When strength is weakness

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The Independent Online
IT IS NOT difficult to see why the Bundesbank cut its discount rate yesterday, just as it is not difficult to see the churlishness of the 'not enough' response. Germany is in recession. But the fact that German interest rates are now heading firmly, though slowly, downwards underlines the perilous state of German industry, and raises the big question: when and how does Germany pull out?

The economic background to the interest-rate cut can be swiftly sketched. Germany has been in recession for a year, with GDP declining for the final three quarters of last year and continuing to fall this year. Unemployment has been rising since the middle of 1991 and is climbing at more than 40,000 a month. It is now 8.4 per cent, and on present trends will rise above 10 per cent by the end of this year. Further, there are a million workers on short- time. If the economy fails to pick up this year many of these people will become unemployed, pushing the total higher.

Adjusted for Germany's stage in the economic cycle - it went into recession a year after the UK - its unemployment problem is, therefore, every bit as serious as ours. This is not just a result of unification. While unemployment in the former East Germany stands at 15 per cent, it is at last gradually falling; the core of the unemployment problem is shifting to the west.

The Bundesbank in the past has been consistent in its interest-rate policy. If it follows the strategy of previous cycles, the discount rate will continue to be cut for the next 18 to 24 months, bringing it down to 4 per cent next year, and maybe bottoming out at 3 per cent in 1995. It reached 3 per cent in the cycles of 1968-69, 1972, 1977-79, and went to 2.5 per cent in 1987. Warburg Securities points out in its latest newsletter that the costs of eastern German reconstruction may limit the pace of the fall, but it still expects a 4 per cent discount rate next year.

That does not necessarily mean money market rates will fall to that level. The discount rate sets the floor for rates, while the Lombard rate sets the ceiling: the Bundesbank operates between these two levels. But we should expect German money markets rates below 5 per cent in 18 months' time.

The trouble is that even a sharp fall in interest rates would have only a limited impact on demand for German products. The British economy is particularly sensitive to interest- rate changes because of the mass of floating-rate debt held in the form of mortgages. We are beginning to see a move away from floating-rate debt, with the offers of fixed or capped mortgages, but for the moment, if interest rates come down, a lot more money is put into the hands of British consumers.

It does not work like this in Germany. Not only are mortgages much less freely available, for lenders tend to require homebuyers to put down 30 per cent of the home's value; they are also generally on fixed rates. This means that when rates go up, there is not the same damaging impact on consumption, but it also means that it is harder to stimulate the economy by cutting rates.

The main mechanism by which interest-rate cuts stimulate the German economy is through corporate balance sheets and construction. But even here cuts in rates will have only limited effect. German industry did not borrow so aggressively at the top of the boom as companies in North America or the UK, and thanks to the spur of unification, property development, particularly in eastern Germany, is running strongly.

If falling interest rates will give only a modest stimulus, what else will? Consumers' real income has been rising, but as in Britain fear of unemployment has led people to build up their savings instead of spending them: a material change in the next year is unlikely.

Exports? That has frequently been the path to expansion for Germany, but this time, it looks closed. Only the US economy is growing reasonably briskly and German exports to the US are relatively small. Look at the list of countries, ranked in order of imports from Germany: France, Italy, the Netherlands, UK, Belgium and Luxembourg, and only then the US. People think that America buys a lot of German exports because of the high profile of companies such as Mercedes and BMW. But in fact the 250 million people in the US buy little more from Germany than the 8 million in Austria.

So growth in the US will not help. The UK may help a little, but not much, particularly after our devaluation. Germany is tied to Continental European demand and that is heading deeper into recession.

This raises the most crucial question of all. Germany's industrial strength is also its weakness. Being good at making the things people bought in the 1980s, such as cars and consumer durables, may not be the path to success in the 1990s, particularly given Germany's cost disadvantages. Germany had been able to offset the fact that it has the highest labour costs in the world by pushing up-market: by producing significantly higher-quality goods. But suppose, in the cautious 1990s, people say they are prepared to buy the slightly cheaper product from some other country and put the difference in the bank. That is certainly happening in the US and in Japan, where German exports have fallen particularly sharply.

At some stage - and it may not be until 1995 - growth in Germany will resume. But the longer-term problem of Germany being too dependent on exporting up-market manufactured products will remain.

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