Recent signs of a slowdown in the German economy have taken many market participants by surprise, coming after years of strong performance, and raised doubts about the health of the wider European economy. But Germany has been down this path before. In the early 2000s, analysts dubbed the country the sick man of Europe because of its sluggish grown and high unemployment. In The German Dilemma, the cover story of our January 2002 issue, Tom Buerkle, now international editor of Institutional Investor, examined the roots of the problem and explained that Germany’s weakness — not its strength — posed the biggest threat to the then-new euro.
Read the full story below.
The German Dilemma
The German economic model needs an overhaul, not a tune-up. But are Germans just too contented to bother?
Germany found itself in a disconcerting position this November: dead last in Europe. The European Commission ranked the European Union’s largest economy as the most sluggish within the 15-nation EU. The commission put German growth at just 0.7 percent in 2001 and forecast a similarly anemic performance this year. Even Europe’s perennial underperformer, Italy, had better prospects.
Nor is this the only recent humiliation for Social Democratic Chancellor Gerhard Schröder and his finance minister, Hans Eichel. The economy’s sudden slowdown in last year’s second half has pushed Germany dangerously close to violating the 3 percent ceiling for government budget deficits under the EU’s Stability and Growth Pact. Exceeding the ceiling would be both ironic and discomfiting for Berlin. It was Germany, after all, that insisted on a strict deficit standard to prevent Europe’s more profligate states from dragging down disciplined Germany.
In a stunning turnabout, it is now Germany, the architect of European monetary union, that is retarding Europe’s recovery and depressing the value of the euro. The country is teetering on the edge of recession. Business and consumer confidence have plummeted. Unemployment is close to 10 percent. Today, says Martin Hüfner, chief economist of Hypo-Vereinsbank, “you hear more and more people talking about Germany as the sick man of Europe. This is something that is new and very worrisome.”
Being Europe’s caboose rather than its locomotive is an uncomfortable role for a country that for decades defined itself largely by its economic achievements, starting with the postwar “economic miracle.” Of course, doubts about Germany’s economic dynamism are hardly new. The country’s steep labor costs, exorbitant taxes and heavy regulation have been debated for years.
Nor is lackluster German growth exactly unprecedented. The country had one of the weakest performances among Group of Seven nations during the 1990s, albeit in no small part because of the costs of German reunification. Annual growth averaged little more than 1.5 percent between 1992 and 2000, according to the International Monetary Fund; by contrast, the U.S. economy surged 3.7 percent a year on average.
It’s the old story, shrugs Norbert Walter, chief economist of Deutsche Bank. “We are still too bureaucratic. We still have too redistributionist a policy. We probably have to start working early. We have to work longer hours, have shorter holidays. We have to accept a wider dispersion of wages.”
But is it the same old story? Can Germany postpone dealing with the root causes of its economic malaise indefinitely? Can Europe’s sputtering “engine of growth” be fixed with just another fiscal and monetary tune-up? Or does the German economy need to be repaired this time with a complete overhaul - the kind of fundamental reforms that challenge the assumptions of the country’s comfortable social welfare system? And do Germans have the stomach for wrenching change in their long-standing consensus on cradle-to-grave security? Do they have any other choice?
The economy’s unexpected stall has brought this oft-deferred issue into painful focus. Chancellor Schröder and finance chief Eichel, along with most Germans, assumed that economic reforms embarked on in 2000 would allow the economy to shake off its torpor. Berlin has slashed personal and corporate tax rates as well as introduced Germany’s first private pension system. In an interview with Institutional Investor conducted via e-mail (see box, page 50), Eichel describes pension reform as a “quantum leap for Germany,” in that it “puts some of the responsibility for old-age provision back in the hands of the citizens.” And for 2000 the economic numbers were encouraging: GDP rose 3 percent and unemployment began to ease.
Thus the setbacks of 2001, while partly connected to the wider global slowdown, were all the more jarring. Indeed, they’ve spurred a spirited debate among politicians, economists and business leaders about Germany’s economic model. What Germany needs, vows Hans-Werner Sinn, an economist at the Munich-based Ifo Institute for Economic Research, is a supply-side revolution to spur competition, trim welfare benefits and get millions of idle or unemployed Germans into productive work. “Germany cannot continue its consensus model,” he says.
