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Economic Challenges for the Next Chancellor

Author: Roger M. Kubarych
September 17, 2002
Council on Foreign Relations

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Remarks at the American Council on Germany

Roger M. Kubarych

Senior Economic Adviser, HVB America Inc. &

Henry Kaufman Senior Fellow for International Economics & Finance,

Council on Foreign Relations

New York, September 17, 2002

Disappointingly slow growth, high unemployment, weak job creation, failing businesses, tepid innovation, and a rising budget deficit: This is a snapshot of the German economy that the two contenders have been battling for months to manage. One of them will come out on top, form a coalition, and then have to come up with a plan to do something about a difficult, perhaps intractable, situation.

At the same time, the next Chancellor will have to tiptoe through an array of tricky European and international issues in the economic and financial sphere. To begin with, that means side-stepping the well-meaning, but somewhat overbearing, Stability Pact, which sets upper limits on the size of budget deficits EU member governments may run. Germany will have company, since France and Italy, among others, will also breech the 3% limit. But those EU partners who have shown greater rectitude, or have just been luckier, will resist efforts to water down the pact. They will be joined by the top officials of the European Central Bank who, like Alan Greenspan at the Fed, are personally and institutionally allergic to deficits. Crafting an acceptable compromise to put the “growth” back into what is formally (but not otherwise) known as the “Stability and Growth Pact” will be a challenge, if not an ordeal.

What may turn out to be even more difficult, however, is to rewrite the entire EU constitution in preparation for what promises to be an unprecedented enlargement of the organization by as many as 10 additional countries over the next couple of years. The present decision-making procedures are already clumsy, but they will soon be utterly unusable. None of the experts I’ve listened to is entirely sure how the compromises will turn out, but they do agree on one thing: The influence of the big countries – and Germany is the biggest of all – will be diminished. It will be up to the next German Chancellor to show enough statesmanship, leadership, and powers of persuasion to guide through a formula that retains as much control as possible for his country, while not jeopardizing the entire enlargement exercise, which is very much in Germany’s long-term economic interests.

There will also be tough questions about how to weigh in on EU-wide policy discussions about the broader issues of international trade and finance. To pick one: whether to risk a meltdown in trade relations with the United States by imposing punitive sanctions against the US for its foreign tax credit regime, which was ruled offside by the WTO. Nobody in Europe has been in a mood to proceed swiftly, but if the EU does not take advantage of the penalties that the WTO has authorized, there isn’t much likelihood that the US Congress will take action to remedy the offending tax code, either. This is not the only fractious trade dispute between the two sides. Boeing continues to press hard for US sanctions against AirBus. US agriculture is up in arms against EU practices in several areas, notably genetically modified grains and hormone-treated beef, where the EU has sometimes been in violation WTO verdicts themselves.

Finally, there is the expensive matter of emerging market debt. Should Germany back the Canadians and the British, who have been supporting IMF ideas that would make it easier for emerging market governments to default on sovereign debt, or should they continue to tilt toward the position of the US Treasury, which has favored far less creditor-unfriendly proposals? German financial institutions and individuals make up a sizable chunk of the creditor community, but the general public leans toward generous debt forgiveness.

But these issues, while certainly important, pale in comparison with the decisions that have to be made about what to do to improve the domestic economy. Unfortunately, much of the campaign debate shed little light on what is doable and what is worth doing. Let me take a couple of moments to sketch out in the most elementary terms what the economic policy considerations are.

1. The most important measure of economic success to most individuals is job creation. This dominates their spending behavior, their confidence in financial markets and their attitudes toward government. This is as true in Germany as it is in the United States.

2. The most important source of job creation is new business formation, together with the expansion of small and medium-sized businesses. In every advanced industrial country, including Germany, the very largest firms consistently reduce staff and that trend will continue. I think both candidates understand this.

3. The most important source of new business formation is the broad category of services: business services, information technology services, health care services, and retailing. Naturally, high tech segments of manufacturing will also play an important role in nurturing and sustaining these companies, but they will not be the major source of job creation. Sometimes reading campaign statements one wonders whether this point is sufficiently understood in Germany today.

4. The most important stimulants for new business formation are as follows: a tax system that does not penalize entrepreneurs, especially the successful; a regulatory environment that makes it easy to establish a business, with a minimum of red tape -- and equally critical, permits failed businesses to exit expeditiously; and a labor market that allows new businesses to recruit, train, retain, and dismiss workers, as business prospects become better or worse. Not all political leaders in Germany like to hear these points.

5. The best tax system is a simple one. Too many confusing or heavily conditional subsidy programs lead to bureaucratic intrusion and a waste of taxpayer resources. Many of the tax proposals we heard during the campaign have not met this test of simplicity.

6. The best regulatory environment is one that is not adversarial but cooperative. Even within a country such as the United States, with a strong record of creating new jobs in start-up businesses, some localities do relatively badly in nurturing new firms because of burdensome controls and regulations. Entrepreneurs go elsewhere. Germany has a better record than some other European countries in keeping them, especially Bavaria I’m told.

7. The most flexible labor market is one that operates at a high level of employment and low level of unemployment. Bringing down the unemployment rate is more important that running a budgetary surplus or reducing a deficit. That will happen anyway as a product of satisfactory economic growth. Whoever is the next Chancellor will be making this case in Brussels soon enough.

8. Successful new businesses must have innovative ideas for new products or services – or more cost effective ways of producing existing products or services. These innovations are often the result of technological breakthroughs in universities. The best thing government can do to encourage innovation is to tax it lightly and to support business-university partnerships where path-breaking theory can be transformed into better products and services most effectively. I did not read anything about this topic during the campaign and suspect it is viewed with great suspicion by many German politicians.

9. Government also has a role in improving the educational system, since a modern economy requires continuous upgrading in the skills of people at every level in an organization. Life-time learning is a prerequisite for a flexible labor market. I have been surprised in my recent visits to Germany in hearing quite passionate criticism of the short-comings of Germany’s educational system in recent years, much like what one hears in California, where there is great nostalgia for the time when that state’s educational prowess was unmatched. No more.

10. There is no inherent conflict between a strong economy and a sound environment. To the contrary, the faster a country expands its economic base, the more resources it has available to improve the environment. But there is no evidence whatsoever that countries can improve the environment substantially by restricting growth.

Let me conclude with a personal gripe. I believe there ought to be a statute-of-limitations on the use of the term “structural reform”, either by candidates or by pundits. At least no one should be allowed to use the term without giving specific illustrations of what counts as a structural reform. Here is one way of thinking about it: To improve economic growth is to improve the allocation of resources in an economy. People, machines, and financial capital all have to be used more effectively. As economists often put it, resources have to be shifted to their best uses. But that shifting is scary, both to workers and to business executives. Politicians know that and rarely play the role of change agent wholeheartedly. They temporize and try to limit the pain, for example by bailing out troubled companies. If that is the policy course followed by the next Chancellor, it is a safe bet that the same problems that plague the German economy today will still be around at the next election in four years’ time.

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