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Friday, November 08, 2002


The economist is again worried about the danger of Germany falling into a deflationary cycle. With reason I think, and even more so now the ECB has maintained interest rates unchanged for yet another month:

America does not yet have deflation. Still, its GDP deflator fell to 0.8% in the year to the third quarter; so long as the level of GDP remains below potential, inflation will keep falling. Deflation currently seems unlikely in Britain or the euro area as a whole, but Germany is at risk. German consumer prices have fallen at an annual rate of 0.4% over the past six months. More worryingly, Germany, unlike Japan in the early 1990s or America today, is not free to cut interest rates or run a looser fiscal policy. Interest rates are set by the ECB on the basis of economic conditions in the whole euro area, and budget deficits are limited by the European Union's stability pact. The risk of deflation may therefore be greater in Germany than in America.

Deflation is particularly deadly when an economy has lots of debt, because falling prices swell the real debt burden. In America and Germany, firms and households have borrowed heavily in recent years, lifting total debts of the non-financial private sector to 150% and 160% of GDP respectively. In the early 1990s Japan's debt burden was equivalent to almost 250% of GDP. Japanese firms are still much more in hock than those in America or Germany. On the other hand, American households look more vulnerable. Even at the peak of Japan's bubble, households remained big savers. Last year German households saved as much as 10% of their income; Americans saved only 1.5%.
America's demographics are more favourable than Japan's, where the population is both shrinking and ageing. A shrinking labour force implies a slower growth rate, future problems for financing public-sector pensions, and greater opposition to reform than in a more youthful country. Germany again appears similar to Japan. Its working-age population is expected to shrink by 0.2% a year over the next decade, compared with likely annual growth in America of around 1%. Our analysis suggests that Germany has more symptoms of the Japanese disease than America. America's bigger bubble infected its economy more severely; but its more flexible markets and institutions should now help it to adjust. For now, both countries remain in danger.
Source: The Economist

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