A pair of deadbeats
Sep 18th 2003
From The Economist print edition
Can Germany and Japan be reinvigorated?
THEY are the world's second- and third-largest economies,Measured at market exchange rates,
Japan and Germany together make up about 20% of global output,And they are both in a
mess,
Germany's economy has been stagnant for three years,It is the sickest in a region with many
weaklings,Unemployment is running at 10%,Japan's economy has barely grown for a decade,
the worst performance of any rich country since the Great Depression,Both unemployment and
public debt levels have doubled over the past ten years,Very recently,however,it has begun
to show signs of life,
Japan and Germany (along with the rest of western Europe) also face serious demographic
challenges as their populations age and fertility declines,Fertility rates in both countries are
well below the level needed to keep the population constant,With a median age of 41,Japan
has the oldest population in the world,Germany,Italy,Sweden and Switzerland are close
behind,These demographics will make Japan and western Europe the first victims of the
pension time-bomb that hangs over most of the rich world,
In America,by contrast,the population is younger and both fertility and immigration are
higher,According to projections by the United Nations,on present trends the median age of
Americans,now 35,will rise by only five years by 2050,and the population will grow by over
40%,Japan's median age,on the other hand,will rise by 12 years to 53,and its population will
fall by 14%,Germany's is due to drop by 4% and Italy's by 22%,Falling and ageing
populations will make it harder to boost demand,As people age and their children grow up,
they tend to save more and spend less,though usually after retirement a prolonged period of
dissaving sets in,
But difficult demographics are only one factor,More importantly,continental Europe's and
Japan's economies have miserably failed to live up to their own potential,thanks largely to
home-made policy failures,Better economic policy could give both regions a shot in the arm,
and would certainly help the global economy to rely less heavily on America,
Top of the list in both Europe and Japan must be structural reforms to make labour and product
markets more flexible and,in Japan especially,to overhaul the banking system,In addition,
both need better macroeconomic policy to make reforms politically viable and allow them to
work,
Does either region have the political will for reform? And can such reform be introduced ahead
of the coming American current-account adjustment,which will make the task that much
harder?
Frozen in time
In Europe,Germany is clearly the toughest nut to crack,It is plagued with rigidities and
saddled with a huge,unaffordable welfare state,As a result,its trend GDP growth rate,at
1.5%,is the lowest in Europe,Until recently,Germany was also the least interested in reform,
While the rest of Europe started,tentatively,to free up labour markets in the 1990s (creating
more than 10m new jobs),Germany did virtually nothing,So when the global economy
weakened in 2001,Germany was hit the hardest,But at long last even Germany is beginning to
make a move,
Four months ago,if you were planning a dinner party on a Saturday night in Germany and had
failed to buy the food before 4pm,your guests would go hungry,Every shop would be shut,by
law,But new opening hours introduced in June give the would-be Saturday host until 8pm to
stock up,After that,he should head for the nearest petrol station,which can stay open much
later,Though officially allowed to sell only,travel provisions”,petrol stations have stretched the
term to include such obvious motoring essentials as wine,ice-cream and washing powder,
Nor is ice-cream after hours the only innovation,In March Germany's chancellor,Gerhard
Schr?der,launched,Agenda 2010”,a package of reforms aiming to cut wage costs and make
the economy more flexible,These include shortening the period during which unemployment
benefit can be drawn,raising pension contributions and revamping health-care benefits,Mr
Schr?der also wants to bring forward a long-planned reduction in the top rate of income tax,
The idea is to have all these reforms in place by the beginning of next year,Though this is far
from certain to happen,there are encouraging signs,Mr Schr?der has secured agreement from
the opposition on sizeable chunks of the agenda,including health-care reforms and bringing
forward the planned tax cuts,
If successfully implemented,Agenda 2010 would have big long-term benefits,It would make
German labour markets substantially more flexible and reduce the burden on employers of high
pension and health-care costs,In a recent study the IMF concluded that reducing the rigidities
in Europe's employment and product markets to America's levels would boost the region's
output by 10%,Agenda 2010 may not turn Germany into America,but according to Adam
Posen,an expert on Germany at the Institute for International Economics in Washington,DC,it
is the most ambitious package of reforms Germany has seen in 40 years,
Nor is Germany the only European country trying to make its economy more flexible,The
French government passed a big pension-reform package in July,defying widespread strikes,
Although the package excludes mollycoddled and strike-prone groups such as railway and utility
workers,it goes much further than anything attempted before,Next on the agenda is the
rationalisation of French health care,to be tackled later this year,
Fine efforts,but will these reforms (assuming they materialise) actually boost demand? After
all,without higher domestic demand Europe will not be able to play its part in rebalancing the
global economy,
In the long term the answer must be yes,Structural reform will allow Europe's economies to
grow faster,thus allowing a sustainable rise in overall spending,But in the short term,the
answer is less clear-cut,Reduced wage costs and greater flexibility should cause firms to invest
more,but cutting long-cherished benefits and weakening safety nets may also prompt workers
to save more,particularly if the overall economic environment is tough,That is why it is so
important for Europe to get its macroeconomic policy right,
Tight-fisted
This presents a problem,For despite continental Europe's economic weakness,macroeconomic
policy there has been far tighter than in America or indeed in Britain,This year,fiscal policy in
America has been loosened by almost 2% of GDP,whereas in the euro area as a whole,and
especially in Germany,it is being tightened (see chart 9),
The tight fiscal policy in Europe has resulted mainly from
