View from City Road: Bundesbank's theology is going to have to bend

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The Independent Online
The sharp fall in German national output in the first quarter is deeply worrying. Germany is now Britain's biggest overseas market, taking 14 per cent of our exports.

Germany is also the biggest market for most other European countries, including France, Denmark, Belgium, the Netherlands and Luxembourg. With Germany now clearly heading into what looks like its most severe post-war recession, it will prove increasingly hard to stop the impact from spreading throughout the Continent.

Any Schadenfreude after our own gruelling experiences should be resisted: the German downturn is now the greatest single threat to Britain's recovery.

The figures paint a picture of an economy in pretty near free-fall. The decline in national output has now spread far beyond industry, which accounts for an unusually high 40 per cent of the total. The real significance of the gross domestic product figures is that the drop is so severe despite other data that suggest industrial production has been flattening out. This means that the recession is spreading through services like wildfire.

To Anglo-Saxon eyes, there is something odd about the ferocity of the German output decline. After all, this is a well-managed economy with low levels of debt, much of which is at fixed interest rates. Yet the response to the monetary tightening of the Bundesbank has been far worse than either it or other analysts expected.

The first factor is that the solidarity pact is cutting wage growth. With earnings growing by 3-4 per cent, real income growth has turned negative, never a bull point for consumption.

The second factor is that government spending has also begun to turn down after the spurt in the immediate aftermath of reunification.

And the third factor is that the German mark is now sharply higher than it was before Black Wednesday against every European currency save those of the core members of the exchange rate mechanism.

JP Morgan's real exchange rate index shows that German competitiveness has worsened by about 9 per cent compared with its 1980-2 average. Allowing for relative labour costs, Germany's loss of competitiveness may be more than a third.

Faced with yesterday's figures, the monetary authorities of most countries would be easing policy quickly. But the Bundesbank is different.

The recent money supply figures worry the secretariat, which has been stressing the limited room for any further interest-rate reductions. The financial markets have taken this bleak prospect on board, discounting only a modest fall in money market rates from the present 7.6 per cent to some 6.2 per cent by the end of the year.

Nevertheless, it is hard to see how the Bundesbank's theology can fail to bend. True, its task is merely to control inflation, not to stabilise output.

But falling output reduces the call on resources, and eases inflationary pressures. Given the sluggish response of the German economy to interest rates, and the impossibility of further fiscal easing, it would not be surprising to see German rates fall faster than either the Bundesbank or the markets now expect. It will be none too soon.