Economic Trends and Market Outlook
The German economy is the world's third largest, and alone accounts for somewhat more than one-fourth of the European Union's GDP. Among European countries, Germany is the United States' second most important trading partner. The German "social market" economy is organized on free market principles but affords its citizenry a degree of unemployment, health and educational insurance and guarantees which go substantially further than such programs in many other industrialized societies. The country's broadly diversified economy affords its citizenry one of the highest standards of living in the world. As one of the world's foremost trading nations, Germany traditionally has enjoyed a substantial trade and current account surplus, although reunification and the resultant surge in demand from the country's eastern region has reduced the trade surplus to such a degree that it no longer compensates for Germany's traditional deficit in services. A strong currency and continued international confidence in the management of Germany's monetary policy ensure full access to external financing.
In the middle of 1994, the prospects for the German economy are looking up. Anticipated growth this year and next will be moderate; in addition, unemployment will remain an intractable problem for the foreseeable future. In 1993, the all-German economy contracted by 1.2 percent, as 7 percent real GDP growth in eastern Germany was not enough to offset nearly a 1.9 percent contraction in the west. Increased exports and investment will contribute to a modest recovery in real output in western Germany in 1994-95. However, consumer spending will remain weak as net real wages will drop and unemployment will rise to around 9 percent, owing to lagging job creation, an inflexible labor market, and structural change in key industries. Eastern Germany will continue to record rapid growth, as large social transfers from the West support personal incomes despite un- and underemployment of up to 30 percent caused by the transformation of the former GDR to a market economy. Although inflation will ease to around 2.0 - 2.5 percent in the west (somewhat higher in the east) by the end of 1994, government and central bank officials see little scope for fiscal or monetary policy stimulus to enhance lagging domestic demand even in the run-up to national elections in October.
The consensus expectation among German forecasters for 1994 is recovery to positive real growth of 1 to 1.5 percent in western Germany, and some further pick-up to perhaps two percent 1995. Continued seven to eight percent growth in eastern Germany will raise all-German growth but it still will reach only about 1.5 to 2 percent. Private consumption spending throughout Germany is expected to decline in 1994, and still show only limited improvement in 1995. This reflects declining real disposable income in western Germany, owing to increased taxes and social security contributions, continued decline in total employment, and a drop in real wages. In the east, wage growth will slow and social transfers will level off. Overall economic growth thus will be largely led by exports and to a lesser extent by increased investment spending (especially in eastern Germany).
German Economics and Finance Ministry officials and private economists all agree that increased foreign orders (4.2 percent higher in the first quarter of 1994 compared to a year earlier) are the most promising indicator of future increased western German exports and overall output. They also point to business confidence surveys which show rising optimism about economic prospects. These developments are mainly attributable to changing cyclical conditions, namely economic recovery abroad and lower labor costs and lower interest rates in Germany. After annual average real wage increases of two percent in western Germany in 1991-92, real wages dropped almost one percent in 1993 and are projected to decline by as much as two percent in 1994 as the result of recent contract settlements. Long-term interest rates stood around 6.8 percent in late May 1994, significantly lower than their peak of 9.2 percent in September 1991.
In eastern Germany, total domestic demand is nearly twice the level of output, with the gap being financed by net transfers of approximately DM 140 billion. While overall GDP expansion thus is completely dependent on outside assistance, progress nonetheless is evident in the slowing of growth in private consumption (from 7.3 percent in 1992 to projected zero to one percent in 1994) and the simultaneous sustained strong pace of investment (16 percent in 1993 and anticipated similarly strong rates in 1994-95). Public sector infrastructure investment is leading the way, but opinion surveys reflect improving sentiment also among business firms in the east.
