If Germany Sneezes, Does Euro Zone Catch a Cold?

Frankfurt, Germany
Carlos Malvar | Getty Images
Frankfurt, Germany

"The government leaders should concentrate on the achievability of the next steps," Chancellor Angela Merkel told her Christian Democrat fellow-members of the parliament in a closed-door Berlin meeting ahead of Thursday's European Union Summit.

Merkel is skeptical about the chances for a quick fix to deepen the economic and monetary union. In the end of November, German parliament Bundestag voted to approve still another round of aid measures for Greece.

According to opinion surveys, most Germans would prefer to see Greece go bankrupt. However, a Greek default is perceived to be followed by the contagion effect and thus too risky.

(Read More: Greece Suffers Setback After Debt Buyback)

Unlike a year ago, the debt measures will now, for the first time, have a direct impact on private creditors. If the reduced interest income is combined with the decision to reserve profits by the European Central Bank for Greece, the revenues of the German 2013 budget will take a EUR 730 million hit.

With current policies, Berlin may have to absorb billions of losses over the subsequent years.

(Read More: With Germany Onside, EU Nears Banking Union Deal)

Export-led model, dependent on the US and China

Until recently, Germany fared much better in relative terms than other core economies in Europe. However, the slowdown of economic activity in the second half of 2012 will be morphing into recessionary conditions in early 2013.

As its export-led growth is eroding, Germany is hoping to rely on private consumption, but the latter cannot compensate for the slowdown in export growth, especially in the short-term.

What does not bode well for the future is that Germany's export growth depends on just a few sectors and regions.

The Eurozone absorbs 40% of German exports. In the first three quarters of 2012, exports to the U.S. and Asia, respectively, generated each some 35% of total export growth in Germany; that is, 70% of the total growth.

Further, exports are highly concentrated in terms of sectors. Cars, pharmaceuticals and mechanical engineering to the U.S. accounted for three quarters of export growth. In China, the accumulation is far greater: the auto industry generated nearly 100% of all German export growth.

If Washington fails to manage the "fiscal cliff," or China's growth engines would slow down, the adverse impact would be very significant in Germany.

(Read More: Franco-German Rift Hampers Plan for Banking Union)

Economic erosion

Signals of steady, though low economic erosion abound. Unemployment rate has climbed to almost 7%. Although business climate has been rebounding, consumer sentiment remains cautious. Inflation has slowed to less than 2% on an annual basis.

Even venerable corporate institutions are scrambling. Recently, GM subsidiary Opel announced it will stop assembling cars in Bochum, Germany by 2016. Similarly, the steelmaker ThyssenKrup posted a loss of EUR 4.7 billion, coupled with huge writedowns on mills in the U.S. and Brazil.

Regional banks are not immune to possible re-escalation in the financial sector.

Problems may be more extensive. Recently, a former employee of Deutsche Bank claimed that it concealed billions of euros in losses during the financial crisis, in order to avoid a government bailout.

(Read More: Are the ECB's Gloomy Economic Forecasts Overly Dramatic?)

Federal elections in 2013

In the coming months, the impending fall elections will overshadow Berlins strategic moves.

Chancellor Merkel has managed to sustain great national popularity, but the support of her center-right Christian Democrats (CDU) has been eroding in the local state elections. Meanwhile Germany's social democrats are uniting behind their candidate Peer Steinbrck.

The main risk facing Germany is an escalating Eurozone crisis, which would spill over into Germany through real and financial channels. A leading German economist Hans-Werner Sinn argues that Greece and Portugal should temporarily leave the Eurozone.

Even if the two dominant parties can sustain their political leadership, economic erosion highlights the fact that German voters will increasingly oppose fiscal transfers, debt mutualization and expansive bailouts.

The timing could not be worse. Germany is struggling to increase the labor force, raising the quality of human capital, and productivity in the services sector. Despite its relative strengths in the short- and medium-term, it is coping with aging population and the associated negative growth effects.

Berlin has reason for anxiety. For all practical purposes, Europe is amidst a lost decade.

(Read More: Germany's Resistance May Prove 'Fatal' to Europe: George Soros)

Dan Steinbock is research director of International Business at India China and America Institute (USA), visiting fellow at Shanghai Institutes for International Studies (China) and in the EU-Center (Singapore).