Economics: Can Germany get to work in time?

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The Independent Online
The trouble with Europe's present preoccupation with the need to meet the Maastricht criteria is that it deflects attention from what it happening to the real economy. The former story keeps hitting the headlines for an obvious reason: if Germany and France cannot meet the Maastricht rules, the rules have to be relaxed in which case it would be hard to keep out countries like Italy and Spain; or the whole plan has to be postponed.

But while this preoccupation is understandable, it is damaging because it focuses attention on the progress of one sort of reform, that of current public finances, and deflects attention from another sort which is at least as important, longer-term general structural reform in the European economies.

There was a prime example of this phenomenon last week. Germany surprised the financial world - and alarmed many of its citizens - on Thursday when it announced that it would cut the overall size of its public debt by revaluing the gold reserves of the Bundesbank. Shock, horror! Germany was, it was claimed, using just the creative accounting devices it had criticised when other countries had done something similar.

But actually valuing gold at something close to its market value (and in Germany it is proposed that 60 per cent of the market value should be the benchmark) is perfectly reasonable. It is also perfectly reasonable to count a nation's gold and foreign exchange reserves as national assets to be set against national debts: the fact that the assets happen to be held by the central bank rather than the Ministry of Finance is irrelevant, for they are still assets of the nation's taxpayers.

This argument, and the parallel one over by how far Germany will miss the 3 per cent budget deficit target this year, deflect attention from something much more important: the fact that Germany is experiencing a jobless recovery. Something of seismic significance seems to have taken place: a disconnection between economic growth and the willingness of German companies to take on more labour.

The rise in German unemployment (see graph) has attracted enormous publicity, but more important has been the collapse in German employment. As you can see, about a million fewer people are now at work than at the beginning of last year. This is despite the fact that the economy has been growing at about 2 per cent a year over this period. Worse, the trend seems to have been deteriorating. On Friday the Economics Ministry said it expected the economy to have grown by about 0.5 per cent in the first quarter of 1997, which while not impressive is better than some private forecasters had feared. But the fall in employment seems to have continued. If anything, the slope of the downward curve has steepened.

All economies are to some extent self-correcting so growth will eventually pick up somewhat more. Consensus forecasts for the German economy this year are around 2.5 per cent. Employment, too, will not spiral down for ever. But there is a serious danger that the economy might reach full capacity long before it reaches full employment. To see that, look at the right-hand graph. That shows that the average level of capacity use in West Germany since 1960 has been about 84 per cent. At the moment the economy is running at 85 per cent. So it is already above its long- term average.

How much higher can it go? It could, of course, tick up a couple of points without problems. But you can never get to full capacity, for a lot of capacity is either in the wrong place or in an inappropriate form: even in 1990, at the height of the boom, capacity use never rose above 90 per cent. Smithers &, Co, the London-based investment advisers who dug out these figures, believes that now there is relatively little spare capacity and that there will be little if any by the end of this year. Even if that is wrong, there will still clearly be a high level of unemployment at the top of the next expansion.

Why is this? What seems to have happened is that, spurred by the combination of an over-strong mark and very high wage and social security costs, German industry has undertaken a massive drive to improve productivity. In one sense this is wonderful. Productivity growth since unification has been even more rapid than before, with the result that the overall productivity of the whole German economy is now higher than that of West Germany in 1991 before unification. But this success story carries a price, which is structural unemployment of a sort which has not existed in Germany since the chaos just after the war.

So the success of German private sector in restructuring itself has created a greater need for the public sector to do likewise.

Since Germany is so important, not just in itself, but as a model for its neighbours, its performance will have a profound impact on the whole region. So the changes now being discussed in Germany - are they big enough, well-crafted, and so on - give a clue to the economic future of the whole of continental Europe.

Several things are happening. One is privatisation, which will now take place more quickly as a result of budgetary pressures. The government will have to draw up a supplementary budget to get closer to the Maastricht 3 per cent, and one element of that will probably be faster privatisation, in particular of Deutsche Telekom.

Another is the seemingly-stalled reform of personal taxation, including cuts in the higher rates of income tax in exchange for closing of loopholes. The problem here is that if it is difficult to demonstrate that such changes are likely to boost overall consumer demand, selling the idea that there are economic advantages of wider income differentials is harder still.

Yet another is general deregulation of economic activities, but the impact of the recent modest liberation of shopping hours has been disappointing. In fact this hardly seems to have increased the shops' share of consumer spending at all. If anything the reverse seems to have happened, for while consumption as a whole is down a bit, retail sales are running 4 per cent down year-on-year, a killer for the poor shops.

But by far the most important reforms are in social security and in particular pensions. Cost of public pensions is now 23 per cent of the national wage bill, financed equally by employer and employee. This discourages people from taking on jobs and employers from creating jobs. More than any other single factor, perhaps, rising pension charges are killing jobs. But if things are bad now, worse is to come. Germany has net public pension liabilities of more than 100 per cent of GDP. Unless benefits are cut, that 23 per cent would rise to 40 per cent by about 2030. Without radical action now, the smaller and smaller workforce will have to pay more and more for the larger and larger army of retired.

Cuts in pension rates have been recommended by a study group, but even if adopted these would still result in a higher contribution rate in the future than at present. This adverse arithmetic is an inevitable result of demographic change, and it similarly applies to both France and Italy. The only possible way through is to cut benefits further and supplement the pay-as-you-go system with a funded pension scheme for those who can afford it. But selling this is extremely difficult, for it requires politicians to admit the present system is something close to a fraud. Nevertheless it has to be done, and if Germany were to take the lead, it would become much easier to become hopeful about European unemployment. More than this, if unemployment could be brought down to US or UK levels the general burden on the social security system would be reduced still further.

So all eyes should be on Germany, but a different aspect of Germany than the one on which most commentators focus. Everyone worries about German attitudes to EMU, but that is really a side-show; we should be looking instead to the German approach to structural reform. Can they make those reforms in time?