Mission Concluding Statement 

INTERNATIONAL MONETARY FUND

Germany—2001 Article IV Consultation

Concluding Statement

1. The past year has been one of setbacks and achievements for the German economy. Powered by an extremely favorable external environment, Germany was, until the middle of last year, enjoying its strongest growth spurt since the reunification boom. A series of shocks to prices and confidence abruptly derailed growth and, since the beginning of this year, unemployment has started to inch up again. However, the slowdown should not obscure the very important progress that has been made in structural reforms. Pension reform has broken the mold of an unsustainable system and created a better framework to address some of the looming pressures on social security. Tax reform has provided significant relief from a high tax burden and improved incentives for businesses and workers. Liberalization in telecommunications and utilities has yielded benefits for consumers and provided new business opportunities. To be sure, plenty remains to be done to increase the flexibility of the economy and to ensure that resources are fully and efficiently employed. Labor market reform heads the list. But the authorities have demonstrated an impressive ability to deliver change in sensitive areas and begin to tackle some of the major obstacles to strong growth.

2. Economic growth has been low in the past year and there are, as yet, few clues as to when recovery will begin. The proximate cause of the slowdown was rising energy prices. Subsequently, a sharp deceleration in global demand dampened confidence and export prospects—although the impact on actual export growth has so far been modest. Disease-related hikes in food prices further reduced consumers' real income. In the face of these setbacks, the 2001 tax cut proved timely, although consumers have so far saved it—perhaps because of increased uncertainty about economic prospects. We expect that as the year progresses price hikes will partly unwind and consumers will start to spend the tax cut, leading a recovery in domestic demand. Assuming such a recovery begins in earnest in the fourth quarter of this year, we project real GDP growth of about 1¼ percent in 2001 and 2 percent in 2002. The overall price level is expected to be broadly stable in the remainder of this year, so that headline inflation will drop to 2¼ percent by the end of the year and an average of only 1½ percent in 2002. While a quicker rebound in consumer confidence or steep energy price falls, could improve the outlook, downside risks also exist: the global economy remains fragile, a sharp appreciation of the euro could harm exports, and high energy prices could persist.

3. The nature of the slowdown, euro-area constraints, and the sizeable public debt burden limit the scope for active macroeconomic policies at this juncture. Monetary and fiscal policy cannot provide an effective antidote to the large part of the slump in growth stemming from higher energy prices; negative effects on incomes are unavoidable. It is critical that this is recognized in the 2002 wage round: efforts to make up for lower-than-expected real wages in the past year would risk setting off a cycle of stagflation and job losses. Other influences on demand, including from abroad, are also contributing to the drop in growth, and it is reasonable to ask whether an easing of monetary or fiscal policy could counter these. Even though, in our view, interest rate cuts would not pose much of a risk from a purely German perspective, monetary policy is driven by the ECB's euro-area wide view. We do not assume much relief from interest rate cuts in the period ahead, although that may change as circumstances in Europe evolve. As for fiscal policy, the benefits for short- term activity of any easing must be weighed against the costs of diminished credibility of deficit and debt reduction objectives, especially given Germany's pivotal role in the Stability and Growth Pact (SGP).

4. That said, fiscal policy should not be squeezed to hit the existing SGP deficit targets. Provided the growth of general government spending is kept to this year's budgeted rate and, next year, below the ceiling of 2 percent, departure from deficit targets due to cyclical weakness in revenues would not be problematic. On current assumptions, we project that the general government deficit will be about 2 percent of GDP in 2001 and 1½ percent of GDP in 2002, in both cases about ½ percent of GDP above the government's SGP targets. Such slippage should not be seen as a departure from the government's consolidation intentions: if the economy were to recover strongly enough over the coming years to eliminate estimated spare capacity, the target of a balanced general government budget in 2004 could still be met with existing tax and expenditure policies. It should be stressed that our deficit projections assume the same degree of fiscal consolidation next year (½ a percentage point of GDP) as in the SGP program. Even this degree of consolidation could present some risk to recovery next year. At this stage, however, with clear reasons to expect a recovery, the risk is acceptable and we would not advocate more stimulative measures, such as bringing forward tax cuts planned for 2003. If, at the end of the year, the outlook for global demand had deteriorated substantially or the domestic slump showed no signs of abating, this conclusion might be revisited.

5. The recent downturn in growth—the third aborted recovery in the past ten years—raises questions about the underlying resiliency of the economy. For sure, just as they were important in the upswing, external factors have played a role in the latest slowdown. Also, excess capacity in the construction sector and the need for fiscal consolidation—both legacies of reunification—have been serious drags on the economy. But the persistence of high unemployment points to insufficient flexibility to cope with change, diminishing Germany's growth potential—now estimated to be about 2 percent per year. As recent structural reforms gestate and the construction sector stabilizes, potential growth should pick up. However, further reforms are essential to improve active participation in the labor market, strengthen productivity growth, and ensure that Germany can take advantage of new growth opportunities.

