GERMAN FISCAL RETRENCHMENT

Germany has announced a an important package of spending cuts as part it's plans for the next fiscal year. Among these are easures which increase the tax burden on both individuals and companies and are expected to raise €4.2bn in 2003. To this will be added €7.4bn of cuts in Federal subsidies to Germany's unemployment and pensions insurance schemes. These two, plus a €2.6bn increase in net new borrowing are intended to enable the government to meet next year's expected €14.2bn budget shortfall. All in all, and despite the increase in borrowing entailed for next year and 2004, the idea is to try to edge Germany towards complying with their stability pact agreement of a balanced budget by 2006.

Germany's election victors on Monday agreed on large tax rises and spending cuts to address a looming gap in next year's budget because of the severe economic slowdown.The additional tax burden agreed between the governing Social Democrats and their Green junior coalition partners will fall on both companies and private individuals. Companies are now facing limits on their right to carry forward losses, in effect introducing a minimum tax.

For private taxpayers, the biggest change will come with lower benefits for homeowners and extending capital gains tax on share dealings, plus steps to tighten. In the past week, Hans Eichel, finance minister, has come under pressure to loosen his strict debt reduction targets, because of the risks of deflation. His position has been additionally eroded by the willingness of some European Union countries, notably France, to play down the importance of the rules for the euro in favour of stimulating their domestic economies.
Source: Financial Times
LINK

The Financial Times mentions the risk to Germany of deflation. Last week the economist had this to say on the topic, (see blog item below, but the importance of this probably justifies reiteration in full):

Germany probably faces a higher risk of deflation than America. The ECB's interest rate of 3.25% is broadly appropriate for the euro area as a whole, given its inflation rate (2.2%), the size of the output gap, and the bank's chosen inflation target of “less than 2%”. But the ECB seems unlikely to cut interest rates until inflation dips below 2%. And its inflation target is arguably too low. Research by the IMF and the Fed suggests that, if central banks aim for inflation below 2%, the risk of deflation rises markedly. If the ECB had an inflation target with a mid-point (rather than a ceiling) of 2%, it could now trim interest rates.

Even then, however, rates would still be too high for Germany. Since it is the highest-cost producer within the euro area, a fixed exchange rate tends to cause price convergence by forcing inflation to be lower in Germany than in the rest of the euro area. Germany's core rate of inflation (excluding food and energy) has averaged 0.6 percentage points below the euro-area average over the past three years; it is now a full point lower, at 1.1%.

Since interest rates are the same across the whole of the euro area, this implies that real rates will be higher in Germany and growth consequently slower. Germany's output gap, at an estimated 2.5% of GDP, is the second biggest after Japan among the G7 countries, and it is likely to widen. Deutsche Bank recently cut its growth forecast for Germany to only 0.1% for this year and 0.6% in 2003. Back-of-the-envelope calculations suggest that, if the old Bundesbank were setting interest rates to suit Germany alone, they would now be below 2%. Worse still, not only is Germany unable to cut interest rates, but the EU's stability and growth pact also obstructs any fiscal easing. Nor can it devalue its currency. Stripped of all its macroeconomic policy weapons, Germany now runs a serious risk of following Japan into deflation.
Source: The Economist
LINK

So let's get this clear, Germany, according to the Economist (and me too) could well be poised on the brink of following Japan into a protracted cycle of deflation. In this context the recent rapid rise in the Euro can only have made matters worse. But far from taking note of the lesssons drawn from the Japan experience in the recent Federal Reserve paper, real interest rates in the Euro zone remain comparatively high (especially for Germany were inflation is now below 1%) and now fiscal policy is being used to apply the brake. All this seems absurd doesn't it? Well yes, and no. Yes, it is absurd, and no, there is an explanation, even if it's a bad one.

To begin to understand what is going on it is worth going back to a document prepared by the UN on the problems which will be caused by FALLING POPULATION in some European countries, to the associated dramatic rise in population dependency ratios, and to the consequent dangerous public debt dynamics which may arise with the double whammy of rising pension obligations and falling tax income. Put bluntly, the off-balance-sheet liabilities of some EU countries make Enron et al. look childs play. (In fact anyone examining carefully the kinds of creative accounting being employed to meet stability pact obligations by eg Italy, would also come to the same conclusion - that is governments are effectively playing with fire with financial derivatives). The UN proposal - like mine - is for replacement migration as a conscious and explicit policy measure.

