All is not well in the German economy

BERLIN — Economic headlines last week bore unexpected good news for Germany: With positive, if modest, growth of 0.3 percent in the second quarter of the year, Europe’s largest economic engine had officially moved out of recession.

But there are more dark clouds gathering on Germany’s economic horizon. Indeed, the president of Germany’s banking association reminded the country that its financial system was a long way from exiting crisis mode.

“It is obvious that every bank will have more to deal with in the next 18 months, in terms of defaults by clients and non-performing loans, than they have had up to now," Andreas Schmitz, president of the Federal Association of German Banks, told the Financial Times.

For those who had been tracking the German economy during the crisis, it was clear what Schmitz was hinting at: German banks had not weathered the storm well, and a credit crunch loomed. That doesn’t bode well for the greater German economy, whose diverse export-dependent businesses rely on lines of credit to finance them in normal times, much less the turbulence of the past year’s global crisis. Already, 57 percent of the country’s largest engineering association — an organization whose members include heavyweights like Volkswagon and Siemens — have reported difficulties accessing credit. In March, only 5 percent of companies reported such problems.

“We shouldn’t be surprised by these developments,” said Fabian Kreidner, an economist at the Free University in Berlin. “We’ve been in denial a long time.”

Independent economic analysts, including Klaus Zimmerman, president of the German Institute for Economic Research, have seen in Germany’s precarious bank balance sheets reminders of Japan’s “Lost Decade” of the 1990s, when the Asian economic powerhouse failed to clean up its banking sector and the country’s economy stalled for years on end as a result. “The problem is going to come when we want to get out of the crisis,” Zimmerman said. “The banking sector has to be there and be healthy. And the banks won’t be able to participate.”

Indeed, the problems with Germany’s banks are compounded precisely by the fact that the country’s political world has made a habit of ignoring their severity. In the early days of financial freefall, Chancellor Angela Merkel and Finance Minister Peer Steinbrueck didn’t shy from pointing fingers at the banks in Britain and America for their risky speculations, but had little to say about their own lending institutions.

It turned out, though, that in many cases German banks were even more deeply leveraged than their Anglo-Saxon counterparts. In fact, it was precisely those German banks that were the most highly regulated — the state-owned and controlled regional Landesbanken — that were found to be the most exposed to the infamous sub-prime mortgage derivatives.

Nonetheless, the government response has been hesitant and piecemeal. Politicians preferred to place populist sentiment before sound policy. The public was already disposed against seeing the government spend large sums of money, thereby risking the inflation of the European currency. In Germany, memories of the country’s hyper inflationary period of the late 1920s and 1930s loom large. And if large sums of money did have to be spent, the public preferred not to see bankers on the receiving end. Indeed, they had been primed for that animus against bankers by their own politicians, who indulged in occasional demagoguery against speculators.

The result was an ad hoc policy toward the country’s banks. Banks were invited to apply for bailout money from the federal government, but it was made clear that stringent rules and public shaming would apply to those that did take funds. The result was that only one major bank took a major bailout, the Hypo Real Estate bank. Other ailing banks kept silent, in hopes of riding out the economic storm and avoiding the stigma of approaching the government for aid. It was only in May that the government admitted that this wasn’t a sustainable solution and introduced legislation in order to provide a comprehensive approach. In order to encourage banks to stop worrying about mounting losses on their balance sheets, the government invited banks to place their losses into a separate “bad bank” backed by the government. But economists who were hoping for a more comprehensive program along the lines of what had been realized in the United States and Britain — a government-funded mandatory recapitalization of the banking sector — came away disappointed.

And sure enough, the credit markets seem not to have improved: Banks are still routinely claiming that they can’t afford the risks of lending, frustrating even the most established of clients. Even record-low interest rates from the European Central Bank have done little to increase liquidity. Politicians have been reduced to chiding the banks for not doing more to distribute money to the rest of the country.

What’s clear is that little more than this sort of pleading is going to happen before the national election scheduled for Sept. 27. Whether the government will do what’s necessary thereafter to recapitalize the banks and avoid a “Lost Decade” is still an open question.

“The politicians know that they’ll have to do something,” said Kreidner. “But, so far, no one has suggested any concrete plans. We’ll see some improvising after the election.”

If campaign promises are any indication, though, things don’t bode well for lenders and borrowers. Merkel’s Christian Democratic party is hoping to form the next government with the free-market friendly Free Democratic Party, which is the only political grouping in Germany that’s criticized all of the major federal interventions to stem the financial crisis to date.