Germany — 2000 Article IV Consultation|
July 3, 2000
1. Before addressing economic policy issues, we should note the historic dimension of these consultation discussions—the first to be centered in Berlin, and coinciding with the tenth anniversary of the introduction of the deutsche mark into eastern Germany. The subsequent decade was a difficult one for the German economy, but it is heartening to observe that it is now on a favorable track. Over the past year an improved external environment, supportive monetary conditions, and clearer direction in domestic policies have boosted activity and confidence: real GDP growth during 2000-01 should average about 3 percent—the best short-term prospect for a decade. The upswing is bringing a welcome decline in the still excessive level of unemployment and, with wage settlements remarkably moderate, underlying inflation is well in check. In this propitious environment, the policy challenge is to reduce structural unemployment, establish conditions for sustained expansion, and exploit growth opportunities offered by advances in information and communications technology (the "new economy").
2. We see several sources of risk to this favorable outlook. In the short term, the most obvious risks stem externally from a "hard landing" in the United States and domestically from a delay in implementing tax reform. Looking further out, the risk is of a repetition of the adverse interplay between shocks, labor market institutions, and policy reactions that has been a key cause of Germany's lackluster output and employment growth performance of recent decades. The concern is that wage moderation cannot be sustained beyond the next two years, and that the convergence of a pickup in wage growth and even a modest shock would lead to another shakeout of overpriced labor, with the negative output and employment effects being amplified by procyclical fiscal policy responses.
3. Since our discussions last year, the government has moved ahead decisively on several policy fronts in its strategy to strengthen economic performance. This is bearing fruit in terms of the improvement in growth and general market confidence and helps set the tone for policy making in the euro area more generally. We welcome the commitment to fiscal discipline, tax and product market reforms geared to strengthening incentives and the functioning of markets, and a pension reform that constitutes a remarkable sea change from past thinking. But the labor market strategy—geared to across-the-board wage moderation rather than fundamental reform—is much less ambitious and we have concerns about its sustainability over the medium to long term.
4. Fiscal policy has a strong foundation in the multi-year program of spending cuts, tax reforms, and deficit reduction established last year. For the near term, the envisaged increase in the deficit in 2001—just as the economy is reaching full stride—is a concern, but the benefits of the proposed income tax reform and its contribution to wage moderation are counterbalancing considerations. The increase in the deficit does, however, make focussing policies on subsequent consolidation all the more important. Firm adherence to the global spending growth targets of the Stability Program will be required to achieve medium-term balance of the underlying (structural) fiscal position of the general government. This will entail identifying specific measures for the period beyond 2001. Moreover, within the overall expenditure envelope, room will need to be made for the fiscal costs of pension and labor market reforms.
5. We remain concerned that the traditional focus on actual rather than structural fiscal outcomes will lead to procyclical fiscal policy behavior if the upswing remains vigorous. In particular, it is important that pressures to relax spending restraint in the face of positive cyclical developments or windfalls be resisted. The commitment to use receipts from the UMTS licenses auction to reduce debt is therefore welcome. At the same time, a fiscal policy that aims at medium-term structural balance at the general government level and that firmly avoids procyclical fiscal impulses is likely, on our projections of medium-term growth, to require the federal balance to move into surplus well before 2006.
6. We strongly share the broad-based support that we have heard expressed for the thrust of the proposed business and personal income tax reform. The focus of the package on cutting high marginal rates and broadening the tax base is welcome: it should increase Germany's attractiveness to foreign investors, while also reducing, on balance, investment distortions and yielding some improvement in labor supply incentives. Given these benefits, the contribution of personal tax reductions to moderate wage settlements, and Germany's record of aborted tax policy initiatives, failure to move ahead with the reform soon would be a serious blow to confidence and economic prospects. Even after the package is implemented, reform of the tax system will still need to be seen as work in progress: reform of the Gewerbesteuer will become more urgent; and there remains considerable scope for simplification and for base broadening.
7. The core issue for the government is reducing the high level of unemployment. The problem is largely structural and is rooted in the institutions for social insurance and safety nets and wage bargaining that weaken employment opportunities and incentives, above all for low-skilled workers. These structures—specifically, a generous social safety net, high social insurance contributions, and limited wage differentiation—create mismatches between reservation wages and take-home pay on the supply side, and between labor costs and worker productivity on that of demand. The result is a malfunctioning labor market that does not adjust properly to shocks and is ill-equipped to handle the challenges of the "new economy," greater European and global economic integration, and an aging labor force. Solving the problem will require fundamental, and of course politically difficult reforms.
