Monday, July 07, 2003

Eating Duisenberg's Hat

Following on from my last two posts, a piece on Germany which Eddie has in the Straits Times last week, but which I somehow overlooked. Perhaps I am just too coy!!

Germany caught in euro straitjacket

By Eddie Lee

EUROPEAN Central Bank (ECB) president Wim Duisenberg should be eating his hat. But the Germans won't find that funny. And Asia had better take notice, for Germany is the world's third-largest economy and is heading the way of Japan, the world's second-largest economy. When the ECB made its decision to hold its main refinancing (refi) rate steady at 2.5 per cent last month, the central bank said 'a gradual strengthening of growth is expected later in 2003 and to gather pace next year'.'Factors supporting this outlook are the expected recovery of global demand and the low level of interest rates,' it declared.A month later, the ECB hastily cut its refi interest rate by 50 basis points to 2 per cent. In its latest twice-yearly projections for the euro zone economy, growth forecasts for both this year and next were slashed.

This year's growth is put at just 0.7 per cent against December's estimate of 1.6 per cent. Next year, growth is expected to pick up to 1.6 per cent, but still well below the euro zone's long-term trend rate of 2 to 2.5 per cent.Mr Duisenberg urged governments to reduce pension costs and unemployment instead of calling for further interest rate cuts.If he got it so wrong on monetary policy, what confidence would you place on his assessment of the efficacy of pension reforms to solve the problem?Germany is in a bind.

The ECB uses average inflation and growth rates to base its monetary policy. While the euro zone's economy is still growing, the German economy has already contracted in the past two quarters.As former Bundesbank director Wilhelm Nolling told the London Telegraph this month: 'The truth is that the ECB is trying to carry out an impossible task. You cannot set one interest rate for 12 very different nations - that's a problem which won't go away.'He added: 'Deflation has already arrived, in that our economic dynamism has disappeared. There is no willingness among the private sector to invest, and euro zone rules have cut back public investment to an extent we haven't seen since the war.'

German Chancellor Gerhard Schroder's Agenda 2010 plans to tackle Germany's problem with structural reforms that Mr Duisenberg would approve. The key elements are to change the system of unemployment and pension benefits, and to alter the employment law allowing greater contractual flexibility.The patient, however, may not be in a condition to take this medicine.Germany's rigid labour market and its generous welfare state are well known.

There is growing awareness of the problems of Germany's ageing population. If you discount immigration and children born to parents of non-naturalised immigrants, the German population is shrinking.In less than 40 years, there will be just one working-age German supporting one retiree, compared to almost three to one today. But reality is worse than the statistics. There are many working-age Germans who are unemployed, and the situation looks like it is worsening.

The most direct impact of ageing will be the staggering fiscal cost. Washington's Center for Strategic and International Studies estimates that the cost will be equivalent to an extra 25 per cent of payroll in old-age benefits. This comes on top of payroll tax rates that already exceed 40 per cent.The pension system is in need of reform. But there are serious complications. And it would be simplistic to say the cause of Germany's problems lies in the intransigence of its unions.Both pension and labour reforms essentially relate to reducing the cost to the company of 'retiring' workers.

Downsizing, or rightsizing, the labour market amounts to a reduction in the value of the worker. Arguably, it is market driven.But as economist Edward Hugh from the University of Barcelona explains, pension reforms will devalue workers' life savings, and is no different from money lost in a bank account.He said: 'For many years, there has been an implicit contract between company and worker that the worker remained with the company, and gave his accumulated experience, in return for job security and anticipated compensation when the time for retirement came.'Then, suddenly, workers are to receive less financial compensation when they leave. The market value of life savings just changed. This devaluation is as important for the economic structure as asset price deflation, but receives much less attention.'German labour and pension reforms are important. But it is surely mistaken to tout them as the economy's elixir.

As Mr Hugh argues, 'sending a lot of middle-aged people out onto the street, with reduced pension expectations and limited job expectancy' does not sound like the way to jump-start an economy.Germany's path to recovery is fraught with danger. But its starting point must surely be to unchain itself from the straitjacket of the euro. It needs to take charge of its macro arsenal and decide the appropriate fiscal and monetary policies for its economy.

The clear and present danger is shrinking demand. Yet the complications of an ageing population mean that German society must also change its mindset and accept immigration as a solution. For how else can it avert the looming pension crisis without seriously deflating its economy?Mr Duisenberg may finally be right about one thing: 'Monetary policy cannot by itself solve the problems underlying the weak growth and employment performance.'
Source: Straits Times

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