Europe needs a strong Germany

In the coming months, the Treasury will complete its assessment of the five economic tests that will determine whether there will be a referendum in Britain on the single currency. Central to the analysis is the idea of sustainable convergence with Euroland. As the policymakers study the data, it will soon become apparent that there has been something of a transformation in the UK’s economic performance relative to Europe over the past decade. In terms of growth, employment, inflation and fiscal balances, Britain looks to be in much better shape than most of the 12 members of the single currency area.

Ironically, Germany, Europe’s largest economy, is now the sick man of Europe, a role filled for so long by the UK. It’s ironic because, for much of the period between 1960 and 1990, the German economy was the engine of European growth. During this period, policymakers here looked admiringly at the efficiency of German manufacturing, at the tradition of industrial trade unionism, at the relationships between banks and the Mittelstand and at the Bundesbank-inspired stability of macro-economic policy.

Now the wheels seem to have come off the German machine and, in each of the past ten years, growth has under-performed even the very modest rates achieved in euroland as a whole. While the British economy has grown by almost 23% since 1995, and eurozone GDP is nearly 19% higher, Germany has managed a rise of just 12.5%. The cost of this lacklustre record comes through most obviously in unemployment. In the UK the jobless rate has more than halved in this period (to 3.2%), but in Germany it’s hovering around the 10% mark.

The impact has spread across the whole economy, affecting government finances and the banking system. A ‘black hole’ of almost #10bn has emerged in the government’s 2002 budget. With corporate bankruptcies running at record levels, banks’ bad debt provisions are rising rapidly. As if this were not enough, the collapsing stock market has seen the value of banks’ industrial stakes tumble. Consequently, the banks’ credit ratings have deteriorated and their share prices have been in freefall.

As 2002 draws to a close, the outlook is once again darkening. After the 2001 recession, current survey evidence (ZEW institute’s monthly index of business expectations) and official forecasts (the government’s council of economic advisers) hint at a possible ‘double dip’ in Germany or, at the very least, subdued GDP growth next year. The traditional response to this would be a loosening of monetary and/or fiscal policy, but today, neither option is available to the German government.

Responsibility for interest rates has now passed to the European Central Bank, which has kept rates on hold for 12 months, despite a deteriorating climate in Euroland. But in Germany’s case, easing monetary policy may not make much difference. There’s a widely-held view that the country’s difficulties are more deep-seated and structural than cyclical, and just lowering interest rates will do little to help. The scope for using fiscal policy is also severely constrained. The current budget deficit is in excess of the 3% limit set by the EU’s Growth and Stability Pact.

The Schroder government is in the uncomfortable position of having to reduce the budget deficit as economic activity weakens.

Even if the government had more room for manoeuvre with short-term policy instruments, it still would not be enough. To regain its position as the powerhouse of Europe, Germany has to face up to major reforms across the whole range of its economy.

For starters, labour markets need to be freer, the industrial relations structure reformed and non-wage costs reduced substantially. Enterprise is being held back by too much regulation and red tape, the tax system needs to provide real incentives, the generous social security benefits have to be questioned and the education and health systems are in need of wholesale reform.

After a generation or more of seeing the Germans top the European economic league, some people in Britain could be forgiven for feeling a sense of schadenfreude. This would, however, be misplaced. Germany is second only to the US as an export market for British exports and there are also strong cross-border investment links between the countries. Britain and Europe need a buoyant German economy. It’s in all our interests that Germany meets the challenges head on.