Hermann Remsperger: Economic outlook and economic policy challenges for
Germany
Guest lecture by Professor Hermann Remsperger, Member of the Executive Board of the Deutsche
Bundesbank, at the Norges Bank (Central Bank of Norway), Oslo, 23 September 2002.
* * *
Ladies and gentlemen
Yesterday, we elected a new parliament in Germany. As you are aware, economic matters played a
key role in the election campaign. I would like to take up some of these matters today in Oslo. Under
the heading "Economic outlook and economic policy challenges for Germany", I would like, first, to talk
to you about the reforms that are needed on the labour market as well as in tax and social policy.
Second, I shall also ask the question of whether we need a new policy mix. And, finally, I shall look at
the eastward enlargement of the European Union as a major economic policy challenge.
My simple proposition is that Germany's economic outlook depends foremost on coping with the
existing economic policy challenges. I am arguing in favour of domestic reforms in Germany, for
careful handling of EU and EMU enlargement and for maintaining the fiscal policy rules in the policy
mix of European Economic and Monetary Union. Not least, these rules have to be applied in such a
way that "budgetary exuberance" is avoided in an upswing.
I am therefore less concerned with short-term cyclical movements than with medium and long-term
economic trends in Germany. For this reason, I shall start by looking back and, in doing so, have to
state that Germany's economic development over the past decade has often tended to be
disappointing by international standards.
I. A look back
In saying that, there was indeed some cause for optimism at the start of the 1990s: German
unification, the opening-up of the east European markets, progress in European integration and, later,
the introduction of the new currency provided a wealth of opportunities for growth. However, at least in
some cases, things did not quite work out as had been hoped.
Since the reunification boom petered out, Germany has been part of the group of countries with weak
growth. While the GDP of the present EMU countries has risen by a total of 15% since 1995, the
corresponding figure for Germany is no more than 10%. In line with this, the annual average rate of
growth in Germany, at a good 11⁄2%, has been lagging 3⁄4 percentage point behind. Comparing
Germany with the euro area as a whole excluding Germany, the German shortfall in growth increases
to just over 1 percentage point. In 2001, taken on its own, the figure was as much as 11⁄2 percentage
points.
Now, there are some commentators here and there who ascribe this performance to increasing
globalisation. However, this argument does not hold up under closer examination. Following a period
of export weakness in the early 1990s, the German economy achieved extremely good results in
foreign trade between 1994 and 2001. Given an overall moderate growth in GDP during the period
mentioned of 141⁄2%, real exports increased by 791⁄2% and real imports by 671⁄2%.
One of the factors contributing to the positive development in exports since the mid-1990s was
improved price competitiveness of the German business sector. This meant that earlier adverse
developments were largely reversed. In the early 1990s, by contrast, price competitiveness had been
severely affected by large wage increases, not least as a result of bringing pay in eastern Germany
more closely in line with west German rates and also due to the sharp appreciation of the D-Mark.
Although the German economy has become more dependent on other countries, it has to be said that
most of the structural problems in Germany cannot be blamed on developments in the global
economy. They are mainly home-made.
Among other things, cyclical influences and special factors have contributed to Germany's relatively
poor performance in the euro area. Above all, it should be remembered that, already in the run-up to
Stage Three of European monetary union, interest rates had fallen sharply in a number of EU
countries with previously fairly high short and long-term rates of interest. For example, interest rates
for long-term government bonds in Italy and Spain, even in 1995, were 5 to 6 percentage points higher
than the rates for German Federal Bonds. Besides, improved fundamentals, market expectations of an
early participation in monetary union are likely to have played an important role in the interest rate
convergence process. As the home of the former anchor currency in the ERM, Germany did not
benefit directly from this process of interest rate convergence.
Another cause of relatively weak growth in Germany to be mentioned is, of course, the crisis in the
construction industry, especially in eastern Germany. In this sector, the capacity that was built up
immediately after reunification exceeded the longer-term ability of the real estate market to absorb
such capacity. Reduced construction activity depressed German economic growth. Without the decline
in investment in construction since the mid-1990s, the shortfall in German growth compared with the
euro area as a whole would therefore not have been so substantial. By contrast, construction activity
in other European countries remained an important pillar of economic growth.
