Europe's powerhouse feels the pinch

LAST WEEK it became clear to everyone that Europe's largest economy had hit the wall. Anyone who had been following the news about German business through the second half of last year would have been aware that the economy was slowing, for there was a series of announcements of redundancies by big firms. But the serious nature of the downturn was not reflected in the official forecasts and, perhaps as a result, there was little discussion of its political and economic consequences.

That has all changed. On Monday, the December unemployment figures suddenly reflected this labour-shedding and (on an unadjusted basis) shot up by 211,800. This brought the overall jobless rate to 9.9 per cent, and the west German rate to 8.7 per cent. After seasonal adjustment the December rise was 68,000, but that followed November's 45,000. In other words, unemployment even in the old West Germany is considerably higher than in the UK, and rising at about the same rate as it did here when we were plunging into recession. The decline in output and the impact on unemployment is shown in the first two charts.

This bad news on unemployment was compounded later in the week, when the economics minister acknowledged that the economy may have contracted in the final quarter; and the government statistics office reported that growth for the year as a whole was only 1.9 per cent, and that the budget deficit would be 3.6 per cent, 0.6 per cent above the Maastricht convergence criteria.

Finally, just to rub in the mood of gloom, several forecasters downgraded their estimates of growth for the current year, with one, DIW, putting it at 1 per cent. That is the bottom of the range, but Dresdner Bank and UBS are predicting only 1.5 per cent and Deutsche is at 1.7 per cent. Expect more downgrades in the weeks ahead.

At least the story is out in the open: that Germany is suffering a mini- recession. Once that is accepted (and remember the German government did not accept it until a week ago) one can go on and have a serious debate about the likely profile of the mini-recession, and its consequences. The profile first.

I do not think that this signals the end of the growth phase and that a regular recession is going to take place this year. Unless something goes terribly wrong, there will be some growth - and that will be loaded into the second half of the year. The first three months are going to be flat or worse, but as the year progresses there will certainly be cuts in interest rates, and maybe a fall in the external value of the mark.

As far as interest rates are concerned, the questions are "when?" and "how low?". The Bundesbank does feel it has some room for manoeuvre. Its December Monthly Report, not usually a particularly forthright document, did acknowledge that it "has virtually achieved the objective of price level stability - that is a signal success after several years of persistent inflationary tendencies in the wake of German unification". It is patting itself on the back, but by the same token clearing the ground for a further easing of policy.

The market seems to expect another cut in the Bundesbank's discount rate by the spring, to 2.5 per cent, which would bring the three-month money market rate to about 3 per cent, the very bottom of its 25-year range - see the right-hand graph. It would be surprising if this were not associated with some weakness of the currency, and together cheap money and a lower mark ought to enable the economy to recover. But it will be, in the words of Deutsche Morgan Grenfell's top economist, Steven Bell, a "jobless, joyless recovery". The big companies will carry on shedding labour, though maybe at a slower rate, and the small ones will be very loath to take on new staff.

The obvious danger is that consumers will become so frightened by continuing job insecurity that they will cut back further and prolong the period of slow or negative growth. However, economies are ultimately self-correcting and there can hardly be any doubt that recovery will resume eventually.

While we all wait, however, there will be consequences. I can see a rethinking of the nature both of European competitiveness and European Union politics.

To explain the first: Germany is certainly the largest but also in many ways the best European economy. Time and time again it is hit by higher costs - a rise in the mark, yet more social security payments, an even shorter working week, or the costs of unification - and time and time again German companies lift their game. They improve their products, increase their efficiency, maintain their markets.

Germany's manufacturers will go on doing so, but at a price. That price will be continued shedding of labour. The test for the German economy then will be whether it can build up service jobs to take up the slack. Of course it can to some extent, but I would expect that the growth will be slow. The counterpart of a highly developed manufacturing sector is an under- developed service sector. Result: Germany will have several years of painful adjustment, similar to that which Britain went through in the early 1980s.

This will lead to a rethinking of Europe's comparative advantage in the world. That rethinking has already taken place in the UK, and has led to our emphasis on service exports. It has also made us think about the direction of our trade and led to efforts to build economic ties with the rapidly growing economies of east Asia. Thus UK exports to Hong Kong, Malaysia, Singapore, South Korea, Taiwan and Thailand have risen from 3.1 per cent of total exports in 1985 to 5.9 per cent in 1994. Still small, you may think, in relation to the 57 per cent of trade with the EU. Sure, but it is growing much faster.

Above all, this return to recession at the heart of Europe will cause the same sort of economic soul-searching in Germany that has taken place here: what can we do that people in mainland China can't do as well, and on one-twentieth of our wages?

If that is the tough economic question, there is also a tough political one: will Germany qualify for EMU? If growth this year is only going to be 1.5 per cent, it will have to tighten fiscal policy to get its deficit down to 3 per cent of GDP, as required under Maastricht. It may not make it.

French growth will be cut, too, for Germany is France's biggest export market, and France is also having a struggle to get its deficit down to 3 per cent. Both countries need to cut their deficits, not from any Maastricht concerns but because of the impact of their ageing populations on their social security budgets. But is it wise for them to do so in the teeth of recession?

If Germany and France cannot make the Maastricht conditions by 1997, what then? It is even conceivable that the only countries which can will be the UK and Luxembourg. If that were to happen it would be quite funny in a (Groucho) Marxist way: the only country which can get into the club is the one that doesn't want to join.