Germany's Budget Gap Sets a Bad Example

The deficit bodes ill not just for the country's economy, but for all of Europe's, too

For months now, the economic news out of Germany has been relentlessly bad: sluggish growth that could turn into recession, rising unemployment, plunging business confidence, huge losses in the banking sector. But no one was quite ready for the shock that came on Nov. 13. After recalculating the flow of tax receipts into Germany's national and state treasuries, the Finance Ministry announced that the shortfall would be $18 billion greater than expected. As a result, Germany's budget deficit will soar to almost $70 billion this year, or 3.8% of the nation's gross domestic product, the highest of the 15 European Union members. "Life isn't getting any easier in Germany," says Klaus Sturany, chief financial officer of RWE, a large German utility.

As late as Sept. 25, Finance Minister Hans Eichel had confidently declared that the deficit would fall below the 3%-of-GDP limit set by the EU's Stability & Growth Pact. Now, instead of bolstering European confidence with rock-solid finances, Berlin is sending shock waves across Germany and Europe. The Continent used to count on Germany, Europe's biggest economy, to lead it out of downturns. No longer. David Walton, chief European economist at Goldman, Sachs & Co. in London, now likens Germany to "a dragging anchor."

In fact, the situation is so dire that under Stability Pact rules, Germany risks being ordered by the EU's Council of Economics & Finance Ministers, or Ecofin, to narrow its budget gap to acceptable levels or face fines that could reach 0.5% of GDP. On Nov. 5, Portugal, whose deficit topped 4% last year and is still expected to exceed Stability Pact limits this year, was given to the end of the year to get its deficit down. On Nov. 13, the EU's Monetary Affairs Commissioner, Pedro Solbes, launched proceedings against Germany.

It's all highly embarrassing for Eichel, who made his reputation as a tax cutter and has long been a supporter of budgetary discipline. On top of that, Germany was the main architect of the Stability Pact, which was meant to underpin the euro with sound government finances. To avoid sanctions, Eichel must convince Ecofin that Germany's widening budget hole is merely the temporary result of a slow economy, rather than the product of long-term deficiencies in how the government manages its money. In pleading his case, Eichel can count on powerful backing from France, whose own 2.7% budget shortfall--which is expected to climb slightly next year--is attracting Brussels' attention.

A looming fracas with Brussels is the least of Eichel's troubles. Within Germany, the revenue shortfall puts the finance boss in a terrible dilemma. He must devise a series of tax increases and budget cuts to narrow the deficit. But he knows that tax hikes will just decrease consumer spending and corporate investment and prolong Germany's economic slump, which analysts now expect to extend through next year.

For starters, the 60-year-old former German language and history teacher plans to raise the contributions that employers and employees make to the state pension system from a hefty 19.1% of salary to 19.5%. That will increase the cost of doing business in Germany by $3 billion a year. "It's a vicious circle," warns Johannes Reich, head of equities at Bank Metzler, a private bank in Frankfurt. "Higher social welfare costs lead to more unemployment, which leads to higher welfare costs and so on." Executives are lobbying hard against this and other tax increases expected to be unveiled soon. "They're probing where they can pick up any little extra revenue," says Holger Schmieding, senior European economist for Bank of America in London. "They're planning to squeeze business." The plan will also cut into take-home pay just when the economy needs more consumption. The mass-circulation Bild newspaper captured the public mood when it caricatured Eichel on the front page as a vampire sucking the lifeblood out of consumers.

Eichel is pondering other revenue-boosting measures. One would expand taxes on the capital gains and interest income of individuals, which economists say will result in less savings even as the government is trying to get workers to sock away more for retirement. Eichel is also contemplating a proposal from his advisers to set a minimum corporate tax, which would hurt companies that have accumulated big tax credits because of losses in the past. A measure to raise the tax on company cars would hurt Germany's largest employers, the auto makers. Berlin's budget woes and the fear of higher taxes were big factors in the large, 19.2-point drop in November's Economic Sentiment Indicator, according to the Centre for European Economic Research in Mannheim.

Meanwhile, Eichel is planning a range of spending cuts that could dampen economic activity. The proposals, likely to get a rough ride, will be presented to the Cabinet in a supplementary budget on Nov. 20 and to Parliament by the end of the month. To tide the government over, Eichel is expected to borrow up to $32 billion this year, well above the $21.5 billion called for in the original 2002 budget.

If tax hikes and budget cuts don't get the job done, there's another option: changing the rules in Brussels. Finance Ministry officials hint that Eichel will support behind-the-scenes efforts by France and other budget-challenged countries to change how the Stability Pact works. In particular, he is said to want more freedom for countries with low borrowing levels and tame inflation to run bigger deficits when their economies would benefit from higher public spending--especially on infrastructure. Says an adviser: "We should be putting money into the economy, not taking it out, and if that means temporarily borrowing more, so be it."

Yet Finland, Spain, Austria, and other countries that have reined in spending aren't likely to agree to such changes without a fight. And the European Central Bank in Frankfurt is dead set against altering the rules. Instead of talking about loosening the pact, Eichel's critics say, he should be deregulating Germany's inflexible labor markets, clearing the red tape that hinders business startups, and cutting tax rates.

But structural reforms take time to implement. And it's harder to force spending cuts through Germany's complex political landscape than tax hikes. So business is unlikely to persuade Eichel to change tack. "I had no illusions before the elections, so I can't say I am disillusioned now," says Reich. "But there is no light at the end of the tunnel." Not much for Europe, either.

By David Fairlamb and Christine Tierney in Frankfurt

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