Europe's self-imposed policy strictures,particularly the
Stability and Growth Pact,This requires countries in the
euro zone to limit deficits to a maximum of 3% of GDP,
other than in extraordinary economic circumstances,
Countries that run excess deficits and fail to reduce them
can be fined by the European Union,But the efforts to
comply with the pact have led to perverse results,Earlier
this year,for instance,Germany was talking about
raising taxes in the middle of a recession to get its
budget deficit down,
However,the roots of Europe's macroeconomic stance go
well beyond the stability pact,Whereas America has
rediscovered Keynes with a vengeance,European
officials remain deeply sceptical about the ability of
macroeconomic loosening,and particularly fiscal
loosening,to smooth economic cycles,European
economists,including several based at American
universities,have spearheaded research that shows how,
in theory,fiscal tightening (especially spending cuts) can
actually boost the economy,A recent study by the
European Commission claimed that roughly half the
instances of fiscal tightening in the EU during the past
decade had been followed by faster economic growth,
Conversely,they argue,the evidence that fiscal
expansion works is much thinner,
They have a point,Given that Europe's overall fiscal
position is worse than America's—with higher tax rates
and bigger debt burdens—there is less room for loosening and greater benefits to be reaped
from discipline,But that does not mean that fiscal policy has no role to play,
Indeed,Europe's big economies now seem to be coming round to the view that it has,France,
Germany and Italy,as well as Portugal,are currently flouting the 3% ceiling on deficits,Yet
Germany is hoping to bring forward much-needed tax cuts that are likely to make the deficit
worse,France,too,looks set to breach the stability pact again next year and Jacques Chirac,
France's president,advocated a,temporary softening” of it this summer,The point is not that
Europe can,or should,spend its way out of the current downturn,but that fiscal policy should
avoid aggravating cyclical downturns,With luck,that trend has now started,
Monetary policy in the euro zone has also been tighter than in America,Since the beginning of
2001 the European Central Bank (ECB) has cumulatively cut short-term interest rates by 2.75
percentage points,whereas the Federal Reserve has cut short-term rates by 5.5 percentage
points,Here,too,the differences are partly due to intellectual attitudes and partly to self-
imposed rules,
Whereas Alan Greenspan,the chairman of the Federal Reserve,has adopted the role of
recession-avoider-in-chief (in line with the Fed's goals of maximising employment as well as
stabilising prices),Europe's central bankers have been dogmatic inflation fighters (their only
official goal being inflation close to,but below,2%),They are also self-styled drill-sergeants for
structural reform,
Despite widespread criticism from the IMF,the OECD and the financial markets for cutting rates
too slowly,the ECB remains unabashed,Wim Duisenberg,the bank's boss from its inception,
once famously quipped that a bout of falling prices was a central banker's dream,He has
regularly claimed that Europe's problems are structural,not monetary,Jean-Claude Trichet,a
former governor of the Bank of France,who is expected to take over from Mr Duisenberg in
November,may take a softer line,
But it is not just a question of personality,A large part of the difficulty lies in making policy in a
currency union of 15 disparate economies,The ECB's decisions on interest-rate changes are
based on region-wide inflation averages,which across the euro zone as a whole have
consistently bumped up against the ECB's target of 2%,However,inflation in Germany—which
makes up 30% of the euro zone's economy—has been rather lower than the average,So
interest rates that are appropriate for the euro zone as a whole are too high for Germany,
To aggravate matters,Germany has a much weaker banking system than the rest,Like Japan,
it has too many unprofitable banks that need rationalising and restructuring,While this is being
done,banks are reluctant to lend,so credit growth is stagnant,The pessimists about Europe
say that the state of Germany's banks,its structural rigidities and its low inflation raise the
spectre of Japan-style deflation that could sink the economic prospects of the entire euro zone,
Do trains pull locomotives?
Optimists about Europe—of whom there are a few—suggest that whereas the ECB may not
have loosened interest rates enough for Germany,its cuts should be enough to get demand
going again in the rest of the euro zone,Growth there,they argue,will eventually pull Germany
along too,Analysts at Goldman Sachs,for instance,point out that real interest rates outside
Germany are negative,and that the euro zone as a whole has a relatively healthy balance sheet
and little spare capacity,They reckon the ECB's rate cuts so far will be enough to boost the
growth in domestic demand in France from 1.1% this year to 3.1% next year and in Italy from
1.4% to 2.9%,
Given Germany's weight in continental Europe,the idea of robust European growth without
Germany seems a stretch,But whether the macroeconomic optimists or pessimists win the day
depends in large part on what happens to the euro,
The lobby of the ECB's Frankfurt headquarters is decorated by a large round mural of the euro
currency,half bathed in sunshine and half submerged under water,This strange installation
symbolises the risks facing Europe,and hence the world economy,If the euro emerges too
quickly into the sunshine,it could sink Europe's economies,because the overall economic effect
of a stronger euro is similar to a tightening of monetary policy,Indeed,the ECB's rate cuts this
year have barely offset the rise in the euro,A further drop in the dollar and appreciation in the
euro,particularly a sharp one,would soon far outweigh any monetary loosening from the ECB,
Tighter macroeconomic conditions would not only deter growth in demand,but would also
make much-needed structural reforms politically more difficult,
In short,a fast-rising euro,which could take some of the pressure off America's current-
account deficit,could harm Europe's economies,and hence any hope that a second engine for
the global economy might get started,
If Europe's macroeconomic policies have made a difficult situation worse,then Japan's have
turned a structural problem into a slow-motion disaster,Although the details are different,the
broad script—necessary structural change put off and then made harder by macroeconomic
ineptness—is exactly the same,
Will the sun ever rise?
