A German question

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Two things scream out from the Bundesbank's decision yesterday not to cut interest rates: the markets do not care too much; and the reorientation of the German economy is not going to be carried out by cheap money.

The first point can be quickly made. In the first part of this week the usual justification for the buoyant equity markets in Europe was that cheaper money was on the way. The wiser Bundesbank watchers duly expressed caution, knowing that quite aside from its usual (and in many ways admirable) cussedness, the break- up, in effect, of the European exchange rate mechanism meant that Germany could follow a monetary policy fitted to its own circumstances, without having to care too much about the effect this policy would have on the rest of the Continent.

Nevertheless, the balance of market opinion was that some sort of cut in German interest rates would come this week, and that this was justification for the run-up of share prices. They were not cut, yet the markets took the 'bad' news calmly, showing only the most obvious 'knee-jerk' disappointment. Unless Continental markets react really badly in the next few days the sensible conclusion is either that they are convinced they have only another two weeks to wait for the cut, or that they are in such a generally bullish mood that they are prepared to wait until well into the autumn.

Structural change

The second point, that the German economy needs structural change, not cheap money, deserves a longer comment.

The process of structural change - or rather the negative aspects of the process - is already evident. Hardly a day passes without news of some new cut in the workforce of Germany's over-sized electro- mechanical sector, in particular the car industry. At least that industry is now aware of a need to down-size, though it may not yet grasp the extent to which it has to do so. It is perfectly possible that the German car industry will never build as many cars as it did at the top of the last boom. By the time the market recovers in the late 1990s, the balance of advantage will have shifted further away from Germany, towards new plants in Eastern Europe and the Far East.

This string of job losses will be very painful. Unemployment, at present 7.5 per cent, is forecast by the OECD to peak at about 9.5 per cent next year. It is possible that the OECD is underestimating the rise: it still expects some growth in 1994, while other forecasters, such as Morgan Grenfell, see GDP falling another 0.5 per cent then (after a decline of 2.6 per cent this year). Morgan Grenfell, it is worth noting, is owned by Deutsche Bank, Germany's largest financial institution. The lesson of this recession is to expect lower growth than predicted by all but the most gloomy forecasters.

But if the negative aspects of structural change are obvious, it is much harder to see the positive ones: it is easy to see what has to be run down, harder to see what Germany can build up. Of course, some segments of industry remain very powerful. It is a world leader in much anti-pollution equipment. Even after cuts it will be Europe's largest car maker. It has great strength in pharmaceuticals and in medical equipment.

What Germany lacks is the vibrant service sector of North America, or even of the UK. Its financial system is still quite primitive, for while its banks are well-capitalised to withstand the downturn, Germany lacks the breadth of financial markets and the range of financial products available in North America or here.

These service industries have not been good at increasing their productivity or holding down their costs. As a result inflation in the cost of services in Germany is dreadful: service inflation is running at around 7 per cent and rising. By contrast, producer prices are flat and import prices (thanks to the strong mark and subdued commodity prices) actually falling. Service industries always find it harder to achieve productivity gains than manufacturing industry, so service inflation is always liable to be greater than goods inflation, but in Germany the divergence is particularly grave.

Looking ahead, service inflation will be cut by the low level of wage rises (hourly wages rising only 3.7 per cent year-on- year to June), but the restructuring problem remains. In a world where competition in goods is becoming less important and competition in services more so, where is Germany's comparative advantage?

Answers to this question will take many months to emerge. It will be fascinating to see whether German medical and professional services can be exported, in particular to Eastern Europe, which is a natural market for them. Germany can also expect to export 'cultural' products - books, films, popular music - to all German- speakers to the east. (The US now makes more from exporting popular music than it does from exporting wheat).

It will be fascinating, too, to see how quickly deregulation in Germany improves the performance of its telecommunications and transport industries, and whether the country is prepared to deregulate its retailing to help boost productivity there.

All these are structural issues that cannot be tackled by cheaper money. Indeed the cost of money is pretty well irrelevant to structural change. But cheaper money does not really do much to stimulate the German economy either. The impact is quite different in Germany than in Britain, because of the different size of the owner-occupied housing sector, and the different way it is financed. So cuts in interest rates do not even give a short- term boost to demand.

Turning circle

Eventually the economic cycle will turn. Eventually, as German inflation subsides, German interest rates will continue to fall, just as happened during previous interest rate cycles in 1970-72, 1974-75, and 1982-83. The pace of decline is almost identical now to the pace then, the difference being that this time the fall has started from a much higher point.

But the lesson of yesterday is not just that the Bundesbank has its own agenda and will stick to it, but that professional watchers of Germany should pay attention to the real economy rather than monetary policy. Anyone who has watched the economy over the past 30 years is well aware of its ability to move its products upmarket. But can it move its services upmarket too?

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