Now for the UN. In a series of country specific studies the UN has applied a number of possible birth rate/immigration scenarios. Firstly - in the case of Germany - there is scenario 1: things stay as they are:

Scenario I, the medium variant of the United Nations 1998 Revision, assumes a net total of 11.4 million migrants between 1995 and 2050. For the years 1995-2005 it estimates 240,000 migrants per year and for the period between 2005 and 2050 a net migration of 200,000 persons per annum. For the overall population of Germany the medium variant projects an increase from 81.7 million in 1995 to 82.4 million in 2005. Thereafter, the population would continuously decline to 73.3 million in 2050 (The results of the 1998 United Nations projections are shown in the annex tables). The population aged 15-64 years would slightly increase from 55.8 million in 1995 to 56.0 million in 2000; between 2000 and 2050 it would continuously decrease to 42.7 million. The share of the elderly (65 years and above) would increase from 12.6 million in 1995 (15.5 per cent) to 20.8 million in 2050 (28.4 per cent). Consequently, the potential support ratio would be halved, decreasing from 4.4 in 1995 to 2.1 in 2050.

In the case of scenario four the UN specualte with the dynamics of maintaining a constant size 15-64 age group:

Scenario IV keeps the size of the population aged 15-64 years constant at the 1995 level of 55.8 million until the year 2050. This would require a total of 25.2 million migrants between 1995 and 2050, an average of 458,000 per year. The total population of Germany would increase to 92 million in 2050, of
which 33 million (36 per cent) would be post-1995 migrants and their descendants. The potential support ratio would be 2.4 in 2050.

and, then there is scenario five, keeping the present dependency ration constant:

Scenario V keeps the potential support ratio constant at its 1995 level of 4.4 until 2050. The total of immigrants needed between 1995 and 2050 to keep this ratio constant would be 188.5 million, which is an average of 3.4 million migrants per year. In 2050 the total population would be 299 million, of which 80 per cent would be post-1995 migrants and their descendants.
Source: UN report on Replacement Migration
LINK

As can be seen maintaining the dependency ration constant would involve a Herculean labour, both from the German themselves (in terms of flexibility in the face of a new population) and from the immigrants. The origins of the stability pact lie in the perception realised in the mid-90's that, without an important structural change in the pension and social security systems, the EU countries would effectively eventually go bust. Hence the preoccupation now that it is in part being abandoned. A number of international organisations are attempting to draw attention to the gravity of this situation, among them the Global Aging Initiative: LINK

The growing imbalance between the population of working people and those who are retired threatens to cause a future fiscal crisis in virtually every nation in the industrial world. This crisis will occur because virtually all social security systems, including elderly health and nursing care, operate on a pay-as-you-go basis. That is, they are not prefunded by contributions that are invested in liquid assets that earn a return on those investments. Current workers support current
retirees through the payroll tax (sometimes called a “contribution” in some countries), income tax, and other taxes.

The old-age dependency ratio, then, is the key economic indicator that economists and demographers watch in their forecasts. This ratio
is the number of people over age 65 for each person in the working-age population. Sometimes this figure is expressed as the support ratio, or the number of people of working-age population per person age 65 or older.

Italy faces a daunting increase in its old-age dependency ratio, which is expected to rise from 0.27 in 2000 to 0.42 in 2025 and to 0.66 in 2050. Germany’s old-age dependency ratio will rise from 0.24 in 2000 to 0.37 in 2026 and to 0.49 in 2050. France’s ratio is projected to rise to 0.44 in 2050.

The prospect of these rising dependency ratios got the attention of the World Bank, which, after two years of research, declared in 1994 that pay-as-you-go systems around the globe clearly were unsustainable. “The world is approaching an old age crisis…[and] existing systems of financial security for old people are headed toward collapse,”25 it warned ominously at a time when public awareness of the extent of demographic transformation and the potential fiscal fallout were just emerging. The World Bank also urged careful consideration of how to reform old-age pension systems.

The World Bank report followed on the heels of currency crises in Europe in the early 1990s. These crises resulted partly from the perception by currency traders and speculators that old-age welfare programs in Europe were unsustainable and were most worrisome in countries with high debt levels and sluggish growth. Some European countries, such as Italy and France, have virtually no employer-sponsored pension systems. Although Japan and Germany have such systems, they are greatly underfunded.

LINK