Japan's main problem is its inability to restructure the financial system that collapsed after the
1980s bubble economy burst,Too many bust banks remain open,keeping too many
unproductive firms alive and locking resources into weak areas of the economy,The
prescription is simple,Japan's banking system needs an overhaul to create a more effective
system of credit intermediation which,in turn,would force much-needed corporate
restructuring,Yet for a decade the government has failed to come to grips with the problem,
This has caused the economy to stagnate and get caught in a deflationary cycle,With prices
falling,the real value of the debt held by Japan's bankrupt banks and firms has risen,
deepening the financial quagmire,
Conventional wisdom argues that Japan tried,and used up,all the traditional fiscal and
monetary tools,Though government debt doubled and short-term interest rates fell to zero,the
economy stayed in a rut,Keynes seems to have failed,
The reality is more subtle,As the IIE's Mr Posen,and Kenneth Kuttner,of the Federal Reserve
Bank of New York,have persuasively argued,Japan's fiscal policy has on balance been tight,
Despite intermittent huge public-spending programmes,they point out,over 80% of the
increase in Japan's public debt has been due to lower tax revenues from a shrinking economy,
On the monetary side,the Bank of Japan did too little,too late,It was slow to cut interest rates
after the bubble burst in 1990 and refused to reflate the economy by printing yen to buy
government bonds or other assets,Though there have been tentative efforts in that direction
during the past year,they did not pack enough of a punch once deflationary expectations had
set in,Instead,Japan's most proactive macroeconomic policy has been massive intervention in
the currency markets to stop the yen appreciating against the dollar and cutting off the
relatively small but vibrant export sector,So far this year the Japanese government has spent
around $80 billion buying dollar assets,In other words,Japan's only policy has been to stave
off the dollar devaluation that would help to rebalance the world economy,
Can Japan sort out this mess? At first sight,the task looks more manageable than Germany's,
Japan's problems are concentrated in the financial sector,whereas Germany's span the entire
economy,But unlike Germany,Japan is showing no sense of urgency,nor does it have a clear
reform agenda,There have been some signs of progress,particularly the government's recent
bail-out and restructuring of Resona bank,But there is still little evidence that policymakers are
willing to undertake large-scale financial reform,
A number of outside observers have concluded that Japan must be forced to undertake
structural reform by letting its currency appreciate substantially,They argue that during the
second half of the 1990s the weakening of the yen allowed Japan to put off structural reform,
and that now the government is deliberately putting it off further through its currency
intervention,A much stronger yen would bring about the much-needed structural reform,at the
same time as helping to reduce the American current-account deficit,
A little arm-twisting
Fred Bergsten,head of the IIE,is one of the most vocal proponents of this thesis,In a recent
testimony to Congress he said America should tell the Japanese to stop intervening to keep
down the yen,If necessary,the administration should threaten to sell dollars to offset the
Japanese efforts,However,many economists disagree with Mr Bergsten,arguing that the
tighter macroeconomic environment created by a sharply raised exchange rate would aggravate
deflation and make the banking reform unnecessarily painful,Even John Snow,America's
Treasury secretary and the man ultimately responsible for any currency intervention,
acknowledged that Japan's desire to stop its currency appreciating is understandable.,They
need a strong export sector to get their reforms done,” he said this summer,
More important,the process of reflation—crucial to getting Japan out of its mess—is likely to
mean a weaker rather than a stronger currency,at least in the short term,There is a growing
consensus among Japan-watchers,led most recently by Ben Bernanke,a governor of America's
Federal Reserve and a renowned monetary economist,that an ambitious combination of fiscal
and monetary easing,coupled with a clear inflation target,would jolt Japan out of its
deflationary spiral,In a recent speech in Tokyo,Mr Bernanke argued in favour of big tax cuts
financed by the purchase of government bonds by the Bank of Japan,
This might prove the surest route to boosting Japanese demand,but it is unlikely to strengthen
the yen,at least in the short term,And even as it got the Japanese economy going again,thus
helping to reduce the world's over-dependence on America,it would aggravate another problem
which adds to that dependence,the extreme reluctance of most of America's Asian trading
partners to let their currencies appreciate,
Copyright? 2004 The Economist Newspaper and The Economist Group,All rights reserved,
