Germany's feeling the pinch

Duisenberg: "We observe some straying"

By BBC News Online's Stefan Armbruster

Germany, Europe's largest economy, is trapped in an economic pincer movement as it struggles to create jobs and boost growth within the constraints of the euro.

Growth figures due out this week are likely to bring more bad news for the government, which must face the electorate next year with an unemployment rate of 3.86 million or 9.3% of the workforce.

At some time this year it will be clear we won't reach the deficit target and Eichel will have to go to Brussels and tell them that.

Christoph Hausen
Commerzbank

Business confidence is also at a low ebb, although new figures released on Wednesday showed no further falls -but the growth figures on Thursday are expected to show that the economy has stalled or may be contracting.

Germany's finance minister Hans Eichel has already described Germany's economic condition as "unsatisfactory", and he is picking this moment to question the European "stability pact", which underpins the euro.

Under that deal, the countries of the eurozone agreed not to run budget deficits in order to ensure that there was no inflation which might threaten the success of the single currency.

European interest rates, at 4.5%, are above those in the United States - and the ECB, which sets rates throughout the 12 eurozone countries, has proved reluctant to cut rates further.

Instability pact?

It appears that the targets of the stability pact and promises made during the last election will both be broken by polling day.

Stability Pact

The EU Stability Pact requires euro zone members to achieve balanced budgets in the medium term or face possible fines.

The pact was designed to limit excessive spending by euro zone governments.

The global economic slowdown has applied a tourniquet to government tax revenues, limiting its spending power under the stability pact's deficit target.

"At some time this year it will be clear we won't reach the deficit target and Eichel will have to go to Brussels and tell them that," says Christoph Hausen, the Commerzbank's economist for Germany and the euro zone.

Chancellor Gerhard Schroeder's promise that he would bring unemployment down to 3.5 million by the time he sought a second term also looks unachievable.

German companies including Infineon, truck maker MAN and Dresdner Bank were amongst companies that cut over 17,000 jobs last month.

Germans have not benefited from tax cuts

"You can't blame the government wholly because they have introduced structural tax reforms which have helped (to stimulate the economy) but were largely cancelled out by the high the oil price," says Mr Hausen.

Germany's main trade union body, the Deutscher Gewerkschaftsbund (DGB) agrees.

"The government has done everything it can within the confines and can't always stimulate the economy because you have to be careful the deficit doesn't get too big," says the DGB's chief economist Wolfgang Scheremet.

"The weakness is not because of any mistake of the government's but due to high energy costs and the global economic downturn."

German stimulus

Last year the Schroeder government restructured business and personal taxation by limiting corporate taxes to 36% while the top band of income tax was to be cut from over 50% to 42% by 2005.

We are concerned that the current unfavorable environment could affect the will of different countries (in the euro zone) to attain objectives fixed in the Growth and Stability Pact.

Wim Duisenberg
ECB President

But that has not been translated into economic growth and the government has twice lowered growth forecasts for 2001 from 2.75% to 2% and most recently to between 1.5% and 2%.

"Tax reforms have released 20bn Deutschmarks (£6.5bn, $10bn) into the economy but there are two reasons this has not translated into higher spending. The price of oil and food have increased and households are saving because of the uncertainty of workplace security," says Mr Hausen.

Next move

But Hans Eichel, who cannot rely on interest rate cuts by the European Central Bank (ECB) to stimulate the economy, is under increasing pressure to create jobs and stimulate growth before the election.

Over the past week he has suggested that euro zone governments should focus more on public spending and not on revenues.

"In my mind it is important that we pursue a course of (budget) consolidation, regardless of whether revenues are up or down in any one particular year due to economic conditions," Mr Eichel said last week.

Christoph Hausen thinks this is "totally the wrong signal to be giving".

"In a European context, Germany established the stability pact and when the founder questions the basis then what signal does that send out?" he adds.

Mr Eichel's assertions have unsettled the financial markets and he has retreated from the remarks.

But the DGB thinks that we are "not in a normal" economic situation and that there may have to be a bit of "forgiveness".

"The question is 'Should the government do anything?' It should stay passive and not stick to the deficit quota," says Mr Scheremet.

"The fault lies with the ECB. Tight monetary policy and loose fiscal policy are just not sustainable".

Interesting rates

The US Federal Reserve cut rates for the seventh time on Tuesday to 3.5% and the prospect of slowing growth, falling business sentiment, and cooling euro zone inflation are seen as raising the chances that the ECB may cut its interest rate of 4.5% on 30 August.

Lower tax revenues due to the global economic slowdown means Germany is not the only one at risk of missing its deficit target, but also France and Italy.

"We are concerned that the current unfavorable environment could affect the will of different countries (in the euro zone) to attain objectives fixed in the Growth and Stability Pact," the president of the ECB, Wim Duisenberg, said in July adding, "And we observe some straying".

German annual inflation is expected to edge up in August to 2.7% but economists are confident that falls in the price of food and oil will bring this down again.

Eurozone inflation slowed to 2.8% in July from 3% in June and its eight-year peak of 3.4% reached in May.

There may also be some relief when eurozone ministers discuss how much deficits could rise due to the weaker economy at their next formal meeting in October.

European Union policy guidelines agreed in June would allowed governments to post higher than forecast deficits in 2001 and probably also in 2002.