Economic Commentary: Fallacies about Germany's success

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The Independent Online
The aim of current economic policy is not simply 'winning the battle against inflation' but radically transforming the status of sterling.

That is what the Prime Minister apparently thinks. Zero inflation at home is to be complemented by hard currency status abroad to the point where the pound is regarded as a stronger currency than the German mark. Most commentators reject this idea as being completely unattainable. I reject it for totally different reasons. I believe that it is attainable, but at an enormous cost in return for benefits that simply do not justify the sacrifice.

For anyone growing up in post-war Britain the contrast with Germany has been painful. For most of the period Germany has enjoyed faster economic growth and lower inflation. Moreover, whenever currency values were changing the mark always went up. Until Margaret Thatcher produced a brief flurry in 1979-81, as the chart shows, sterling always went down.

Now we have a prime minister who has said enough is enough. Of course he may be dissembling, perhaps in order to prevent a sterling crisis during his EC presidency. But there remains the awful possibility that he is serious.

Does he believe that the Germans achieved rapid economic growth because they had monetary stability and an appreciating currency and that, similarly, if only we could equal their monetary achievements we would also match their output performance?

In fact low inflation played only a facilitating role in Germany's success. The influence of monetary factors on economic performance is rather like that of governments on human happiness - they have enormous capacity to do harm when they go wrong, but not much capacity to do good when they go right.

You do not need a degree in monetary economics to explain Germany's post-war success. It was built on a compendium of real, down-to-earth factors. After the trauma of the war the people worked extremely hard to rebuild. There was a feeling of common cause between workers, government and management that produced pay restraint. They saved and invested heavily. Their education and training systems were extremely effective.

Nor did the Germans start by overvaluing the mark when it was established in 1948. But the improvement in real competitiveness, combined with the effects of wage restraint, rendered the mark progressively more undervalued.

This meant that industry could readily withstand an appreciation of the currency. After the appreciation, as the same dynamic factors were repeated, the mark soon became undervalued again and the conditions were established for the next successful appreciation.

Indeed, this pattern has been repeated across the world. Japan enjoyed strong productivity growth and structural improvement from the starting point of a fairly or even undervalued exchange rate, which then enabled it to withstand successive appreciations of the yen. But no one suggested that Japanese strength derived from the appreciating yen.

Although the British government might like to think that it is now trying to copy the German experience in adopting a strong pound policy, in fact the situation in Britain is radically different. Our most recent embrace of the fixed exchange rate constraint in 1990 was at a challenging, if not downright overvalued, rate against the European currencies.

Meanwhile, the currency became progressively more and more overvalued against the dollar bloc as the dollar weakened. Moreover, we are still not gaining ground against our competitors on non-price factors and may, indeed, still be losing it. So the result is that the whole economy is being squeezed through the traded goods and services sector.

This is in line with a long British tradition. There are many examples - the period between the restoration of the Gold Standard at its old parity in 1925 and its abandonment in 1931, the clinging on to the dollars 2.80 parity between 1964 and 1967, the indifference to the absurd heights to which the pound floated in 1979-81.

Yet there is no evidence to suggest that this deliberate or tacit acquiescence in overvaluation - and the concomitant tight domestic policies, including high interest rates, that it implies - produces a strong export sector, let alone a strong economy overall. Indeed, quite the opposite. The effect in 1979-81 was to shrink the traded goods sector, which has meant that the long-term capacity to compete internationally has been reduced, weakening the underlying trading position and resulting in large-scale unemployment.

The line of causation in Germany ran precisely the other way round - from wage restraint, structural strength and productivity growth to a strong exchange rate. And the results were exactly the opposite - a strong traded goods sector.

Of course, there are those who argue that Britain does not have any competitive problems at the current exchange rate. They advance two pieces of evidence - first the fact that British exports have managed to grow over the past year by 2.5 per cent and secondly that British businessmen do not complain about the DM2.95 parity.

Both arguments are weak. Although exports have grown, so they should in an environment where world trade is continuing to expand and especially when the domestic economy is so depressed. Moreover, imports have grown much faster. How large the trade deficit would become if ever Mr Lamont's green shoots started to sprout, heaven knows.

The main reason why few British businessmen complain about the DM2.95 parity is that only those who are still in business are asked for their views. By definition these are the ones who do find it competitive. Those who do not have gone bust. It is like saying that the average ability of the England cricket team to withstand top bowlers has improved because we have decided not to field the weakest four batsmen.

Moreover, those businesses that have survived and profess to find DM2.95 perfectly acceptable have modest ambitions, shrunk down to match Britain's straitened circumstances. For them a competitive exchange rate means one that enables them to cope.

But coping means continuing to shed masses of labour and continuing to underinvest. Yet what Britain needs now is not an exchange rate and monetary policy that enables it to cling on to markets but rather one that enables production to grow enough to boost demand for labour and to generate sufficient profits to invest for the future.

After the continual slide into deficit during the 1980s and the excessive growth of personal consumption the economy needs to shift resources into investment and net exports.

Perhaps the greatest irony in the idea of running monetary policy by trying to become more German than the Germans is that the French are up to the same game and, strangely enough, the Germans have not entirely given up the idea.

In a world where every country is trying to gain economic advancement by achieving lower inflation and/or a stronger currency than its competitors, for the group as a whole the enterprise is bound to fail. If there are benefits to be had, they must derive from the low absolute levels of inflation attained in the attempt.

It is precisely here that support for the Government's case is weakest. The only mechanism through which low inflation can bring recovery is low nominal interest rates and even then, in a world of debt deflation, the result is unclear. But, as we all know, it is precisely the objective of sticking with the firm pound policy through thick and thin that is keeping interest rates high.

If we have to seek salvation by copying something German, let it be their education system, technical training system or arrangements for housing. Why do we instead succumb to the belief that our troubles are mainly monetary? Could it be because this is easier than tackling the real economic factors that underlie our disappointing economic performance?

Roger Bootle is chief economist at Greenwell Montagu.

Gavyn Davies is on holiday.

(Graph omitted)

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