MACROECONOMICS

"...we share a common commitment to a medium-term strategy: credible fiscal consolidation programs, successful anti-inflationary policies...".

(a) Anti-inflation policies - score: +1

Germany has been very successful in meeting this commitment. Inflation has continued to trend down from the inflationary spike induced by unification and remains within bounds set by the Maastricht agreement. Average annual CPI inflation in 1996 was 1.5%, down from 1.8% in 1995. Only a modest pick up is expected in 1997 with CPI inflation averaging 1.7%.

---Policy operation---

Monetary policy in Germany is under the control of the Bundesbank which has strict autonomy from the central government. The Bundesbank does not explicitly target CPI inflation. Rather it sets targets for monetary growth which, once allowance is made for changes in the velocity of money and growth of potential output, currently provides an implicit target for CPI inflation of about 2%. This operational preference relies on the long term relationship between monetary growth and inflation. This relationship had been widely used as a basis for monetary policy in other G7 countries, but has come under pressure due to the increased volatility in the behaviour of the demand for monetary aggregates. It was abandoned in the US and Canada in the 1980s.

---Maastricht inflation target---

The Bundesbank currently faces an inflation target for 1997 as part of the Maastricht agreement leading to the first stage of the EMU in 1999. The criterion is that inflation should be less than the average of the three lowest inflation rates plus 1.5%. The average of the three lowest inflation rates - in Finland, Sweden and - was about 0.5% in 1996 which implies a Maastricht target of not more than 2.0%. However, according to the IMF, the reference for 1997 has now probably increased to about 3.1%. It is now fairly certain that Germany will meet the inflation target.

---The economy and inflation---

The operation of monetary policy in Germany has been complicated in recent years by the confluence of unification in 1990, recession in 1992 and the Maastricht targets for 1997. Interest rates were raised significantly in 1990 to offset the inflationary impact of unification. By early 1992, the 3-month FIBOR had risen to 9.6% while inflation had topped 5%. However, while inflation subsequently subsided, both high interest rates and fiscal tightening (other than the large investment program in East Germany) then moved the economy into recession during 1992. The German economy has continued to labour under the costs of unification as well further fiscal retrenchment to meet the 1997 Maastricht fiscal targets. This has been only partially offset by monetary policy since, although interest rates have continued to decline, the DM has been volatile both versus the US dollar and in trade weighted terms. As a result, apart from some strength in 1994, economic growth has been very weak since 1991 and growth has been below 2% in both 1995 and 1996. The IMF has estimated that the level of economic activity moved below potential in 1993. The IMF estimates that the negative output gap ranged around 2% in 1993-1995 but actually widened to 3.1% in 1996. The weakness in the economy together with tendency for monetary conditions to be only sporadically accommodative has provided a downward drag on inflation. Although CPI inflation has trended down from just over 5% in 1992 to 1.5% in 1996, it was only in 1995 that inflation fell back below the 2% benchmark.

---Monetary targets---

The successful reduction in inflation over the past seven years has not gone altogether according to design, since the annual monetary targets have now been missed four times in the past five years, including 1996. Following the tightening in 1991, the monetary growth target range was loosened in 1992 and 1993. Even so, monetary growth was above the upper target in both years. The target range was reduced to 4-6% for 1994 and 1995, but while the target was met in 1994, monetary growth was significantly below target in 1995. To accommodate the evident volatility in the demand for M3, the Bundesbank increased the upper limit and set the target range for 1996 at 4-7%. Even so, monetary growth again exceeded the target coming in 8.1% for 1996.

The volatility in the DM has contributed to the difficulties in meeting the monetary growth targets. The DM has continued to trend upwards versus the US dollar since the upward surge in the middle of the 1980s. But there has been some considerable volatility in recent years. The overscoring of the monetary targets in 1992 and 1993 and again in 1996 was associated with a sharp depreciation of the DM, while the underscoring in 1995 was associated with a sharp currency appreciation in late 1994 and into 1995.

---Monetary conditions---

The volatility of the currency has also implied some considerable fluctuations in monetary conditions. Although the Bundesbank has reduced the benchmark 3-month FIBOR from 9.6% in early 1992 to just over 3% in early 1997, the trend in monetary conditions has not been as smooth. The IMF estimates that the nominal monetary conditions index actually rose in 1994 and into 1995 though it has declined since. The same is true for the index expressed in real terms (the interest rate adjusted for CPI inflation and the exchange rate adjusted for unit labour costs differentials). However, while the nominal index is now lower than over the high interest period of the early 1990s, in real terms it is actually considerably higher. This indicates that monetary policy has actually been even more restrictive over the past two years than it was in the high interest rate period in the early 1990s. Even so, monetary conditions did ease through 1996 due to lower interest rates as well as due to a lower real exchange rate that reflected both a depreciation of the DM as well as weak growth in domestic unit labour costs.

---Outlook---

Although still weak, the economy has started to revive and output growth is expected to pick to 2.3% in 1997 up from 1.4% in 1996. As a result, German short interest rates and the DM versus the US dollar have now probably bottomed out. However, the recovery does remain fragile so that changes in monetary conditions are likely to be neutral over the short term. The Bundesbank has now set the target range at 3.5- 6.5% -centred on 5% - for both 1997 and 1998. Allowing for a one percent increase in the demand for M3 resulting from the trend decline in the velocity of circulation and allowing for 2.-2.5% growth in potential output, this implies a CPI inflation target of not more than 2%. Both the IMF and WEFA estimates are for CPI inflation below 2% (1.8% and 1.7% respectively) so that Germany is expected to satisfy the Maastricht inflation target easily.

