Germany - Europe's Japanese Economy

Germany - Europe's Japanese Economy

Also published by United Press International (UPI)

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November 20, 2002

On Monday, the unthinkable happened. The European Commission has initiated "excessive budget deficit" procedures against the two biggest members of the European Union, France and Germany, for having breached the budget deficit targets prescribed by the much-reviled Stability Pact. This seems to have vindicated the voices in both countries who blame their economic woes on the stringent requirements of the compact intended to stabilize the euro.

Yet, the Stability Pact is merely a convenient scapegoat. It is because Germany brazenly -and wisely - ignored it that it is being cited by the Commission. Still, despite an alarming budget deficit of close to 4 percent of gross domestic product (GDP) this year and a transfer from Brussels of 0.25 percent of GDP as flood aid, the German economy is stagnant.

It is set to grow by 0.5 percent this year and by 1.5 percent in 2003, says the government. Not so, counter its own council of independent economic advisors, the "five wise men". Growth this year will be a paltry 0.2 percent and next year, fingers crossed, 1 percent.

The IMF is more optimistic. Growth in 2003 will be 1.75 percent, it predicted last week. Even so, German GDP is growing at 3 GDP points below trend. The excess capacity translates to deflationary pressures on prices and to rising unemployment, currently at over 4 million people, or almost 10 percent. One of every six adults in the eastern Lander is out of work.

The much-observed monthly index of business expectations, published by the ZEW Institute, predicts a nosedive in economic activity in the first half of 2003. Moody's have just downgraded the rating of yet another German household name, the Allianz insurance group.

German banks are caught in a worrisome spiral of loans gone sour, interest rates set stiflingly high by the European Central Bank (ECB), the removal of state subsidies and yet another looming recession. Business confidence is extinct, unemployment and bankruptcies soaring. More than 1000 firms go belly up every week - three times the rate in 1992.

The two pillars of the German economy - the small, family-owned, businesses (Mittelstand) and the export industries - are in dire shape. Eurostat, the European Union's statistics bureau, has just announced that industrial output in the eurozone during the third quarter actually contracted by 0.1 percent. In the USA, Germany's other big export destination, if one takes intermediate goods into account, the anodyne "recovery" relies entirely on the ominous profligacy of ever less solvent consumers.

Germany's problems - like Japan's - are structural. It is ageing fast. It is inordinately expensive. It is bureaucratic. Its banks are tottering, unable to create new credits. The state is overweening and interventionary. Many of the country's industries are already uncompetitive.

Germany's labor markets are rigid, its capital markets either dissolute or ossified. The scandal-ridden small caps Neuer Markt was closed down this year, having lost more than 90 percent of its value since March 2000. Both the average German and decision-makers are loth to reform a virulent system of prodigal social welfare coupled with all-pervasive rent-seeking by various industries, especially in construction, banking, the media and agriculture. Germany is living off a past of miraculous wealth creation. But the signs are that it may have exhausted the principal.

Germany faces a series of painful choices between unpalatable alternatives. The Minister of Finance, Hans Eichel, must either hike taxes - including on wages, in contravention of campaign promises only two months ago - or lose control over the public finances.

According to new proposals, pension contributions will go from 19.1 to 19.5 percent. Another idea is to set a minimum corporate profit tax, thus preventing businesses from using accumulated tax credits. A host of business-friendly tax loopholes and deductibles will be abolished. These measures will surely discourage hiring and investments and may cause long-suffering multinationals - both German and foreign - to relocate.

German household debt is higher than in America. But taxes on capital gains and interest - about to be raised - discourage savings. This will be further compounded by the ballooning deficits of both central and state budgets. Even if all the right ideas are implemented, including massive spending cuts, the government, according to Business Week, will have to borrow $32 billion this year - crowding out the private sector.

Fiscal largesse is considered to be an automatic stabilizer in a recessionary economy. But whether it is depends on how much new money is included in government spending and how productively it is targeted. Japan's river of squandered supplementary budget packages, for instance, did little to revive the moribund economy.

In an apocalyptic analysis published last week, The Economist warned that Germany is under a serious threat of deflation. It endured an asset bubble, it has large private sector debts, a weak banking system, structural rigidities, it suffers from political and social paralysis and a shrinking and ageing population. "Our analysis suggests that Germany has more symptoms of the Japanese disease than America." - concluded the paper somberly.

Germany is luckier and more resilient than Japan, though. It is subject, willy-nilly, to intense competition within the single market and thus is being forced to shape up. Its banks, though in crisis, are far more robust than Japan's. Business inventories may be already declining.

Furthermore, most of Germany's excess spending goes on welfare benefits. Poor people consume more of their disposable income than does the middle class. Thus, welfare checks almost immediately translate into consumption. Even the IMF warned Germany last week not to cut its budget deficit too fast lest it damages a hesitant economic recovery.

Moreover, interest rates in the eurozone - and the euro's exchange rate - are bound to come down as fiscal rectitude is restored and industrial production plummets. German business confidence largely hinges on the ECB's inflation-obsessed policies.

A relaxation in monetary policy will result in an export-led investment mini-boom and a reversal of the rising trend of unemployment. Declining oil prices as the Iraqi conflict unwinds one way or the other will help a nascent recovery. Should the government implement its own recommendations for labor-market and pensions reforms, it will have removed growth-stifling rigidities.

