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Germany - Euroland's basket case

The launch of the Euro was the fulfilment of a French dream. But it is turning into a German nightmare that is waking the French to a sour reality. Few ever thought that the weak link in the Euro's armour would be Germany; this week's drastic cut in the Euro-interest rate is the panic response. The European Central Bank (ECB) has intimated it will be 'the last'. Well, we shall see.

All the talk until recently was of the 'periphery' having problems that Germany would be called on to bankroll. The assumption was that the German economic powerhouse would go on blasting out energy and dominating the competitive environment of Europe. That assumption is now seen to be deeply flawed. The German economy is slowing down again after the briefest of recoveries last year, even though interest rates have been close to 3% for three years. Business confidence continues to fall, and retail sales are 2.6% down on a year ago; unemployment is still 10.5% as the 'recovery' splutters to a halt. But because of raft upon raft of labour market restrictions - designed to 'preserve jobs' - many more than the unemployed have withdrawn from the labour market. 'Participation' - the percentage of the working age population actually looking for work - is some 10% lower than in the USA or here; if one were to count in these institutionally-discouraged workers unemployment would be well over twenty percent.

Some of this unemployment is accounted for by Eastern Germany; the story of how reunification was bungled economically is indeed an important part of the current disaster. But even if one strips out the East the situation is poor. Unemployment in the west alone is 7.3% on US-style definitions but low participation flatters this too; adjusted for it the rate would still be close to 20 percent.

It is sometimes said that matters cannot be that bad in a country whose GDP per head (in the West) is some 15% higher than here. But this is to miss two points. First, it is not much consolation to your average German citizen to know that his living standard, though not growing, is still ahead: what about his aspirations? Secondly, GDP per head is a strongly lagging indicator of an economy's health; it reflects successes long past whereas people are naturally concerned with the future. Thus the man on the Frankfurt tram notices that higher taxation has already reduced his disposable income below that of the man on the Clapham omnibus; that his state pension is under threat; and that unemployment is high and threatening to rise again as recovery stalls.

How serious is this predicament? Could it just be a passing 'cyclical' phase? After all ten years ago the phrase 'Eurosclerosis' was coined by the distinguished German economist, Herbert Giersch, to describe German problems. Yet suddenly reunification burst upon the scene, creating a runaway boom as eastern consumers spent the proceeds of Ostmark conversion at one per Deutschemark and state infrastructure spending on the east also rocketed, paid for mainly by borrowing. Talk of sclerosis fell away in those heady days. Could the same not happen all over again? This was what Mr. Lafontaine was arguing: that a good old Keynesian stimulus was all that Germany needed.

For various reasons this cannot be so. First, there is no scope for such a stimulus. The level of public debt is already above the Maastricht criterion of 60%; this is anyway too high for safety given looming pension problems. Secondly Germany no longer has control of its own interest rates so that monetary policy is not available either - though clearly the ECB has taken fright. But thirdly it is dawning on neutral observers that the problem is deeper than demand management; the unemployment seems to be 'structural', requiring action on the 'supply side'.

In other words Professor Giersch was right all along; the underlying disease was concealed by the flush of a Keynesian boom. What is more, while the disguise was in place, a deeper worsening was occurring - the addition of the east under totally inappropriate supply conditions. Eastern money was converted at a grossly overvalued exchange rate (perhaps by 200%) and in a further malign twist eastern wages were ratcheted up under unions' insistence towards parity with the west; eastern wages are now some 80% of western against productivity at a third. Far better, as so many advised, to have one country two systems for a long transition. But Herr Kohl overruled economics with politics.

Even cautiously apolitical economists are now bewailing Germany's state. Four such are Fabio Canova and Morten Ravn, professors at Barcelona's Pompeu Fabra University (CEPR discussion paper 2038); and John Driffill and Marcus Miller, respectively professors at Southampton and Warwick Universities, in a paper available from Warwick's Centre for Globalisation. Both sets of authors emphasise the large excess supply of unskilled workers, swollen by reunification, facing a lack of the labour market flexibility that could find them jobs.

The big question is: how can Germany solve these supply-side problems while remaining in the Euro? Supply-side reform is politically difficult to carry out at the best of times because of union and other left-wing opposition; without the tools of exchange rate and monetary policy it may be impossible. When the labour market is deregulated it throws millions on the dole. To soak them up quickly requires a demand stimulus usually from a sharp devaluation that creates competitiveness rapidly in a host of new industries. Such was our experience in the UK when in the mid-eighties we lowered interest rates and let the pound fall; unemployment then rapidly fell from its appalling high watermark of 12% and the service expansion was born. Even so we have had a couple of painful decades.

Will Germany - unthinkably - suspend its participation in the Euro (a currency not due to be issued until 2002) temporarily? It is more thinkable than we suppose. There is much soothing magic in those words 'temporary suspension'. The Euro-11 on average is still growing steadily; parts of it - Ireland, Spain - are in positively rude health. The ECB will resist further cuts in interest rates with some reason. But Germany will become increasingly desperate. What odds a German Teresa Gorman rocks the Berlin boat? Place your bets.

Patrick Minford is professor of economics at Cardiff Business School and visiting professor at Liverpool University.
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