Senior officials in Berlin, who have heard such arguments before, contend that the government is, in fact, preparing further reforms - for after September’s parliamentary elections. “It’s health reform and more labor reform that will have to be done” in the new legislature, Deputy Finance Minister Caio Koch-Weser tells Institutional Investor.
But does Chancellor Schröder, who owes his 1998 election in part to union backing, dare attack the labor protections and social welfare programs that, though they may be stifling growth, are at the heart of Germany’s national identity?
The chancellor Himself is certainly not averse to change. Schröder is a self-styled reformer who led the tax and pension initiatives. He has also shown boldness in the way he has allied Germany with the U.S. in the war on terrorism, overcoming misgivings among his Green Party coalition partners and winning a vote of confidence on sending German troops to Afghanistan. This added to SchrÓder’s stature and should strengthen his hand in championing further reforms.
Nevertheless, as an instinctive politician, Schröder also recognizes that there are limits to Germans’ willingness to accept change. “In Germany job security is very important. Social security is very important. We believe in a socially balanced society, and we will keep that pattern in the future,” cautions Alfred Tacke, deputy economics minister and Schröder’s key adviser on G-7 issues.
Trying to reconcile Germany’s obvious need for growth with its long-standing commitments to social welfare and European monetary union was never going to be simple. Schröder has sought to undertake reform in “politically digestible doses,” says former U.S. ambassador to Germany John Kornblum, who heads Lazard’s Berlin office. But “the world is changing much faster than Germany is willing to take the medicine.”
The urgency of the current debate over Germany’s direction would have been inconceivable as recently as a year ago. SchrÓder’s government had just passed a massive personal and corporate tax reduction, the largest in German history. Over five years the basic personal income tax rate is to drop from 23 to 15 percent and the top rate from 51 to 42 percent. The average business tax was sliced immediately from 52 to about 39 percent.
The abolition later this year of the capital gains tax on companies’ sales of stakes in other companies is expected to trigger an unwinding of corporate cross-shareholdings. These have contributed to German industry’s too cosy, inward-looking character, and shedding them should accelerate the shift to more of an American-style focus on shareholder rights.
The pension reforms, though modest, mark a sharp symbolic break with the past. Beginning this month, Germans can make pretax payroll contributions to retirement accounts. In effect, Berlin is acknowledging that the state social welfare system will soon lack the wherewithal to cope with an aging population.
To Schröder’s partisans, the pension and tax measures signify that he is willing to move aggressively on reform.(Both measures had been unmet goals of former chancellor Helmut Kohl.) “This government has done over the past three years what governments over many years have failed to do,” boasts Koch-Weser.
Germany has also been the pacesetter in continental Europe in liberalizing its markets. Berlin has opened energy and telecommunications to private competition and has privatized everything from Deutsche Lufthansa to Deutsche Telekom to Deutsche Post. “Market opening has occurred very, very fast in Germany,” says Tacke. “It meant huge structural change because the sectors that we opened to the markets were big employers. So I think the structural effect is underestimated. Other European states haven’t gone as far as we did.”
Perhaps because Schröder and Eichel were so swept up in implementing reforms and liberalizing markets, they badly misread the signs when the economy started to falter. The finance minister, who kept insisting that growth was on track, was later forced to reduce the government’s forecasts time and again. Output started to stagnate in last year’s second quarter, and as of October, industrial production had dropped almost 4 percent from year-earlier levels. That same month, Ifo’s business climate index had its lowest reading since the 1993 recession. Unemployment, meanwhile, had climbed for nine consecutive months through November 2001, reversing a two-year decline. Schröder’s campaign promise to reduce joblessness to 3.5 million went unfulfilled. By late 2001, 3.94 million Germans, or 9.4 percent of the workforce, were unemployed.
“We were wrong in thinking that Europe in a sense was decoupled and somewhat immune from any slowdown in the U.S.,” says Koch-Weser. Large-scale German investments in the U.S. during the 1990s, such as Daimler-Benz’s acquisition of Chrysler Corp., had linked the two economies more tightly than officials supposed. Today German companies’ U.S. units generate five times as much in sales as German direct exports to the U.S.
