Sunday, September 18, 2005
Polls apart, Germany is on top
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Last Sunday it was Japan’s turn to re-elect a reform-minded prime minister. Which way will the Germans jump when they vote today, and will their choice of chancellor — Angela Merkel or Gerhard Schröder — matter for the economy?

Germany remains the world’s third-largest economy until 2007 when it will be overhauled by China. The federal republic is Britain’s biggest trading partner; exports and imports together totalled £30.5 billion in the first half of this year compared with £25.4 billion for trade with America.

Germany has in recent years been the mirror image of Britain. The UK economy has been propelled along by consumers, creating a virtuous circle in which their spending creates jobs in the economy, which in turn generates more spending. Keynes’s multiplier has been alive and well, at least until it stalled a few months ago.

Germany, meanwhile, has been caught up in something like Keynes’s liquidity trap, in which interest rates — set by the European Central Bank and standing at 2% — cannot be cut low enough to stimulate the economy while at the same time controlling inflation.

The International Monetary Fund expects only 0.8% growth this year. Nor does it see the clouds lifting soon, whoever wins today’s election. Growth next year is put at 1.2%.

Germans have kept their euros under lock and key, depriving the economy of the oxygen of demand. The result, over a decade, has been a rise in unemployment to 5m.

Germany has been the mirror image of Britain in another way, however. While manufacturing in the UK has suffered, in Germany it has prospered. While Britain has racked up record trade deficits, Germany remains a country with a substantial surplus, including an annual surplus with Britain running at £15 billion.

Official figures produced last week showed UK productivity per worker is 3% higher than in Germany, although behind it on an output-per-hour basis. For once, however, the figures do not tell the full story. Fifteen years after unification, German productivity is still dragged down by the inclusion of the eastern states.

The reality, as David Frost, director-general of the British Chambers of Commerce, ruefully points out, is that Germany is much better at producing the kind of high-value products that consumers in other countries want. It has maintained its Mittelstand of medium-sized firms, despite the fear that the euro, over-regulation and high labour costs would kill it off.

What kind of economic choice do German voters face? On the face of it, quite an important one. The Christian Democrat Union (CDU), led by Merkel, would cut direct taxes, reducing the lowest rate of income tax from 15% to 12% and the highest from 42% to 39%.

Employment costs would be cut, with the unemployment insurance rate reduced from 6.5% to 4.5%. Like Margaret Thatcher in 1979 (although Merkel is not much like her), this would be funded by a rise in Vat from 16% to 18% and by closing tax loopholes. Corporation tax would be reduced from 25% to 22%.

There might yet be a flat tax, although not until 2009 at the earliest. Professor Paul Kirchhof, brought in by Merkel, has livened up the campaign, but not in the way she intended. His advocacy of a flat tax has scared some German voters. In truth, the most the CDU can be expected to do is move to a “flatter” tax structure, of the kind George Osborne of the Conservatives has been talking about here.

Schröder’s Social Democratic Party (SPD) has less new to offer, perhaps because it has been in government for seven years. It would cut corporation tax to 19% but increase income tax on high earners from 42% to 45%. It would proceed with plans to cut entitlement to unemployment benefit but leave most of the country’s consensus-based industrial relations untouched. One interesting idea, intended to stimulate the building trade, is that homeowners would be able to deduct 20% of their spending on maintenance and modernisation from tax.

The election outcome is uncertain, but one thing is certain — after it there will be a coalition of some sort. This could be any one of five possibilities, from a centre-right grouping comprising the CDU, the Bavarian Christian Social Union (CSU) party and the liberal Free Democrats, to a continuation of the Red-Green coalition, with Schröder kept in office by the support of the Left party and the Greens. The big fear is of a “grand” coalition of the politically opposed CDU and SPD, last seen in the 1960s.

How damaging would that be? One argument is that this would be a recipe for policy drift and guarantee a halt to the economic-reform process. The Schröder government’s Agenda 2010 reforms have made some progress, reducing tax rates, cutting unemployment benefit and preparing the people for later retirement. The World Bank has praised Germany for its labour reforms.

Much of the real reform, however, has been driven by business. And, it could be argued, this is a time when business should be allowed to get on with it and government take a back seat. Some of the Merkel proposals, for example the proposed Vat rise, might do more harm than good. Policy paralysis may be no bad thing.