Finally, consideration also has to be given to the fact that living standards in the monetary union are
still very disparate. Since the poorer countries are supposed to catch up with the EMU average, they
have to go on growing more strongly than those countries which have already achieved a high level of
income. A comparatively low level of growth in an already advanced country should therefore not have
too much importance attached to it.
II. Labour market problems
One very important - if not the most important - reason for the inadequate pace of economic growth in
Germany is the continuing heavy burden of taxes and social security contributions as well as strict
regulations in parts of the economy. However, these reasons cannot explain the differentials in growth
among the core countries of European Union, which have similarly serious deficiencies in terms of
reform. Rather, they are a major cause of the shortfall in growth vis-à-vis the United States. Above all,
there is too little labour market flexibility in Germany. Also, wage rate policy was indeed characterised
by restraint in the second half of the 1990s, but its overall stance was, at best, neutral. Furthermore,
differentiating pay in terms of skills, sectors and regions is not enough. Wage policy did not make a
major contribution to the creation of new jobs.
In periods of a cyclical downswing, the rise in unemployment in Germany was far sharper than the fall
during periods when there was an upturn. For instance, the number of people out of work in western
Germany rose from its cyclical low point between 1991 and 1997 by some 1.3 million to around
2.5 million. By 2001, the number of unemployed had been reduced by no more than just over half a
million. An additional factor to contribute to the high level of persistent unemployment is that, as firms
see it, the skills to work evidently decrease the longer unemployment lasts.
For non-working members of the labour force, the incentives to take up employment were limited by
the high-level marginal burden imposed by taxes and other public levies. Most types of household in
Germany have a marginal burden of taxes and levies of 50% or more. In other words, from every
additional euro that is earned, around 50 cents are deducted. Moreover, social benefits which are at a
high level by international standards act as a reservation wage. In Germany, it is difficult, especially for
low-skilled persons, to find a suitable job. The "wedge" between gross and net wages also led to the
emergence of a considerable black economy.
Furthermore, the skills profile of those seeking work often fails to match that of the jobs on offer.
Unemployment would thus remain high even if the number of vacancies corresponded to the number
of people looking for work. The German labour market is characterised by a high level of mismatch
unemployment. The proposals of the Hartz Commission, which was set up by the previous Federal
Government, and the embryonic reform of the labour exchanges, which is already under way, are an
attempt to tackle that situation and to increase the efficiency of the job placement process.
The most pressing tasks of labour market policy from my point of view can be split into three
categories: first, measures to increase the supply of labour; second, proposals on strengthening the
demand for labour and, third, changes in the wage-formation process.
One of the things to be examined with regard to increasing the labour supply is whether, say, the
period of time for drawing unemployment benefits does not lead to people remaining in unemployment
longer than is absolutely necessary. As I have mentioned, in empirical terms, it is evident from the
perspective of the enterprises that the skills of the unemployed rapidly lose their value the longer
unemployment continues. For that reason, purportedly generous arrangements may even become
"poverty traps" for the unemployed. Combining social assistance and unemployment assistance also
has to be considered. Neither of these types of state benefit is an insurance benefit. Rather, they are
granted according to specific need. They should therefore be merged.
Many experts agree that the demand for labour in Germany also suffers from the very complex legal
arrangements relating to work contracts. Enterprises are so cautious in recruiting labour because it is
so difficult to make redundancies.
If there is to be a sustained decline in unemployment, some elements of the wage-formation process
have to be subjected to more scrutiny. Collective pay agreements should set only general framework
conditions in order to take greater account of the individual situation in which firms find themselves.