Moreover, the tax cuts and pension reforms didn’t provide much resiliency for the economy. The stimulative effect of the cuts in personal income taxes were offset by rising energy prices and health insurance costs. And in many quarters the pension plan has been criticized for being too timid to energize the financial markets. In any case, the pension reforms’ impact has been overwhelmed by the plunge in stock prices (almost 38 percent from the March 2000 high, as of year-end 2001), putting a damper on Germans’ brief love affair with equity investing.
The Schröder government’s labor initiatives held back growth as well. Berlin championed regulations to extend and strengthen worker representation in smaller companies and give all employees the right to choose flexible, part-time schedules. The measures were a body blow to German manufacturers, which already cope with the stiffest labor costs in the world (nearly 20 percent higher than those in the U.S.).
To reignite growth, Berlin should borrow a solution from Washington - a fresh round of tax cuts - argue many analysts. Five of Germany’s influential economic think tanks have urged the government to bring forward tax cuts scheduled to take place in 2003. Leading industrialists and the opposition Christian Democrats have echoed this call.
“We cannot just rely on the U.S. to stimulate the world economy and be free riders. All countries have to make a contribution,” asserts Ifo’s Sinn, one of those advocating swifter adoption of the tax breaks. HypoVereinsbank’s Hüfner proposes an even more dramatic gesture: Eichel should invoke Germany’s 1967 stability and growth law to declare a 10 percent cut in income taxes immediately. “It would be a disaster if we do nothing until the [September] election,” Hüfner says. “Then we will have a real deterioration.”
The opposition Christian Democratic Union has joined the call for tax cuts, saying they would stimulate the economy and ease the pain of labor reforms and other structural measures. “Fifty percent of economic policy is psychology,” says Mathias Wissman, the CDU’s economic policy spokesman. “Limited stimulus would have a big economic effect if it is accompanied by other measures.” But the CDU has little credibility as a force for economic change, a fact that Schröder’s critics lament. Its current proposals ring hollow because the party failed to implement many reforms during its 16 years in power (1982-'98), and indeed oversaw much of the steep rise in taxes that has undermined growth. The CDU also appears too preoccupied with internal divisions - particularly the question of whether its chancellor candidate should be party leader Angela Merkel or Edmond Stoiber, leader of its Bavarian sister party, the Christian Socialist Union - to mount a serious challenge to Schröder in September.
Schröder and Eichel have resisted all entreaties to speed up the tax cuts. With the tax reform package in place, Eichel says in an e-mail, “we have made full use of the available possibilities for fiscal action. We have done all we can without abandoning the [EU] consolidation course.” The government insists that Germany must stick with its budget policy to avoid breaching the Stability Pact’s 3 percent deficit ceiling; not doing so could result in a fine but mainly in a huge loss of face. Berlin predicts a deficit of 2 percent this year, based on 1.25 percent growth, but concedes that the deficit could widen to 2.5 percent if growth is weaker. Others see a narrower margin for error. The European Commission forecasts a 2.7 percent German deficit.
Berlin officials contend that speeding up the tax cuts would not only jeopardize compliance with the Stability Pact but also do little to stimulate the economy. Germans would save rather than spend their windfall, they argue, and if there were any stimulative impact, it wouldn’t be felt until after the economy had already begun to recover. Eichel estimates that bringing the 2003 tax cuts forward to this year would cause a revenue shortfall of about E7 billion ($6.2 billion). The regional Länder, or German states, would have to absorb about half of that and would be hard-pressed to present prudent budgets, the finance minister adds. As Berlin sees it, the meager gains from hastening the tax cuts aren’t worth the risk of a policy U-turn that would hint at panic. “The loss of credibility of not pursuing the strict [European] consolidation course would outweigh the benefits,” states Koch-Weser.
If the government had any lingering doubts, the Bundesbank has also warned Berlin against trying to reflate the economy. “If discretionary measures are taken by the government to stimulate the economy, the risk is very high of the deficit’s hitting 3 percent,” says chief economist Hermann Remsperger, a member of the bank’s governing Central Bank Council. “If you put in question the Stability Pact, this would have negative consequences for the whole project of European monetary union.”
