Jitters in Germany

The Bundesbank explained its surprise cut in interest rates yesterday on the grounds that the strength of the mark during the past two months had made such a cut possible. That is fine as far as it goes; the strength of the mark did indeed make the cut more credible. But behind this lies real fear.

Like any competent economic body, the Bundesbank is frightened by the possibility that the German economy did not bottom out in the summer, as the federal government claims, but may have been heading south again this autumn. If that were so there would, naturally, be the gravest consequences for the entire Continental European economy.

No one in the official world ever says anything like this. There is a conspiracy of silence: recovery is always just around the corner, and in one sense it is, for economies are ultimately self-adjusting. But there are some reasons to fear not only that the German economy is heading into a second downward leg, but also that it will continue to do so despite this latest cut in interest rates.

The analytical problem is separating the cyclical from the structural. In cyclical terms the economy did seem to be moving up again as early as the second quarter of this year. But that was thanks to heavy stock-building and it would not be sustained in the absence of any recovery in domestic demand.

Real earnings

Meanwhile the savage structural changes taking place in Germany - a forced and rapid deindustrialisation - make it unlikely that there will be such a recovery in demand. Since the peak of the cycle, 650,000 jobs have already been lost. Most big industrial companies have already announced further cuts in staff, and it would be astounding if there were not yet more in the pipeline. Wage settlements have fallen dramatically, reflecting this change in the job market.

The result is a two-sided squeeze on real earnings. The job cuts mean that payrolls are contracting by 2 per cent a year, while real monthly earnings for those still in work are falling by 1 per cent. Personal incomes will be further cut during the next year by tax rises as Germany seeks to correct its fiscal deficit. With incomes falling in this way it is very difficult to see where the recovery in demand will come from, and harder still to see it showing through until the second half of next year. To take just one set of forecasts, Kleinwort Benson is now looking for only 0.6 per cent growth in Germany next year, after a decline of nearly 2 per cent this year.

There is another worry. It is that the rapid growth of money supply in Germany, the feature that has inhibited the Bundesbank in cutting rates, is building up inflationary pressures in asset markets. Falling demand for labour has 'solved' the wage problem, the inverted commas because though they are now rising only slowly, in absolute terms German wages are way out of line with those of the rest of the world. But some people believe that the money that has been pumped into the German economy over the past year will move into higher house prices, and a sustained boom in share and bond prices.

This view was articulated this month by Goldman Sachs, which suggested that Germany might face something of the asset price boom that countries like the US, UK and Japan experienced in the 1980s, but that Germany escaped. As worries about rising consumer prices faded, they would be replaced by worries about rising asset prices. Whether or not Goldman is right and an asset-price boom is really to be feared, concern can be expected to temper the desire of the Bundesbank to push interest rates too low. Goldman reckons that by the middle of next year the trough in money market rates could be reached.

In any case, it is not at all clear that lower rates will have much impact on economic growth in Germany. One transmission mechanism whereby lower interest rates boost growth, through a fall in the exchange rate-stimulating exports, is not likely to take place. If the mark weakens too much, the Bundesbank will stop cutting rates further. There is little direct transmission from interest rates into demand in Germany for, unlike the UK, mortgages tend to be on fixed rates, and consumer borrowing does not have such a large role in sustaining purchases.

There are two indirect transmission mechanisms, both weak. One is via a rise in asset prices, as noted above: because share and bond prices rise, people will feel richer and spend more money. The other is via export demand, as interest rate disarmament in Germany enables other countries to cut rates too. As the US discovered, even very low interest rates will not promote a strong recovery. The danger for Germany is that fairly low rates will not promote a recovery at all.

Ultimately Germany's recovery can be sustained only by structural change: by building new jobs to replace those lost in manufacturing. The manufacturing sector will eventually recover, but it is most unlikely to re-employ the people it has expensively made redundant. For manufacturing, it really will be a jobless recovery. The new jobs will have to come from elsewhere, and in particular from private sector service industries. A few may come from construction, a few from the public sector, but these are not going to be substantial. So one has to ask about the private sector service industry's capacity to grow.

Labour flexibility

The signs are not encouraging. Established businesses will need more labour as demand recovers. But Germany has not been good during the 1980s at new business creation, or at promoting self- employment. It is now having to make the structural change that Britain went through in the early 1980s, but without the labour flexibility that Britain at that time encouraged and against a background of European recession.

It is easy to get too depressed. German manfacturing industry is restructuring more quickly than many people outside the country had expected. Structural change is also taking place rapidly in 'new' industries like telecommunications. The culture of attention to detail among the workforce is just as useful in service industry as in manufacturing. But change takes time. That is why no one should expect much recovery in Germany next year. And that is why the Bundesbank is scared.

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