There are two sources of concern. The first is the proposal to increase the VAT in mid-1997 as a measure to reduce the fiscal deficit in line with the Maastricht deficit target poses a threat to the inflation target, but it appears that this is unlikely to occur. The second is the threat to inflation from the depreciation of the DM which by April 1997 had dropped 12% versus the US dollar. This however is expected to be short lived since the currency is now expected to appreciate.

(b) Fiscal consolidation - score +1

The German government has made strong efforts to reduce the fiscal deficit and has met this Lyons commitment towards fiscal consolidation. However, due to the weak economy, the general government deficit, and the federal government deficit in particular, increased in 1996 for the third consecutive year. Under current policy measures, both the general and federal government deficit are expected to decline in 1997. However, in the absence of new measures, Germany will almost certainly fail to meet the Maastricht fiscal criteria.

The Maastricht fiscal criteria call for the general government deficit and debt to fall below 3% and 60% of GDP respectively. Since the Maastricht fiscal criteria refer to the general government account and not just to the federal government, this should be a consideration in the assessment of the central government's compliance with the Lyons commitment towards fiscal consolidation.

On a national accounts basis, the federal government deficit rose from 1.5% of GDP in 1995 to 2.2% in 1996. Under current policies, the federal government deficit is expected to fall to 1.7% of GDP. On a national accounts basis, the general government deficit rose from 3.5% of GDP in calendar 1995 to 3.8% in 1996. Under current policies, the general government deficit is expected to fall in 1997 but only to 3.3% of GDP - thereby missing the 3% GDP Maastricht deficit target.

---Government structure---

Under the constitution, Germany is a federation of states and the structure of government is highly decentralized. There are four major accounts to the general government account: the federal government, the Landers (states), the municipalities and social security. Since unification, there has also been a special account, the Treuhandanstalt, which has adopted the deficit and debt associated with integrating East Germany.

---Fiscal consolidation 1991-1994---

Fiscal policy over recent years has been complicated by the confluence of unification in 1990, the recession in 1992 and the Maastricht fiscal targets set for 1997. Unification led to a significant rise in the deficit. By 1994, a string of tough budgets and expenditure cuts reduced the structural deficit of the general government from 5.2% of GDP in 1991 to 1.2% in 1994. Despite high interest rates and a lacklustre performance of the economy, it appeared that Germany was well on its way to wrestling down its deficits: the actual deficit of the general government had been reduced from 3.3% of GDP in 1991 to 2.4% while the actual deficit of the central government had fallen from 1.9% of GDP in 1991 to 1.5%.

---Fiscal deterioration 1994-1996---

Deficits deteriorated sharply in 1995 and again in 1996: the general and federal government deficits increased to 3.8% and 2.2% of GDP in 1996 respectively. This was only partially result of the weak state of the economy and a climbing rate of unemployment, which had adverse implications for tax revenues and social security support payments. The easing of the general government's structural deficit back up to 1.8% in 1996 suggests an easing in fiscal policy stance. But, this is misleading. The deterioration in 1995 was largely due to the consolidation of the unification accounts in 1995 and the incorporation of the debt service charges on the unification debt into the general government fiscal accounts. The deterioration in 1996 - almost entirely to the federal deficit which rose 30% - was also due to two court decisions which together added Dm30 billion to the deficit. The first decision increased the basic income tax threshold (which required the government to raise personal income tax rates) while the second shifted the subsidy to the mining sector from a surcharge on energy bills onto the government account. In 1996, the government had attempted to offset these court decisions with other expenditure cuts so as to keep the general government deficit unchanged from 1995. However, the impact on revenues nevertheless resulted in a unplanned DM11.4 billion rise in the general government deficit.

---Fiscal consolidation in 1997 budget---

The threat of missing the EMU targets for 1997 prompted an extensive fiscal consolidation package for 1997 that combined reduced spending in the near term and more long -term social security reforms. The government has also tabled proposals a tax reform package to start in 1998.

In December 1996, the 1997 federal tax bill proposed to reduced the nominal value of the federal deficit back to 1995 levels and the level of the general government deficit back to 1993 levels and back below 3% of GDP. As well as expenditure cuts, the plan includes: a hike in the property tax rate, tighter property valuations rules for inheritance tax but the abolition of a tax on private wealth, and increased child benefits.

Social security measures include cuts in unemployment benefits, an increase in pension contribution rates and a reduction in pension benefits (as well as an increase in the female retirement age from 60 to 65 in 2000), a cut in statutory sick pay from 100% to 80% of earnings, and a 0.4 percentage point reduction in the public health contribution rate.

In March of 1997, the government also signaled its intention to undertake a broad reform of the tax system that would broaden the tax base and lower tax rates to be undertaken in two steps in 1998 and 1999. The option of an increase in the VAT was retained to offset too large a decline in tax revenues, but is unlikely to be exercised.

---Outlook---

These stringent measures are expected to reduce the general government structural deficit by 0.,7 percentage points from 1.8% of GDP in 1996 to 1.1% in 1997. However, despite the measures, the continued weakness in the economy and in revenues in particular make it likely that the reduction in the federal government deficit will not be as large as hoped for - only a 0.5 percentage point improvement to 1.7% of GDP is expected. As a result, the general government deficit may only reach 3.3% of GDP - thereby missing the Maastricht 3% GDP target.

Recent proposal include the sale of a further package of Telekom shares already this year (rather than in 2000, as was originally planned), an immediate budget freeze, a hike of the mineral oil tax rate, and the sale or revaluation of Bundesbank gold reserves. The federal government thought that the sale or revaluation of Bundesbank gold reserves would provide the simplest solution especially since this was planned to occur in 1998 anyway. The Bundesbank has begged to differ citing defense of both its autonomy and the credibility of the Maastricht process.