To many critics of the government, however, the real issue is not the timing of tax cuts but their scale. Reducing certain taxes is beside the point, they argue, if Germany’s overall tax and benefit burden remains the same or actually increases. They note that in October the government raised taxes on tobacco and insurance by Dm7 billion ($3.15 billion), ostensibly to pay for increased national security post-September 11. Curiously, the security measures cost just Dm3 billion. The country’s ecology tax, a levy on electricity and motor fuels, just went up 6 pfennig per kilowatt hour and 5 pfennig per liter on gasoline and diesel fuel. Health insurance premiums rose 0.5 percentage points this month, to 14 percent of an employee’s salary (half paid by the employer).
“The question is not whether to have tax reductions early in 2002,” says Axel Nitschke, an economist for the German Chamber of Commerce and Industry. “The question is to stop tax increases that are put in place.” Ferdinand Graf von Ballestrem, chief financial officer of German truck maker MAN, would like the national discussion to shift from specific levies to the overall level of taxes as well as social security, which amount to a burdensome 47 percent of GDP. This is less than in European welfare states like Sweden, but much more than in Japan or the U.K. (about 37 percent), not to mention the U.S. (31 percent). Von Ballestrem is skeptical that Eichel, despite his reputation as Germany’s “savings minister,” will reduce the total tax take. “Eichel in reality is not what he is taken for,” von Ballestrem says.
Others contend that the finance minister is too quick to react to a problem by slapping a tax on it. For instance, his new withholding tax on construction activities is designed to reduce tax evasion by black market operators, but critics say it ignores the real reason for the black market: onerous taxes. “This is the absolutely typical reaction of this government: to deal with the symptoms of the problem and not deal with the causes - the high level of taxes and social charges,” says Hans-Olaf Henkel, vice president of the Federation of German Industries.
In fairness the burden on German taxpayers stems in significant measure from the ongoing cost of German reunification. This also helps explain the economy’s subpar performance over the past decade. Integrating 16 million people from formerly Communist East Germany into a market economy and modernizing their outdated plants and dilapidated infrastructure has been much more costly than anyone expected. Twelve years after the fall of the Berlin Wall, Germany still spends E75 billion a year, or 3.5 percent of its GDP, on welfare benefits, industrial aid and infrastructure building in the East. Servicing reunification-related debt costs a further 0.5 percent of GDP.
These costs exert a considerable drag on the economy. “Which other country has absorbed and reformed a state-run economy like East Germany’s?” asks Koch-Weser. “It’s not a ten-year proposition but a much-longer proposition. Nobody knew the extent of the adjustment that was needed.”
Ifo’s Sinn faults German policy toward the East for promoting consumption rather than production through high wages and benefits and thus encouraging mass unemployment. Workers in the East are only about 75 percent as productive as those in the West yet earn more than 90 percent as much. The result: Unemployment in the East as of November stood at 16.7 percent, more than double the West’s 7.4 percent. “East Germany is not the dynamo we dreamed of,” concedes Ulrich Ramm, chief economist at Commerzbank.
To boost growth and employment, the government might begin dismantling the country’s rigid labor regulations. Along with high pay, German workers enjoy some of the shortest hours and tightest job security in the world. In western Germany a manufacturing employee averages 1,592 hours per year (or about 31 hours a week), compared with 1,771 hours in France, 1,817 in Japan and 1,904 in the U.S. High wages, short working hours and restrictive labor practices have driven German manufacturing enterprises to invest heavily in production overseas.
The Schröder government, however, has only added to labor costs. To employers, the biggest irritant is the extension to small and medium-size companies of workers’ right to formal representation. Even staffers at companies with as few as five employees can now request a “works council” to represent their interests (and voice their grievances) to management. Companies with 200 or more employees are required to hire a full-time employee to work exclusively for the works council; the old threshold had been 300 employees.
Trumpf Gruppe, a roughly $1 billion-a-year, family-owned maker of machine tools and lasers, will soon have to hire a fourth staff person for its works council, which represents 1,400 workers at Trumpf’s main plant near Stuttgart. “I have a problem seeing what the three are doing,” says Berthold Leibinger, the company’s chairman.
The government characterizes German workers’ new right to shift to a part-time schedule as promoting job creation and helping employees achieve a better work-family balance. However, smaller companies regard it as a management nightmare. One in five members of the German Chamber of Commerce and Industry report that some of their workers have demanded to go part-time. Twelve percent of the chamber members say the measure has made them more reluctant to hire new employees.
