Despite all the bad news on the US economy over the past year or so, it has still contrived to do better than some of its major competitors. Last week, Germany announced that its growth rate had been only 0.6 per cent in 2001 (or 0.8 per cent on the calendar-adjusted basis used by most economists). That compares with a likely growth rate of 1.0 per cent for the US.
The odd thing about this comparison is that, while the US suffered from an earlier period of excess – which might go some way to explaining the subsequent hangover – Germany only managed to plod along before falling over the edge of last year's recessionary cliff. Germany appears to have the worst of all worlds – no decent expansion in the late 1990s but a rotten recession to follow. It doesn't know how to party but it still ends up with terrible hangovers.
Germany's weakness is a peculiar affair not just in relation to the US but also relative to other countries within the eurozone. France, Italy and others have all had better growth rates last year relative to Germany's less-than-satisfactory achievement. Something, therefore, has gone wrong that is specifically related to the performance of the Germany economy alone.
In this column a few weeks ago, I suggested Germany's problems partly stemmed from difficulties associated with reunification. In particular, the boom in construction spending at the beginning of the 1990s was still in the process of unwinding, leaving the domestic economy very poorly supported relative to the likes of France. Earlier excess was thus being paid for by persistent economic under-performance.
This, however, may prove to be only one part of the underlying story. Germany's present-day experience is also an interesting test case for the euro. Could it be that the euro is leading to the emergence of winners and losers within the eurozone? Could it be that, contrary to received wisdom, Germany is proving to be the biggest loser from the euro's formation? And could it be that the fiscal Stability Pact – a key plank supporting the euro – is likely to be sorely tested from that most unlikely of sources, the hitherto fiscally respectable Germans?
Consider the evidence. There's a good chance that Germany has suffered from an "inappropriate" entry level for its exchange rate into the euro, reflected in a poor competitive position against its near neighbours. One way to show this is to look at relative unit labour costs, shown in the first chart. These numbers, produced by the IMF, track exchange rate movements adjusted for movements in wages and productivity. They show that, for Germany, the "real exchange rate" has remained very high relative to those in other European countries. Ultimately, this story is bad news for profits and capital spending. Given these figures, it is no wonder Germany has found it very difficult to attract capital inflows from abroad.
Then there's the issue of interest rates. The "one-size-fits-all" policy certainly seems to fit France like a glove but, for the Germans, it's more like a straitjacket. Germany's growth rate has been persistently lower than the eurozone average. Had the Bundesbank been left to its own devices, there's a good chance that German interest rates would have been lower than the levels set by the ECB. That's not a criticism of the ECB: rather, it's a reflection of the divergence between German needs and eurozone reality. By German standards, real short-term interest rates are on the high side, particularly given the contraction in GDP that began (just) in the second quarter of last year.
Finally, Germany is about to go into fiscal battle. Its own earlier attempts to underpin the euro through the Stability Pact are now in danger of backfiring badly. Whereas the US – assuming Congress can ultimately agree on the detail – will be loosening fiscal policy by a further 1.5 per cent of GDP this year, Germany may have to contemplate tightening fiscal policy.
The key reason is last year's budget deficit overshoot. According to the latest figures, the deficit came in at 2.6 per cent of GDP, just a tiny fraction away from the 3 per cent Stability Pact limit. Germany's problem for the year ahead is straightforward (if unfortunate): faced with a likely growth rate in the economy of less than 1 per cent, revenue undershoots and spending overshoots could combine to leave the budget deficit at more than 3 per cent of GDP. In normal circumstances, this could leave Germany open to being fined by the other members of the euro, not exactly a vote-winning strategy in an election year.
Under these circumstances, the choices are straightforward: raise taxes, cut spending or, given the election, adopt some creative accounting, thereby making a mockery of the Stability Pact rules. The last option is, in the short term, the most likely: however, it still leaves Germany without the fiscal flexibility likely to be enjoyed by the US (and, incidentally, the UK) over the next 12 months.
In a nutshell, Germany's "euro" problems are as follows: too high an entry rate for the Deutsche Mark; too slow a growth rate to cope with the average level of short-term interest rates across the eurozone as a whole; and too big a budget deficit in the first place to give room for manoeuvre in the light of the global economic downswing. The lessons from Germany's experience for potential new members of the euro are, therefore, straightforward. First, make sure you enter at the right exchange rate level. Second, make sure you converge on average euro rates from above rather than from below. Third, make sure your budget is roughly in balance, thereby avoiding the constraints threatened by the Stability Pact.
These arguments suggest that Germany's problems are not, of themselves, reasons for others to stay out of the euro. It's more a case of ensuring that a country definitely meets the right entry conditions. This observation may prove to be relevant for the UK. In some ways, the UK is in a very good position to join: interest rates can converge on the rest of Europe from above. And the budget deficit is likely to be no more than 1 per cent of GDP in 2002, well within the Stability Pact guidelines.
Yet there are still two key uncertainties, even on this very limited view of appropriate entry conditions. First, there is the exchange rate problem. Most economists now believe the UK could enter the euro at an exchange rate only a few per cent lower than where we are today. This view is based on the UK's relative success on economic growth in recent years despite persistent sterling strength. Yet there must be medium-term risks with this view given the squeeze in company profits that has taken place over the last few quarters. Second, there is a potential medium-term fiscal problem. On our forecasts, the UK budget deficit rises to roughly 1.5 per cent of GDP in 2003, not dissimilar from Germany's deficit just before the euro was first introduced in 1999. This may not matter that much so long as the UK's growth rate holds up well: but the lesson from Germany is that an inappropriate entry position can leave chancellors – whether of the German or British variety – with an undesirable balancing act to perform on tax and public spending.
Stephen King is managing director of economics at HSBC.Reuse content