Despite what have been characterized as "mildly optimistic" economic prospects, there is a consensus that serious long-term structural problems will remain in western Germany even as cyclical recovery occurs in 1994-95. Excessive regulation of business and continued expansion of the country's very generous social security system have introduced disincentives to entrepreneurial activity and labor mobility. The associated increased costs of production and drag on productivity and competitiveness are matters of widespread concern. Several economic institutes have called for deregulation and accelerated privatization of government enterprises. The president of Germany's central bank (the Bundesbank) has repeatedly cautioned that Germany needs a fundamental reform of its social security system (pensions, health, unemployment compensation, and welfare).
In the private sector there is evidence of some structural change. In the face of low capacity utilization and rising unemployment, labor unions in the 1994 wage round accepted settlements implying real cuts in wages. Reduced unit labor costs will result from businesses' consolidation and trimming of their work forces, which contribute to improving productivity; however, this also is contributing to increasing unemployment. As elsewhere, job creation lags recovery in Germany as initially a fuller use of existing capacity occurs. Aggravated by fundamental shifts from traditional manufacturing to high-tech and services, the western German labor market is expected to experience an increase in unemployment from 7.3 percent in 1993 to about 8.5 percent in 1994 and around 9.0 percent in 1995.
The process underway in eastern Germany is the very quintessence of structural change. Approaching the fourth year of German economic and monetary union (effected in July 1990), the eastern German economy elicits metaphors such as "shock treatment," "hothouse growth," and "forced feeding." The unprecedented privatization of thousands of formerly state-owned enterprises is nearly complete. A massive shift of resources from basic industries to construction and other services is well under way. Public investment has modernized telecommunications and transportation very rapidly. An array of tax breaks and low- interest loans have attracted investment, much of it away from western Germany. On the other hand, wage rates increased too rapidly in 1990-93, eroding an important element of competitiveness, greatly raising the incidence of bankruptcy, and contributing directly to massive unemployment. However, current job creation appears to be catching up with continuing job losses - official unemployment is expected to level off at about 16 percent in 1994-95, while disguised unemployment (forced early retirement, short-time work, retraining programs) should remain at perhaps an additional 15 percent.
The government's declared primary objective is the restructuring and integration of eastern Germany into the overall German economy. The chosen approach, although criticized by some as an excessive financial burden on the west, is to support personal incomes and consumption in the east at near western levels through massive transfer payments, while also promoting public and private investment. The latter aims at creating a local capital stock adequate to generate jobs and raise productivity and competitiveness, which in turn eventually will close the consumption/production gap and permit self-sustained economic growth. The stated overall goals in western Germany are to restore non-inflationary economic growth of 2.5 to 3.0 percent and encourage private and public structural change.
There is considerable consensus on these objectives but growing disagreement on the appropriate policies to achieve them. Some outside of government have questioned the appropriateness of budgetary constraint in the midst of recession and have called for accelerated monetary easing to lead short-term interest rates lower.
The government, however, perceives financial and political constraints on its ability to promote growth and to implement its ambitious agenda of structural reform. It is committed to continued extensive income support in the east (and the west), but in 1994-95 will restrain other expenditures and raise taxes in a determined effort to reverse the dramatic deterioration in the fiscal accounts and associated increase in public sector debt that occurred in 1990-93. Political sensitivities in an election year suggest that large privatizations, meaningful cuts in subsidies, and fundamental regulatory/social reforms will be postponed until 1995 or 1996.
On the monetary side, the Bundesbank has continued to relax its stance. Some believe that this has occurred in light of the recession and the widespread expectation that consumer price inflation in western Germany will decline from a peak of 4.4 percent year-over-year in January 1993 to perhaps less than 2.5 percent year-over-year late in 1994. In 1994, despite first having decelerated the rate of monetary easing because of concern over rapid M3 growth and alleged vulnerability of the DM, the Bundesbank has cut Germany's discount rate on four occasions to the present level of 4.5 percent. Many observers now believe that long-term interest rates bottomed out when they fell to near 6 percent earlier this year, and that there remains only limited scope for further cautious easing of short-term rates in 1995.