Germany in crisis: the unification challenge, macroeconomic policy shocks and traditions, and EMU

Abstract

Conventional wisdom blames Germany's ongoing economic and fiscal crisis on the unification shock of the early 1990s and structural problems in labour markets. Challenging this view, this paper offers a fresh assessment that focuses on macroeconomic demand management. It is shown that Germany's fiscal crisis cannot be attributed to unification per se; it arose as a consequence of ill‐guided macroeconomic policies pursued in response to that event. Many structural problems that popped up along the way were mere symptoms of persistent macroeconomic mismanagement and protracted domestic demand stagnation. Arguably, systematically ill‐guided macroeconomic policies of this type are potent enough to wreck any real world economy, no matter how flexible it may be. Because Germany provided the blueprint for Europe's stability‐oriented macroeconomic policy regime, it comes as no surprise that a peculiar repeat of certain symptoms that started to arise in Germany a decade ago may now be observed across the euro area—protracted domestic demand weakness and inflation stickiness because of ‘tax‐push inflation’ in particular.

Keywords:

• German unification
• budgetary sustainability
• tight money
• policy inconsistency
• EMU

Notes

Estimates by the Bundesbank and the Council of Economic Experts (Sachverständigenrat [SVR]; in the following referred to as the ‘wise men’) seemed to suggest that the economy was running at its potential by 1989. Accordingly, these authorities were much surprised about the economy's ‘puzzling’ supply‐side elasticity as the unification shock hit (see SVR Annual Report 1990‐1, Art. 156; SVR, AR 1991‐2, Art. 120; Bundesbank AR 1990, p. 19, for instance. Of course, current estimates of potential output show a huge positive output gap around 1990—given protracted sluggishness of GDP growth since 1992. Von Hagen (1994) notes that the Bundesbank's forecasts of budget deficits were consistently on the high side. Kloten (1997) provides insights into the thinking behind the Bundesbank position. See Roloff (2002) for a critique of German fiscal dogma. See Schettkat (2003) for a critique of the structuralist explanation of European unemployment.

For instance, Schlesinger [Bundesbank president from 1991–1993] et al. (1993, p. 251) judge that: ‘In view of prevailing circumstances there was no realistic alternative to an increase in indebtedness in the short term’ (my translation). Perhaps it could be argued that the implementation of the third stage of the income tax reform might have been postponed (Vesper, 1995). If raising indirect taxes represented the alternative, this will be conceded. For German experience has clearly shown that a shift from direct towards indirect taxation may be hazardous if central bankers ignore distortions in headline inflation caused thereby (see below). Recall that when Keynes (1972) recommended tax hikes to restrain aggregate demand, he referred to a fully‐employment war economy largely cut off from external resources. Germany of 1990 and after was far from such conditions.

Figure 2 depicts an eclectic measure of core inflation designed to eliminate the direct effects of, first, the oil‐price shock of 1986 and, second, tax‐push inflation since 1991. Measures for core inflation and ‘tax push inflation’ shown here for the years 1992–1998 are based on Weeber's (1994, 1998) calculations, providing the most comprehensive index of its kind available for western Germany. Data for 1991 (western Germany) and 1999–2003 (All‐Germany) is based on the wise men's calculations. Apart from tax‐push inflation, policy‐induced inflationary pressures also emerged through the ‘Tooke effect’, as the wise men vigilantly observed that: ‘high interest rates contributed significantly to the increase in unit costs this year’ (SVR, AR 1990‐1, Art. 158; my translation).

The wise men's calculations (SVR, AR 1998‐9, tables 52 and D2), which have the advantage of also showing the role of privatisation revenues, are based on Financial Statistics rather than National Accounts. In the early 1990s, the former show a deficit that is roughly 1 percentage point larger than National Accounts data (relevant for the Maastricht fiscal criteria and used for cross‐country comparisons below).

Its monetary targeting strategy was partly responsible for the Bundesbank's ill‐guided policies. Initially, there was the fear that the conversion of East German marks might lead to a ‘monetary overhang’, a myth quickly debunked by Kregel (1991). As it turned out, monetary growth even undershot the Bundesbank's (arguably, too low) target for 1991, until it was revised downward in mid 1991. Monetary growth then accelerated with the ‘Schlesinger shock’ (a 100 basis points hike in key policy rates) in August 1991, and sizeable target overshooting occurred until mid 1994. Overshooting in these years did not reflect any inflationary risks though, as the Bundesbank and some observers (Neumann & Wesche, 1994, for instance) wrongly claimed, but the fact that the Bundesbank's tight stance caused an extreme inversion of the term structure and corresponding attractiveness of term deposits relative to bonds (see Flassbeck, 1992; Flassbeck & Pohl, 1992; Bibow, 1998).

Public demands that the Bundesbank should play a more active role in stimulating aggregate demand and employment were rejected by the Bundesbank, notoriously claiming that unemployment was largely structural (see Hesse & Naujokat, 1998, for instance). It is noteworthy that employment grew and unemployment fell quite significantly in subsequent years thanks to protracted currency weakness (i.e. monetary easing through the exchange‐rate channel) and strong US growth—while the OECD criticised Germany's labour market reforms (and hence, presumably, structural unemployment) as moving in the wrong direction.

As von Hagen (1992, p. 215) put it: ‘The Bundesbank gave a high priority to credibility considerations and chose a tight stance without too much regard to the risk of unnecessarily choking off the economic growth badly needed in the transition phase’.

Since 1990 Germany's debt ratio has increased by more than 25 percentage points. Contrary to conventional wisdom, only a third of that is directly attributal to unification (Bibow, 2003b).

It should not be overlooked in this context though that private debt developments were the mirror image to the public sector's improvement; similar to the US (Godley & Izurieta, 2003).

The ECB's role in it was to act as a twofold propagation mechanism First, the ECB's ongoing communication problem brought market psychology up against the euro and created conditions akin to a one‐way bet situation. Second, misinterpreting its pro‐growth environment, the ECB ran into a time‐inconsistency problem so that its aggressive interest rate hikes weakened rather than bolstered the currency (Bibow, 2002a).

In the third quarter of 2003, US GDP growth was boosted to 8 per cent by massive fiscal stimuli. By contrast, domestic demand shrank [sic!] at an annual rate of six per cent in Germany; while an export spur pushed Germany's GDP growth back into positive terrain (following three negative quarters). Ironically, and much in contrast to its earlier assertions about Euroland as a zone of stability sheltered from external shocks (Bibow, 2002b, 2003a, 2004b), the ECB has developed a penchant for referring to imbalances ‘elsewhere in the world economy’ that might pose a risk to the euro area's export‐led [sic!] recovery of late 2003. The bank notoriously blames protracted domestic demand stagnation on ‘structural problems’ and fiscal profligacy.

The ECB (2003a, 2004) estimated that tax‐push inflation may have at times added little less than one‐half of 1 percentage point to headline CPI inflation in Euroland since 1999. In late 2003, tax‐push featured particularly prominently among factors that were keeping HICP stubbornly above 2% (FT.com, 17 December 2003), which also led the ECB to raise its projections for 2004 inflation accordingly (ECB, 2003b). The [Eurostat] data was kindly provided to me by the ECB, remarking that these were rough proxies (particularly the administered services price series) and should not be treated as official ECB data.