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Germany is facing a decisive political shift as dramatic as the fall of the Berlin Wall, but much healthier for its economy and financial assets. Chancellor Helmut Kohl’s Jobs and Growth plan aims to cut 2% of gdp off the budget deficit, shrink government, free up small-company labour practices and reduce anti-work social security benefits. Other measures are being taken to liberalize, such as opening up the energy markets and extending shopping hours. And I think that the bulk of these reforms are likely to be implemented. In Chancellor Kohl, Germany has the west’s only living political leader whose name will be remembered in 20 years. He is the antithesis of an economic animal, but his political skill, vision and control of his party are remarkable. And now he’s started leading Germany in the right economic direction. Combined with the extension of the German economic machine into eastern Europe, this will produce a powerful Germany that surpasses the dreams of many (and the nightmares of the French authors of Maastricht) within 10 years. The consensual model of Mitbestimmung by which Germany has been ruled since World War II, with power split evenly between the Bonn political machine, the corporate sector, the Bundesbank and labour unions, is dead. Kohl-the-uneconomic has undergone a Pauline conversion on the road to Maastricht. He clearly now believes that Germany has a major competitiveness problem; that the state can’t solve it by using macro measures and traditional job-boosting pacts; and that the German consumer/employee will vote him out of office unless he delivers higher living standards and a feel-good Faktor. Kohl now knows that he can achieve this only by supply-side reform and by shrinking government. He’s tried everything else, including the world’s biggest Keynesian boost after the fall of the Wall. The impetus for change is coming not only from the top in Bonn; it stems from the corporate sector, too. The employers have scrapped the Alliance for Jobs. They want to put an end to collective national bargaining for everything beyond basic pay and hours. Wage deals are increasingly being struck locally, in return for productivity gains. And Germany’s demographic time-bomb is on its way to producing an Anglo-Saxon-style world of funded pension funds and sharp shareholder investors. Not unnaturally, more and more German companies are changing philosophy to maximize shareholder wealth and walking away from the consensual model of running their businesses in partnership with trade unions. Most remarkable is the fact that the entire programme contains no reference to European monetary union (emu) or to the Maastricht criteria for entering it. Kohl is in the business of providing German business and German jobs for German people. Meeting the Maastricht criteria may be the happy fallout, but they are not one of the chancellor’s targets in this programme. Radical reform package Kohl’s conversion to radical reform came with the trouncing of the opposition Social Democrats (spd) in three Länder elections in March. This coincided with the collapse of the Alliance for Jobs between government, unions and the corporate sector. That chunk of economic irrationality sought to create jobs in return for stable wages. It ignored the fact that Germany’s problems are not the rate of wage increases but absolute labour costs (German car workers cost dm60 an hour, French ones half as much). And the problem of labour markets is not the absence of agreements, but the existence of too many sclerotic ones that stop people working. The Alliance for Jobs was destined to be Kohl’s last attempt to work with the labour unions to produce the jobs that Kohl needs in order to keep his own job and his Christian Democrats (cdu) in power. The Länder elections in March showed Kohl that Germans still consider the spd too economically irresponsible to be in office. It was tantamount to granting Kohl a licence for economic change. He grabbed it and emerged like a man awakening from a long sleep. He promptly introduced a legislative programme that is so far-reaching and complex that it is being criticized by all and sundry as incoherent. It is anything but. Of course, the programme makes difficult and boring reading – but then many great legislative departures do. What the package seeks to achieve is change so radical (and initially painful) that only a German government could inflict it. A French or Italian government could never dream of shaking its citizens up like this. Expect the German unions to protest, but don’t expect riots and reversals. Kohl’s programme can be split into six parts: 1) Balancing the budget The package will eventually chop 1.5% of gdp off the budget deficit. All the measures are expenditure cuts – there are no tax increases! According to our sums, that means Germany will hit the Maastricht criteria even if it maintains only 2% annual real gdp growth between now and 1998. 2) Reducing the size of government from 50% to 46% of gdp by 2000. 3) Comprehensive tax reform which will simplify tax structure to three simple bands, slash marginal rates and reward high-fliers and risk-takers, as well as reduce tax avoidance and fraud. The wealth tax will be abolished. And the cost to employers of home-helps will be tax-deductible, to create jobs. 4) Freeing up labour markets for small companies employing 10 or fewer people. Such companies account for 80% of total corporations registered in Germany and around two-thirds of employment. 