Germany: Not Much Room to Maneuver

Germany is on the verge of a recession. But at a time when the government should be cutting taxes and boosting spending, euro zone budget rules are forcing it to do just the opposite. The result: Economic, social, and political forces are on a collision course in 2003 as current woes point the spotlight on Germany's structural flaws.

Based on surprisingly weak December reports on manufacturing activity and retail sales, real gross domestic product may decline in both the fourth and first quarters. Many economists are now looking for growth of less than 1% for all of this year.

Nevertheless, with Germany's 2002 fiscal deficit near 4% of GDP, budget cuts in 2003 will reach nearly 1% of GDP, and further tightening in 2004 may be needed to meet the euro zone's 3% limit. Monetary policy isn't helping. With inflation at 1%, a percentage point lower than the euro zone average, real interest rates are a full point higher than average. Plus, banks are more restrictive in their lending.

Higher taxes will hurt both households and companies. Rising social security contributions for state pensions and health insurance, higher taxes for energy and tobacco, and some still-pending levies will hit consumers in January. Companies will have to cover half the rise in social security contributions, and they'll likely face less generous depreciation allowances and loss provisions.

Business is trying desperately to cut costs and restore profitability, and that means job cuts. Unemployment, already at a four-year high of 4.16 million in November, or 10% of the workforce, will rise further, adding to the stress on policymakers. Heavy wage demands by some unions aren't helping. More than 4 million public-sector workers are threatening to strike.

Germany's missed opportunities at labor market and pension reforms during the strong-growth years of 1998-2000 may come back to haunt policymakers in 2003. Something has to give. The best outcome: The current situation will force additional reforms.

By James C. Cooper & Kathleen Madigan

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