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Thursday, February 27, 2003

Germany: This One Looks Scary

Under the heading 'Germany's Stagnation is Beyond its Control', two JP Morgan economists argue the case today, Germany's short-term difficulties are not about the need for mid-term structural reform, they are about the absence of control over fiscal and monetary policy. And where does this loss of control come from, why from the participation in a common currency better known as the euro. Well, as regular readers to Bonobo Land will already know, I wholeheartedly agree. One minor caveat: it is unfair to blame all the loss of control over fiscal policy to the euro and the stability pact. Control was effectively lost by earlier German governments (Kohl??) who failed to see the demographic time bomb, the large unsecured liabilities of the German welfare system, and the impact of IT and the internet on the way we workand play. It is the failure to change tack and reform and change mentality earlier - especially in the area of welfare funding reforms, working and contractual practices, attitudes to individual risk-taking, and above all national identity and immigration - which has now left Germany a hostage to fortune on the fiscal deficit problem. Also note the suggestion that monetary conditions are far too loose for Spain and Italy, that in the case of Spain applying a Taylor rule would produce an interest rate nearer to 7%, remember the Spanish housing bubble, and watch out for the crash.

Structural rigidities are widely blamed for Germany's economic stagnation. But although it suffers from a number of structural problems, notably in the labour market, these do not explain the contraction that started in the fourth quarter of last year. Market rigidities explain why Germany has a very low potential growth rate: the latest Organisation for Economic co-operation and Development estimate is 1.5 per cent. But recessions come about owing to a lack of demand. To understand what is going on in Germany, look at the traditional drivers of the business cycle: monetary and fiscal policy and the exchange rate. All these are helping to depress German demand relative to that of its neighbours: monetary policy is tighter in Germany than elsewhere; fiscal policy has tightened, while it has remained neutral in France and Italy and has eased slightly in Spain; and, given its greater trading links to the rest of the world, the higher exchange rate is hurting Germany more than its large neighbours.

Although a common interest rate applies to the whole of the eurozone, this does not mean that the monetary stance in each country is the same. The best way to compare monetary stances is to look at Taylor rules. These were originally developed by John Taylor - now undersecretary for international affairs at the US Treasury - to indicate how a central bank should set policy rates given the extent to which actual inflation has diverged from the central bank's target, and the degree of spare capacity in the economy. Applied to individual countries in the eurozone, Taylor rules show what level of policy rates would be appropriate if each country still had an independent central bank looking at growth, spare capacity and inflation.

There are three clear messages. First, before 1999, monetary policy in Germany (and for the region as a whole) was set on the basis of macroeconomic conditions in Germany. The gap between policy rates set by the Bundesbank and those implied by the German Taylor rule was very small. For France, Italy and Spain, interest rates were higher than their respective macroeconomic conditions required, in order to keep exchange rates stable. Second, since the launch of the single currency, the monetary stance set by the European Central Bank has been too tight for Germany but too loose in Italy and Spain. The gap between ECB rates and the Taylor rule for France has been very small. And third, the divergence in monetary stances has increased. Since 1999, the ECB's policy rate has on average been almost 1 percentage point too high for Germany. But by the fourth quarter of last year, the ECB's policy rate was almost 2 percentage points too high.The implications are dramatic. If the Bundesbank were setting rates purely on the basis of conditions in Germany - as it did before 1999 - they would be close to 1 per cent, rather than the ECB's current 2.75 per cent. Similarly, the Bank of Spain would have raised rates close to 7 per cent. Inappropriate monetary stances are pushing growth rates apart. Meanwhile, in response to pressure to comply with the stability pact, German fiscal policy is tightening this year by 0.5-1 per cent of gross domestic product. The degree will depend in part on the centre-right opposition that has strengthened its control of the upper house. But whatever the outcome of the political negotiations, Germany's fiscal position is tightening after a modest easing of 0.5 per cent of GDP last year, while elsewhere in the eurozone policy is closer to neutral.

Last, of all the big eurozone economies, Germany is the most sensitive to the exchange rate. Although global trade growth will eventually return to a healthy pace, the trade-weighted euro is now 20 per cent higher than its trough in October 2000. This currency appreciation will further widen the growth gap between Germany and the other large economies in the region. Since German weakness is a result of negative shocks to demand rather than greater structural rigidities, only an improvement in demand will get the economy going again in the near term. Here lies Germany's predicament: there is no silver bullet. Even though the ECB is expected to cut rates in the coming weeks, they will still be too high for Germany. And the pressure on fiscal policy will remain intense: with its budget deficit stuck above the 3 per cent ceiling, Germany may be forced by the EU to go further in cutting spending and raising taxes.The only ray of hope is the possibility of a powerful upswing in global growth that is not offset by further appreciation of the euro. This seems unlikely. The outlook for Germany is grim indeed.
Source: Financial Times

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