Analysis: Slowdown could make Germany rethink euro crisis stance

FRANKFURT/BERLIN (Reuters) - After being held up as a model of strength in a region saddled with debt and low growth, Germany suddenly finds itself in a perfect economic storm that could force it to rethink its approach to the crisis plaguing the wider euro zone.

New business sentiment figures from the Munich-based Ifo institute confirmed on Wednesday what tepid second-quarter growth data suggested last week: Europe's largest economy is slowing, and slowing sharply.

The reasons are many. Weaker demand from key trading partners in Europe, the United States and China has begun to weigh on German exports.

Meanwhile, growing doubts about whether euro zone politicians can lead the bloc out of its sovereign debt crisis are unsettling companies, consumers and financial markets, with consequences for the real economy.

It is too early to say how steep the slowdown in Germany will be, or whether the economy will be pushed into recession again, two years after it suffered its worst annual contraction since World War Two.

But the poor data is sure to get the attention of Germany's leaders, who have basked since early 2010 in the glow of an impressive economic recovery and have blamed the economic problems of their European partners on fiscal mismanagement and a lack of competitiveness.

"Germany appeared to be on a very good footing on both the fiscal and growth front, and this gave it leverage with its European partners," said Jacques Cailloux, chief European economist at RBS in London.

"The recent data show it is not immune, and that should be a wake-up call to policymakers in Germany."

SHOCK

How the slowdown will influence policy in Berlin probably depends on the extent of the downturn and how long it lasts.

Last week's preliminary data showed Germany's gross domestic product expanded just 0.1 percent in the second quarter of this year. Detailed GDP figures next week will reveal how big a drag private consumption was on growth, and whether temporary seasonal factors, which probably depressed construction activity, played an important role.

The Ifo report, a monthly survey of 7,000 German firms which is the most closely watched leading indicator for the economy, offered reasons for pessimism on Wednesday.

The main index fell to 108.7 in August from 112.9 in July, the steepest one-month drop since November 2008, shortly after the collapse of U.S. investment bank Lehman Brothers triggered the global financial crisis.

"The numbers have come down hard," said Mark Wall, co-chief European economist at Deutsche Bank. "We haven't had a Lehman Brothers or a September 11th event but this has the air of a shock to it. It is disconcerting to see how fast things are deteriorating."

Like many other economists, Wall now forecasts economic stagnation for Germany through the end of the year, followed by meager growth in 2012.

In the short term, if slower growth pushes up unemployment and reduces tax revenues -- crimping Germany's ability to meet its own ambitious targets for cutting its budget deficit -- domestic political opposition could grow against extending more aid to weak euro zone countries such as Greece and Portugal.

Germany faces a crucial vote in its parliament next month on bolstering the powers of the European Financial Stability Facility (EFSF), the euro zone's bailout fund.

Grumbling within Chancellor Angela Merkel's conservative party has grown in recent weeks, with one senior ally of hers vowing this week to vote against the measure, which still seems sure to pass because of support from leading opposition parties.

"If Germans feel poorer and more troubled in their own economy it will make them less generous in providing aid, in making full use of the EFSF, in considering things like euro bonds. They will have more worries, be more insecure," said Charles Grant, director of the Center for European Reform in London.

That could fuel opposition to aid for weak euro zone states in smaller donor countries which to some extent take their lead from Germany, such as the Netherlands, Austria and Finland.

Last month, euro zone leaders agreed in principle on a second bailout of Greece that would include a further 109 billion euros ($157 billion) from the EFSF and the International Monetary Fund through mid-2014.

Any recession in Germany could, initially at least, sap Berlin's political will to continue administering the bailout over several years, and to provide additional financial guarantees if necessary so that the EFSF can protect other countries under attack by the bond market.

POST-LEHMAN U-TURN

If the economic slowdown is deep, however, German politicians could come to believe over the longer term that they are putting their own economy at risk by refusing to take bold steps to solve the euro zone's debt crisis.

One such step might be creating a common euro zone bond that governments would issue jointly. So far, Merkel has strongly resisted this idea, arguing that Germany would end up paying more to finance itself and that the bond would encourage irresponsible spending by other governments.

A growing number of economists and European business leaders, however, think a common bond may be the only way out of the region's crisis; Sergio Marchionne, chief executive of Italian car maker Fiat, endorsed this view on Wednesday.

If it becomes clear to Berlin's political class that such radical measures are needed to restore economic growth to the euro zone and by extension Germany, policy will shift.

The German government's initial response to the Lehman Brothers bankruptcy and subsequent turmoil in 2008 was to dismiss the crisis as American and play down its impact on the domestic economy.

But once it became clear that the crisis posed a major threat to Germany, Merkel took a series of aggressive measures which were deeply unpopular -- such as repeated bailouts of stricken banks -- to protect the economy.

"If the government sees that its own European policy is hurting the economy at home, it could lead to a change in their approach. They could in fact become more generous," said Wall of Deutsche Bank. "But it's very hard to predict."

(Writing by Noah Barkin; Editing by Andrew Torchia)