We should now admittedly not overlook the fact that initial cautious steps have already been taken
towards making the German labour market more flexible. The strict principle of regionally agreed pay
deals has already been relaxed somewhat by opt-out and opt-in arrangements. Furthermore, the
labour market has been made more adaptable with the extension of part-time work. Finally, with the
help of Germany's training system it has been possible to keep youth unemployment at a
comparatively low level by European standards. According to Eurostat figures, the unemployment rate
among under-25-year-olds amounted most recently to 9.3%, compared with 16.4% in the euro area as
a whole.
III. Tax and social policies
All things considered, the underlying conditions for the German economy have also been improved by
the tax reform that was adopted two years ago. For incorporated enterprises, corporation tax was
lowered from 40% for retained profits (and 30% for distributed profits) to 25%. For non-corporations,
the previous burden imposed by trade tax has largely been removed. Furthermore, their situation is
also being eased by the fact that the income tax scale is to be lowered in stages until 2005.
The tax reform makes restructuring in the corporate sector easier because profits from sales of
corporations' participating interests are no longer subject to taxation. However, the tax depreciation
facilities for spending on fixed assets have been made worse.
There has been progress in Germany in the field of old-age pension provisions. The pension reform,
which was adopted last year, pursues two objectives simultaneously. First, payments under the state
pay-as-you-go scheme are being cut back, and, second, private provision is being strengthened.
Pension increases over the coming years will remain below the level of increases in wages and
salaries. This means that, in the long term, the increase in the contribution rate will be around
11⁄2 percentage points lower than would otherwise have been the case.
The pension reform will mainly benefit the younger generations. They will gain from the lower burden
of contributions. They will have greater scope for making their own provision. For those who are older,
however, the cutbacks in payments will weigh more heavily.
The promotion of private old-age pension provisions nevertheless entails considerable burdens for the
public sector budgets. Furthermore, what is known as the "Riester pension" has been constricted by a
set of fairly tight regulations. The stock of capital that has been saved up may be paid out, for
example, only in regular and life-long instalments. In contrast to this, at company level, a flexible
instrument has been created in the form of the pension fund. Not only does this allow largely free
decisions on investment, it also makes defined contributions possible for the first time. Precisely
because of the associated fiscal strains, there is hardly likely to be a significant increase in national
savings as a result of this reform. However, Germany as a location for investment will probably play a
greater role in future in the increasingly important market for pension products.
All things considered, there has indeed been some economic policy progress in Germany.
Unfortunately, it has been moving forward at no more than a snail's pace. There is still much left to be
done.
Further reforms of the labour market and the social security system are a matter of urgency in view of
the increasingly unfavourable age structure of the population in Germany. The ratio of people aged
over 60 to the group of 15 to 59-year-olds was just under 40% in 2000, but this ratio might increase to
around 80% by 2050. The higher age ratio will have an adverse impact on the social security system
and, given the existing entitlement to benefits, will call for higher contribution rates.
It is by no means certain whether the recent reform of the pension system will be sufficient to cope
with these challenges. An additional factor is that demographic developments will place a strain on
other parts of the social security system, such as the health insurance institutions and nursing care
schemes. The welfare state system will have to be adapted to cope with these challenges if problems
for future economic growth are to be avoided. As a general guideline, it may be said that a closer
match in social security contributions along with a stronger personal contribution by the individuals
concerned will improve economic efficiency and thus open up opportunities for growth.
IV. EU enlargement
One of the reasons why I believe that the reforms inside Germany are so important is the fact the we
are also facing challenges from outside. The planned enlargement of the European Union is certainly
one to be mentioned. The negotiations which are currently being conducted with 12 countries, situated
mainly in central and eastern Europe, are now far enough advanced for the first round of enlargement
to take place as early as the middle of this decade.
Especially from Germany's point of view, setting the right course for the integration of the new member
states is of considerable importance. Both Germany's geographical location and its close economic
ties with its neighbours to the east mean that Germany is affected by EU enlargement more than other
countries in the Union.
