and consumers are not buying enough French wine, Spanish oranges and Italian machine tools to trigger a broad recovery in Europe.

Germany racked up GDP growth of 2.2 per cent in the second quarter, the fastest quarterly growth rate since it reunified in 1990, compared with just 0.6 per cent in France and 0.2 per cent in Spain. The Greek economy shrank by 1.5 per cent. This imbalance may increase political tensions within the bloc by prompting accusations that Germany is expanding at the expense of its neighbours, and fuelling resentment by countries such as Greece that are lumbered with crippling austerity programmes imposed largely at Germany's insistence in return for EU aid. But it is unlikely to be the cause of a second crisis in the euro-zone's financial system.

Germany's export strength has long been a source of contention in Europe, and the French government stepped up the criticism this year by complaining that Germany needs to boost its domestic demand to scale back its chronic trade surpluses with the rest of Europe. Christine Lagarde, the French economy minister, took the unusual step last week of welcoming German trade union calls for wage increases, a move she said would help boost domestic consumer spending and increase imports.

Critics say German companies have been snatching foreign contracts away from their euro-zone partners because they have radically reduced unit labour costs in recent years in an efficiency drive that has kept real wage increases low, hampering domestic consumer spending. Germany has argued with some justification that it has only been doing its homework. Its companies have undergone painful restructuring since 2004 when the country was being labelled the "sick man of Europe" and was languishing under a bloated welfare system and zero growth.

Besides, they argue, Mercedes and BMWs remain more expensive than Renaults or Peugeots and the Chinese still prefer them because of the quality and the power of the brand. And Germany's huge sector of medium-sized industrial businesses, the so-called Mittelstand, supplies precisely the range of specialised machinery for which emerging economies are clamouring. Other European companies, especially in the engineering sector, produce nothing to rival the output of the Mittelstand, so any cost advantages are irrelevant, the Germans say.

The fact that German economic growth has not been consistently stronger than that of its neighbours over the years should allay fears that the current gap will tear the euro zone apart. After all, the euro zone has seen wide regional differences in growth since it was set up in 1999. A few years ago, Spain, Portugal and Ireland were booming while Germany was in the doldrums. The debt crisis did not stem from those growth differentials but from the shock of the global downturn in 2008 and the lack of fiscal consolidation by some euro-member states.

The growth momentum has reversed, but the German economy is unlikely to keep expanding at this rate. China, one of its biggest growth markets, is showing signs of slowing down and German inflation is set to accelerate next year as a result of wage increases and low interest rates. The European Central Bank (ECB) is widely expected to keep interest rates down until well into next year to avoid causing further stress to the embattled southern economies. As a result, the ECB's leading rates will soon be far too low for a German economy projected to exceed 3 per cent growth this year.

The consequent rise in price and wages will hurt Germany's competitive position and will present an opportunity for its neighbours, whose products and services will become relatively cheaper. Uncomfortable though growth differentials may be, they highlight the need for restructuring and fiscal reforms. As such they could end up benefiting Europe rather than harming it. [e-mail]