Abstract

In 1989, for the second year in a row, the pace of economic growth in the Federal Republic of Germany (FRG) exceeded most projections.1 Real GDP rose by 3¼ percent, and, with an unusually fast rise in investment income from abroad, real GNP grew by 4 percent, the highest rate seen in a decade (Table 1, and Chart 1 in Chapter I). The principal source of stimulus was strong foreign demand, particularly from European trading partners. Despite an acceleration of investment, domestic demand expanded less quickly than in 1988, as consumption growth slowed noticeably. Indeed, the increase in investment in 1989, although markedly stronger than in any other year since 1979, was exceeded by the rise in national saving; as a result, the excess of national saving over investment, the mirror image of the external current account surplus, widened by ½ of 1 percentage point of GNP to 4½ percent. Despite continued rapid growth of demand, underlying inflationary pressures remained moderate, with economy-wide unit labor costs rising by less than 1 percent; the rate of increase of consumer prices did double in 1989 to 2¾ percent, but this was due principally to indirect tax measures introduced at the beginning of the year and a deterioration in the terms of trade. There was a notable improvement in labor market conditions—job creation far exceeded the expansion of the labor force resulting from higher immigration—and the unemployment rate fell by ¾ of 1 percentage point.

Thomas Mayer, Donogh McDonald, Garry J. Schinasi, and Günther Thumann

The Real Economy

Overview

In 1989, for the second year in a row, the pace of economic growth in the Federal Republic of Germany (FRG) exceeded most projections.1 Real GDP rose by 3¼ percent, and, with an unusually fast rise in investment income from abroad, real GNP grew by 4 percent, the highest rate seen in a decade (Table 1, and Chart 1 in Chapter I). The principal source of stimulus was strong foreign demand, particularly from European trading partners. Despite an acceleration of investment, domestic demand expanded less quickly than in 1988, as consumption growth slowed noticeably. Indeed, the increase in investment in 1989, although markedly stronger than in any other year since 1979, was exceeded by the rise in national saving; as a result, the excess of national saving over investment, the mirror image of the external current account surplus, widened by ½ of 1 percentage point of GNP to 4½ percent. Despite continued rapid growth of demand, underlying inflationary pressures remained moderate, with economy-wide unit labor costs rising by less than 1 percent; the rate of increase of consumer prices did double in 1989 to 2¾ percent, but this was due principally to indirect tax measures introduced at the beginning of the year and a deterioration in the terms of trade. There was a notable improvement in labor market conditions—job creation far exceeded the expansion of the labor force resulting from higher immigration—and the unemployment rate fell by ¾ of 1 percentage point.

Table 1.

Federal Republic of Germany: Indicators of Economic Performance

(Percent change from previous year)

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Sources: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen; Deutsche Bundesbank, Monthly Report; and authors’ estimates.

Before July 1, 1990 defined as the current account balance of west Germany vis-à-vis areas other than east Germany. From July 1, 1990 defined as the current account of the entire deutsche mark currency area.

Chart 1.
Chart 1.

Federal Republic of Germany: Immigration from the German Democratic Republic and Eastern Europe, First Quarter 1986–Second Quarter 1990

(In thousands)

Source: Bundesanstalt für Arbeit, Arbeitsmarkt in Zahlen.1 Ethnic Germans from Eastern Europe (Aussiedler).

Data for the first half of 1990 indicated continued strong growth and, for the year as a whole, GNP is expected to rise by about 4½ percent, spurred by the increased demand emanating from German economic, monetary, and social union (GEMSU). The unemployment rate is projected to fall by a further ½ of 1 percentage point in 1990 despite rapid growth in the labor force. Although the rise in oil prices has boosted consumer prices in the second half of the year, consumer price inflation is expected to be about the same as in 1989 (2¾ percent). A significant decline in the current account surplus is likely, reflecting the diversion of part of west Germany’s saving surplus from foreign use to financing the resource needs in the area formerly constituting the German Democratic Republic (GDR).

Aggregate Demand

Real Domestic Demand

In 1989, final domestic demand rose by 2¼ percent, somewhat slower than the 3 percent rate of increase over the previous three years (Table A1). This reflected weaker growth of private consumption and a decline in public consumption; gross fixed investment, on the other hand, picked up steam.

The relative weakness of private consumption was a response to the slower expansion of real disposable income: although nominal disposable income increased at about the same pace as in 1988, growth of real disposable income was almost halved as a result of higher consumer price inflation (Tables A2 and A3).2 The effect on consumption of the slower real income growth was moderated, however, by a fall in the household saving rate.

Real public consumption declined in 1989, reflecting reductions in health care expenditure in response to the 1989 health reform. The fall in medical expenses was in part a technical reaction to the surge in the demand for health services that had occurred in the previous year in anticipation of cuts in entitlements under the 1989 reform. The modest nominal increase in civil service wages and salaries (2½ percent) also restrained public consumption.