5) Reducing the burden of social security payments for the corporate sector and for the state, by cutting benefits. 6) Deregulating markets The government wants to open up the energy market and is building a consensus for longer opening hours for shops. Before anyone criticizes my views, I’m not saying this programme is perfect. Labour liberalization needs to go much further. Subsidies to industry of between dm150 billion ($98 billion) and dm180 billion (between 4% and 5% of gdp) have not been cut and should be, though there is a proposal in the 50-point Action Programme for Jobs and Investment to reduce coal subsidies, with effect from 1999. And a lot of these measures, such as tax reform, are slow-burners whose beneficial effects won’t be felt until the next century. But at least Germany is travelling down the right road. The programme is radical, but will it succeed? Kohl’s strategy is to get the package implemented in such a way that it won’t get torn to shreds in parliament (where the spd has the majority in the Bundesrat, the upper house). It will inflict economic pain now, in return for economic gain in time for legislative elections in 1998. Kohl has carefully timed it so that there are no significant elections in Germany in 1996 and 1997 (only Lower Saxony in September 1996, Hesse in March 1997 and Hamburg in autumn 1997). At first glance the legislative package may look like an egg splattered against a wall. In reality, it is a clever political construct designed to maximize the chances that it will be implemented. First, on tax reform, the spd agrees with most of the measures because it too perceives the burden of taxation as being unfairly distributed in Germany. The complexity of the current system allows the rich to escape most taxes. Second, measures to shrink government and budget deficits are designed to pass into legislation almost without spd support. Of the total spending cuts of dm70 billion (2% of gdp), almost dm50 billion can be implemented without agreement from the spd. That’s because the related measures either don’t have to go to the Bundesrat at all (if they don’t affect Länder finances), or because the degree of support they need in the Bundesrat means they can pass without spd support. A further dm5 billion to dm10 billion of cuts are likely to get through. Long-term gains There are some key implications for Germany of this major shift in its economic model. First, Kohl and the cdu/csu/fdp alliance will run again in 1998 and win. Second, short-term German growth will suffer, but long-term sustainable growth will be raised. Third, the deindustrialization of Germany, through the relocation of industry to eastern Europe and other emerging economies, will happen more smoothly. That’s because swifter job creation in the small-company and service sector will absorb labour shed by the bigger industrial companies as they move abroad. Fourth, Germany will remain the European economy with the lowest inflation rate. Bunds, the Deutschmark and equities will benefit, despite short-term margin pressure on industry from a stronger Deutschmark and a deflationary fiscal stance. Fifth, interest rates will be ratcheted down structurally, both because the fiscal stance will be less stimulative and because structural inflation will be reduced. Finally, and most important, far from strengthening the likelihood of emu happening, Germany will create a bigger quality gap between itself and the rest of Europe. The rest will appear to be still tinkering with big government and practices that hamper the free market. The biggest fall guy will be France, whose financial assets price in a successful emu, but which will now be quite incapable of getting anywhere near German quality (fiscal or otherwise). Bunds and the Deutschmark will be beneficiaries of these reforms, despite the negative impact on trade and capital accounts of globalizing the German economy and relocating factories abroad. German equities are also likely to be major beneficiaries. I estimate that German economic reform could add 0.25% annually to long-term earnings-per-share growth rates and cut 0.5% off long-term interest rates. That would boost the internal rate of return on German equities. And it would reduce the long-run risk-free rate of return. So, in the future, investors should get paid more to hold equities than they did in the past. The short-term impact of the Kohl programme is undeniably deflationary. There may also be some hefty initial restructuring costs to be debited to Germany gmbh’s profit-and-loss. But the long-term effects are unequivocally positive for the corporate sector. The removal of costly market distortions, such as high taxes offset by widespread subsidies and exemptions, will raise efficiency. The impact of this is highly dynamic. This is going to be one of the rare high-quality restructuring surprises in the world. In the short term, German equities may well get cheaper as short-term interest rates rise and if doubts grow about the viability of emu. That would be the ideal buying opportunity.
David Roche is president of Independent Strategy, a London-based research firm. |
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