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Terrorist Attacks Reinforce Cyclical Downswing - Recovery not Before Next Year

Press Release of October 23, 2001

The economies of the United States and of the rest of the world were hit by the attacks of 11 September during a phase of pronounced cyclical weakness. Pro-vided there are no additional massive terrorist attacks, there is no extension of the conflict, and there is no reduction of petroleum supplies, a world-wide re-covery that also gives new impetus to world trade may be expected from the first half of 2002. A crucial factor for the cyclical recovery is the fact that in the industrialised countries economic policy had been expansionary already before the attacks and that additional stimulating measures were decided afterwards. In the United States, the current recessionary phase will be overcome early next year, and the economy will recover markedly in the course of the year. In Ja-pan, output fell noticeably during the first half of this year, and a recovery is not expected until the second half of next year. In the euro area, economic growth has slowed considerably since last spring. In the course of next year, the forces of upswing will gradually prevail, with exports and domestic demand gaining momentum.
The German economy is presently at the brink of recession. The cyclical down-swing started already a year ago, and the direct and indirect effects of the ter-rorist attacks put an additional strain on the economy. The phase of weakness will last until the end of the year. In the current year, real gross domestic prod-uct will only rise by 0.7%. Next year the economy will improve again. Starting with a recovery of exports, domestic demand will also gradually strengthen. Thus, private consumption will benefit form the decline in inflation, and business will expand investment again in view of more optimistic sales and profit expec-tations. At 1.3%, the average annual increase in gross domestic product will remain relatively small in 2002 due to the low starting level. The number of un-employed will initially continue to rise and reach 3.9 million, seasonally ad-justed, in the coming winter months; unadjusted this corresponds to 4 ¼ million. In the course of next year, unemployment will decline again and probably amount to 3.8 million at yearend.
The government deficit ratio will be higher - at 2.5% this year and 2% next year - than planned (1.5% and 1%, respectively), primarily for cyclical reasons. In view of the present cyclical weakness and the considerable uncertainty regard-ing future developments, fiscal policy is facing a difficult task. If it resorts to ex-penditure cuts in order to meet the deficit goal of the stability programme at least in 2002, it will exacerbate the downswing considerably. If, in contrast, it follows a very expansionary course next year, the credibility of the consolidation course will be at stake. Necessary is, in the view of the Institutes, a fiscal policy that takes account of the cyclical risk while keeping an eye on medium-term consolidation, thus avoiding a loss of confidence. In 2002, fiscal policy - in its entirety - should be cyclically neutral (on this the Kiel Institute of World Eco-nomics has a different opinion). The government deficit would not decline, but would be almost as high as this year; the same deficit number would hide a small increase of the cyclical deficit (due to the further reduction of overall ca-pacity utilisation) and a slight decline of the structural deficit. If this strategy were followed, it would be possible to advance the stage of the tax reform planned for 2003 to the coming year. This corresponds to a tax cut of DM 13 ½ billion. Advancing the tax reform would not only help to stabilise demand, but would also further improve supply conditions. Important is, furthermore, that state and local governments, in particular, do not continue to cut back invest-ments, but rather increase them. This requires that federal and state govern-ments do not further reduce their investment support to the local communities, but rather increase it. This course of fiscal policy does not violate the stability pact. The 3% upper limit of the deficit/GDP ratio will be respected, and the structural deficit will be reduced in the medium term as planned - provided ex-penditure discipline is maintained.
In view of the narrow countercyclical scope of fiscal policy in the euro area, monetary policy, in particular, must assume the task of countering the down-swing quickly while maintaining price stability, and of preparing the ground for an upswing based on domestic demand. The ECB, which had lowered its cen-tral rates by half a percentage point before the terrorist attacks, and by another half percentage point thereafter, is likely to reduce interest rates by a further quarter percentage point, to 3.5%, this year. Monetary conditions will thus pro-vide the impetus whose full effect will unfold in the course of next year.
Moderate wage increases will improve the chances of success of the central bank's stability policy because they will keep inflationary pressures low that may emanate from this side. This means that in next year's wage round there should be no demands for a second helping. Although this year prices have risen faster than expected, the inflationary push came from the foreign sector and from special factors, so there is nothing additional for distribution. Therefore, announcements like a tough wage round should not be implemented.