Business fixed investment was boosted by a number of factors. Among these, the high degree of capacity utilization in manufacturing, accelerator effects related to strong export growth, the favorable liquidity situation,3 and positive profit expectations (related in part to the single market program of the European Community—EC) were important. Machinery and equipment investment grew particularly rapidly (9¾ percent), but business construction, which benefited from a mild winter, also expanded at a strong pace (5¾percent).

Nonbusiness investment, which is almost entirely construction, also picked up steam in 1989. Residential building responded to housing shortages in the major urban areas, the strong real income and savings positions of households and, perhaps, also to expectations of a rise in mortgage interest rates;4 higher rates of household formation and the large influx of ethnic Germans from the countries of Eastern Europe may also have played a role.5 As a result, the number of dwellings completed rose by 14½ percent and the number of residential building permits by 29 percent. Public construction recorded its fastest growth rate since 1986 (3¾ percent), reflecting favorable financing conditions at the state and local government levels.

Inventory investment contributed ½ of 1 percentage point to the rate of growth of GNP in 1989. It should be noted that this category of expenditure also includes statistical discrepancies—in the FRG the output measure of GNP is statistically better founded than the expenditure measure. Thus, a comparatively high contribution to growth from stockbuilding could reflect an underestimation of one or more of the other expenditure components.6

Data for the first half of 1990 indicated an acceleration of domestic demand. Private consumption grew at an annualized rate of 7 percent after relatively slow growth (2 percent) in the course of 1989. Important factors were the boost to disposable income from the tax cut which took effect in January 1990, the falling out of the inflation effects of the indirect tax increase of 1989, and spending by immigrants and visitors from the GDR.7 Investment growth was even stronger, particularly in the first quarter of 1990, when the mild winter allowed construction expenditure to expand at an extraordinarily fast rate. For 1990 as a whole, the growth of final domestic demand is projected to be twice that of 1989. Most of the increase reflects an acceleration of private consumption, after its sluggish expansion in 1989, but public consumption and fixed investment are also expected to contribute to faster demand growth.

Foreign Balance

In 1989, for the first time since 1985, the real foreign balance made a significant contribution to real GNP growth (amounting to 1¼ percentage points). Half of this resulted from an unusually large increase in the surplus on real net factor services from abroad,8 reflecting the rise in net foreign assets, a higher rate of return on foreign assets,9 and the depreciation of the deutsche mark.10 Real net exports of goods and nonfactor services gained strongly, too, reversing part of the decline that occurred in 1986–87. The rate of growth of exports of goods and nonfactor services jumped from 5½ percent in 1988 to 9¾ percent in 1989, owing to strong foreign demand (in particular from European countries) and the real effective depreciation of the deutsche mark in 1988 and the first half of 1989. Despite the depreciation of the deutsche mark and slower growth of GDP, imports of goods and nonfactor services quickened, rising by 8¾ percent in 1989 compared with 5¾ percent in the previous year.

In the balance of payments, the rise in the real foreign balance more than offset a deterioration in the terms of trade, and the current account surplus widened by DM 16 billion to DM 104 billion (Table A4). About two fifths of the increase reflected a higher trade surplus (Table A5).11 The services balance improved even more, from a deficit of DM 8½ billion in 1988 to a surplus of DM 7 billion in 1989, largely due to the rise in net factor incomes (Table A6). Partially offsetting these gains, the deficit on supplementary items and transfers widened by DM 6½ billion.

In the first half of 1990, the real foreign balance provided a stimulus to growth (amounting to ½ of 1 percent of GNP), but this was not sufficient to offset the decline in the foreign balance that took place in the second half of 1989; the real foreign balance was thus below the level in the first six months of 1989. For 1990 as a whole, the real foreign balance is expected to be broadly unchanged. However, with a terms of trade gain, the nominal surplus on goods and services, on a national accounts basis, is likely to rise. This increasing surplus of the western part of Germany (on a national accounts basis) masks a notable shift in composition, with a significant surplus vis-à-vis the eastern part of Germany (compared with small deficits in the past) concealing a decline in the surplus against other areas.12 Excluding transactions between the western and eastern parts of Germany,13 the external surplus is likely to decline in 1990 as the pace of domestic expansion, higher capacity utilization, and a real appreciation of the deutsche mark boost imports and discourage exports. Furthermore, looking at the transactions of what now constitutes the deutsche mark currency area, the decline will be even greater—from over DM 100 billion in 1989 to about DM 80 billion in 1990.14

