Economic prospects: Small plus, big risks

Created: 12/21/2022, 8:06 p.m

Prof. Stefan Kooths is Vice President of the Kiel Institute for the World Economy and Director of the Research Center for Business Cycles and Growth.

© N. Bruckmann/M.

Litzka

At the turn of the year, the prospects for the German economy brightened slightly.

The head of economic activity at the Kiel Institute for the World Economy, Prof. Stefan Kooths, makes this clear in the guest article.

The unexpectedly robust consumption plays a key role here.

However, it is still too early to give the all-clear, warns the economist.

The prospects for the German economy have brightened slightly since the energy crisis escalated in autumn.

Although economic output is likely to decline slightly in the winter half-year, overall there are now signs of somewhat firmer development for the coming year.

This is made possible by a less burdened consumer economy as a result of comparatively less rising energy prices.

In addition to declining prices on the wholesale markets, the massive subsidization of gas and electricity consumption has a major impact.

This counteracts the much sharper slump in real disposable income that would otherwise be expected in the coming year.

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Higher prices reduce the purchasing power of consumers

At the same time, the upward trend in prices continues to significantly reduce the purchasing power of consumers.

After three years of declining real incomes, these are not likely to increase again noticeably until 2024.

Non-energy-intensive industrial production will continue to be supported by high backlogs of orders and easing supply chain problems well into next year.

Overall, this results in a somewhat more favorable economic development compared to the situation in autumn.

At the Kiel Institute for the World Economy, we have increased the expected growth rate in gross domestic product for 2022 and 2023 by 0.5 and 1.0 percentage points, respectively, to 1.9 percent (2022) and 0.3 percent (2023).

Nevertheless, the energy crisis continues to weigh heavily on the German economy.

Measured against our winter forecast from the previous year, which depicts the otherwise possible economic development, economic output will fall by 180 billion euros in 2022 and 2023 alone and at the end of this period will still be 4 percent below the reference scenario.

For the year 2024, we expect an increase in gross domestic product of 1.3 percent and thus an overall restrained dynamic, which is also based on a lower potential path, which is also reduced by the energy-related stress factors.

Lower inflation rates bought with high government deficits

Massively increasing subsidies are hidden behind the so-called electricity and gas price brakes.

The associated additional expenditure will burden public budgets with 87 billion euros in the coming year and 17 billion euros in the year after next.

Financing is mainly provided by the "Economic defense shield against the consequences of the Russian war of aggression", with which the federal government has granted itself additional credit authorizations of up to 200 billion euros for the coming years, making use of the exceptional clause in the debt brake that is still valid.

Although the price brakes are designed as consumption-independent payments, they are recorded as price-dampening in the official statistics.

Taken by themselves, the gas and electricity subsidies will push the inflation rate down by 2.4 percentage points in the coming year, and the abolition from April 2024 will then increase inflation by 1.1 percentage points in the same year.

Overall, the inflation rates are likely to be 8.0 percent (2022), 5.4 percent (2023) and 2.2 percent (2024).

As a result, the deficits in the state budget will increase to 160 billion euros (2023) and 90 billion euros (2024), after 55 billion euros in the current year.

Fiscal policy is thus taking a highly expansive course.

Significant risks in energy supply remain unchanged

The prices for natural gas and electricity continue to fluctuate considerably on the spot and futures markets.

This is mainly an expression of an uncertain supply situation, especially for natural gas.

The purchase of liquefied natural gas (LNG) comes into question as a replacement for the lost Russian supplies.

With a supply that is hardly responsive in the short term, the additional demand from Europe can essentially only be met by buyers in the rest of the world being squeezed out by higher price bids.

This pushed the price of natural gas up to over 300 euros per megawatt hour (MWh) in August.

This was not least due to the purchases from Germany made on behalf of the state to fill up the gas storage facilities.

Although this has made a gas shortage in the current winter half-year much less likely, the question of security of supply for the cold season of 2023/2024 arises again.

The prices at which LNG will be available on the world market in the future depend not least on the economic development in Asia – especially in China.

If there is a significant recovery there, the demand for gas will also increase and with it the world market price for LNG.

Overall, the possibility of strong price increases must therefore continue to be reckoned with.

After the gas price brake expires in April 2024, these would again determine the effective end consumer prices.

On the energy side, it is also relevant that the nuclear power plants in Germany will be shut down in mid-April 2023 according to the current decision, which means that further electricity generation capacity will be taken off the grid.

The extent to which this affects the supply situation and pricing on the German electricity market also depends on how quickly the French reactors, which are currently being affected by maintenance work, are producing again.

Overall, there is still considerable uncertainty on the energy markets and thus also for the economy in Germany.

Energy crisis and turnaround in interest rates increase insolvency risks

So far, the corporate sector appears resilient to significantly higher energy and financing costs.

Up to now, there has been no noticeable finding either in terms of insolvencies or business deregistrations.

However, the risks increase the longer these burdens last, because in companies that cannot pass on the higher costs to their customers or other suppliers, the equity capital is gradually eroded.

