There has been some talk recently in Bonobo Land as to whether Wim Duisenberg should, by rights, eat his hat. One thing is clear, if the optimists are right, and the German economy does make a surpringly robust recovery, I will have to think again, and wear sackcloth and ashes for at least six months. Meantime allow me to remain the 'doubting Thomas' of the pack. First a piece from today's FT
Germany's Ifo business climate index, one of the most closely-watched economic indicators of eurozone growth, rose for a third successive month in July, further underpinning hopes for recovery in the country's feeble economy. The rise in the Ifo index followed a dramatic jump in another growth indicator, the ZEW economic institute's monthly expectations indicator earlier this month. Together, the indices provide a much-needed boost to the government, which is in the midst of pushing through an ambitious reform agenda in an effort to revive the stagnant economy. Crucially, the Ifo' s third rise - helped by recovering stock markets, the slightly weaker euro and the reform debate - signals that the real economy can be expected to follow the trend. "Based on previous experience, an improvement in the Ifo business climate three months in succession signals a coming economic upturn," Ifo president Hans-Werner Sinn commented. Unlike the ZEW, which is based on a survey of financial market analysts, the Ifo index, which is based on a survey of 7,000 companies, also provides firmer evidence that the turnaround in sentiment extends to businesses. At the same time, however, Monday's rise in Ifo's key index for western Germany was smaller than expected - to 89.2 from 88.8 in June, less than the 89.8 that had been forecast - highlighting that caution is still needed amid mixed signals from the real economy. Numerous economists, including at the IMF and Bundesbank, have revised down their expectations for German growth to near zero for this year, and 1.5 per cent for 2004, well below the government's official forecasts. With the economy still flirting with recession, and much dependent on whether the euro will again strengthen against the US dollar, the pressure remains firmly in place for chancellor Gerhard Schr?der to rapidly deliver on the "Agenda 2010" reforms he outlined in March.
Source: Financial Times
Now clearly the expectation is one of a global recovery lifting all boats. For a look at what Keynes would perhaps have called the 'treasury view' let's make a brief visit to Morgan Stanley's Elga Bartsch last Friday:
Six months ago, I published a report entitled Is Germany Doomed? (January 6, 2003), in which I argued that the German economy would be reaching a critical point this year, in terms of both the business cycle and economic policies. As I feared at the time, the economy slipped back into recession in the first half of this year and is unlikely to do anything but stagnate for the year as a whole. Nevertheless, I am now ready to give three cheers to the Chancellor on the progress he is making in pushing through his reform agenda (see German Economics: Schroeder's Masterplan, March 16, 2003).
The first cheer is for the attempt to push through structural reforms, notably on labour market regulation. On my estimates, these reforms could add 0.75% to GDP over the next few years -- a small, but not negligible, effect. The second is for trying to lower (or at least limit further increases in) social security contributions, notably by trying to contain healthcare expenditure, reduce unemployment benefits and freeze pension spending. The third cheer is for pulling forward income tax cuts of about €15 billion that were originally scheduled for 2005, to next year, thereby bringing the total tax relief in 2004 to €20 billion, or 1% of GDP.
In light of these developments, we are revising up our 2004 GDP growth forecasts from 1.7% to 2.1%. If confirmed by official data, 2004 would record the second-strongest growth rate since 1994. Only the exceptional boom year of 2000, when the German economy registered a strikingly high growth rate of 2.9%, would surpass our new 2004 GDP forecast. The upward revision to the growth outlook, which brings our numbers to the upper end of the range of available forecasts, is concentrated in domestic demand, the long-standing Achilles heel of the German economy. In particular, we are raising our forecasts for consumer spending by almost a full percentage point to 2.1%, the highest growth rate since 1999. We are also increasing our forecast for investment spending from 1.3% to 1.8%, as small and medium-sized companies, which do not pay corporate taxes but income taxes, will also benefit from the income tax reduction. To some extent, the stronger domestic demand will also translate into stronger import demand, which comes as good news for Germany's neighbours.
Even though a growth forecast of 2.1%, almost one-third above trend growth, may already seem a little vertiginous, we believe that our forecasts are still on the conservative side. In particular, we have not factored in a reduction in social security contributions implied by efforts to contain spending on healthcare, pensions and unemployment benefits. In our view, January 1, 2004, will be too early to expect a marked reduction in contributions, which are equally shared between employers and employees, because we think that the cyclical upward pressures on contribution rates are likely to prevail in the near term.
With monetary policy remaining overly restrictive for the German economy and with fiscal policy under the scrutiny of the excessive deficit procedure, bold structural reforms really seem to be the best way forward. A recent IMF report estimates that by embracing US labour market regulations, the euro-area unemployment rate could be lowered by some 3.5 percentage points and output boosted by 5.25% in the long run. This simulation assumes that the replacement ratio of unemployment benefits, employment protection legislation and labour taxes are lowered to US levels. Of these three factors, however, it is really the replacement ratio and the employment protection legislation that matter most. Both of them are at the heart of Chancellor Schroeder's reform agenda. If, in addition, euro-area product markets were as deregulated as their US counterparts, this would boost output by roughly the same amount as a change in the labour market regime (see Unemployment and Labour Market Institutions: Why Reforms Pay Off, IMF, April 2003). For an economy that has underperformed the rest of the euro area for almost a decade now, attempting to unleash additional growth potential of 10% would not be a bad move. In fact, it might be the best one.
Source: Morgan Stanley Global Economic Forum
Now as regular readers will know all too well, I am not in principle opposed to the 'labour market reforms', nor to product market deregulation, nor to pension reform, what I am not sure about is whether these measures when applied will produce the anticipated recovery. Elga convinces me of one thing, when you want to be convinced, it's not too hard to convince yourself - 10% additional growth potential, just like that, and you didn't even see my hands move! As Eddie once said, everything here is timing, timing and a broader view of the problem. Among other quaint details, I fail to see why we have to note that the monetary conditions are overrestrictive and leave matters there. If they are overrestrictive, shouldn't they be loosened? Finally, something Eddie sent in the mailbox this morning seems strangely to the point.
It seems to me that people tend to think one-sided. When they talk about structural problems like rigid labour markets, they think supply side. Remove the disincentives to work and flexibilise labour markets. People forget the demand side effects (which become larger, as they are a function of the demographics?)
And when you talk about determination of monetary aggregates for example, a large part of the reason why central banks are having less of an impact must be they are having less of an influence on the relationship between banks & their clients – the reason being the changing demograhics (non-linearity over the age curve?)
While the underlying causes are different, the deflation we get is always Keynesian - insufficient demand. But because of the differences again, much of which is where we are on the age curve, the cures, I agree, would have to be a lot more creative than standard Keynesian remedies.
My sense is that many people out there (particularly policymakers) think all we need to do is get the costing correct. I guess it’s essentially neo-classical thinking? They think micro and not macro.