Employment, Wages, and Prices

Over the past three years, the labor force in the FRG has been boosted by high immigration from Central and Eastern Europe. Chart 1 shows that the number of immigrants rose notably from mid-1987. Initially, this was due to the inflow of ethnic Germans (Aussiedler) from Eastern Europe but, from the summer of 1989, also reflected the surge in GDR citizens moving to the FRG (Übersiedler). In 1989, 377, 000 ethnic Germans and 344,000 GDR citizens migrated to the FRG;15 the corresponding numbers for 1988 were 203,000 ethnic Germans and 40,000 GDR citizens. Despite the sharp increase in immigration, however, the growth of the labor force in 1989 (½ of 1 percent) was a little slower than in 1988 (Table A7).16 Employment, on the other hand, grew by 1½ percent in 1989, almost twice the rate of increase of the previous year. As a result, the unemployment rate fell from 7¾ percent in 1988 to 7 percent in 1989.

In the first half of 1990, employment growth strengthened. On average, the number of people employed was 2½ percent higher than in the corresponding period of 1989. Although the labor force also rose markedly (by 1½ percent), reflecting the large immigration of ethnic Germans in 1989 and of GDR citizens after the fall of the Berlin wall, the unemployment rate was about ½ of 1 percentage point lower than a year earlier.17 Immigration remained strong in the first six months of 1990: the cumulative inflow of GDR citizens and ethnic Germans amounted to 470,000 adding, over time, a potential ¾ of 1 percent to the FRG labor force. The inflow of GDR citizens was concentrated in the early months of the year and fell off significantly after March 1990 as the political outlook in the GDR improved in the wake of the general election and as prospects for GEMSU became clearer. In January-March, 184,000 people moved from the eastern part of Germany to the west, but only 55,000 migrated over the next three months.18 The number of ethnic Germans immigrating into the FRG from Eastern Europe (232,000) was, however, more evenly distributed over the six-month period.

Despite the strong economy in 1988 and 1989, cost pressures remained subdued. In 1988, the rise in hourly earnings (3¼ percent) was almost matched by the rise in productivity, with the result that unit labor costs remained virtually stable. In 1989, unit labor costs rose by almost 1 percent, reflecting faster growth of hourly earnings (3¾ percent) and slower productivity growth (2¾ percent). The relatively small rise in unit labor costs in 1988–89 allowed profit margins to widen and, thus, the decline in the labor share of national income since the beginning of the 1980s continued (Chart 2).19 In 1989, the labor share was sharply lower than in the 1970s when it had been historically high; indeed, since 1986, the labor share has been beneath the low level of 1960.

Chart 2.
Chart 2.

Federal Republic of Germany: Labor Share of Net National Product, 1955–891

(In percent)

Source: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen.1 Adjusted for changes in the composition of employment between dependent employment (employees) and self-employment; measured as the share of employee compensation in net national product, holding the distribution of employment between dependent employment and self-employment constant at the level of 1970.

The fall in the labor share in the 1980s was related to market pressures for an unwinding of the excessive increase of the labor share in the 1970s20 and the conciliatory stance in successive wage rounds taken by the trade unions; for most of the 1980s, the unions put greater emphasis than previously on a reduction in the statutory number of hours worked per week and less on wage demands. In 1988–89, the strength of the economy, in conjunction with the prevalence of moderate multiyear wage agreements, reached when the outlook was less buoyant, seems to have been an important factor behind the further decline in the labor share.

More recently, however, it appears that the wage climate has been changing, albeit not radically. Whereas, in 1989, the major sectors of the economy remained covered under multiyear wage agreements, contracts covering 11 million of the 18 million private sector employees expired in 1990. In the new agreements replacing these expiring ones, there has been a return to one-year contracts; further reductions in the work week have been delayed; and pay increases have been less moderate. The new agreements implied a rise in tariff wages and salaries of 6 percent on average for 1990.21 Multiyear agreements covering 7 million private sector workers have remained in effect in 1990; the average increase implicit in these contracts amounted to 3 percent. With government sector workers also covered by a multiyear agreement, earnings per employee are expected to rise by close to 5 percent in 1990, compared with 3 percent in 1989, and unit labor costs to increase by 2½ percent (after a 1 percent rise in 1989).

Consumer price inflation, at 2¾ percent, was higher on average in 1989 than in any other year since 1983 (Chart 3). However, excluding the effects of the increase in excise taxes and postal prices at the beginning of 1989, the rise in the consumer price index (CPI) was about 2 percent, compared with 1¼ percent in 1988 and ¼ of 1 percent in 1987. This acceleration in the CPI (after adjusting for increased taxes) mainly reflected a 4½ percent increase in import prices in 1989. However, from the middle of 1989, import prices fell, owing to a strengthening of the deutsche mark and declining international commodity prices. As a result, the 12-month rate of increase of the CPI came down from 3 percent in the final quarter of 1989 to 2¼ percent in the second quarter of 1990. The downward trend in import prices came to an end in June 1990 and the subsequent increase in oil prices is expected to add ¾ of 1 percentage point to the level of the CPI in the last few months of the year. For 1990, on average, the CPI is expected to increase by 2¾ percent with about ¼ of 1 percentage point reflecting the influence of higher oil prices.