The German approach “is exactly the wrong way to do it,” says Humboldt University of Berlin economist Michael Burda, a labor specialist. “It has to be a voluntary thing.”
“We are tangled up in regulations more and more, and we have less room to move,” says Trumpf’s Leibinger. “It’s like a dust that covers the whole environment. It’s not one issue; it’s a number of things.” His company is following German multinationals in investing more in facilities abroad. Although Trumpf has no plans to cut back in Germany, where it employs 3,800 workers, most of its future growth will come in the U.S., Asia and Switzerland, where it already employs 1,800. “The climate for hiring people has worsened step by step,” says the Chamber of Commerce’s Nitschke.
Corporate leaders regard the labor-friendly rules as a sop to Schröder’s union supporters, who objected fiercely to the tax and pension reforms. Schröder economic adviser Tacke doesn’t attempt to counter this impression. “From the point of view of the business community, we have less flexibility than in the past,” he grants. “We think it’s a balance that we can accept. If you have huge structural change, there’s also the promise of more job security. We need that balance in Germany.”
Tacke vows that labor reforms will figure prominently in any second-term Schröder agenda. But he rules out a shift to easier hire-and-fire policies in the current economic climate because he believes it would encourage layoffs, not job creation. “A more flexible labor market policy would have helped us in the upturn of the economy to fill the jobs,” he says, “but it is no recipe for the downturn.”
Eichel is less conciliatory. “Compared to these two enormous reform projects [taxes and pensions], the few new regulations on the labor market, which are perceived as a burden by employers, are negligible as cost components,” he asserts. “All we wanted to do was to remove false incentives and to keep the social component of our market economy from being put at risk by competition.”
Some companies have gained more flexibility in managing their workforces. Volkswagen, for example, agreed with the IG Metall union last summer on a new minivan project that will generate as many as 5,000 jobs that pay Dm5,000 a month - or about 20 percent less than prevailing VW wage levels. The deal also gives the company leeway to extend working hours and to schedule Saturday production.
Schröder, who sat on the VW board when he was president of Lower Saxony, hailed the pact as a model for other companies. But on closer inspection, the accord seems to have few broader applications. MAN’s von Ballestrem notes that VW’s existing wage scale was well above the local industry norm and that even with the 20 percent pay cut, the new VW workers will be better paid than employees of MAN’s nearby truck factory. “We have a constant pressure from our people to raise their pay to VW levels,” he says.
Industrywide wage agreements exhibit remarkable resilience in Germany, despite evidence that they stymie job creation because they don’t give employers the flexibility to match wages to local productivity levels. Fully 65 percent of the jobs in Germany’s West and more than 50 percent in the East are covered by industrywide pay deals. Yet this corporatism often suits business as well as union interests. Although it maintains high wages for workers, it limits price competition among companies (and also keeps bureaucrats contentedly employed by unions and industry associations). “The overwhelming majority of German industry is restricted by these arrangements, and nobody wants to rock the boat,” says the Federation of German Industries’ Henkel.
Staunch defenders of the status quo can be found in boardrooms as well as on shop floors. Just as the EU, after 12 years of debate, was about to adopt a takeover code that would have facilitated mergers by requiring boards to get shareholder approval for defensive tactics, Germany balked. Worried German executives led by VW chairman Ferdinand Piëch lobbied Schröder to block the code, and German members of the European Parliament duly obliged. Instead, the German parliament adopted its own merger code, which gives company supervisory boards more power to sell new shares or divest crown-jewel assets to frustrate hostile bidders. (Anyone who thought that Vodafone AirTouch’s acquisition of Mannesmann in 2000 would usher in a new era of Anglo-American style capitalism simply wasn’t paying enough attention to Germany’s still strong instinct for consensus.)
The whole EU takeover code episode was “regrettable,” says Paul Achleitner, chief financial officer of Allianz and mastermind of the insurer’s E23.4 billion purchase of the 80 percent of Dresdner Bank that it didn’t already own. “It restores the image that these [German corporate] guys are not willing to change.” Achleitner suggests, however, that the reality may be brighter than the perception. He points out that selling new shares to avoid a takeover is a good idea in theory, but that in practice it’s likely to depress a company’s stock by diluting existing shares, thereby making the company more vulnerable to a takeover. He’s also convinced that corporate restructuring will accelerate as companies like Allianz and conglomerate E.On take advantage of the end of capital gains taxes on the sale of corporate stakes. “There are opportunities for those who really know what’s going on,” he says. “Progress is much deeper, more meaningful than people give credit for.”