Despite considerable progress in terms of macroeconomic stabilisation and in the implementation of
market economy reforms, the erstwhile socialist countries in transition, in particular, still display
significant structural differences from the current EU member states. One of these differences is that
the accession candidates are in a process of catching-up economically. They generally have inflation
rates which are higher than those in the more mature and more slowly growing EU member states.
This is an outcome, first, of differences in productivity gains across countries and sectors - known as
the Balassa-Samuelson effect - and, second, of shifts in demand.
The resulting real appreciation does not pose an obstacle to EU enlargement in terms of progress in
the liberalisation of foreign trade and its ensuing welfare gains for the EU as a whole. Nevertheless, if
the EU accession candidates participate in monetary union before the existing structural disparities are
eliminated, the single monetary policy in the euro area will not meet the needs of all the member
states. A hasty enlargement of EMU would therefore harbour stability risks for the euro area and might
generate tensions among the participating countries.
Accession to the EU, however, does not imply immediate full membership of EMU. Instead, the EU
accession countries will participate initially as "member states with a derogation" in the Third Stage of
Economic and Monetary Union. The precondition for full EMU membership is that the accession
countries achieve a high degree of sustainable economic convergence. The convergence criteria laid
down in the Maastricht Treaty are the yardstick for this. These criteria set unambiguously verifiable
requirements in terms of price stability, long-term interest rate levels, the government fiscal position,
and participation in the exchange-rate mechanism of the European Monetary System, ERM II. In
addition, pursuant to Article 121 of the EU Treaty, the examination of the sustainability of achieved
convergence "should also take account of ... the results of the integration of markets, the situation and
development of the balances of payment on current account and ... the development of unit labour
costs and other price indices".
The convergence criteria are designed to guard against inflationary tendencies within the monetary
union and to prevent tensions arising from structural divergences in inflation. The task of stabilisation
does make stringent demands on the monetary policy of the accession countries, but price stability
may be regarded as a sine qua non of sustainable growth. For that reason, the accession countries -
not least in their own interests - should not enter EMU until the process of catching up economically
has already made significant headway and the adjustment function of the exchange rate can be more
easily dispensed with.
Such a step-by-step enlargement process would also be in Germany's interest, since it would enhance
the opportunities arising from an enlargement of the Union and limit the associated risks, especially
the monetary policy risks.
V. Policy mix
After discussing domestic reforms in Germany and my comments on EU enlargement, I would now
like to deal with a third economic policy issue: the policy mix in the European Monetary Union. The
present division of tasks is based on the insight that each area of policy should concentrate on its
relative strengths. The monetary policy of the European Central Bank is geared to price stability, for
example. In line with this perspective, wage policy is responsible for achieving a high level of
employment and budgetary policy should ensure an efficient supply of public goods and fairness of
income distribution but, in doing so, not impair incentives to work, to save or to invest.
This - as I see it - generally tried and tested allocation of responsibilities is often the subject of
criticism, however. Calls are made to allocate macroeconomic responsibilities differently, accompanied
by the demand that monetary, fiscal and wage policymakers should coordinate their operations
instead of focusing on their own strengths.
According to this "new division of labour", wage policy would have the task of keeping down inflation.
This would be conditional on wage and salary earners and their trade unions forgoing pay rises
precisely in periods when the economy is booming - at times when they could easily push through
such increases. It is probable that there would then be a wage-price spiral, which also happens to be
the historical experience in Germany and in other countries. There was no success in the early 1970s,
for example, in restricting pay rises, even though the trade unions were tied into a corporatist alliance
called "concerted action".
Frequently, the call is made that monetary policy should not be geared - or not be primarily geared - to
price stability, but attempt to stimulate economic activity. That way of seeing things, however,
overrates monetary policy's influence on developments in the real economy. Changes in the monetary
policy stance act with varying time-lags on investors and consumers. Furthermore, it is often difficult to
diagnose the cyclical situation properly. Finally, monetary policy action would have to be administered
in the correct cyclical dosage. In the age of globalisation with open borders and integrated capital
markets, that would be very difficult to do. In short, there is little to suggest that the monetary
policymakers' strengths lie in the fine-tuning of the business cycle. Monetary policy is far better suited
to the long-term safeguarding of price stability.