Chart 3.
Chart 3.

Federal Republic of Germany: Inflation, 1984–90

(Annualized rate in percent)

Source: Deutsche Bundesbank, Monthly Report, Supplement 4.1 The increase over the previous six months of the seasonally adjusted consumer price index, converted to an annual rate.2 The increase over the previous six months of the seasonally adjusted import price index, converted to an annual rate.3 Moving average of unit labor costs (in the total economy) in the current and in the previous quarter relative to the corresponding calculation for the previous year.

The moderate domestic price environment has been reflected in sectoral statistics. In July 1990, before increased oil prices began to affect statistics, industrial producer prices were only 1½ percent higher than 12 months earlier and agricultural producer prices in the first half of the year were actually lower than in the corresponding period of 1989. The only significant exception to this picture was in the construction sector. Reflecting excess demand, prices for residential construction have been accelerating since early 1988. In 1989, they rose by 3½ percent and in August 1990 they exceeded their year-earlier level by 6½ percent.22 It should be noted that, historically, construction prices have tended to lead inflationary developments in the FRG (Chart 4).

Chart 4.
Chart 4.

Federal Republic of Germany: Construction Prices and Consumer Prices, First Quarter 1961–Third Quarter 1990

(Percent change from the corresponding quarter of the previous year)

Sources: Deutsche Bundesbank, Monthly Report; and International Monetary Fund, Data Fund.1 Residential construction.

Potential Output and Capacity Utilization

Most estimates of economy-wide potential output in the western part of Germany suggest that the output gap which opened up in the course of the 1981–82 recession will have been closed in 1990. A new study, presented in Chapter VII, confirms the impression that capacity utilization is high. Indeed, the study finds that, adjusted for institutional rigidities in the labor market, output in 1988 was at about its potential level.23 Sectoral data present a similar picture. Demand pressures in the construction sector have already been noted. In manufacturing, pending capacity limits are suggested by order backlogs, overtime worked, reported shortages of skilled labor, and the Ifo Institute’s indicator of capacity utilization.24 Historical experience would suggest that, in such an environment, inflation pressures are likely to emerge. Chart 5 illustrates that the joint trajectory of inflation and the output gap has tended to take the form of backward bending loops since the early 1960s.25 While the chart does suggest that, in the last three years, inflationary pressures have increased in line with historical experience, caution needs to be exercised in such an interpretation as the picture is distorted by the low inflation rate in 1986–87 related to the large terms of trade gain. As already observed, the underlying inflationary pressures in the economy, with the exception of the construction sector, were relatively moderate.

Chart 5.
Chart 5.

Federal Republic of Germany: Inflation-Output Loops, 1961–891

Sources: International Monetary Fund, Data Fund; and authors’ calculations.1 The vertical axes show the percent change in the consumer price index and the horizontal axes show actual GDP in percent of potential.2 Inflation rate excluding the effects of the 1989 increase in indirect taxes.

In these circumstances, what can explain the rapid growth of output in conjunction with limited price pressure? It is true that the strong immigration into the FRG in conjunction with the higher level of investment has boosted potential output growth. Moreover, the analysis in Chapter VII suggests that, based on past experience, the inflationary pressures of recent years have not been inconsistent with measured levels of capacity utilization. But even taking these factors into account, the supply elasticity in the FRG in 1988–90 has surprised many. In part, price pressures may have been delayed by multiyear wage agreements. There are grounds for believing, however, that potential growth has been faster than measured by increases in potential labor and capital inputs. First, greater flexibility in working arrangements (e. g., shift working) has boosted the available supply of capital services in a way not captured by measures of the capital stock based on investment data. Second, the downward movement of the labor share has lowered the “equilibrium” level of unemployment and the high level of immigration may have had a significant effect on the bargaining power of unions. The growth pattern in the present upswing (Chart 6) would seem to support the view that supply conditions have improved in the last few years.26

Chart 6.
Chart 6.

Federal Republic of Germany: Pattern of Growth Cycles, 1967–90

(Percent change of GDP)

Sources: International Monetary Fund, Data Fund; and authors’ projection for 1990.

Developments in Money and Financial Markets

Overview

Money market conditions were tightened considerably in the FRG during 1989. As a result, and despite the buoyant economy, the expansion of M3 slowed to a growth rate of 4¾ percent during the year (fourth quarter to fourth quarter), compared with an increase of 6¾ percent in the course of 1988. Thus, in 1989, after three years of overshooting, the Deutsche Bundesbank met its monetary target (M3 growth of about 5 percent).