Yet, averting recession and the much-feared risk of deflation would do nothing to tackle the fundamental problems faced by the German economy. According to the Financial Times Deutschland, the Bundesbank warned on Monday that the government's budget plans will actually harm prospects for long term growth.

Hobbled by a partisan, opposition-controlled, upper house and an election victory barely snatched from the jaws of defeat, there is little Gerhard Schroeder, the embattled Chancellor, would be able to do to counter the increasingly militant and strike-happy unions.

The two axes of Germany's multiple problems are its monstrous welfare system and no less overwhelming red tape and bureaucracy. Employees and workers pay one seventh of their wages to finance only the increasingly troubled healthcare system. Another fifth goes into retirement funds. According to The Economist. labor costs are set to grow to an unsustainable 42 percent of gross wages next year.

The welfare state is sacrosanct. Schroeder himself admitted as much last month. In a speech to the nation, he taunted the opposition. Voters re-elected him, he boasted, because he "expressly did not decide to scrap the welfare state, cut benefits indiscriminately and roll back employees' rights" - though "some entitlements, rules and allowances of the German welfare state" must be reconsidered, he added, incongruously. The opposition promptly - and somewhat justly - accused him of "electoral fraud" for hiding the true state of the economy and making false campaign promises.

German workers indeed want more of the same, as the re-elected Chancellor has astutely observed. IG Metall, Germany's largest trade union, called for both the provisions of the Stability Pact and the ECB's monetary policy to be relaxed to allow for "offensive impulses (read: more government spending) against the stagnant economy." German workers, concerned with job security and bent on escalating wages, actually prevent the creation of new jobs for the unemployed by opposing the formation of part time and contract "mini-jobs".

Germans are wealthy. Average annual income, according to the BBC, is $25,500. The unemployed in Germany are better off than many workers in Britain. But, as work ethic, good corporate and state governance and plant modernization increased throughout Europe, they declined in Germany, David Marsh, of the Droege Group in Düsseldorf told the BBC. Since unification, 12 years ago, Germany has avoided facing reality by embarking on a borrowing binge, partly to finance a net annual transfer of 4 percent of GDP to the former East Germany.

In all fairness, west Germany's performance is still impressive. It is being dragged down by the eastern parts whose productivity, compared to the west's, is one third lower and unit labor costs one tenth higher. Unemployment in the east is double the west's, the infrastructure is decrepit and brain drain is ubiquitous.

Germany will survive. But the gradual decline of the third largest economy in the world and the most prominent in Europe might have serious geopolitical implications. The first to pay a heavy price would be the economies of central and eastern Europe. Germany is by far their largest export market and Germans the biggest foreign investors. It absorbs close to 40 percent of the exports of Poland, the Czech Republic and Austria.

Germany also holds a majority of the sovereign and private sector debts of these countries - more than half of Russia's $140 billion in external debt, for instance. During the devastating floods, according to Stratfor, the strategic forecasting consultancy, Germany was able to call on $172 million in Russian obligations. These links within an emerging common economic sphere are mutually-beneficial. Hence Germany's avid sponsorship of EU enlargement.

Central and eastern European polities will not be the only casualties of a German meltdown. The European Union itself will suffer greatly. Germany and France form the economic core of the alliance. Germany, once the economic powerhouse of the continent with one quarter of the EU's GDP, could well have become a drag. Until recently, according to the Economist Intelligence Unit and the IMF, Germany was the target of one third of Dutch and Swiss exports and one quarter of Danish, Belgian and French goods.

Will Germany recover? Most likely so. Will the recovery lead to a new era of prosperity? Unlikely. It is hard to contemplate painful reforms on a full stomach, regardless of how imminent the dangers. What Germans need is another crisis, a shock to wake them up from the stupor of affluence. It may well be on its way. Alas, the cost of German reawakening is likely to be paid by every single European country - except Germany.

Appendix - Impact of Minimum Wage on Germany's Economy

Interview granted to Matt Moore of Associated Press, June 14, 2007

Germany is debating the introduction of a minimum wage. The country is a special case because it is a hybrid capitalist-socialist economy and it has the Mittelstand (family-controlled small and medium enterprises). Labor mobility is limited (the labor market is not ideal or frictionless).

These may be the effects of a minimum wage on the German economy:

1. By "competing" with generous unemployment benefits, the minimum wage may create incentives to work. This will decrease the cost of various welfare programs. The surge of new entrants will, at least at first, INCREASE the unemployment figures.

2. The minimum wage may stimulate consumption (studies show that every additional euro earned by low-wage workers is spent on consumption, not saved). This plus a general increase in the price level (to offset increased labor costs) will have inflationary effects.

3. It may enhance productivity (employers will likely insist on increased productivity to offset increased costs) and cause entrepreneurs to move out of labor-intensive and into capital-intensive industries and sectors.

4. The minimum wage may encourage technological innovation (to substitute for expensive labor inputs). This, in addition to a general reduction in demand for low-skilled, low-wage workers will again increase unemployment.

5. Finally, the minimum wage may cause German manufacturers and service providers to offshore activities and manufacturing to Central and Eastern Europe or even Asia. Anything from car manufacturing and pharmaceuticals to back office operations (credit card processing, customer relations managements, flight ticketing, insurance claims processing) can move from the hinterland of Germany to its European "colonies" or to Asia.