Erstellt am: 21.11.2005 Autor: Edward Roby Status: Senior
Will ice suffice?
Two key questions about the outlook for the German economy were partly answered on Friday, Nov. 18, in Frankfurt and Berlin. The president of the European Central Bank announced that the euro’s leading interest rates were about to go up. And Germany’s two dominant parties inked a coalition deal that relies mainly on higher taxes, rather than savings, to restore fiscal discipline, the new government’s highest priority.
Even the more doctrinaire supply-side economists must now be wondering what good such a double dose of fiscal and monetary tightening might do for Germany, where weak domestic demand has been widely identified as the No. 1 economic problem. And what about all that sound and fury which culminated in Germany’s ballot-box political stalemate of mid-September? Will it now bring forth nothing more than a sterile accounting exercise aimed at a more blanced public budget?
The urgent quest for investment, hiring and growth, which seemed to have won some political converts during last summer’s campaign, isn’t directly addressed by the impending policy mixture of rising taxes and higher interest rates. Such austerity is normally prescribed for an exuberant economy that may be in danger of overheating. In the perennial see-saw battle between inflation and deflation -- fire and ice -- it looks like Germany is going to get two more ice cubes. Will ice suffice for this chilled economy?
Just minutes after Jean-Claude Trichet dropped his rate bombshell at the Frankfurt’s European Banking Congress, the ECB president was forced to bob and weave around the specter of deflation this interest hike might help to awaken in Germany. In an audience studded with banking economists, a representative of Morgan Stanley wanted to know whether Germany would henceforth look like deflationary Japan of the 1990s, after its notorious asset bubble burst.
One rate fits all
Defending the impending interest rise, the first in five years, Trichet pointed out that the ECB’s mission is to “preserve price stability” in a euro zone of 311 million people, not just in the EU’s largest national economy. The data do indeed show that inflation is becoming a problem in other parts of Euroland. The currency zone’s consumer inflation rate of 2.5 percent in October was cruising half a point above ECB’s supposed ceiling for price stability.1
The comparison with Japan, though, ought to strike a raw nerve in slow-growing Germany, where it is exceedingly hard to find an asset bubble that may need bursting. Germany’s only price drivers nowadays are imported energy and a colorful assortment of buoyant charges imposed by government at all levels.
It was partly a sovereign monetary policy, something Germany surrendered in 1999, that lifted Japan out of its seven-year bout with deflation by means of real official interest rates that long lingered below zero. And that was just one of the anti-cyclical efforts Japan made to revive its own weak domestic consumption. “One could say that Japan is getting out of the prolonged stagnation at last,” Eiji Hirano, the assistant governor of Bank of Japan, said in the same panel discussion in which Trichet took part.
Unlike Japan of the 1990s, Germany today isn’t afflicted with deflation. But wages, product and asset prices are not exactly sprinting ahead. And an examination of consumer inflation, which fell to 2.3 percent in October from 2.5 percent in September, reveals an ambiguous picture. Less then one percentage point of this rate can be attributed to core inflation, according to an analysis by Ralph Solveen’s Commerzbank economic research department. All the rest is coming from energy prices and those administrative charges imposed by government. This has been the case since the end of 2002, according to the bank’s presentation made at the end of October.
The Commerzbank economists projected sharply falling headline inflation in Germany next year, as the oil price subsides somewhat and the core inflation rate meanders at levels just slightly above the current one. More ominously, the bank’s economists also held out “little hope for private consumption.”
This crucial pillar of the domestic economy was projected to shrink this year and hover next year just slightly above zero, as it had in 2003. Private consumption, frequently described as the Achilles’ heel of the German economy, had actually risen by about half a percentage point in 2004.
Within the modest core inflation rate, unit-labor costs are an important influence. After declining in 2004 and most probably this year as well, unit-labor costs were projected to rise slightly in 2006. But a downward drift in wages, which has prevailed since the end of 2001, was expected to continue. This wage drift, which has a bearing on aggregate private consumption, is the difference between hourly wage scales and the actual gross hourly wages and salaries. And while the actual earnings lag behind the collective bargaining scales, even the latter were projected to rise by only 1.4 percent on average in 2006.
The competitive business logic of globalization has been putting downward pressure on payrolls in the form of both wage concessions extracted from employees and in jobs lost to rationalization or the shifting of production abroad. And the seasonally adjusted number of payroll employees in Germany has been falling for five years.
This figure was expected to have declined to about 26.5 million earners this year from close to 28 million the start of 2001. Stabilization of the job market remains an issue. The only bright spots detected in the economic firmament were strong exports, a perennial in Germany, and investment in business equipment, described as “o.k.”
At the bottom line, the weakness of private consumption of the past four years has neatly corresponded with the near stagnation in real disposable income. And the savings ratio during this same period has climbed more than a percentage point to nearly 11 percent of disposable income – the personal response of German earners to their financial and job uncertainty.