Despite the tighter monetary stance, the deutsche mark lost value in the first half of 1989, as adverse sentiment in the foreign exchanges was reflected in large long-term capital outflows. In the second half of the year, with the abolition of the withholding tax on interest (which had come into effect in January 1989) and prospects of higher real yields on investments in Germany, the long-term capital account turned around and the exchange rate recovered. On balance, the deutsche mark gained in value during the course of 1989 (December to December), by ¾ of 1 percent against the U.S. dollar and by 3¾ percent in nominal effective terms.

In the first nine months of 1990 monetary growth continued to be restrained and short-term money-market rates rose gradually. There was, however, a sharp rise in long-term interest rates, particularly in response to the announcement in early February of plans for German economic and monetary union. In September, the external value of the deutsche mark was about ½ of 1 percent higher in nominal effective terms than in December 1989, with appreciations against the U.S. dollar and the yen largely offset by a weakening against currencies participating in the exchange rate mechanism of the European Monetary System, the Swiss franc, and the pound sterling.

Monetary Aggregates

In December 1988, the Central Bank Council of the Bundesbank announced a target for growth of M3 of around 5 percent from the fourth quarter of 1988 to the fourth quarter of 1989. As in the previous year, it used M3 as its monetary target, but it deviated from its usual practice of announcing a target range.27

During the early months of 1989, money growth was faster than targeted: in the first quarter, M3 was 6 percent (at an annual rate) above the target base (Table A8). Monetary growth in January was affected by a shift out of longer-term financial assets into monetary assets and currency in particular; this, apparently, was influenced by the withholding tax on interest.28 The demand for currency abated after the announcement in April that the withholding tax would be abolished on July 1. Reflecting this and the influence of interest rate increases by the Bundesbank, monetary growth slowed and, by June, M3 was below its target path. From June to December, M3 grew at a rate of a little under 5 percent and, in the final quarter of 1989, it stood 4¾ percent above the target base (Chart 7). However, an extended M3 aggregate, taking into account, in addition, the deutsche mark deposits of German nonbanks on the Euromarkets and holdings of short-term bank bonds, grew by 8¼ percent over this period.29

Chart 7.
Chart 7.

Federal Republic of Germany: Monetary Targets and Monetary Developments, January 1985–September 1990

(In billions of deutsche mark)1

Source: Deutsche Bundesbank, Monthly Report, Supplement 4.1 Log scale.

In December 1989, the Central Bank Council announced its monetary target for 1990. The underlying assumptions of the target (which, as usual, was set in a medium-term context) were an expansion of about 2½ percent in productive potential, an increase of 2 percent in the price level, and a trend reduction in velocity of ½ of 1 percent. On this basis, M3 was targeted to grow in the range of 4–6 percent; thus, the midpoint of the range corresponded to the target that had been set in the previous year. From July 1, 1990—the effective date of the currency union with the GDR—the Bundesbank has controlled monetary policy for the entire deutsche mark currency area. As of October 1990, however, no official pronouncement had been made as to how this would affect the design and implementation of monetary policy. Meanwhile, the Bundesbank has continued to publish separately monetary data for the western part of Germany.30 On this basis, M3 in September was 5 percent (at an annual rate) above the target base and thus in the middle of the target path. The extended M3, however, continued to grow somewhat faster than M3.31

Financial Market Developments

Interest Rate Developments

Following its restrictive policy stance in the second half of 1988, the Bundesbank continued to push interest rates to higher levels through 1989. The discount and Lombard rates were increased on four occasions, in three steps of 50 basis points in the first half of the year (January 20, April 21, and June 30) and by a further 100 basis points later in the year (October 6); at the end of 1989, the discount and Lombard rates stood at 6 percent and 8 percent, respectively (Table A9 and Chart 8). The rate on repurchase transactions—the Bundesbank’s principal tool for managing the money markets on a week-to-week basis—rose by a similar amount during the year, with the increase more evenly spread.

Chart 8.
Chart 8.

Federal Republic of Germany: Interest Rate Developments, January 1985–September 1990

(In percent a year)

Sources: Deutsche Bundesbank, Monthly Report and Monthly Report, Supplement 2.

Market forces were also generating upward pressure on interest rates. The economy was growing at a rapid pace and there were fears of inflationary pressures related to the rising capacity utilization, the upcoming wage round, and the weakness of the deutsche mark in the first half of the year. The three-month interbank rate increased by almost 3 percentage points between December 1988 and December 1989, ending the year at just over 8 percent.

Meanwhile, the rise in long-term bond yields was more moderate; in December 1989, the yield on public authority bonds with maturity of nine-ten years was less than 1 percentage point above its level one year earlier. The increase was concentrated in the latter part of 1989, apparently influenced by developments in Eastern Europe, particularly in the GDR. Reflecting the sharper increase in short-term rates, the yield curve became inverted in the middle of 1989 and remained so for the rest of the year.

