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The story of Germany's demise has been much exaggerated, and it's time to set the record straight about what's happening in the economic engine of the EU, writes Kiron Sarkar of World Money Analyst.

A number of economists and analysts have recently penned positively downbeat reports on Germany. Their argument is that Germany will be dragged down by the problems in the Eurozone. Some have suggested that Germany will return to the days of being “the sick man of Europe,” as was the case in the 1990s. I have to say, I very much disagree with this assessment.

It is true that German GDP is around 40% dependent on exports, which have declined materially to the Eurozone, in particular, given the ongoing problems in the region. However, the German domestic economy remains strong, with consumption and the construction sector still buoyant. In addition, German industry has successfully targeted emerging markets, such as China, while exports to the US are rising.

The key to understanding Germany is to understand Chancellor Angela Merkel and the German political and economic view. Merkel is a consummate politician. She has successfully navigated her way through the EZ minefield and placed Germany as the clear head of the region. The Eurozone is no longer managed as an equal partnership between Germany and France.

A United Europe
Merkel was raised in East Germany, and as a result is not comfortable with expressing her view openly, and is not a naturally open leader. She prefers to hammer out deals in dark, smoke-filled rooms with the doors bolted firmly shut. After all, to express a dissenting political view in communist East Germany would have landed you in serious trouble.

However, she believes fundamentally in a united Europe, something reinforced by her East German upbringing, and the fact that the German Constitution calls for it. A scientist by training, Merkel reads and masters her briefs far, far better than any other politician in Europe. She is risk-averse and a consensus builder and not at all dogmatic.

Importantly, she does not believe that even Germany can compete with the emerging economies of China and India unless it forms a political union. In particular, she understands that to survive, the Eurozone must improve its competitiveness by instituting the necessary structural and labor reforms.

Merkel understands that Germans are reluctant to pick up the tab to bail out the spendthrift peripheral Eurozone countries, especially with the impending general elections in September this year. Accordingly, she will reject measures such as debt mutualization (Eurobonds) until after the elections. Germans are only too aware of the cost of unifying East Germany, and they were fellow countrymen.

Having said that, a majority of Germans prefer to retain the euro, not just for economic reasons (a return to the deutsche mark would result in the currency becoming supercharged like the Swiss franc, destroying German industry/exports), but also because the majority believe in a united Europe, in particular given the history of the continent in the first half of the last century.

Merkel’s CDU party is polling around 40%, with the opposition SPD some ten points behind. However, her current coalition partner, the FDP, is toast and may fail to get the 5% of the votes it needs to gain representation in Parliament.

Merkel must find a new coalition partner and would prefer not to link up with the main opposition, the SPD, to form a “grand coalition.” Somewhat counterintuitively, German political commentators speculate that she may team up with the Greens. The head of the Greens is an East German, and I understand that the two ladies get along.

But it’s early days. Equally important is the fact that the main German opposition party is even more pro-Europe and less euro-skeptic than Merkel’s CDU. It is expected that Merkel will win the next German general election.

Immigration’s Impact
Let’s return to the economy. Yes, German exports, industrial production, and unemployment data have shown signs of weakness.

Yet, the more important IFO, ZEW, and consumer confidence indices are up sharply, in spite of the problems in the Eurozone. German domestic consumption is increasing, and unemployment, while slightly higher, is near a two-decade low—not at all bad, given the serious economic problems in the Eurozone.

Indeed, I would not be surprised if employment strengthened in the second half of 2013 as Germany still produces the goods that the world wants. Businesses have become more efficient and far more market-oriented.

In spite of the financial crisis affecting the Eurozone in 2012, Germany produced a budget surplus of +0.1% of GDP last year. Only Germany could pull this off. Continued surpluses in coming years will give Germany added flexibility to introduce growth measures, though the Finance Minister stated that other Eurozone countries should not expect Germany to undertake significant growth policies. However, the temptation, ahead of a general election, to introduce at least modest growth measures will be strong.

The Bundesbank (the German central bank) expects German GDP to increase by just 0.4% this year, with fourth-quarter 2012 negative and Q1 2013 flat. Although I will go along with the Q4 2012/Q1 2013 estimates, I believe that German GDP will increase by between 1% to 1.25% this year—a German business lobby is forecasting 1% growth.

In addition, a number of analysts have failed to factor in the rise of immigration into Germany, particularly from other Eurozone countries. My well informed German friends estimate that Germany will benefit from roughly 500,000 new immigrants each year.

The increase in residential construction to cope with this inflow, combined with a rise in consumption, will, of course, raise GDP for many years ahead. Immigration will also help counteract the impact of an aging population and help plug skill gaps.

Austerity Policy in Question
Importantly, Merkel will want to avoid problems in the Eurozone ahead of the elections. That means she is less likely to be fixated on austerity policies, and I believe that she will turn a blind eye to countries (such as Greece, Spain, Italy, Portugal, and France) that miss their budget deficit targets. The EU may approve some growth measures, a policy she will not likely oppose, though not necessarily approve openly.

Policymakers in the Eurozone (finally) are beginning to understand that austerity will fail due to the impact of fiscal multipliers—the chief economist at the IMF has admitted that they have made a mistake. The likelihood of the Eurozone avoiding additional crises this year is slim, with Cyprus the latest country to rear its ugly head. Merkel, to date, has handled the situation well, and I see no reason why that would change.

So far, Merkel has had to rely on the support of the opposition SPD to push through measures in Parliament to ease the crisis in the Eurozone, but most of the crisis-solving measures have been undertaken by the European Central Bank (ECB). Merkel and the head of the ECB, Mario Draghi, have a good relationship, and there is no doubt that he briefs her constantly.

Merkel is perfectly happy for the ECB to take the necessary policy actions, in spite of opposition from Bundesbank President Weidmann, so long as she is not seen to have promoted or been associated directly with such policies. Although Weidmann has expressed opposition to most of the ECB’s policies, he is her man—he was her previous advisor, and she got him appointed as head of the Bundesbank.

Political Union
Post-election, I believe that Merkel will press ahead with banking and fiscal union, in addition to setting up a transfer union. In other words, a political union.

Clearly, such a union will cost Germany, but I believe that Merkel understands that and is prepared to play her part. The biggest obstacle to such a union will be France, which wants to retain its political independence. The UK will not agree to a transfer of sovereignty, but the UK is not in the euro, and, accordingly, the key problem country is France.

The economic problems facing France are significant, and relations between Merkel and the new French President François Hollande are bad and will undoubtedly get worse. France is forging a closer relationship with the Club Med countries of Spain and Greece.

Italy, under Mario Monti, will remain closer to Germany than France, as will Portugal under the current administration. This is another losing strategy for France, which together with Spain remains the most serious threat to the Eurozone.

To conclude, I believe that stories of Germany’s demise are premature. A cheaper euro (around or even below $1.20), which I believe will be the case this year, will benefit German industry. The ECB is likely to cut interest rates by 25 basis points to just 0.5% in coming months, as EZ inflation declines below 2%.

Further, German exports will rise as the Eurozone stabilizes later this year and markets in emerging countries and the US remain strong. Employment will improve as well. The German consumer remains confident, as does German industry.

The Germans are afraid of inflation rising, whereas foreign investors are concerned that Germany will not be able to resist the downturn in the Eurozone. Both assessments are wrong, in my humble view. Essentially, I would not bet against Germany.

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