Buttonwood RESEARCH TOOLS Economist.comsuRveYs A pair of deadbeats Sep 18th 200 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 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 urope 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%0. Germany's is due to drop by 4%and Italy,'s by 22%o. 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
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 Schroder, 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 Schroder 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 schroder 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 regions 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 nationalisation 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
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 Schröder, 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 Schröder 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 Schröder 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 important for Europe to get its macroeconomic policy rig ent is tough that is why it is so to save more, particularly if the overall economic environm Tight-fisted his presents a problem For despite continental Europe' s economic weakness, macroeconomic olicy 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 Who's easy? euro zone to limit deficits to a maximum of 3% of GDP, Policy changes, 2000-02 other than in extraordinary economic circumstances Countries that run excess deficits and fail to reduce them 8o.5 Japan. can be fined by the European Union. But the efforts to comply with the pact have led to perverse results. Earlier/a 1.o Germany. Euro area Italy this year, for instance, Germany was talking about raising taxes in the middle of a recession to get its budget deficit down s Britain s2.5 However, the roots of Europe's macroeconomic stance go 53432 1-0+12 well beyond the stability pact. Whereas America has Change in structural fiscai balance rediscovered Keynes with a vengeance, European officials remain deeply sceptical about the ability of macroeconomic loosening, and particularly fiscal Expected policy changes, 2002-03 loosening, to smooth economic cycles. European German economists, including several based at American in theory, fiscal tightening(especially spending cuts)can/5Is. United States,francet universities, have spearheaded research that shows how,1.0 Italy Canada actually boost the economy. a recent study by the European Commission claimed that roughly half the Easier instances of fiscal tightening in the eu during the past 器25 decade had been followed by faster economic growth 3.0 Conversely, they argue, the evidence that fiscal 4321-0+12 expansion works is much thinner. Chonge in structural fiscal balance of potential GDP They have a point. Given that Europe's overall fiscal Source: IMF 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 orse. 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
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 tructural 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%to2.9% 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
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 selfimposed 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 ECBs 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 ighter 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 hav broad script-necessary structural change put off and then made harder by macroeconom he turned a structural problem into a slow-motion disaster. Although the details are different, the 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 overnment 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 tive macroeconomic policy has been massive intervention 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
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 currentaccount 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