[A-List] Germany: baying for "reform"

["Michael Keaney" <michael.keaney@xxxxxx>]

This is a brilliant piece of analysis: Germany is not facing deflation,
because wages are high and are structurally prevented from adjusting too
quickly downward -- this is a good thing. Germany needs to reform its system
of wages because they are high and structurally prevented from adjusting
quickly downwards. No wonder Allianz Group is not doing so well if this is
the best its chief economist can come up with.


Germany needs reform, not reflation
By Michael Heise
Financial Times: October 31 2002

The German economy, like Japan's, has been anaemic of late. Growth of only
0.5 per cent in the past two years and a steady slide towards the bottom of
the growth league table since the mid-1990s have tarnished its reputation as
the economic powerhouse of Europe. Germany suffers from weak domestic demand
growth and a protracted investment slump, although not as much as Japan.
However, there is no deflation in Germany. Consumer prices will be 1.5 per
cent higher in 2002 than they were in 2001. Over the past decade they have
climbed by 2.3 per cent a year, while in Japan they are more or less
unchanged.

But now that the stock market bubble has burst, will Germany not see a
deflationary spiral? This is unlikely. First, wage levels adjust more slowly
in Germany than in Japan and will keep prices from falling for longer.

Second, there is no property bubble as there was in Japan when deflation set
in. The bursting of the property market bubble affected the whole of
corporate Japan, wiping out wealth equivalent to almost twice the gross
domestic product. German house prices have been flat for years, with
house-owners desperately waiting for them to rise. Third, the leveraging of
the economy, the build-up of a credit bubble resulting in unsustainable and
un- profitable production capacity, is in no way comparable to Japan's.

These differences also show up in the real economy. In Germany, there is
little idle capacity. Manufacturing is highly competitive in world markets.
Since 1992, the share of German exports in world trade has remained steady
at about 10 per cent, whereas the Japanese share has tumbled from 9 to 6 per
cent. With its more open economy, with higher foreign direct investment,
Germany has had to adjust more directly to changes in international markets.
And, although Germany is not one of the economies with the freest markets,
there has been far less state interference than in Japan.

It is true there are similarities in the banking sector. But the differences
are much greater. In Japan, the story begins with the deregulation and
liberalisation of financial markets during the 1980s. Instead of adapting to
increasingly global and open markets, Japan clung on to its main-bank
relationships, keiretsu networks and links between business and government.

In the 1990s, Japanese banks saw their collateral collapse with the bursting
of the stock market and property bubbles. But, fearing the consequences of
cleaning up their loan books, they pinned their hopes on a swift recovery.
As a result, the once influential banks became too weak to provide risk
capital for the economy. Enormous public work projects kept the economy
afloat until the financial crisis of 1997-98 caused outright deflation.

Germany's banking problems are more closely related to the recent capital
market boom. High investment banking revenues concealed structural problems
such as excess capacity and almost ruinous competition in the loan business.
In the past five years, profits totalled ?100bn. There was, it seemed, no
need for harsh structural adjustment and disinvestment. On the contrary, the
boom triggered heavy investment in capital market operations and their back
offices and expensive inter- national mergers. When capital markets
collapsed and risk provisions soared in an ailing domestic economy, it
became clear that the bloated cost base would not be sustainable.

Delaying these necessary adjustments, for example by looser monetary or
fiscal policies, would be pointless. Weaker growth prospects may justify a
cut in interest rates - maybe by half a percentage point - but attempts to
devalue the currency or reinflate the economy, as in Japan, would be
counter-productive for Europe.

Fears of devaluation and inflation would push up bond yields and hinder
acceptance of the euro as an inter- national currency. International
imbalances - a eurozone trade surplus and a large US trade deficit - would
be perpetuated, not diminished. What is needed is not demand management but
a strong euro and steady internal growth in the eurozone economies. To
achieve that, many reforms are required, especially to labour markets.

The main lesson from Japan's economic debacle of the past 10 years is that
structural problems have to be dealt with by appropriate reforms, not by
macroeconomic demand management. Germany's economic problems stem from high
wage costs caused by an expensive social security system, high taxes,
overwhelming bureaucracy and inflexible labour markets. Low inflation is not
the problem. On the contrary, it is a welcome reaction of the economy to the
business activity slump as it limits the loss in purchasing power.

Beware of bad policy prescriptions arising from misleading comparisons.
Before slipping into deflation, Japan ducked overdue structural reform with
the help of expansionary fiscal and monetary policies. Let us not repeat
that mistake in Europe.

The writer is chief economist of Allianz Group