By Anatole Kaletsky (THE TIMES, 22/02/07):
The sick man of Europe has risen from his death bed. Will he now recover to be the strong man of old? Last week the European Union’s statistical service reported that Germany was the fastest-growing economy among the leading industrialised countries, expanding by 3.7 per cent in the year to December, compared with Britain (3 per cent), America (3.4 per cent), Japan (2.1 per cent) and 3.3 per cent in the eurozone as a whole. A decimal point or two is not in itself significant, but these figures suggest that Germany has emerged finally from its decade of postunification convalescence and may be returning to its traditional role as the main engine of European growth.
The implications would stretch well beyond mere economics — as is already evident from the renewed self-confidence not only in Germany’s business community, but also among its political leaders, especially Angela Merkel.
It is still far from certain whether Germany has genuinely recovered from the traumas of unification. A convincing case can be made that last year’s strong economic growth was due largely to special factors.
As Norbert Walter, the respected chief economist of Deutsche Bank, has noted, 2006 was a year of extraordinary effects for the German economy: “The boost from the Government’s investment programme; the stimuli from temporary introduction of an accelerated depreciation scheme; the boost to sales and Germany’s image from the football World Cup; and finally the effects of purchases being brought forward to beat the increase in value added tax to 19 per cent.” This year, by contrast, Germany will be hit by a potentially lethal combination of higher taxes, rising interest rates and a less competitive exchange rate. As a result, most economists expect a significant slowdown, and forecast GDP growth just below 2 per cent.
But as Dr Walter maintains, to characterise the difference between last year’s near-boom conditions and the much more challenging prospects for 2007 “by a somewhat lower average growth figure simply would not be doing it justice”. The issue is not whether Germany will suffer a bit of a slowdown this year, followed by an acceleration in 2008, which is what most economists are expecting. It is whether the 2006 recovery will prove to be a false dawn, to be followed by relapse into another long period of economic stagnation — the fate suffered by Japan after a similarly promising, but temporary, recovery in the mid1990s.
Whether Germany’s recovery proves sustainable or fizzles out in the year ahead is a vital question for the whole of Europe – and not just because of Germany’s weight in the EU economy or because economic conditions will have an impact on Mrs Merkel’s popularity and self-confidence. An even more important factor is Germany’s role as an economic model for other European countries seeking alternatives to the Anglo-Saxon approach to economic management. The latter has been in the ascendant since the mid1990s, when the German and Japanese economies deteriorated abruptly, while America and Britain forged ahead.
This divergence had many possible causes but one of the most significant — the different approach to macroeconomic policy — is now being subjected to a controlled experiment in Germany. The German Government imposed a huge tax increase on consumers last month without offsetting it by any easing of interest rates, as similar tax rises were offset, for example, in Britain in 1981 and 1993.
If Germany can pass unscathed through this fiscal squeeze, it will prove that macroeconomic policy does not really matter and that interest rates can be set by a supranational institution, such as the European Central Bank, that pays no regard to conditions within national economies.
If, on the other hand, the German economy suffers a substantial slowdown, key tenets of the single currency project and the ECB’s philosophy will be undermined. This is where the comparisons between Germany today and Japan in the 1990s become intriguing.
Germany and Japan have very similar economic structures, both dominated by famously efficient manufacturers and exporters but hobbled by nervous consumers, relatively underdeveloped service sectors and flat or falling property prices. Germany is now following a macroeconomic policy remarkably similar to Japan’s in the mid1990s, imposing a big tax increase on consumers after only one year of decent economic growth. By an uncanny coincidence, the three percentage point rise in Germany’s VAT rate this year is exactly equal to the increase in consumption tax introduced in Japan in 1997.
Moreover, the near-universal confidence in Germany that the VAT increase will have no lasting economic impact, is exactly in line with Japan’s experience ten years ago. Just before the big tax increase of 1997, Japan, like Germany today, had experienced a year of unexpectedly strong recovery, after its long recession of 1991-95. The quietly confident economic assessment issued by the Bank of Japan immediately after the increase in consumption tax could have been written by the Bundesbank today: “The economy continues on a moderate recovery trend. Despite the decline in demand which followed the consumption tax hike, the recovery trend in personal consumption does not seem to have been hindered.” And the overconfidence about Japan’s prospects in 1997 was not just a function of domestic political complacency. The International Monetary Fund’s forecast for Japanese growth, published only two months before the 1997 tax rise, was uncannily similar to today’s consensus forecasts of German growth. Japan’s economy was forecast to slow to 2.2 per cent in 1997 and then reaccelerate to 2.9 per cent in 1998.
The outcome was very different — Japan’s growth fell to only 1.4 per cent in 1997 and this slowdown was followed not by the expected acceleration, but by a GDP collapse of minus 1.9 per cent. Not only did this slump in economic activity represent one of the deepest recessions suffered by any advanced economy since the Second World War; it also triggered a financial crisis across Asia that brought down almost every government in the region.
There are many reasons why Germany is very unlikely to suffer a Japanese-style slump — not least because France, Spain, Italy, Sweden, Denmark and other European economies are being powered by Anglo-Saxon style house price and mortgage booms that will continue to provide orders for German exporters. According to the internationally dominant view on the impact of taxes, however, the Germans really will have proved that there is a Euro-Japanese model quite distinct from the Anglo-Saxon approach. All we can do now is wait and see whether German’s convalescence is followed by full-scale recovery or relapse.