Still, perceptions matter. The Bundesbank’s Remsperger, too, worries that the merger code and the new labor regulations tarnish Germany’s image at a time when the country should be reaching out to foreign investment. “What I note in talking to institutional investors is that these examples are very often used to show that this process of reform has not been continued,” he says.
Pressure on Berlin to address Germany’s structural problems will only intensify. The reason, ironically, is the euro. The currency was designed in Frankfurt, and many European countries opposed monetary union at first because they feared it would bind them to a German-style anti-inflation ethos, backed up by an iron-willed central bank. The euro, as a common currency with its own strong central bank, threatens to eliminate one of Germany’s major competitive advantages within Europe: currency stability and low interest rates.
This will put a harsher focus on Germany’s comparative weaknesses. Now it must compete with EU economies that are faster growing, such as Spain, the Netherlands and Ireland, but which share the same interest rate and currency policies. Monetary union “shows up the structural deficiencies - it magnifies them,” observes HypoVereinsbank’s Hüfner.
The next few years will bring more uncertainties. “We will experience a reshuffling of savings capital to the European periphery, where there will always be a tendency to grow faster. Investment opportunities, due to low wages and low financing costs, are now much better in these countries,” says Ifo’s Sinn. Unless Germany radically revamps its labor, social welfare and other policies, Sinn believes, it faces another decade of below-average growth.
Right now, the political will to reengineer the German economic model is simply lacking. Certainly, a decade of lackluster growth hasn’t ruined Germany’s quality of life. “The situation is not difficult enough” to force major changes, says MAN’s von Ballestrem. “Ninety percent of Germans are living with a good standard of wealth. Why should politicians harm their voters?” And, as always, official optimism prevails. Listen to Eichel: “Germany’s economy is essentially healthy and competitive. This will soon become evident again.”
Allianz’s Achleitner shares some of von Ballestrem’s disappointment with the pace of reform. “Is it all going fast enough?” he asks. “Probably not.” But he also sees the potential for real progress. Germans’ growing realization of the scale of the problem, dramatized by the country’s fall to the bottom of the European league tables, has shattered their “illusion of satisfactory underperformance,” the Allianz CFO says. “It is crystallizing discussion.”
Schröder must turn the talk into action.
,The economy is essentially healthy and competitive,
A year ago German Finance Minister Hans Eichel could declare himself Europe’s leading reformer. He had introduced a five-year tax cut package that sharply reduces personal and corporate rates. Meanwhile, the Labor Ministry had created the country’s first private pension program. Combined with ongoing market deregulation, the reforms were expected to usher in a burst of economic activity.
Instead, Germany’s growth has lagged, and Eichel has found himself grappling with a budget deficit that threatens to exceed the 3 percent euro zone ceiling. In an e-mail interview with Institutional Investor, Eichel discusses Germany’s prospects both for recovery and for longer-term growth.
Institutional Investor: You have published two forecasts for growth and the budget deficit in 2002. What are the probabilities of achieving your optimistic scenario - 1.25 percent growth and a deficit of 2 percent of GDP - and what do you see as the main risks to that forecast?
Eichel: The European Stability and Growth Pact requires that the annual stability program should contain an alternative scenario of how consolidation will progress if growth turns out weaker than expected. It is solely in order to fulfill this requirement that we have published a second forecast.
We still believe that we can achieve 1.25 percent growth next year. If, however, the recovery in Germany should commence significantly later than we have forecast, because, for example, the world economy, contrary to our expectations, does not recover soon or because the price of oil rises dramatically, we shall have to postpone our objective of presenting a balanced budget in the year 2004.
Why shouldn’t Germany bring forward to 2002 the tax cuts scheduled to take place in 2003, as the German economic institutes have suggested?
