In October 2010, we proclaimed a ‘last golden decade’ for Germany. Reaping the benefits of its post-2003 reforms, Germany can enjoy roughly one decade of faster trend growth, lower unemployment, a healthy fiscal position and stronger gains in private consumption than in the two decades before. (For details, see our report Understanding Germany, 13 October 2010.) By and large, 2011 surpassed our expectations. Despite a serious softening of activity at the very end, we can count 2011 as the second year of Germany’s golden decade. Following a gain of 3.6% in 2010, the German economy expanded by 3.0% in 2011, driven mostly by domestic demand. Germany managed to reduce its fiscal deficit to a mere 1% of its GDP last year.

Euro crisis
Unfortunately, Germany is heading for a rocky start into 2012. Since the decision in July 2011 to restructure Greek debt without protecting Italy, contagion has spread across the Eurozone. The escalating euro crisis is very bad news for Germany’s open economy. In the final quarter of 2011, the German economy started to contract modestly.

Still, we expect the German economy to weather the storm comparatively well. Germany can draw on some major sources of resilience.

Exceptional labor market dynamics
Ever since Germany reformed its labor market in the years after 2003, its labor market dynamics have been exceptionally positive. Even the post-Lehman recession, the worst economic shock in 60 years, caused only a small and temporary drop in core employment. The number of employees earning enough to be subject to payroll taxes rose by 2.6% year-on-year in late 2011. Firms which had been scrambling to find enough suitable workers until the autumn of 2011 are unlikely to fire many workers in a 2012 downturn.

Germany has no need to tighten fiscal policy significantly. Abstracting from cyclical factors, Germany has achieved an almost balanced budget. If it had not been for the economic downturn that Germany itself triggered in July 2011, Germany would probably have registered a fiscal surplus in 2012.

Strong domestic demand
Contrary to a widespread assertion, German growth is driven largely by domestic demand. Domestic demand has firmed to well above the pre-Lehman level whereas net exports have recovered only part of their post-Lehman losses.

German consumers are in good shape. With household debt at 98% of annual disposable income in 2010, Germany looks better than the US (125%) and the UK (165%). Thanks to strong gains in employment, German nominal wages and salaries rose by 4.6% year-on-year in the first three quarters of 2011, up nicely on the 2.7% gain in 2010. While employment growth will slow down significantly, this will be partly offset by less subdued wage inflation (probably 3.5% in 2012 after roughly 2.5% in 2011). With declining headline inflation, this leaves room for a modest gain in private consumption.

Germany faces little risk of a credit crunch. The Ifo credit constrain indicator remains at an exceptionally relaxed level. Germany benefits from a dense network of small regional banks (savings associations and cooperative banks) which have only very limited exposure to external shocks. Also, comparatively buoyant domestic demand gives banks the chance to earn money at home even if some of their holdings of non-German assets look shaky.

One way or the other, the Eurozone will likely manage to contain the euro crisis in the first half of 2012. If so, the German economy can rebound strongly thereafter, as it did when the US Fed ended the post-Lehman turmoil in March 2009.

For 2012, we project a shaky start and a strong finish for Germany, leading to an average annual gain in GDP of 0.4%. Once again, Germany will likely fare much better, or less badly, than almost all other European countries.

Solid real estate fundamentals
Reflecting the health of Germany’s domestic economy, we look for further strength in many segments of the real estate market, especially for residential real estate in key urban centers. Financing conditions are likely to remain exceptionally favorable as the European Central Bank continues to provide ample liquidity at quite low rates with a policy stance that partly has to reflect conditions in the much weaker periphery of the Eurozone.

The risks to our outlook are unusually grave but largely balanced. It could be much worse (i.e. the euro fractures beyond a possible exit of Greece) or much better (i.e. the crisis abates in early 2012 already).