Saturday, April 05, 2003
Germany's lost decade
Posted by David Smith at 08:29 PM
Category: David Smith' s magazine articles

A few weeks ago George W. Bush was reported to have said that the problem with the French is that they did not have a word for entrepreneur. Whether he said it or not, there is now an alternative on the other side of the Rhine: What is the German for angst?

Germany’s economy is deeply angst-ridden. It has just slipped back into “technical” recession, with a drop in gross domestic product in the final quarter of 2002 likely to have been followed by another in the first three months of 2003. Economic growth this year, which even the government forecast at only 1%, is likely to be zero at best.

DIHK, the German Chamber of Commerce, finds in its latest survey of small and medium-sized firms, the legendary Mittelstand, that business expectations are at their weakest since the last time the economy was in recession, in 1993.

Mittelstand firms, the cornerstone of German economic success, are being hit in several ways. As family firms, they are encountering a reluctance to take on the business by younger family members. Unlike bigger multinational companies, it is difficult for them to uproot and move to cheaper locations. They are suffering from the relatively high exchange rate at which Germany entered the euro. And they are experiencing a “credit crunch” as banks are increasingly reluctant to lend.

Small and medium-sized firms are not the only ones in trouble. Bigger German companies are increasingly exasperated with the lack of direction from Gerhard Schroder’s government. The big German banks, with an average return on equity of under 2% (compared with 11% to 23% for UK banks) are warning that things cannot go on this way.

Nor is there any cheer among consumers. Businesses and households are usually on the same wavelength in Germany, and today is no exception. Unemployment of over 4m and deep corporate gloom is enough to keep consumers from spending.

What’s gone wrong for Germany? Like that other post-war economic giant, Japan, its previous strengths are now seen to be weaknesses. The problem for economies built on consensus is that they find it hard to change.

Germany has the highest labour costs in the industrialised world and some of the toughest labour laws. It probably needs a Margaret Thatcher to shake up its working practices but there is little likelihood of a reforming politician being elected, at least not until the economic crisis is several notches worse than now. Edmund Stoiber, the defeated conservative candidate in last year’s federal election, promised only modest reforms.

As already mentioned, Germany’s last full-blown recession was in 1993. The great optimism that greeted the tearing down of the Berlin Wall in 1989 and formal unification in 1990 produced a powerful but short-lived boom. On one explanation, the very subdued growth since then, Germany’s equivalent of Japan’s lost decade, can be put down to a huge and prolonged post-unification hangover. Fiscal transfers from the former West Germany to the eastern states, equivalent to up to 5% of gross domestic product, represent a substantial, and continual, burden.

The unification factor should not be dismissed, even if policy mistakes made it worse than it needed to have been. Helmut Kohl, Schroder’s predecessor, made the political gesture of converting the ostmarks to deutschemarks at a one-for-one exchange rate, despite the East German economy’s woeful lack of competitiveness. Both eastern and western lšnder continue to pay for that decision.

It is not all unification, however. Some would say that European monetary union was also essentially a political act for Germany. Certainly is it hard to see what it has got out of the euro. Not only did Germany enter with very high labour costs, she also entered at a high exchange rate. Perhaps there was a belief that the miracle economy of the post-war years, the Wirtschaftswunder, which thrived on a strong currency, could be recreated. If so, the faith was misplaced.

For a British audience, there is a close parallel between Germany’s euro difficulties and that of Britain in the European exchange rate mechanism (ERM) in the early 1990s. Germany desperately needs lower interest rates, as Britain did then. But Germany has to wait until the European Central Bank (ECB), based just along the road from the Bundesbank in Frankfurt, decides lower interest rates are appropriate for the whole of the “euroland” area. So far the ECB has been slow to respond to Germany’s particular needs.

In some ways Germany’s plight is more serious than Britain’s ERM straitjacket. There was nothing in the early 1990s to prevent the UK government relaxing fiscal policy, a freedom John Major’s government seized upon enthusiastically. But Germany is constrained to keep her budget deficit below 3% of GDP, as a result of the Stability and Growth Pact (SGP) it campaigned so hard for to prevent countries like Italy operating reckless fiscal policies.

So what does Germany need? It needs a lot of reform to its labour markets and to the other laws and red tape constraining business. It needs either a reduction in labour costs or a big increase in productivity. And it needs a more flexible monetary and fiscal policy approach in the euro area.

Whether it gets any of these is open to serious doubt. In the meantime there is another big problem looming. The recent rise of the euro has substantially increased the risk that Germany will slip into deflation – falling prices. And that, alongside the country’s existing economic stagnation, is a very dangerous combination, as Japan can testify.

From Professional Investor, April 2003

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