In considering the appropriate policy mix in the monetary union, the terms of the Stability and Growth
Pact mean that the role of fiscal policy undoubtedly occupies centre stage. In the field of budgetary
policy, several countries are having considerable difficulties in fulfilling their existing European
commitments. These provide for a 3% limit for the general government deficit ratio and, at the same
time, a budgetary position that is in surplus or close to balance over the entire business cycle. Since
the deficit in Germany, at 2.8% of GDP, already came quite close to the 3% ceiling last year - mainly
on account of the tax reform - the risk that it might now exceed that limit in the current year has
become greater. Furthermore, there are some doubts as to whether German fiscal policy will be able
to deliver on the self-commitment - reaffirmed in spring - to achieve a budget position close to balance
by 2004 unless there are further cuts in public payments.
Given the budgetary problems that also exist in other EMU countries and in view of the weak cyclical
situation, calls are increasingly being made for a relaxation of the fiscal policy rules in European
Monetary Union. The main point of criticism about the existing provisions of the Maastricht Treaty and
the Stability and Growth Pact is their alleged inadequate cyclical flexibility. It is claimed, for example,
that these rules force budgetary policy to act in a procyclical manner counter to the requirements of
stabilising the economy.
Such criticism does not, however, take due account of the rules of the European Stability and Growth
Pact. It is, in fact, precisely the task of this pact to ensure that government budgets can "breath" during
the business cycle without breaching the deficit limit of the Maastricht Treaty. Such flexibility is to be
achieved through a budgetary position which is at least close to balance over the medium term - in
other words, when seen over the cycle as a whole. If that condition is met, the automatic stabilisers
can develop their full effect within the 3% margin. The fact that there is, even so, only a narrow "safety
margin" from the limit in some countries should not be blamed on the fiscal policy rules. It is rather the
case that there has been a failure over the past few years to bring about a structurally balanced
budget.
"Softening" the fiscal policy rules would undermine the credibility of the Maastricht Treaty and the
European Stability and Growth Pact. The associated capital market effects would also have adverse
implications for economic growth. The existing fiscal rules are necessary in order to counter the even
greater latent incentives to borrow in a monetary union and to prevent monetary policy from being
caught up in the slipstream of unsound government finance. The fiscal policy rules strengthen the
functional independence of the European Central Bank and thus facilitate a stability-oriented monetary
policy in the single currency area. Watering down those rules might give rise to conflict between fiscal
policy and monetary policy. Therefore, German fiscal policymakers, too, must not shirk their
responsibility to make further consolidation efforts so as to achieve a budgetary position close to
balance in the medium term.
If one wishes to achieve a balanced budget over the business cycle - in other words, if the intended
benchmark for the structural deficit is zero - in order to assess the fiscal position of a single year it is
analytically necessary to adjust the budget balance for cyclical effects. This does not require any
addition to, or modification of, the Stability and Growth Pact. It is, in fact, a matter of implementing its
rules in the stability programmes in a consistent manner. And that naturally also implies not under any
circumstance calling into question the nominal maximum limit for the deficit of 3%.
As I see it - and I would like to conclude on this point - more attention has to be paid in future to
budgetary policy transgressions not being allowed in times when economic conditions are favourable.
During an upswing there exists a risk of "budgetary exuberance" - in other words, a lower deficit being
interpreted as progress in terms of consolidation, even though it is due solely to an improvement in the
cyclical situation. Particularly in periods when the economy is improving, finance ministers who take
consolidation seriously have to look not only at the unadjusted budgets. They have to look at the
adjusted budgets too.
At the same time one should not make the mistake to see the problem with the adherence to the
stability and growth pact under business cycle aspects only. In Germany these problems are also a
symptom of an insufficient basic dynamism in the economy. We do not need to change the stability
and growth pact. What we need are more reforms which lead to higher employment and growth. The
newly elected German Parliament should approach these reforms with courage.