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Joint Analysis Fall 2006 (Die Lage der Weltwirtschaft und der deutschen Wirtschaft im Herbst 2006)

Press Release of October 19, 2006

In the autumn of 2006 the upswing in the world economy continues although it has slowed down somewhat during the course of the year. The main reason is the weaker economic growth in the United States and to a lesser extent in Japan. This was not offset by an acceleration of the expansion in the euro area and in the United Kingdom. In the emerging economies the increase in output remained strong, growing again more robus-tly in China in the first half of the year but slowing overall in the other emerging econo-mies of East Asia. The differences in the growth dynamics among the industrialized countries are due to the economies being at different stages of the economic cycle. Raw material prices continued to increase strongly in the first months of 2006, also due to the robust world economic activity. Higher prices on the raw material markets were passed on to consumer prices; labour costs increased moderately, on the whole, in the industri-alized countries. The expansion of the world economy will weaken somewhat in the forecast period, but will remain strong in a longer-term comparison. On the whole, real world GDP – as defined by the Joint Analysis – will increase by 3.1% in 2006 and by 3.7% in 2007. World trade will expand this year by 8.5% and by a good 7% in 2007. Price increases will weaken somewhat.
The economy in the euro area is in an upturn phase. The increase in real GDP has accel-erated especially in those countries, such as Germany and Italy, that had registered be-low-average growth rates in the preceding years. The primarily stimulus came from domestic demand, since investments in plant and equipment in particular have expanded strongly. Private consumption expanded slightly, and construction spending grew per-ceptibly. Net exports expanded since exports increased clearly more strongly than im-ports. The European Central Bank tightened its monetary-policy course in the light of the expanding economy in order to counteract inflation risks in good time. The ECB will increase its key lending rate to 3.5% by the end of the current year and will retain this level in the coming year. This rate roughly corresponds to the neutral interest-rate level. The situation of the public budgets in the euro area improved slightly. In the com-ing year the economic expansion will remain strong but will slow down somewhat as a result of the reduced expansive effects of monetary policy and the easing boom of the world economy. Real GDP in the euro area will increase by 2.1% in 2007 after 2.6% this year. The inflation rate will stand at 2.1% for 2006 and 2.2% for 2007.\r\n\r\nThe upturn in the German economy intensified considerably this year. With exports continuing to increase strongly, the expansion is not increasingly being supported by domestic demand. In light of on-going, robust expansion of the world economy, exports of goods and services will grow by 10% this year. The further improved sales and profit expectations of businesses and the increased rate of capacity utilization have led to an increase of plant and equipment spending of nearly 7%. Construction investments have also risen, ending a ten-year slump. Private consumption has only recovered hesitantly, but will be stimulated in the second half of the year by purchases made before the VAT hike takes effect in January. Real GDP will increase this year by 2.3%, or, after work-ing-day adjustments, by 2.5%. This is the second highest growth rate in the past ten years. The boost in the capacity utilisation rate has been so clear that companies are more frequently taking on new staff. The number of employees, especially those subject to social insurance, has increased perceptibly, and the unemployment rate will decrease this year by around ¾ percentage points to 10.4%.\r\n\r\nThe starting position for the coming year is thus favourable, and much speaks for a con-tinuation of the upswing. However, fiscal policy has shifted to a noticeably restrictive course. On balance, the structural deficit rate will be reduced by fiscal-policy measures by 0.9 percentage points in 2007. In light of this, considerable insecurity exists about whether the upswing is already so consolidated that aggregate capacity utilisation will continue to increase next year. The insecurity is also a result of various assessments of which stage of the business cycle the German economy is currently going through.\r\n\r\nSome of the institutes participating in the Joint Analysis expect economic activity in Germany to slow down noticeably in 2007. Domestic demand will remain expansive but is not yet sufficiently consolidated. In particular, the outlook for earnings has not im-proved to the extent that a sustainable increase of employment and private consumption can be expected. All in all, total economic output will continue to increase in the course of next year but only at a rate that corresponds to a moderate growth trend.\r\n\r\nOther institutes see indications that the upswing is now so strong that the dampening factors will only have a short-term effect on the expansion and that afterwards capacity utilisation will continue to increase perceptibly. In this view the improvement on the labour market will continue so that earnings will increase during the forecast period and the expansion will be supported more and more also by private consumption.