Using the stick of shifting production to low-cost labour locations in eastern Europe, firms such as Daimler Chrysler, Siemens and Volkswagen have been pushing through significant changes in working practices. This had improved the performance of corporate Germany and lifted the stock market.

It has been even more important at the macro level. Germany entered the euro in 1999 at a competitive disadvantage, its unit labour costs being higher than those of other members. Gradually, however, productivity improvements have been ground out and Germany’s relative unit labour costs have fallen. The fears that were around before the launch of the euro, that a highly competitive Germany would wipe the floor with weaker economies like Italy — deprived of the devaluation weapon — are now a reality.

What will this mean? Gabriel Stein of Lombard Street Research, in an article titled How to leave Emu, sketches out the mechanics of withdrawal if the pressure gets too intense. Previous monetary unions have broken up, he points out, as have recent political unions (Yugoslavia, Czechoslovakia and the Soviet Union). Unions, perhaps, are meant to be broken.

In the case of Italy withdrawal would be fraught with risks but it could also provide huge opportunities. Stein argues that it could be presented as the kind of successful liberation from an economic straitjacket that Britain experienced on leaving the European exchange rate mechanism in 1992.

Will it happen? Not yet. But in the long run there may be no alternative.

PS: How come fears of petrol shortages, however misplaced, led to panic buying, while “bra wars” worries about autumn clothing supplies from China did not? The answer, of course, is that petrol is a necessity while new clothing rarely is. Nor was the panic buying good news for petrol stations. Having got their fill at the pumps, motorists did not linger as long as usual to buy other items.

Actually, last month was not bad for clothing. Sales volume was slightly up from July to August and the value of clothing sales was 1% up on a year earlier. The overall retailing picture is gloomy, however, with no growth in sales volume last month and only 0.8% in the past year. Retailers could do with some panic buying.

From The Sunday Times, September 18 2005


Germany has a real choice - the future or rhetoric. My guess that rhetoric will prevail. Germans lost their courage to look at the world as it is a long time ago. Anti-American attitudes mererly reflect the bitterness of a souless nation that prefers comfort to challenge.

Posted by: anne at September 18, 2005 03:21 PM

Blimey, what a message of depression. Call for Social Services! Ah, but of course that won’t actually help because the Blair/Brown social model doesn’t work – and neither do their ineffectual manufacturing, energy, housing and pensions models.

At least the German social model did work when it was needed and now there is an acceptance, by the main parties at least, that things have to change. The current negotiations are about power, not policy.

Btw, Germany did see the Iraq invasion for what it was. And the German people did prefer to challenge George Bush - because, as all like-minded people will tell you, they were anti-Bush, not anti-American.

Posted by: David Sandiford at September 19, 2005 12:23 PM

From the Sept. MPC minutes:

“11 The Committee could choose to accommodate the first-round impact of higher oil prices and allow headline CPI inflation to rise temporarily above the target. If wage settlements did not pick up in line with the increase in CPI inflation, this would reduce the growth of real consumption wages. But this accommodative strategy could prompt an increase in agents’ inflation expectations and an associated rise in wage settlements. If this were to occur, the tightening in monetary policy needed to bring inflation back to target might be associated with larger fluctuations in output and employment.

12 Alternatively, monetary policy could respond to the first-round effects of the oil price shock and seek to bring CPI inflation back to target more quickly, thereby limiting any change in agents’ inflation expectations. This would imply a tighter monetary policy in order to reduce inflation in the non-oil sector, offsetting the direct effects arising from higher oil prices. This would push down on growth and employment, reducing the growth in real consumption wages through lower wage settlements.”

Quite. It’s interesting how explicit they are in linking inflation to wage rises and the control of inflation to increasing unemployment – i.e., unemployment brought about by monetary policy.

Posted by: David Sandiford at September 21, 2005 10:53 AM

The future for Germany as well as the rest of EU is closely linked with the US I think. regards

Posted by: bil at December 13, 2005 04:51 AM

No, I will have to disagree Bill. Why do you think so?

Posted by: Leie Tilhenger at January 13, 2008 01:41 AM