While Germany emerged from Europe’s recent turmoil with accelerating economic growth and strengthening exports, the Eurozone still faces imbalances.

Growth accelerated despite debt turmoil
For the second quarter, Germany reported a stronger-than-expected expansion of 2.2% — its best quarterly result since 1990, the year of the country’s reunification. It achieved this despite the market turmoil surrounding Europe’s debt crisis. In August Germany’s central bank, the Bundesbank, lifted its growth forecast for 2010 to 3%, providing a welcome piece of positive news in a summer otherwise dominated by pessimism.

Germany maintained export competitiveness
Germany’s recent strength can be credited to its competitiveness as an exporter over long- and short-term periods. However, Germany’s efforts have also become a source of friction with its Eurozone neighbors, which may complicate the region’s future economic outlook.

Monetary policy favored Germany
The recent European crisis has been focused in countries on the region’s periphery that experienced the biggest booms earlier in the past decade, which were focused primarily on the real estate sector. Arguably both these booms and the subsequent busts resulted from an unfortunate combination of excessively generous local fiscal policies and monetary policy that was too loose. At the time, the European Central Bank (ECB) held interest rates low to support Germany, which was suffering an economic hangover following the country’s reunification. In other words, Germany was partly the cause of the problem, yet it was spared the same boom-bust cycle of its peripheral Eurozone partners, and later emerged from the crisis in relatively strong economic condition.

The weaker euro helped Germany
More recently, the German economy weathered the global economic downturn of 2008—09 better than many of its neighbors because of its well-established strengths as an exporter of advanced engineering products into faster-growing developing economies that were less affected by the financial crisis. In addition, the sovereign debt crisis, which has affected mainly the periphery of the Eurozone, has arguably given a massive boost to German economic growth by driving down the value of the euro and enhancing the attractiveness of German exports.

Labor costs are an advantage
Germany maintained its export competitiveness in part by implementing broad labor reforms over the past decade that materially reduced its unit labor costs relative to other developed economies of Europe. This is in stark contrast to other major Eurozone economies that have failed to take necessary similar actions.

The German government protected jobs
After following these cost-reducing policies over the past decade, the German government proved more pragmatic during the recent downturn by implementing temporary labor subsidy measures, which allowed German manufacturers to retain highly skilled staff and benefit from the rebound in economic activity when it came. Having supported the economy through the downturn with these measures, the German government has now set a course toward a more conservative fiscal stance and is gradually implementing an austerity budget.

Credit has continued flowing
The German banking system is well known for the poor performance and weak capital of the regional state-owned banks, or Landesbanken; however, thanks to efforts at restructuring these banks behind the scenes, credit availability has generally been less of a problem in Germany than in some other countries in Europe.

Consumption growth would help the region
While Germany has done relatively well through this period, its strength is also a potential future weakness because of its over-reliance on exports. Domestic consumption remains lackluster and is a source of friction with its Eurozone partners who feel they have supported Germany’s mercantilist, export-driven model while Germany has done little to help them by stimulating domestic demand for imports of its neighbors’ products. These conflicts may resurface as the Eurozone continues to address structural economic and financial imbalances.