Germany exports its disease

Germany is not only exporting goods and services as well as the cash-for-clunker scheme, it is also exporting its economic malaise, the "German disease". In the Eurozone there are always some countries with higher-than-average inflation rates and some with below-average inflation rates. The downside of this is that the low inflation countries have - given the same ECB repo rate - above-average real yields. Germany earlier this decade had limited growth and limited inflation, resulting in above-average real yields at levels which were deemed too high for the state of the economy. This held back investment in the domestic economy as well as demand for housing. In turn, the economy underperformed, resulting in ongoing low inflation. Two factors help to come out of such a vicious circle: time and restructuring/reforms. Time will help as lower inflation than the other currency area members (and main trading partners) will lower the relative price level of goods and services over time and help corporates to become relatively more competitive again. Furthermore, the low growth environment will force corporates to restructure to become more competitive and will necessitate structural reforms at a national level. All of this happened in Germany, rendering businesses more competitive again and in turn promote export growth. As this happens, unemployment can fall again and in a second stage revive the domestic economy. However, this is a long and painful process.
In Spain on the other side, the starting price level when joining the Euro was lower than elsewhere and Spain joined the euro with an undervalued exchange rate. Furthermore, in the run up to joining the euro, interest rates dropped close to the German Bund yield levels. This helped the domestic economy to grow and inflation to be at an above-Eurozone average level. In turn, real yields were below the average prevailing in the Eurozone. This further supported growth via increasing investments and also led to the creation of a housing bubble. However, on the downside, corporate comptetitiveness dropped over time while housing markets became overvalued, corporoates amassed a huge financial deficit and corporates & households became increasingly indebted.
The table below shows how the price levels changed in the various Eurozone countries between January 1999 and July this year (1996=100):

	Price level Jan 1999	Price level Jul 2009	Change
Eurozone	102,8	127,4	23,9%
Germany	101,9	121,1	18,8%
Austria	102,1	123	20,5%
France	101,6	123,1	21,2%
Finland	102,4	124,2	21,3%
Belgium	102,8	125,8	22,4%
Netherlands	104,1	131,4	26,2%
Italy	104,6	132,3	26,5%
Portugal	105,3	137,6	30,7%
Luxembourg	100,8	135	33,9%
Spain	104,7	141,5	35,1%
Ireland	103,6	140,9	36,0%
Greece	110,6	153,9	39,2%

Source: Eurostat

During this 10-year period, prices in Germany rose the least, by roughly 19%, whereas in Spain it rose by 35%, in Ireland by 36% and in Greece prices rose by even 39% (however, Greece only joined the Euro in 2001). So the German price level rose by up to 20% less, a significant difference. It also highlights how time helps to adjust relative differences in price levels and in turn promotes competitiveness for the underperforming and less inflationary economy within the Eurozone.
Everything changed, though, with the bursting of the housing bubble. Unemployment in Spain is skyrocketing, inflation has dropped below the Eurozone average and therefore real yields have moved above the Eurozone average. This will put further downside on the housing market and force corporates and households to reduce indebtedness. While Germany has gotten rid of its economic disease, it has not disappeared, it was just exported into the periphery of the Eurozone. Given the size of the economic challenges, it will take a long time to restore the health of corporates' and households' balance sheets and restore competitiveness. Whether the state is able to support this process via structural reforms remains to be seen.

The chart below shows that Spanish inflation for the first time during the existence of the Eurozone is now below German inflation while Irish inflation has fallen even further. This raises the risk of a debt-deflation spiral developing in these countries and suggests that Ireland and Spain have caught the German disease. Greece inflation so far has failed to fall below German inflation. However, this just delays the inevitable as it suggests that Greece continues to lose competitiveness relative to the Eurozone average.

Source: Eurostat

The consequence of all this is that while the past decade was about peripheral countries' living standards playing catch-up with a lame-growth Germany, the next decade is likely to see peripherals trying to restort competitiveness and growth will underperform vs. the core of the Eurozone. As this happens, domestic investment and consumption in the core of the Eurozone (and especially in Germany) should fare relatively well whereas it promises to be very weak in the periphery. This should also be mirrored in the relative performance of financial assets with a likely substantial underperformance of peripheral markets vs. core markets.