German disarmament

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The Independent Online
So the Bundesbank's nerve has cracked. The cut in its discount and Lombard rates comes a couple of months before the markets expected, but several months after the Bundesbank should have moved. What should watchers of financial markets conclude from this?

The reasons for the cuts are painfully obvious. The primary reason is the collapse of German industry, as yesterday's figures showed: while western German industrial production rose in May, that was almost entirely because the April figures had been revised downwards. Year-on- year production is down nearly 8 per cent, with capital goods down nearly double that. The Bundesbank board has always reflected industrial opinion, and German industrialists are contemplating a sharper fall in demand than they have seen since the first oil shock. In that sense the psychological shock is even greater than that which struck British industry in the early 1980s. At last, the message has got through and is being reflected in monetary policy.

To this should be added the secondary reason that Germany's trading partners are suffering too. The Bundesbank council will pay no attention to the opinion of foreign governments about German monetary policy - this cut is not a result of pressure from the French. The transmission mechanism is through the company sector, which sees exports declining as a result of the impact of high German rates on European markets. VW or Daimler-Benz carries more clout with the Bundesbank than the French government.

Finally, the Bundesbank was always likely to respond in some way to the tightening of the German fiscal stance. The federal government has just agreed to cut DM25bn out of spending next year, with something like DM6bn more of cuts in 1995. It has also increased taxes by DM36bn and DM34bn in the two years. Those are big numbers, equivalent to 2 per cent of gross domestic product in the first year, 1.2 per cent in the second. An excess of demand pressure will not be a problem for Germany for the next three years at least.

If the reasons for the move are clear, its likely effects are not. Of course there was some knee-jerk reaction on the exchanges, but the lack of follow-through on the markets demonstrated that they are aware that the timing of an odd half-point off German rates is not going to have more than a marginal effect on Europe's economic performance.

While these cuts will be helpful to France, given the scale of fiscal retrenchment in Germany, there will have to be many more before German growth recovers. From a British perspective, it now looks as though there will be three years of faster growth in the UK than in Germany, not just two.

The problem with relying on an easier monetary policy to stimulate demand, while tightening fiscal policy, is that in the very short run cuts in rates may actually be counter-productive. In Britain last autumn they worked because they were so large and were combined with a devaluation. They also struck an economy that was just starting to recover anyway. But in Germany, a large segment of the population, that which lives on savings, will find its income cut. The indebted companies will benefit, but they will use lower rates to rebuild their balance sheets. As for the private borrowers, thanks to a combination of Germanic thrift and the unsophisticated nature of the country's financial services industry, there simply are not enough of them for the interest rate cut to have much effect overall.

Of course there will be some effect. But it will take a long time to matter. Remember how it took two years of very cheap money to establish a reasonably secure recovery in the US; Germany still has quite expensive money by US standards.

An important call for central banks around the world to continue their interest rate disarmament came yesterday from Henry Kaufman, the former guru from Salomon Brothers in New York, who now runs his own consultancy. Testifying to the Senate banking committee, he argued that there was no need for a pre-emptive tightening by the Federal Reserve. The only force encouraging growth anywhere in the world was monetary policy. Given the slow recovery in the US and the lack of any rekindling of inflation, there was scope for a co-ordinated cut in world interest rates. Indeed there was a greater risk in not easing policy than there was in easing it.

The US has led the way to lower rates, and so its scope for further cuts is limited, but Dr Kaufman did not see any need for a pre-emptive rise this summer, and saw some opportunity for the Fed to cut rates further if other central banks did so. There would be a need to increase interest rates, and to do so forcibly, when the recovery was mature and inflation threatened to rise, but that would not be until 1994, maybe 1995 or 1996.

This testimony was prepared before the Bundesbank's decision was known, and throws an interesting light on international investment policy in general. If Dr Kaufman is right and inflation is beaten, at least for the time being, then recent falls in bond yields can be sustained despite large public sector deficits. Indeed yields are probably too high. If he is wrong, then they are vulnerable. And if bond yields are set to rise, then equities are overvalued.

Meanwhile, a final irreverent thought: the president of the Bundesbank said yesterday that he thought the German economy had bottomed out. Technically he could prove to be right, but it sounds awfully like Mr Lamont's green shoots.