In the first nine months of 1990 there were no changes in the discount or Lombard rates. The Bundesbank’s repurchase rates and short-term money-market rates rose at a more moderate pace than in 1989; in September 1990 they were about ½ of 1 percentage point above their levels in December 1989. Long-term rates, however, rose quite sharply with yields on nine-ten year bonds jumping by 1¾ percentage points over the same time period. Much of this increase occurred in February, after the announcement of Chancellor Kohl’s proposals for economic and monetary union with the GDR.

Exchange Market Developments

Over the 12-month period ending in December 1989, the value of the deutsche mark appreciated by ¾ of 1 percent against the U.S. dollar and by 3¾ percent in nominal effective terms (Table A10 and Chart 9). Particularly strong gains were recorded against the Japanese yen (17¼ percent) and the pound sterling (15½ percent). There were, however, rather divergent developments in the first and second halves of the year. The deutsche mark was under strong downward pressure in the first six months: between December 1988 and June 1989, it declined by 11½ percent against the U.S. dollar and by 1½ percent in nominal effective terms. In the summer, it fluctuated with no pronounced trend and then appreciated sharply in the last few months of the year. During the first three quarters of 1990, the nominal effective value of the deutsche mark increased by a further ½ of 1 percent. There were gains Vis-à-vis the U.S. dollar (11 percent) and the Japanese yen (7¼ percent), while losses were recorded against the pound sterling (6 percent) and the currencies participating in the ERM (1 percent).

Chart 9.
Chart 9.

Federal Republic of Germany: Exchange Rate Developments, First Quarter 1980–Third Quarter 1990

Sources: International Monetary Fund, Data Fund; and Deutsche Bundesbank, Monthly Report.1 Vis-à-vis countries participating in the exchange rate mechanism of the European Monetary System; January 1980 = 100; includes Spain from June 1989.2 Vis-à-vis industrial partner countries; January 1980 = 100.

The short-run time pattern of exchange rates is often difficult to explain with reference to contemporaneous developments in goods and financial markets. For example, changes in interest rate differentials can spark exchange rate changes or may themselves be a market reaction to changes in sentiment in the foreign exchange markets; Chart 10, for example, illustrates that the relationship between long-term interest differentials and exchange rates has varied considerably across countries. Broadly speaking, the weakness of the deutsche mark in the first half of 1989, which was relatively minor compared with the strength over the preceding three years, can probably be attributed to adverse sentiment related to the coming into effect of the interest withholding tax and concerns about higher inflation resulting from the booming economy and the forthcoming wage round. In the second half of the year, investors moved back into assets denominated in deutsche mark, as the tight stance of monetary policy moderated inflation fears, the withholding tax was abolished, interest rates continued to rise in the FRG, and developments in Eastern Europe, particularly in the GDR, strengthened profit expectations for German industry. Thus, while there had been a large outflow of long-term capital in the early part of 1989, the improved sentiment in favor of the deutsche mark was seen in sizable long-term capital inflows in the last quarter of the year (Table A11). In 1990, the debate over GEMSU and the fears of inflation that it rekindled created some uncertainties in the financial markets. Indeed, there was a sizable long-term capital outflow in the first quarter of the year, but any adverse influence on sentiment in the foreign exchange markets appears to have been more than offset by prospects for higher real yields.

Chart 10.
Chart 10.

Federal Republic of Germany: Bilateral Exchange Rates and Interest Rate Differentials vis-à-vis the Deutsche Mark, January 1987–October 19901

Sources: International Monetary Fund, Data Fund; and Deutsche Bundesbank, Monthly Report.1 Exchange rate data are in terms of the units of the currency specified per deutsche mark and are expressed in index form with January 1980 = 100. Long-term interest differentials are calculated as the interest rate for the currency specified minus the deutsche mark interest rate.

Fiscal Policy and Structural Reform

Overview

After an expansionary stance in 1988, fiscal policy turned restrictive in 1989. This was the result of fiscal drag and of discretionary policy measures—an earlier planned increase in indirect taxes took effect. The withdrawal of fiscal stimulus from the latter had an unintended, but not unwelcome anticyclical effect. The interaction between fiscal policy and the real economy has been, perhaps, less fortunate in 1990. As a consequence of a large cut in direct taxes, enacted in 1987, and strong expenditure growth, fiscal policy has been expansionary, at the same time as economic growth, already strong, has been boosted by GEMSU. Meanwhile, there seems to be little spare capacity in the economy. Some important structural measures taken in recent years, in particular the three-stage reform of direct taxation, have put the supply side of the economy in a better position to respond to the increased demand, but much remains to be done in the areas of subsidies and government regulation of the economy.

