Economics and politics - comment and analysis
13. January 2023 I Heiner Flassbeck I Economic Policy, Europe

The supply shock that is a demand shock

At the end of September, Federal Finance Minister Christian Lindner gave a remarkable diagnosis of the state of the German economy in a name article in Der Spiegel. He wrote: “In the Corona crisis we experienced a demand shock. Here the state replaced a lack of demand with tax money. Today we have a shock on the supply side. In times of scarce supply, we need to increase it with ambitious measures.”

This statement is first remarkable because the minister obviously believes that the state can compensate for a lack of demand with “tax money”. But he cannot. If he first has to raise taxes to generate the funds he needs to stimulate demand, then by raising taxes he lowers the demand he wants to increase. No, no, dear Mr Lindner, look at your books and you will see that it was new debt that was used to support demand.

Even more serious, however, is the minister’s misunderstanding of what came after the demand shock triggered by the Corona measures. Here the Minister believes he is dealing with a supply shock. That is wrong. There is indeed a supply shock, but it has brought with it a massive demand shock. If the Federal Minister of Finance does not recognise this and does not understand the underlying relationships, then he will inevitably make big mistakes that will fall on his feet later.

Financing balances show the connection

The financial balances (the balances between income and expenditure) of the economic sectors show this very well. Private households in Germany currently save about 250 billion euros per year. This means that there is per se a demand gap of this magnitude in the national economy. Income of private households is paid out by the state and companies in the order of 1,600 billion euros per year (the so-called mass income), but only 1,350 billion comes back via purchases of goods and via taxes. Over the past almost twenty years, this gap has been closed very reliably by foreign countries, which most recently had a current account deficit of this magnitude vis-à-vis Germany.

What happened in the wake of Corona is now easy to understand. Households were prevented in one way or another from spending as much money as in previous years, but incomes continued to run for the most part (supported by the state to a considerable extent), so that savings increased. Their total sum, i.e. the surplus income of private households, rose to well over €300 billion in 2020 and 2021. This is the demand shock that Lindner is referring to.

This drop in demand coming from private households was compensated for in 2021 by the state and – again – by foreign countries. The state deficit amounted to a good €130 billion, the foreign deficit even rose to €260 billion. Consequently, German companies (the balances must always add up to zero, as shown many times) made a surplus of over €100 billion, which even meant an “improvement” in their position.

Foreign trade turnaround in 2022

Last year, however, the picture changed dramatically. It is true that households reduced their savings again to a value of about €230 billion, which brought some relief to businesses. For the state, however, this in no way meant that it could reduce its own expenditure surplus (its net debt).

The rise in commodity prices, which in itself can indeed be described as a supply shock, brought about a drastic reduction in the German current account surplus. It almost halved from €270 billion to €150 billion. The oil and gas bill rose to unimagined levels. This again created a huge demand gap in Germany. Although this was largely closed by the state with a deficit of almost €100 billion, the savings position of companies nevertheless declined considerably.

The reason for the demand gap is easy to understand. Those in the world who benefited from the rise in commodity prices did not demand nearly as much as would have corresponded to their additional income. In other words, their savings increased thanks to very high savings rates, which means that in 2022 there was again a demand shock due to rising savings, this time triggered by foreign rather than domestic demand. If Lindner thinks it is right in principle to react to such demand gaps by increasing government demand (financed by debt), then he would have to do it this time as well.

What will happen in 2023? Most forecasters have settled on a variant in which private households in Germany once again reduce their savings significantly, from €230 billion to about €190 billion. However, this is not particularly realistic in view of the population’s declining real income. They also expect a slight improvement in the current account balance of about €20 billion. In this scenario, the state would have to take on at least €30 billion in new debt in order to maintain the corporate position at the 2022 level. If, however, private households do not reduce their savings rate, the sum that the state has to raise rises to €70 billion.

Mind you, even if the state were to do this, companies would be kept at a level that they would presumably find threatening in a recession. If companies try to improve their situation through their own spending cuts and reduced investments, the situation for the economy as a whole will be much worse. Because interest rates are also rising, a revival of investment activity, as assumed by the forecasters and the government in their projection for 2023, is completely implausible.

A collapse in investment is the much more likely outcome and thus the task of the state to once again counter it with even more new debt. One can only talk about a return to the debt brake if one does not know that every attempt to significantly reduce the state deficits this year will immediately and massively further worsen the situation of businesses. One is amazed that the leader of a party that likes to be close to business does not know this.

Persistent imbalances in the EMU

It could also turn out quite differently. The sharp drop in commodity prices in recent months may cause Germany’s current account surplus to recover very quickly. If the oil and gas bill falls and the global economy does not collapse, the German surplus can very quickly move back towards €200 billion and more and largely close the demand gap of private households. Then the finance minister would not be out of the woods yet, because corporate investment could still collapse, but he would have to go far less into debt.

With this “solution”, however, it must be borne in mind, especially for the Federal Finance Minister, that with its current account surpluses Germany continues to create an imbalance in the European Monetary Union that blatantly contradicts the specifications of the so-called European Semester accepted by all member states. If Germany were to comply with these requirements and significantly reduce the imbalance, the German state would have to accept high government deficits every year in order to prevent a permanent contraction of the German economy. The debt brake in the German constitution can only be complied with by those who permanently violate European law.