8. Against this background, the proposed pension reform is a landmark change. The planned diversification of the pension system would reduce the burden of aging on the first (public) pension pillar and the need for increases in social contribution rates that would harm labor market performance. At the same time, the larger the relative size of the new funded pillar, the greater would be the beneficial incentives for workers to remain in employment until reaching the statutory retirement age. Any pension reform has significant intergenerational equity implications that need to be carefully considered, but it is also important to distribute the burden across generations in a way that is mindful of distortions to work incentives. We support the proposal to exempt contributions to the funded pillar from tax, with appropriate alternative arrangements for those below the income tax threshold.
9. Apart from the potential benefits from pension reform, the main plank of the current strategy for reducing unemployment is across-the-board wage moderation. The results so far—low wage settlements and the two-year duration typical of this year's agreements—are reassuring for competitiveness and employment prospects in the near term. But across-the-board wage moderation is not sustainable and should be seen as buying time for more fundamental change, rather than as a long-term strategy. The flat or even declining unit labor costs expected this year and next are unlikely to be more than a temporary phenomenon; if the upswing remains robust, pressures for significantly higher wages are likely to be strong in two years' time, with the risk of renewed labor shakeout.
10. Reforms of wage bargaining and the social safety net are thus key, but so far missing, pieces of the puzzle. There are some indications that the market is evolving toward greater flexibility in working conditions and wages: in eastern Germany, where the problems are most acute, wage flexibility appears to have increased; the emerging high-tech sector is essentially outside the traditional bargaining framework; and, in the context of moderate wage settlements, firms may have the leeway to raise wages of workers with above-average productivity growth rates. Such aspects of the labor market should be actively encouraged. But progress overall is gradual, and legal changes to allow employers and workers to reach wage agreements more in line with firm-level conditions are still needed. The area, however, where we see less change but which should be accorded highest priority is the mismatch between reservation wages and take-home pay, particularly of the lower-skilled. The critical measures for addressing this problem are stricter activation requirements for benefit recipients, including a limit on the duration of unemployment assistance. An essential complement would be a restructuring of tax and social contributions for low-paid workers to ensure a level of in-work income that is attractive relative to unemployment compensation and consistent with social equity concerns. The various pilot schemes geared to low-income workers are valuable, but the time frame for reaching conclusions is too long. Active labor market programs may also have a role to play—by enhancing the skills and employability of the unemployed—but an evaluation of the effectiveness of the existing array of programs needs to be undertaken.
11. Germany's financial sector appears to be sound, with vulnerabilities having diminished as the emerging market crises receded. Stock market valuations look stretched, but because household share ownership is still not widespread, the direct macroeconomic consequences of a sharp correction in German equity markets are not a major concern. The universal banking system is equipped to manage the ongoing disintermediation, hastened by the advent of the euro, given their capacity to provide intermediation services in the capital markets. The shift toward a set of more diversified business financing opportunities, including a growing use of equity and bond issuance, is an encouraging sign that the financial sector is adapting to the challenge of financing startup businesses and aiding the restructuring of existing ones. Corporate restructuring would also be stimulated by the proposed exemption from corporation tax of capital gains on shares in other corporations. Although immediate risks appear at bay within the banking sector, existing ownership structures, notably for savings and cooperative banks, close off opportunities to raise efficiency through consolidation across banking categories: this could leave these institutions poorly positioned to adapt to new costly technologies such as e-banking. In view of the pressures that globalization and the formation of financial conglomerates place on Germany's financial supervision, the proposals for consolidation are welcome, and it is important that decisions be made quickly.
12. Germany's recent record of product market reforms, especially in the utilities sector, is impressive. Current plans for further privatization should be implemented vigorously. A particular challenge for Germany in the area of product market regulation is to ensure its ability to take advantage of the growth and productivity gains associated with the "new economy." Germany is well-placed to reap the benefits of information and communications technology diffusion as telephone costs have fallen dramatically following deregulation of the telecommunications sector. Moreover, Germany's large number of small and medium-size businesses makes it a prime European platform for business-to-business (B2B) operations that match buyers and sellers in virtual marketplaces. An alteration of strict retail regulations, however, will be needed to accommodate the growth in e-commerce at the retail level. Measures to assure attainment of commitments made at the European summit at Lisbon to embrace information technology and stimulate e-commerce and internet usage are also needed.
13. Regarding statistics, we welcome the achievements of the past year in closing the gaps that had arisen in the context of the adoption of new international standards. Further adaptations will likely be needed in future as standards evolve in response to the requirements of monitoring the "new economy."
In closing, we would like to express our thanks for the warm welcome and close cooperation that we have received in Berlin, Frankfurt, and Wiesbaden.