Given the concerns that exist over the high degree of capacity utilization in the economy, questions arise as to how fiscal and structural policy measures might be used to alleviate any adverse consequences of the increased pressure on demand resulting from GEMSU. The remainder of this section reviews recent developments in the areas of fiscal and structural policy as background to an analysis of the role for these policies in the coming years. This latter question is taken up in Chapters I and XII.

Budgetary Developments in 1989

The budget deficit of the territorial authorities declined by more than DM 25 billion to DM 26½ billion (1¼ percent of GNP) in 1989 and reached its lowest level during the present upswing (Table A12 and Chart 11).32 The favorable budgetary developments were primarily the result of strong growth of tax revenue (Table A13). This growth had three main sources: first, several excise taxes were raised at the beginning of the year;33 second, a withholding tax on interest income was in effect for the first six months of the year;34 and, third, the buoyant economy reinforced the effects of fiscal drag and contributed to a strong rise of income and corporation taxes. As a result, tax revenue of the territorial authorities rose by 9½ percent. Other current revenue, after declining in 1988, increased by 9 percent as profit transfers from the Bundesbank recovered from their low level of 1988.35 The increase in total revenue, at close to 9 percent, was a little slower than that of current revenue as the rise in current receipts was in part offset by a drop in capital revenue, which reflected the winding down of the Federal Government’s privatization program (see below).

Chart 11.
Chart 11.

Federal Republic of Germany: Selected Indicators of Fiscal Policy, 1950–89

(In percent of GNP)

Source: Statistisches Bundesamt.1 National accounts basis.2 The sharp jump in revenue in 1953 reflects the recording of a large capital transfer from abroad as foreign loans were converted into grants.3 Administrative basis.4 In percent of expenditure.5 In 1953 debt increased despite the recording of a surplus in the accounts of the territorial authorities. This was due to the inclusion in the debt statistics of liabilities related to war reparation and pre-1945 external debts, as agreed in the London Debt Agreement of 1953.

Expenditure growth in 1989 (1¼ percentage points above the medium-term target rate of 3 percent) was buoyed by capital spending and current transfers. Investment at the municipality level was encouraged by favorable revenue developments and by an investment incentive program launched by the Federal Government in 1988.36 The Länder also raised their investment spending, in response to the DM 2½ billion transfer to “structurally weak” states from the Federal Government.37 The rise in current transfers of the territorial authorities reflected increased federal transfers to the Labor Office38 and higher social spending, including support of immigrants.39

The budgetary outcome for the social security system was even more favorable than for the territorial authorities. On a national accounts basis, the budgetary surplus increased by about DM 15 billion to DM 16 billion (¾ of 1 percent of GNP). This was largely the result of an improvement in the finances of the health insurance system,40 but the accounts of the unemployment insurance system also strengthened as a result of more favorable labor market conditions.41

Reflecting the smaller deficit of the territorial authorities and the larger surplus of the social security system, the financial balance of the general government (on a national accounts basis) improved by some DM 50 billion and, for the first time since 1973, the general government accounts were in surplus (Chart 11 and Tables A14 and A15).42 The share of general government expenditure in GNP dropped by almost 2 percentage points, with one half of this decline on account of a lower ratio for public consumption, while the share of revenue rose by about ½ of 1 percentage point. Among revenue items, the increase in direct taxes was particularly notable; the rise in indirect taxes as a proportion of GNP was considerably smaller, despite the increase in excise taxes, reflecting the relatively slow growth of consumption in 1989.

Budgetary Developments in 1990

The federal budget for 1990, which was passed by parliament in December 1989 foresaw an increase in expenditure of 3 percent in line with the Government’s medium-term target. Additional demands on federal outlays, however, required three supplementary budgets. The first supplementary budget (DM 6.8 billion) was passed by parliament in March 1990, the second (DM 4.8 billion) in May, and the third (DM 25.8 billion) in October. The additional borrowing needs resulted primarily from developments in east Germany. But, even excluding transfers to the GDR, expenditure of the Federal Government is expected to rise by about 5½ percent. Expenditure of the Länder and municipalities is expected to rise at an even faster rate. On the other hand, revenue collections of the territorial authorities in 1990 have been influenced by the third stage of the 1986–90 tax reform, which provided net tax relief of some DM 25 billion (about 1 percent of GNP) with effect from the beginning of the year (Table A16). Thus, despite strong economic growth, tax revenue is projected to increase by only 2 percent.

