The euro zone needs German inflation to rise, so as to address the imbalances in competitiveness between member states without condemning much of the currency union to semi-permanent slump and unsustainable indebtedness. Countries such as Italy and Spain have to be able to undercut German inflation - and hence rebuild their price competitiveness - without suffering deflation and the resulting increase in their debt burdens. However, German consumer price inflation (on the EU harmonised measure) is standing at just 1.8% year on year, in line with the euro zone average and below levels in Spain and Italy.
Inflation in Germany should certainly be rising relative to the rest of the currency union. Although activity has slowed recently, the German economy has continued to grow in recent years (unlike much of the rest of the euro zone) and unemployment is low (whereas it is rising rapidly across the rest of the currency union). Companies and households can borrow cheaply, as funds have flooded into Germany from other euro zone countries, in a flight to safety. Moreover, Germany has a strongly undervalued real exchange rate. With this stimulus, domestic demand should be growing robustly, pushing up inflation. But domestic demand actually declined slightly in 2012 and leading indicators suggest only moderate expansion at best in 2013. Inflationary pressures remain weak.
Gross fixed capital investment fell in 2012 and remains well below pre-crisis levels. The Bundesbank (Germany's central bank) attributes this to uncertainty caused by the problems elsewhere in the euro zone. But all this really shows is how structurally dependent on external demand the German economy has become. Underlying reasons for the weakness of investment demand are overwhelmingly domestic. One reason is the sluggishness of private consumption. Another is structural: according to the OECD the German economy is held back by insufficiently competitive product markets, especially those for services. This discourages companies from investing in new goods and services, and also helps explain the poor productivity performance of Germany's service sector.
Will Germany experience a surge in domestic demand, underpinning a rise in inflation and facilitating rebalancing within the euro zone? Interest rates will certainly remain low: the European Central Bank (ECB) will not raise rates with much of the currency union in recession. Indeed, with the euro zone economy set to remain exceptionally weak, the ECB is likely to loosen monetary policy further, putting downward pressure on the euro and providing additional stimulus to German exports. With worries persisting over the solvency of many of the struggling euro zone economies, Germany is likely to retain its safe-haven status, ensuring that German banks can finance themselves cheaply and provide credit at low interest rates to households and businesses.
But there is little chance of German reflation. The OECD, the IMF and the Economist Intelligence Unit all expect the German economy to grow sluggishly at best, and inflation to remain low. The European Commission is slightly more upbeat, but even it only expects German inflation to outpace that of the euro zone as a whole by a marginal amount. There is little chance of action to address the structural reasons for the extreme weakness of domestic demand, such as the weak product market competition; the German government continues to show little interest in implementing such structural reforms.
Unemployment will remain low and wage settlements should edge up a bit, but there is little indication of a surge in wage settlements; Germany's wage bargaining systems ensures a high degree of wage restraint. The public finances have improved sharply in recent years, recording a small surplus in 2012 to the envy of many, but the government is planning to tighten fiscal policy slightly over the medium term.
If these forecasts prove correct and the German economy grows only slowly with persistently low inflation, the implications for the rest of the euro zone will be far-reaching. With the exception of a few small euro zone countries whose economies are highly synchronised with the German one and have similar structural characteristics (the Netherlands and Austria, for example), the rest of the euro zone will find it difficult to share a currency with Germany. If other member states are unable to reduce their real exchange rates within the euro zone without experiencing a prolonged period of deflation, fears that they will slide inexorably into insolvency and default will persist.