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Economic Growth Returns, But Uncertainty Remains High

Press Release of June 30, 2010

DIW President Zimmermann: “Another opportunity missed at the G-20 summit in Canada.”

The German economy will grow at a moderate pace through 2010 and 2011. According to the quarterly forecast released today by the German Institute for Economic Research (DIW Berlin), the German economy will grow with an average rate of 1.9 percent in 2010, and 1.7 percent in 2011. “The recovery is gaining momentum, but the engine of growth is once again foreign demand,” says DIW President Klaus F. Zimmermann.

According to DIW forecasters, domestic demand is weak because consumer confidence has been rattled by the European debt crisis. And rightly so, in Zimmermann’s view: “The financial crisis is far from being fully dealt with, and there has been a lack of action at the international level to institute financial market reforms.” The G-20 summit meeting in Canada represents another missed opportunity to make markets shoulder greater responsibility for the crisis, Zimmermann criticizes.

Freedom of Action is Available to Consolidate Public Finances

“The austerity measures announced by the German government have dampened consumer sentiment and are depressing private consumption,” says Christian Dreger, the head of DIW’s Department of Macro Analysis and Forecasting. “We must nevertheless use this opportunity to consolidate the federal budget. The announced budget cuts are simply not large enough to address ballooning debt levels. Tax increases will eventually be unavoidable.”

According to DIW’s economists, current growth rates provide sufficient freedom of action to bring public finances back on a sustainable course. Zimmermann rejects calls for an extension of the country’s deficit-financed economic stimulus measures. “Anyone who claims that budget consolidation is ill-advised at close to 2% growth doesn’t know much about the European economy,” Zimmermann says, welcoming the pledge made by industrialized countries at the G-20 summit in Canada to cut deficits in half by 2013. This pledge is not binding, however. “Such promises are nothing new. Yet without sanctions, it’s unclear how much deficit cutting will actually take place,” Zimmermann says.

Current Growth is Export-Driven; Domestic Demand to Remain Flat Until Next Year

After a difficult winter, the strong growth of recent months has been fuelled by pent-up demand, particularly in the construction industry. “For the second quarter we anticipate a seasonally adjusted growth rate of 0.9 percent compared to the previous quarter,” says DIW forecaster Ferdinand Fichtner, noting that while the adverse effects of bad weather have subsided, domestic demand will still be too weak to drive strong growth in the second half of the year.
“A singular focus on exports is simply not sufficient, particularly as our most important trading partners are also burdened by high debt levels and need to cut back spending,” he says. “This is true of our European partners as well as of the US and Japan.” According to the Institute’s forecast, domestic demand will make a measurable contribution to growth next year thanks to increased household purchasing power and rising investment.

Economic Stimulus Measures Should Be Phased Out

A premature stop to economic stimulus measures represents the smallest of all dangers to global growth, DIW economists say. In the area of fiscal policy, the situation in Greece demonstrates that capital markets will not tolerate profligate spending over the long term. In the area of monetary policy, tightening is needed as well, DIW economists say, pointing to the danger of a new bubble forming in asset markets. With regard to China in particular, overinflated asset prices as a result of loose monetary policy are a cause for concern.
Europe is in a unique position on account of its debt crisis, however, as trust between banks is still lacking. “No one trusts the next guy. In this environment, banks are dependant on money supplied by the European Central Bank. To pull the plug on ECB support would be toxic for the stability of financial markets,” Fichtner says.

Background

The Global Economy is on a Path to Recovery

The global economy is on a path to recovery following the massive losses of 2009. While emerging markets remain the engine of global growth, developed countries have also been expanding at a fast rate since the middle of 2009, DIW economists say. The recovery remains hesitant solely in Europe, but early economic indicators and the expansion of activity witnessed in the first quarter of 2010 point to stronger euro zone growth in coming quarters. Nevertheless, both the euro zone and the UK have yet to make up for the production losses inflicted by the recession.

In the US, by contrast, real GDP has nearly returned to its pre-crisis level thanks to three quarters of robust growth. For the spring–summer period of 2010, DIW expects global growth to stabilize and growth in the euro zone to slightly increase. Nevertheless, according to the Institute’s forecasts, global economic growth will remain moderate in coming months, as the phasing out of expansionary monetary and fiscal policies will have a dampening effect on economic activity beginning in the second half of 2010 and particularly in 2011.

European Monetary Policy: “The Depreciation of the Euro is No Cause for Concern”

According to DIW economists, the depreciation of the euro as a consequence of the European debt crisis is no cause for concern. Measured in terms of purchasing power, the euro is not inappropriately valued against other currencies at present. Nevertheless, jittery bond markets remain a problem, as the ability of companies and banks to borrow money has worsened and the threat of a credit crunch is looming larger. The bailout of Greece organized in mid-May by the ECB and EU member states in coordination with the IMF had a decisive – albeit temporary – calming effect on markets at a critical juncture.

DIW also considers the ECB’s bond purchasing program to be appropriate in light of the extraordinary market environment. The operation has damaged the credibility of the ECB, however, and care must be taken to avoid the excessive influence of political interests, DIW economists say. A more restrictive monetary policy may be necessary in the near future should the economy strengthen and inflation begin to climb. “The ECB would be well advised in such a situation to underscore its strategy of ensuring price stability with resolute action – even if this impedes consolidation efforts by increasing the costs to refinance government debt, in turn triggering considerable political pressure,” DIW economists write in their quarterly outlook of economic trends.

Germany’s Public Finances: Austerity Measures Do Not Go Far Enough

Thanks to a return to growth, Germany will run a deficit of less than 5 percent of GDP in 2010 – a figure significantly smaller than initially feared. Nevertheless, according to DIW economists, efforts to consolidate Germany’s public finances are imperative. The austerity measures passed by the German government are insufficient in scope and in many areas ill-conceived. Estimates of the savings that will be obtained from the reform of the armed forces or budget cuts at the Federal Employment Agency – to name two examples – are excessively optimistic. It might not be possible to implement new taxes such as the planned tax on nuclear energy or the bank tax. Other new sources of revenue, such as the dividend payments the government will seek to collect from Deutsche Bahn, Germany’s national railway company, could well prove to be nothing but an accounting trick, DIW economists say. Tax breaks and subsidies will need to be rolled back if government deficits are to be reduced on a sustainable basis. For example, aid granted through the “Deutschlandfonds” – a credit assistance program for domestic businesses – is in pressing need of scrutiny. Significant budget relief could be obtained through the abolishment or modification of (1) the method currently used to assess the income tax obligations of married couples (the so-called “Ehegattensplitting”); as well as (2) the tax breaks granted for work performed on Sundays and holidays. “Furthermore, policymakers must work to simplify the tax system by eliminating exceptions and special tax breaks. The current administration has not made progress in this area – on the contrary, it has taken a step in the wrong direction with the tax breaks recently granted to the hotel industry,” DIW economists write in the Institute’s quarterly outlook.

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