Bringing the stage of the tax reform planned for 2003 forward to the year 2002 would considerably jeopardize our consolidation course. The government sector as a whole would have to absorb revenue shortfalls of about E7 billion [$6.2 billion]. The Länder, or German states, would have to bear about half of these shortfalls. Some of them would then find themselves unable to present the type of budget required by Germany’s constitution - that is, a budget without excessive indebtedness. The Tax Reform 2000 in its present form, that is, with further cuts in the years 2003 and 2005, fits in exactly with our consolidation course.
Would you consider a coordinated fiscal stimulus in Europe if the economy falls into recession?
In the future there will be no room at the European level for classical cyclical programs such as those that used to be applied in the past at the national level. Nor are they necessary. Europe will not fall into a recessionary phase that would require such programs. And I think such programs are wrong. The best way to ensure that recessionary phases stay short is to follow consistent policies.
Germany used to be seen as the locomotive of Europe, but in recent years it has ranked near the bottom of Europe’s growth table. How do you explain the weakness? Is it primarily cyclical or structural?
There are a number of reasons for the present weak growth in Germany. For one thing we are feeling the effects of weaker growth in the world economy. That is certainly a cyclical component. On the other hand, we also have to deal with structural problems dating from the time of German reunification. These are both the large need for investment in the new Länder in the area of infrastructure and also adjusting the much too high capacity in the construction industry. After reunification, the building boom in the new Länder - additionally stimulated by government depreciation allowances - created enormous surplus capacity. Without the recessionary adjustment in the construction industry, Germany’s growth in 2000 would have been about 0.75 of a percentage point higher. If growth in 2001 were about 0.5 percentage point higher, the recession in the construction industry would already be over. Nor have the sharp cutbacks in the public sector in the past ten years, laying off about 1 million people, helped to stimulate growth. About half of these layoffs were a consequence of the overstaffing that existed in certain sectors in the new Länder. The structural problems can thus be considered dominant, but some of them will be solved as soon as the next recovery gets under way.
What can be done to lift Germany’s potential growth rate?
Germany’s economy is essentially healthy and competitive. This will soon become evident again. Its great potential for innovation forms a strong basis for vigorous economic growth. In order to preserve this innovation potential, the German business community will have to intensify its efforts in the area of research. The state is supporting this by putting more emphasis on basic research. At the same time, with the Tax Reform 2000 we have for the first time given the German economy a tax system that meets the demands of a globalized economy. Parallel to this, the tax rates have been lowered drastically. The strength of investment and incentives to investment have increased. We shall continue on this path with further tax cuts in 2003 and 2005. In combination with maintenance of a strict consolidation course, this will not only stabilize the expectations of all economic operators and create confidence, it will also make it possible for monetary policy to realize its potential for interest rate cuts. At the moment, financing costs in Europe are very low. The situation would certainly be quite different without the strict consolidation course that has been followed at all levels of government.
Monetary union has allowed all 12 euro countries to benefit from exchange rate stability and low interest rates, an advantage that German industry used to enjoy by itself. Has the euro eroded German competitiveness?
The euro is a unique success story. Germany’s economy, which is very strongly export-oriented, benefits from the fixed exchange rates and, in consequence, from the disappearance of exchange cover costs and exchange rate risks. Long-term trade and investment relations are much easier to establish and maintain in this stable environment. This is precisely where Germany has its strong points.
No doubt other member states of the euro area have more to gain from the low interest rates than do German firms, which have long enjoyed stable monetary policies and low rates. We do not begrudge this advantage to any of our partners. Germany’s economy needs strong partners.
Do you see any signs that the outflow of investment from Germany during the past decade will be reversed?
Germany has a very open national economy. We are not only export-oriented, our enterprises produce in many countries. This also protects jobs at home.
In order to make Germany more attractive to foreign investors, we have changed the tax system and reduced the tax burden. Germany’s tax rates are now internationally competitive. We nevertheless offer a highly developed infrastructure and a well-trained labor force as well as all the advantages of a mature economy with a large market. Strikes are infrequent due to the social elements of the economic system.
Once the planned enlargement of the EU to the east takes effect, Germany will no longer be on the periphery, as it now still is. After enlargement, Germany will be in the geographic center of an internal market that is developing ever faster. For foreign investors this will offer the opportunity to choose a location with excellent infrastructure, in the vicinity of and with traditionally good contacts with the rapidly developing markets of Eastern Europe.