\r\n\r\nThe present indicators provide no unambiguous signals for determining which of these scenarios is more likely. On the one hand, the business expectations of the enterprises have clouded over in recent months; on the other hand, the improvement of the labour market situation could be indicative of a robust economic development. The forecast for 2007 is complicated by further risks. Since VAT has never been raised so strongly in Germany, it is difficult to estimate the extent to which fiscal policy will dampen eco-nomic activity and how strong the advance-purchase effects will be. In addition, it is still unclear whether the ten-year slum in construction activity has come to a standstill or whether it has only been interrupted.\r\n\r\nAfter weighing up various arguments, the institutes have agreed on a middle variant. They forecast for 2007 that the upswing will continue at a slower speed than this year. GDP will increase accordingly by only 1.4% for the year. Investments in plant and equipment will remain the key driving force and will increase again strongly, also since the depreciation conditions will worsen at the beginning of 2008. Private consumption will stagnate, on average for the year, since real incomes will be burdened by fiscal-policy measures by approximately 1 percentage point. The advance purchases made this year will also be felt. This factor alone will mean that the rise in real GDP in 2007 will be ¼ percentage point lower than without this advance-purchase effect. Export growth will be weaker due to the slight cooling of the world economy. The weaker growth in domestic demand will also dampen the increase in imports. The inflation rate will probably increase to 2.3%.\r\n\r\nThe increase in employment should continue in the coming year, but at a by far lower rate than this year. The number of unemployed persons will fall only little in the course of the year. On average for the year, the unemployment rate will decrease from 10.4% to 9.9%. The government deficit in relation to the gross domestic product will fall from -2.4% this year to -1.4% next year.\r\n\r\nThese are favourable conditions for economic-policy reforms to tackle fundamental problems, especially to increase the flat growth path and to reduce high structural un-employment.\r\n\r\nIn recent years economic policy has taken some steps to correct the growth conditions and the employment outlook. The tax burden has been decreased and a number of re-forms of the labour market and the social insurance system have been introduced. In addition, moderate wage settlements have contributed to a turnaround on the labour market. The trend growth rate is still much too low, however, and the unemployment rate, especially for the low skilled, is too high.\r\n\r\nIn its coalition agreement, the federal government named four areas where it intends to implement reforms to fundamentally improve the German economy: The consolidation of public budgets, the reform of enterprise taxation, health care reform and making the labour market more flexible. If major reforms were introduced in these areas, the growth perspectives and the outlook for the labour market at the end of this legislative period would certainly be considerably more favourably than is now the case. The fun-damental question is whether the major turnaround will be achieved. A final assessment of the government’s programme is not yet possible since all measures in these four areas have not been announced. On the basis of the information that has been presented, how-ever, the institutes are of the opinion that the intended reforms will fall far short of what is necessary for a clear improvement of the growth and employment conditions. In terms of labour market policies, the parties of the coalition government are discussing measures that would even impair the growth outlook.\r\n\r\nThe reason for this pessimistic assessment is that the federal government apparently cannot bring itself to reduce the intervention of the state in areas where the market proc-ess supplies better solutions and allows for more direct responsibility. This appears to be case with the planned health-care reform. The federal government still regards it as an essential task of the state to bureaucratically control private health care insurance and to limit spending by various means such as cost ceilings and price fixing. What is required is a system change that would allow citizens more choice in terms of how much and what types of insurance they require. Instead, especially with statutory health-care in-surance, the state is intervening in many instances, motivated by redistribution policies, but it in fact remains unclear as to who benefits and who bears the costs of this redistri-bution. \r\n\r\nThe government deficit will indeed be clearly reduced; however, the consolidation is mainly taking place on the revenue side. To achieve better growth, a greater reduction on the consumption side, especially government subsidies, would be necessary. In terms of qualitative consolidation there has been hardly any headway, in particular state in-vestments must be increased again. Overall, there is still considerable savings potential for further reducing the budget deficit. \r\n\r\nIn the planned reform of corporate taxation, the standard tax burden is to be reduced clearly, but to finance this the government plans to tax financing costs independent of earnings and to worsen depreciation allowances. If the draft legislation is enacted, nei-ther the neutrality for decisions nor the transparency of the taxation system will be im-proved. Overall, the growth effect of the enterprise tax reform would be small at most.\r\n\r\nIn labour market policies, major decisions are pending. The institutes have their reserva-tions about ideas expressed in the current discussion. They fear that unsystematic meas-ures will be introduced in connection with the reform of the low-wage sector as well as the introduction of a minimum wage
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