Hamish McRae: Nobody does it better ... so the signs are bad if even Germany is in the mire

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The Independent Online

The clouds are as dark in Germany as they are in Britain. It seems that being a hugely successful manufacturing nation is no more protection than being a pretty successful services one. A short visit to Germany to talk to managers at an industrial conglomerate brings little more cheer than a meeting with bankers in London.

Not that you see it in the streets, for on the surface the Rhineland is still its usual calm and apparently prosperous self, a key contributor to the West German economic miracle. The infrastructure works. Unemployment is low. Along perhaps with the hi-tech companies of Bavaria, this is about the most competitive place on the Continent at what it does. But it cannot escape what is happening around the world.

Viewed globally, the past few days have seen mounting evidence that the downturn will be similar to that of the early 1990s. Even a month ago there seemed a reasonable chance that the UK at least would escape a little more lightly than then. But there have been several adverse signs, the most shocking being the fall-off of demand in China. That, plus the US slide into in recession, accounts for oil being back at $50 a barrel.

But Germany, along with the rest of the eurozone, actually entered recession a little earlier than the US, or indeed the UK. It has had two quarters of negative growth. And on Friday came evidence that eurozone manufacturing output has fallen off a cliff. The so-called "flash" November purchasing managers survey showed that manufacturing had declined for the seventh month on the trot and was at its lowest level since the series began. Since Germany is by far the largest element of eurozone manufacturing, this is worrying.

It is worrying as Germany has done everything right. It has the strongest fiscal position of any G7 nation, with the possibility it might even be in surplus this financial year. The UK, by contrast, faces a fiscal disaster – even before the tax cuts we are to be told about tomorrow – with ill-disciplined public spending and stagnant tax revenues. (Readers won't be surprised to know we are in a fiscal mess because I have banged on about it. My concern is that we are in an even bigger mess than I had appreciated.)

Germany has also had very disciplined companies. To generalise, when high German wages made domestic production prohibitively expensive, they shifted lower-value items to eastern Europe and negotiated lower wages, or longer hours, with their workforce. And as always, they upped their quality still further. So despite shifting production offshore, Germany remains the largest exporter of manufactured goods in the world. The UK, by contrast, has relied on earnings from services, particularly financial services, to balance the books – actually, not even that.

And yet Germany entered recession some three months before us, and though its forecasts for growth (or lack of it) next year are a little better than ours, they are being pared back all the time. What has gone wrong?

The answer comes in three parts. If you look at the structure of German manufacturing, it is very strong in capital goods and the motor industry. However, the banking crisis has led to many companies around the world postponing investment projects because they simply can't get the finance. As for the motor trade, it has been hit savagely by the present uncertainties. Being excellent is not good enough.

The second part of the answer is that relying on external demand to support an economy carries risks. In Britain demand has been driven to a much greater extent by consumption, financed in fair measure by borrowed money – in the US, even more so. It took a while for the shutdown in the banking system to work through and change people's habits, though this is now happening. In the previous downturn we were able to replace foreign demand by boosting it at home, using the strong fiscal position to do so. In Germany, which has depended on exports to sustain demand for many years, replacing foreign demand will be harder, despite its far better fiscal position.

The third part of the answer is that European banking is in bad shape too and that German companies, which have relied more on banks for finance, are being squeezed. The country has a huge range of medium-sized firms, the so-called Mittelstand, which have given it much of its strength.

This leads to a further concern. A senior manager explained that he felt his generation of business leaders had benefited from the technical training they had received and for which Germany used to be renowned. But education had not moved with the times and German industry could not draw on the new skills needed in the way it could on the old ones.

So there is a structural problem as well as a cyclical one. That must be partly right. In past cycles, Germany has used the pressure from a downturn to lift its game. Can it do so yet again? What could German firms do that Chinese ones could not learn to do, and with much lower costs?

I don't know the answer to that. It is really a question for Europe as a whole but it matters particularly for Germany because the country has done so many things right. We know we have made mistakes, most notably in allowing a housing boom to get out of control and maybe by becoming too dependent on a single industry, financial services. But Germany has not made those mistakes and it is in trouble too.

Much depends on the duration of the downturn. There has been a lot of debate about the depth of the recession next year, but it seems to me to be more important that recovery is sustained, rather than things being puffed up for a few months and then flopping back again. From the UK perspective, the key issues are associated with the housing market, for once that revives then our recovery would seem secure. From the perspective of Germany, the big issue is less parochial: when will the world economy recover? For the world's biggest exporter cannot prosper until it does.

Which model copes with stress better? We cannot know. I am always encouraged when talking to German business people by their calm, their intelligence and their global perspective. But manufacturing excellence, however wonderful, has not enabled the country to escape recession. We are all in this one together.

If we're so good at economics, why is Britain plc in such poor shape?

Something more cheerful. It may not help the economy, but it seems the UK does have good economists. "Economics research in the UK is exceptional by international standards, second only to the United States, and thriving." So says an assessment by an international panel of eminent economists chaired by Professor Elhanan Helpman of Harvard.

We are, apparently, the world-leader in micro-econometrics and have strength and influence in a number of other sub-fields such as labour, public and development economics. The report also notes "the high quality of applied work in the UK and the huge impact that this has on policy and practice. This assessment is testimony to the expertise and commitment of scholars at all levels of the discipline."

The question then is, if we are so good at economics and have lots of economists in influential positions, including the Governor of the Bank of England, why is it that we don't seem to be coming through this economic cycle in better shape?

There are, really, three answers to that. One is that the UK did pull itself up in economic terms, through the 1980s and 1990s, and that was largely the result of structural reforms devised by economists. If the country has since made a serious macro-economic error in the past six or so years by not correcting its budget deficit during the good years, this was a political decision by the then Chancellor. Had he stuck to his original plans, we would be better placed. This was a political error, not an economic one.

The second answer is that there is a huge gap between an academic subject and its application; and that, in a world where ideas are openly available to anyone, as they should be, you cannot tell where a good idea will be applied. I recall being told by a top Chinese banker that British economists were influential in China in the early days of its move to a market economy. The Russians, he said, in contrast listened to the Americans and look what a mess they made.

A third possibility, however, is that people who have to make big financial decisions should take economic advice with a pinch of salt. Having economists, particularly those who build mathematical models, advising on hedge funds in the US has not been a wild success. My defence: you have to have the right sort of economists.