German Macro Policy Time to relax a little

German Macro Policy
Time to relax a little?

The German government is only in the first throes of rethinking its austere approach to fiscal policy, Gavyn Davies told a lunchtime meeting on 9 March. The agreement earlier this year to cut taxes in 1990 was encouraging, but Davies argued that more radical policy changes would be needed to avoid a slump in the growth of output during the next 18 months. Because the German economy is now constrained by demand- rather than supply-side factors, an overall easing of macroeconomic policy should allow real output growth with very little effect on inflation. But if the fiscal stance were eased without an accommodating monetary policy, the real exchange rate would be likely to appreciate further. This would probably 'crowd out' the effects of the fiscal relaxation, leaving the economy still very depressed.

Gavyn Davies is Chief UK Economist at Goldman Sachs International and a Governor of the Centre. He is also an Adviser to the House of Commons Select Committee on the Treasury and Civil Service and was an Economic Adviser in the Prime Minister's Policy Unit (1974-9). The lunchtime meeting at which he spoke was one of series sponsored by the German Marshall Fund of the United States, focusing on the international economy. The opinions expressed by Mr Davies were his own, however, and not those of the German Marshall Fund or of CEPR, which takes no institutional policy positions.

Davies began by surveying the behaviour of the German economy over the past decade. He argued that the Kohl government's desire to implement a programme of fiscal 'consolidation' was initially understandable, since there was evidence that economic growth was then constrained mainly by supply phenomena, notably the failure of real wages to fall in the late 1970s in response to increased energy prices. The absence of real wage adjustment caused a squeeze on profits, which reduced the overall level of investment and shifted investment towards more labour-saving (capital-deepening) techniques. As a result the German capital stock was then inadequate, and this constrained overall economic expansion. It also prevented employment from growing, as it normally would have following the 1978-81 fiscal stimulus (which represented about 2.7% of GNP). At that time the rise in the government debt/GNP ratio was beginning to concern both the government and the private sector, and this may have led to the unusually large increases in real interest rates which accompanied the fiscal relaxation of the early 1980s.

The Kohl government tightened the fiscal stance by the equivalent of about 3.5% of GNP from 1982-5. At the same time, the Bundesbank allowed real interest rates to rise to exceptional levels. Davies argued that the tightening in fiscal policy after 1982, though understandable in terms of the need to control the public sector debt ratio, reduced the growth rate of nominal demand. This initially increased actual unemployment above the NAIRU (the non-accelerating-inflation rate of unemployment), and led to downward pressure on inflation. Tighter policy succeeded in disinflating the economy, but only at the cost of considerable lost output. The economic 'recovery' after 1982 owed much to a rise of 7% per annum in export volume, stemming mainly from additional sales to the United States. Contrary to the theoretical predictions of the supply-siders, lower inflation did not revive growth in real demand and restore the economy to its original unemployment rate but with a lower rate of inflation. Instead, the reduction in the inflation rate was associated with a drop in the rate of real output growth as well, and the economy became trapped in a spiral of low growth, low investment, and high unemployment.
This had undesirable long-term effects on the supply side of the German economy and may have increased the NAIRU itself. Recent research suggests that the long-term unemployed gradually lose their skills and motivation and tend to withdraw from the labour force. Since they no longer compete actively for jobs, they cease to place downward pressure on wage bargaining. Prolonged high unemployment can thus raise the NAIRU. According to OECD estimates, the NAIRU in Germany has almost doubled from 3.1% in 1977-82 to 6% in the last four years. Davies drew attention to cross-country econometric studies which indicated that this increase could be explained by demand-side variables (such as fiscal and monetary policy and world economic activity) rather than by supply-side variables (such as the real wage and import shocks).

The failure of unemployment to fall at a time when supply conditions (such as the share of profits) were improving suggested to Davies that inadequate demand was becoming the real constraint on the German economy. The fall in oil prices in 1986 had largely been absorbed in higher saving by the personal and company sectors and had not boosted growth. The surge in the Deutschmark, especially against the dollar, depressed Germany's share of world export markets to a greater extent than anticipated. Recent indicators suggest that the export sector remains weak and that investment demand is slackening. Real GNP growth in 1987 is unlikely on present policy to exceed 1-2%, according to Davies.

He maintained that since the economy is no longer supply- constrained, an easing in demand policy should have an immediate effect on output growth with little or no adverse impact on inflation. The German government is beginning to recognize this, but the sustantial tax cuts agreed by the coalition will not take effect until 1990. The German economy therefore needs an immediate stimulus from demand policy in order to avoid a slump in output growth in 1987-8. Should this stimulus come from the fiscal or monetary side? Davies argued that if monetary policy were unchanged, a fiscal expansion could cause a further appreciation of the real exchange rate, and the consequent loss of competitiveness would eliminate much of the intended boost to the economy. Fiscal policy is also constrained by an understandable reluctance to increase the public sector debt ratio. Davies calculated, however, that on the assumption of a 1% trend rate of inflation, the general government deficit could increase from the present 0.9% to around 1.75% of GNP without requiring any increase in the long-term debt/GNP ratio; but this may not be large enough to provide the required boost to economic activity. Monetary policy may therefore need to be eased simultaneously. Davies argued that the Bundesbank was beginning to realize that high real interest rates were exacerbating rapid monetary growth by attracting capital inflows from abroad, much as they did in 1978. Lower interest rates need not, therefore, lead to faster monetary growth, and even if they did inflation would not be much affected. An overall easing of policy would now affect output rather than inflation, Davies concluded.

The discussion which followed touched on whether an expansion without inflation was indeed possible in Germany. One questioner noted that labour costs had risen sharply in Germany in 1986 and 1987. Did this not signal a build-up in inflationary pressure? Davies disagreed: the share of profits in income showed no signs of falling and was at its highest level since the 1970s.