What Germany Must Do

Germany is in real danger of slipping into a Japanese-style deflation. Prices in May rose just 0.7% year-on-year, and economists predict that inflation will turn negative by the beginning of 2004. Meanwhile, the economy is mired in recession, while its traditional locomotive, the export sector, is being derailed by the strong euro. To make matters worse, unemployment is soaring, reaching 10.7%, and consumer spending power has been slashed by recent tax hikes and rising social security payments. Corporations have little pricing power and their profits are getting squeezed.

Immediate help is needed. The European Central Bank must give the economy a boost by cutting its key interest rate -- currently 2.50%, twice the Federal Reserve's level -- by at least 50 basis points when it next meets on June 5. It should then follow through with other cuts over the summer until euro zone rates are down to U.S. levels. Such dramatic action may spur growth and inflation in Spain, Ireland, and other countries on the euro zone's more dynamic periphery. Without it, Germany, the euro zone's largest economy by far, has little hope of recovering this year or next. And should the country drop back into recession, it would almost certainly drag down growth across the Continent.

Cutting rates is just a start. Euro zone governments need to free themselves from the constraints of the Stability and Growth Pact, which limits budget deficits to 3% of gross domestic product. That would allow Germany to stimulate growth by cutting taxes and increasing public spending. The pact must be made more flexible, too, with governments permitted to run big deficits during recessions and tighten up fiscal policy during economic expansions. Finally, Germany must tackle the serious structural problems -- such as rigid labor laws and high social security costs -- that weigh heavily on companies and hold back growth.

Such actions may be unpopular with many voters. But without them, Germany -- and the rest of the euro zone -- risk being sucked into a deflationary spiral from which it will be that much harder to escape.

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