Death and taxes being life’s only proverbial certainties, German earners can now form a somewhat clearer picture of what’s in store for them in the medium term. Apart from the ECB’s interest hike, they can consult the coalition agreement signed by the ruling parties Nov. 18 in Berlin. While Solveen’s projections go only through 2006, the real fun should begin in 2007. That’s when the next big tax increases are slated to kick in.
Tax now, save later
In its rather sudden outbreak of zeal to reduce Germany’s chronic public deficits, the new ruling condominium of Christian Democrats and Social Democrats has decided to rely largely on taxpayers again in lieu of lowering the government’s own outlays. Tentatively slated to take effect the start of 2007 were:
- An increase in the standard rate of value-added tax to 19 percent from 16 percent. This was supposed to net €24 billion a year, of which €16 billion would be earmarked for lowering non-wage payroll costs so that the withholding for unemployment insurance would fall to 4.5 percent from 6.5 percent.
- An increase in the insurance policy tax to 19 percent from 16 percent. It was supposed to capture another €1.5 billion a year.
- An increase of 3 percentage points in the personal income tax rate for incomes of €250,000 for single taxpayers and €500,000 for married coupled. It was tentatively supposed to raise €1.3 billion a year.
- Curtailment of a grab-bag of tax breaks designed to capture €11 billion more revenue a year. Slated for reduction were tax exempt savings, gifts, dining of business contacts, special tax provisions for farmers, deductions for home offices and breaks for living far from the workplace.
Also on the agenda were new rules on taxing capital gains and gains from the sale of stake-holdings, tax deductions for tradesmen’s bills for household repairs and incentives for parents to save privately for retirement in 2008. Some €8 billion in grants to families to encourage house ownership was supposed to get the ax in 2006. And another cluster of changes which appeared to have a neutral effect on revenue were listed for the corporation tax and business taxes.
The economic research department of Commerzbank commented on this proposed policy as it stood on Nov. 14: “The fiscal deficit in government’s budget will naturally be reduced by this. But private consumption in 2007 will simultaneously be burdened considerably, meaning that no strong upswing can be anticipated.”
Without significant economic growth, it is difficult to envisage a lasting improvement in the unemployment situation. And government’s exorbitantly high share of gross domestic product already imposes certain limits on new revenue raisers earmarked to do the heavy lifting in restoring fiscal discipline under these adverse conditions. As Bundesbank President Axel Weber told the Frankfurt European Banking Congress, “Consolidation on the revenue side is unlikely to be sustainable in the long run.” At some point the ruling coalition’s fiscal strategists might want to brush up on the simple and relevant logic of the Laffer Curve.2
The combined impact of more restrictive fiscal and monetary policies on a large, straggling economy could also aggravate the latent political tensions within Euroland, where economic convergence remains a distant goal. And Germany apparently has company here. Mario Baldassarri, Italy’s vice minister of economics and finance, told the Frankfurt congress that he saw no reason to increase euro interest rates unless the euro achieves parity with the dollar. He placed strong emphasis instead on the need to do something for Europe’s consistently weak growth in comparison with competing economic and monetary blocs.
For the moment, the problems of such export-driven economies are mitigated by the strong performance of world trade. Germany’s only consistent source of economic growth has been net foreign trade. An asymmetric shock spreading outward from the vulnerable financial sector in a world full of growing external payments imbalances has potential to change that, too. A major disruption of foreign markets could have a deflationary effect on trade a country pursuing a strategy of producing more than it consumes.
Many good arguments are being made for the twin decisions for higher taxes and interest. Some Euroland countries clearly need more restrictive monetary policy. And Germany’s fiscal stewards cannot ignore their endless deficits. With all its pressing problems, the German economy is just one of the competing interests to be served. For the average German, though, Baldassarri’s parting quip about a new barnyard joint venture between a pig and a chicken seems to capture the one-sided spirit of this budding austerity arrangement. The pig appreciated the promised benefits but was curious about his role in the enterprise. Simple, replied the chicken, I deliver the eggs, you deliver the bacon.
- Unmentioned was the fact that the euro has been losing ground against the dollar because of recent Fed rates hike and the apparent strength of the U.S. economy. No central banker would admit to targeting a foreign exchange rate as a weapon in global competition for capital flows. Trichet said his ECB governing council remains committed to growth and job creation and would maintain an “accommodating” policy.
- First plotted on a restaurant napkin at the start of the Reagan era, economist Arthur Laffer’s famous curve is both a serious message and a political joke. The curve is a parabola which intersects the ordinate axis at its origin of zero and again at its maximum of 100 percent. The percentages on the ordinate axis measure a country’s effective tax rate. The abscissa measures the amount of revenue a tax authority will collect at those rates. The parabola is a truism: Neither an effective tax rate of zero – total laissez-faire -- nor an effective tax rate of 100 percent – perfect collectivism or confiscation -- can yield any revenue. Revenue is maximized somewhere in the middle range of effective tax rates – with diminishing returns as one moves higher on the ordinate axis of state share of GDP.