In particular, it is unclear to what extent the long phase of low interest rates, which is unprecedented in modern economic history, has kept zombie companies on the market whose business models will prove to be obsolete once monetary policy normalizes.

Bad surprises are not excluded here.

New energy policy strategy urgently needed

With the stop of pipeline-bound natural gas deliveries from Russia, the most important bridging energy carrier for the energy transition in Germany has broken away.

So far there is no replacement available.

The federal government has promoted the development of terminal capacities in order to be able to land liquefied gas directly in Germany and thus expand European import capacities;

but this is only a necessary condition.

Because little would be gained if LNG tankers that have hitherto called at other European ports were only diverted to Germany.

There must also be incentives to significantly expand LNG production overseas and to provide the corresponding transport capacity.

This usually takes the form of long-term supply contracts.

However, these are subject to the political risk that Russian deliveries will be resumed.

Economic policy should contain this investment risk – ideally coordinated across the EU – for example by imposing a tariff on Russian gas deliveries, which offsets the price advantage compared to liquid gas.

Without such incentives for an expansion of production overseas, the only option left for LNG supply in the medium term would be purchases on the spot market, where buyers from other regions of the world would have to be priced out.

As a result, gas supply would remain even more expensive in the long run than it is anyway due to the switch to LNG.

Alternatively or in addition, German energy policy could consider tapping into domestic gas deposits via fracking.

In addition, there are six operational nuclear power plants in Germany, with which part of the growing demand for electricity could be covered in a largely CO2-neutral manner.

An accelerated expansion of renewable energies alone is not a solution as long as there is not enough storage capacity to cover dark doldrums.

Overall, a supply-side approach to energy policy would address the problem of high energy prices appropriately and help to stabilize expectations about future energy price levels in Germany, especially as a basis for investment decisions.

Only then can an entrepreneurial estimate be made as to which industries can continue to be operated competitively at the local location and which should move abroad.

Because the industrial basis of an economic area must be self-sustaining and must not be dependent on subsidized energy sources – certainly not in the long term.

Energy aid with the watering can fuel inflationary pressure

The electricity and gas price brakes are designed in such a way that they noticeably reduce the officially reported energy prices and thus the overall inflation rate.

Economically, they represent a purchasing power injection to a considerable extent for the private sector, which is offset by a correspondingly higher level of government debt.

The funds that will be handed out to electricity and gas customers via the protective shield in the coming year will amount to around 2 percent of economic output.

With these funds, the private actors can also plan.

If they affect demand on the goods markets, they also increase price inflation.

This effect would be less significant in severe underutilization.

However, surveys of capacity utilization indicate that the German economy is still largely overutilized.

In addition, the shortage of staff in many sectors is still extremely high.

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Even the overall economic production potential estimated using statistical methods does not currently show much room for improvement, although after a crisis phase of almost three years the estimate is less reliable than with normal economic development.

In addition, domestic gas consumption will have to be reduced by a total of around 20 percent in the forecast period in order to avoid a gas shortage in normal weather.

As a result, part of the affected production capacity will be lost, at least temporarily.

All in all, the massive fiscal stimulus runs the risk of fueling inflation outside of the energy-intensive sectors as well.

This risk could be significantly reduced if state aid were concentrated on those private households that would otherwise find themselves in dire financial straits.

This could be done, for example, by granting the aid under the proviso that it will be drastically reduced with the next income tax return, depending on income - not as in the previously envisaged solution with the income tax rate, but at a withdrawal rate that is up to the average income cashed back in full with the original aid.

This is much more coherent than first distributing aid to rich and poor with a watering can and then turning the control screw to compensate.

Use market mechanisms, not weaken them

Business aid should be handled even more restrictively and – if at all – take the form of loan guarantees.

Because marketable companies can pass on higher energy costs to their customers or pass them on to their other procurement markets.

This ability shows whether business models are macroeconomically important enough to be continued even when the energy supply is limited.

In this way, the market mechanism identifies where the use of natural gas in particular can currently best be avoided, with the decentralized distributed knowledge being mobilized to the maximum.

That doesn't automatically mean everything will be fine.

Even the efficiency of the market system cannot get rid of the drastic energy shortage.

It continues to be painful.

But the pain – measured in terms of lost value – is less than with any other allocation method.

Such a market-based approach works all the better the more closely it is combined with a supply-oriented energy policy.

Even if most economic researchers have recently raised their economic forecasts for the coming year, there are still massive risks for the overall economic development in Germany.

So no reason to sound the all-clear.

And even less reason to sit back - least of all for economic policy.

Because the previous course of countering the energy crisis essentially with a lot of state money is neither market nor stability-oriented.

About the person: Prof. Stefan Kooths is Vice President of the Kiel Institute for the World Economy and Director of the Research Center for Business Cycles and Growth there.

He teaches economics at the BSP Business and Law School in Berlin/Hamburg and is chairman of the Friedrich A. von Hayek Society.