I’ve just returned from Germany, visiting the great in government, bureaucracy, Bundesbank and the European Monetary Institute. I’m convinced the Bundesbank will raise interest rates by 25 basis points before the year-end and by around 200bp by the end of 1998.
The German economy is now recovering, as export-led growth is starting to spill over into domestic demand. Capacity utilization is higher than in the US. Companies are making huge profits, which have grown dramatically as a share of national income because unit labour costs have dropped as corporations rationalize. So capital investment is taking off. A lot of it is offshore, but that still results in rising demand for capital goods. Once recovery is confirmed, the Bundesbank will switch to a more neutral monetary policy.
Unemployment has topped out in western Germany. Wage demands may grow from here. So the contribution of low unit labour costs to low inflation will probably peter out over the next year. CPI inflation is at the Bundesbank’s upper threshold and will get worse. Sure, administered prices have caused a lot of it. But PPI inflation is up too. That’s due to import price inflation. The Bundesbank, for this reason, doesn’t want a weaker Deutschmark. Around Dm1.80 to the dollar is really the limit. Forex markets look set to test Buba’s resolve in moving from jaw-jaw to action to defend the Deutschmark. This will be the trigger for higher rates.
The Bundesbank is irritated by talk that it cannot increase rates in the pre-Emu period for political reasons. It is more likely to do so because of all this talk, which stems as much from the Bonn bureaucracy as from market pundits. The bank reckons current low interest rates are contributing to a lack of political will to undertake economic reform because it makes it easy for politicians to do nothing.
At a recent meeting of the EMI council, the Bundesbank was asked to increase short rates by all European central bank governors except France. And it has a motive to tighten rates to make sure Emu membership is decided on “sustainable improvement” in budget deficits, not just on cyclically low interest rates. Rising German rates would be the acid test for Italy.
No meaningful tax reform will happen before the federal election in September 1998. Some compromise agreement may be reached, but the great German supply-side tax revolution is off the agenda. This means no cut in solidarity tax for the consumer, and continued weak consumer recovery. But it also means the Bundesbank is more likely to increase rates, because of the lack of structural reform.
The stage is set for a major reversal of European monetary policy over the next year. Asset prices do not yet reflect this. And once Germany tightens, it will be by far more than the market expects.
I’m sure Germany will meet the Maastricht criteria this year and next. Recovery will start to help tax receipts, which have been below budget so far this year. Accounting changes to exclude government deficits on hospital spending will knock another 0.1% to 0.2% off the deficit. But reaching the Maastricht targets will make it more difficult for Germany to accept Emu membership for countries which don’t (or those which have fudged to do so).
Almost total unanimity reigns on Emu in the German bureaucracy. You have to admire this German elitist Emu-consensus. It’s like a thick wall of a dam holding back mega-tons of water representing German popular sentiment against giving up the Deutschmark.
If anything, the prose from the bureaucracy is getting more dogmatic and dismissive of voices that say Emu won’t be on time. One senior bureaucrat in Bonn told me I didn’t understand the new French administration. “They are pragmatic, willing to learn from us and [UK prime minister Tony] Blair, and are changing policies to what we need for Emu.” These words fell sonorous and heavy on the carpet. But the body language was squirmy.
The reaction of the political elite was similarly shrill to Bundesbank chief Tietmeyer’s mild suggestion that an Emu postponement wouldn’t be the end of the world. Methinks they protest too much. The bureaucrats even shrug and say that “of course, the criteria have to be fudged a little” and “Italy will be in if they pass some credible form of pension reform” (something the Germans have yet to do, by the way).
If you believe in the thickness of the dam’s walls, then you will go with market consensus that Emu is 80% likely to happen and be a broad church with Italy inside at the outset. Sure, the dam wall is impressive. But so are the dumb waters of resistance behind them. And did you ever see a dam burst slowly? The chances are that the dam will burst and Emu will not start on time.
However, my grounds for staying pessimistic about a 1999 Emu start have shifted. French premier Jospin has turned out to be less principled than I thought. He has moved the rhetoric towards achieving Emu. But France’s policy thrust works against the sustainable achievement of the Maastricht criteria and the stability pact. The recent Kohl-Jospin summit was a disaster. The French again sought to obtain a politicized stability council to control the European Central Bank. The Germans said no.
It’s Germany now where Emu caution should focus. Things are going to get very difficult for Kohl. His government is seen as Emu-obsessed and bereft of any economic policies that could help Germans. The Deutschmark is going to get rubbished again unless the Bundesbank raises rates (and I see the rubbishing coming first – providing the justification for raising rates). When interest rates go up, that will hit Germans’ wealth. The relatively weak Deutschmark will combine to hit their almost constitutional right to travel abroad cheaply.
SPD Lower Saxony premier Gerhard Schröder, who was blessed recently as a possible Kanzlerkandidat by Oskar Lafontaine, his party leader, may be officially nominated earlier than we think. That will really put Kohl on the defensive. And jobs will remain much scarcer in Germany than in France. In order to pretend that Kohl can plain-sail Emu through the reef of these political liabilities, you have to believe one other thing – that Kohl is more interested in getting Emu through than getting re-elected. I doubt it.
The real crunch is the attitude of German burghers to Emu. If they think the Deutschmark will turn into a rubbishy euro, they will shift their savings out of the Deutschmark. The man from the Bundesbank put it starkly to me.
“They may say that Emu is a political decision and a ‘done thing’, but it is neither. Papers appear every day now saying the euro has to be strong because it will be big in terms of reserves, trade, transactions and investments. Some even say it will be strong because governments will run big deficits and the European Central Bank will struggle against loose fiscal policy with tight monetary policy. That argument is clearly absurd. By that logic, the more deficit-ridden countries were included in Emu, the stronger the euro would be. In reality, Emu can only happen, and the euro will only be a decent currency, if ordinary Germans agree to hold it instead of the Deutschmark. In an electronic age, they can transfer out of the Deutschmark in a moment. So they don’t have to make up their minds now. They will make them up when they are told the euro is to happen. Then it is they with their savings, and not the politicians, who will decide the fate of Emu.”
Kohl’s coalition partners, the CSU, have a perfectly valid and sensible delay option for Emu. So have the opposition. Over the next year, Kohl will be clearly seen as an electoral liability. A full debate on Emu membership is breaking out among the German political elite, culminating in the Emu vote in parliament next spring. In that environment, the idea that the chancellor can ride roughshod over his coalition partners and the opposition parties requires a big suspension of disbelief. I don’t buy it.
David Roche is president of Independent Strategy, a London based research firm.