6. In the labor market, trade unions have responsibly pursued wage moderation, and this needs to continue. The rewards to wage moderation were evident in the rise in employment prior to the current slump in activity. However, the full benefits of wage moderation will be felt only when wages are brought into line with productivity. A decisive commitment to continued moderation in the next wage round would not only have beneficial effects on actual and expected labor costs but also provide scope for much-needed increases in wage differentiation.

7. Job creation will be further enhanced by efforts to make employment practices more flexible and to allow wages to match productivity at the firm level. In this regard, reports of greater wage differentiation in eastern Germany are welcome. However, the recent strengthening of rights to part-time work and of co-determination represent moves in the wrong direction. Proposals to reserve public procurement contracts to firms that pay at least according to local collective bargaining agreements should be abandoned.

8. The problem of high unemployment among the low skilled calls for appropriately priced job opportunities as well as efforts to improve work incentives. Sufficient downward flexibility of wage costs to match skills needs to be combined with a reform of the benefit system, which currently provides, for too many people, little financial incentive to work. The generosity of unemployment benefits and social assistance should be examined with a view to limiting these disincentives. At the same time, schemes to reduce low-skill wage costs through a progressive schedule of social security contributions or earned income tax credits, need more serious and objective consideration. Better designed studies than the ongoing pilot projects in this area should be undertaken along with closer and independent scrutiny of active labor market policies to ensure that resources available for enhancing employment prospects for the low-skilled are used most effectively.

9. The breakthrough in pension reform is an important first step toward addressing future strains on the social security system and the upward pressure on contribution rates. Structural policies to promote economic growth can help to meet demographic challenges. So can immigration, a topic that is appropriately under public debate. But the future strains on both the pension and health care systems, in their current forms, will be intense under almost any scenario. Issues concerning the relative size of the public and private pillars of the pension system, the level of replacement rates, and retirement ages need to remain under discussion as more change will be necessary. The upward trend in health care expenses also puts health care at the top of the reform agenda.

10. More generally, we strongly endorse your medium-term goals for controlling the growth of public expenditure, lowering the tax burden further, and reducing the role of government in the economy. A fiscal framework focused primarily on expenditure restraint would help entrench these objectives and promote the degree of counter-cyclical fiscal management that is missing from deficit targets. Expenditure control is not just an issue for the federal government, but also needs to be a policy commitment shared by the Länder and Gemeinden. In the absence of a clear expenditure rule, regular reporting, monitoring, and assessment of fiscal projections and outturns of all levels of government, institutionalized through an inter-governmental institution such as the Finanzplanungsrat, would increase accountability. We welcome the improved incentives for efficient revenue collection in the recent reform of the Finanzausgleich. Also, the new Solidarity Pact clarifies longer-term public spending commitments to eastern Germany: the challenge will be to ensure that the substantial sum involved is spent effectively.

11. Recent liberalization of product markets has put Germany ahead of many European countries, but the reform momentum should not stop. Liberalization and privatization are still needed in several sectors, while barriers to effective competition remain to be addressed in some of the newly liberalized network industries. We welcome the recent elimination of formal regulations restraining rebates and gifts. Still, shop opening hours need to be liberalized.

12. Germany's financial sector appears to be sound. Indications are that the serious credit and management difficulties at a major bank are limited to that bank, although such problems suggest that supervisors should remain especially vigilant about banks' exposures to potential problem areas such as the telecom sector, emerging markets, and real estate in eastern Germany. Moreover, effects of the global economic slowdown on credit quality and profitability deserve ongoing attention. More generally, the ability of the financial sector to fulfill its role as an intermediary for the euro area requires that it be kept healthy with state-of-the-art supervision and regulation. To this end, the proposal to merge banking, securities, and insurance supervision under a single agency should be moved ahead expeditiously. The longer-term profitability of financial institutions and their adaptability to change would be enhanced by addressing the state guarantees underlying the public banking system. Within this context, the costs and benefits of public banks and their structure should receive careful scrutiny. Looking forward, we are encouraged by the preparations for the Basel II Capital Accord despite the fact that its calibration has yet to be finalized. The increased attention to credit evaluation and management will place Germany's financial institutions on a solid footing to meet the challenges of globalization. Germany's interest in participating in a Financial Sector Assessment Program is highly welcomed.

13. For the most part, official statistics are timely and of sufficient detail for effective analysis. To improve cross-country comparisons, we would encourage the authorities to adopt price deflators that appropriately adjust for changes in product quality. Some gaps in the national accounts, notably the poor quality of data on inventories, should also be addressed. Finally, we encourage Germany to work with the IMF to review standards and codes in the fiscal area.

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We would like to thank our many interlocutors for their cooperation and hospitality.

Berlin, July 9, 2001