upside risks for inflation. it is important that higher inflation expectations do not become a permanent fixture. * * * turning to germany, the economic recovery there accelerated somewhat in the second quarter of 2004. gdp increased by 0. 5 % on the quarter. this implies an annualised growth rate for the current year of 1¾ % meaning that there was an increase in average capacity utilisation for the first time in some while. even so, the recovery in germany is not broadly based. domestic demand has remained weak. only exports have contributed to growth. in the first half of the year, exports grew by 6. 2 %, while imports grew by 3. 7 %. this is in part also due to germany ’ s ability to engage in highly competitive pricing. it is therefore likely that german enterprises will continue to benefit from strong growth in their export markets. enterprises ’ export expectations also support this claim. it is striking that the appreciation of the euro has had a far less dampening effect than many had expected. it seems that the growth - driven increase in partner countries ’ demand for german products has more than offset the exchange rate effects. exports to the usa, for instance, which had declined last year, have increased again. there was a particularly sharp rise in exports to non - eu countries, especially to russia and china. gratifying as the german economy ’ s export successes are, one must not lose sight of the flip side of this export bias. the german economy is also vulnerable to changes in the global cyclical climate, and this, in effect, constitutes the german economy ’ s achilles ’ heel. this is because, at the moment, no other expenditure component is driving growth. corporate investment, which decelerated in the first quarter, remained flat in the second quarter. even so, the environment remains conducive to enhanced investment activity. the cost situation has eased and is helping to stabilise earnings. on the financing side, the way has been paved for more growth. incoming industrial orders and industrial output rose again in july following a weak june. capacity utilisation in the manufacturing sector increased considerably in june, exceeding medium - term average capacity utilisation for the first time in some while. housing construction made no contribution either. in the first half of 2004, investment in new residential buildings declined further. judging by the number of incoming orders and construction permits, no turnaround is in sight. the structural problems in housing construction, particularly the housing surplus above all

potential output has remained flat. potential growth is considerably below that of the euro area and particularly the usa. the problems ensuing from the reunification of germany have undoubtedly also loomed large in the weak growth of the german economy. at the start of the 1990s, for instance, state subsidies ignited a construction boom which petered out in the middle of the decade, not least because public authorities had to curb their investment and overcapacity already existed in the private sector. the subsequent adjustment process is still continuing. the economic dynamics in germany have been additionally slowed by a sharp increase in the level of taxes and social contributions in order to finance the burden of reunification. moreover, the process of interest rate convergence during the changeover to the euro is likely to have been one factor impeding growth in germany in relation to the rest of the euro area. as a result of this convergence germany lost its former interest rate advantages and competition for investment became more fierce. beyond these specific german conditions, a solow growth decomposition shows that labour made a considerably greater contribution to economic growth in the usa compared with germany. apparently, the usa has been more successful in integrating labour in the production process, whereas in germany, high unemployment has left enormous potential output untapped. capacity is not being fully utilised owing mainly to labour market rigidities. however, as i have already mentioned, germany has set the ball in motion in this area - and that is no small feat. the labour market has undoubtedly become more flexible of late both with respect to the institutional framework and as regards collective wage bargaining and working hours. the hope that the economic recovery will later give a fillip to the labour market is therefore well grounded. even so, increasing international competition for investment in manufacturing locations and jobs will mean that the pressure to become more flexible will remain high or even increase further. it is for this reason that additional efforts are needed, particularly in the area of wage structures, to utilise the labour potential which until now has remained untapped. * * * one area where germany is currently still facing considerable problems is public finances. last year the deficit ratio was 3. 8 %, thereby overshooting the ceiling of 3 % set by the ec treaty for the second year in succession. according to our calculations, the bulk of the deficit is of a structural nature and is not attributable to cyclical factors. the debt ratio actually reached an historical high of 64. 2 %. the deficit ratio is likely to show little