Reflecting these developments, the deficit of the territorial authorities, including all GDR-related expenditure in the three supplementary budgets of the Federal Government, is expected to widen by about DM 58 billion to DM 84 billion (3½ percent of GNP). In addition, the German Unity Fund (see below) is expected to raise about DM 20 billion on the financial markets. As part of the increase in the territorial authorities’ deficit reflects lending activities and as the surplus of the social security funds is likely to widen, the deterioration in the financial position of general government is expected to be of the order of DM 75 billion (including the Unity Fund). Incorporating all GDR-related borrowing of the Federal Government, the general government is expected to record a deficit of some DM 70 billion (3 percent of GNP) in 1990, compared with a surplus of DM 5½ billion in 1989.

Fiscal Implications of GEMSU

From a fiscal policy point of view, unification of the two German economies came at a favorable time. Owing to stronger-than-expected economic growth, the tax estimates prepared by a group of experts43 in May 1990 produced a substantial upward revision in revenue projections—accumulating, between 1990 and 1993 to DM 115 billion (compared with the May and November 1989 estimates).44 It was recognized, however, that this would not be sufficient to cover all the additional expenditure related to GEMSU, and that, despite a reduction in other expenditure (in particular for regional subsidies),45 borrowing would be larger than anticipated in earlier budgetary plans.

To undertake the additional borrowing associated with GEMSU, the Federal Government and the Länder agreed, in April 1990, to establish an off-budget fund (the so-called German Unity Fund). The total endowment of the Unity Fund was set at DM 115 billion. Of this, DM 95 billion would be raised in the capital market, with the remaining DM 20 billion to come from the federal budget.46 The Federal Government would bear half of the debt service costs of the Fund, with the remainder paid by the Länder and municipalities (see Table 2). Transfers from the Unity Fund were intended to finance a significant part of the deficits of the territorial authorities in east Germany, with government units in the east financing the remainder on the capital markets. Thus, the establishment of this off-budget fund would allow continuation of the existing system of financial relations between the Federal Government and the Länder until the end of 1994 in that the agreement excluded the Länder of the east from the revenue sharing arrangements existing between the Länder of the western part of Germany and the Federal Government.

Table 2.

German Unity Fund: Transfers to Eastern Germany and Their Financing1

(In billions of deutsche mark)

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Source: Bundesministerium der Finanzen.

As laid out in the State Treaty on GEMSU.

Based on a 30-year repayment schedule. The annuity after 1994 will be DM 9.5 billion.

In the months after GEMSU took effect, it became apparent that the budgetary costs would be much higher than previously expected. However, it was decided not to make any changes in the budget of the German Unity Fund, particularly since the accelerated path to political unification fundamentally changed the prospective nature of financial relations between the Federal Government and government units in eastern Germany. The Unification Treaty stipulated that 85 percent of the resources of the German Unity Fund would be directed to the Länder governments in the former area of the GDR, with the remainder going to the Federal Government; the additional budgetary costs at the federal level would be borne directly by the budget of the FRG. As already noted, a third supplementary budget became necessary to cover the additional budgetary costs in 1990. Borrowing related to the eastern part of Germany in 1990 that was incorporated in the three supplementary federal budgets for 1990 or that was to be undertaken by the Unity Fund is shown in Table 3.Table 4 presents the public sector borrowing requirement for 1990 for all of Germany, that is, including also the borrowing authority granted to the Government of the GDR.47

Table 3.

German Unity Fund and Supplementary Federal Budgets: Additional Borrowing Related to East Germany

(In billions of deutsche mark)

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Source: Bundesministerium der Finanzen.

Relative to the budget passed by the GDR’s parliament in July 1990. See Chapter XI for details.

Table 4.

Germany: Public Sector Borrowing Requirement, 1990

(In billions of deutsche mark)

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Source: Authors’ estimates.

See Table A12.

Includes only borrowing after July 1, 1990. The State Treaty on GEMSU granted a borrowing authority of DM 10 billion.

Does not include guarantees on commercial bank credits to enterprises.

The federal budget for 1990 includes DM 7 billion in profit transfers from the Bundesbank. The actual transfer was DM 10 billion and the difference is being used to retire federal debt.

Structural Reforms48

In the area of “qualitative fiscal consolidation,”49 the completion of the 1986–90 tax reform represented a considerable achievement. Attention has now begun to focus on the reform of business taxation. With a view to undertaking such a reform during the next legislative period, the Government appointed, at the end of 1989, an expert commission (consisting of members of the academic, business, and political communities) with the mandate to publish recommendations for reform in early 1991. Debate has centered on how marginal tax rates relate to those in other countries and on the existence of taxation unrelated to company profitability.50 The authorities believe, in addition, that some net reduction in the tax burden of businesses is warranted. But the size of the cut and the timing of the reform have become more uncertain owing to the fiscal costs of GEMSU. Agreement, however, has been reached on the abolition of the stock exchange turnover tax (Börsenumsatzsteuer) in 1991 and of the company tax (Gesellschaftsteuer) and the bills of exchange tax (Wechselsteuer) in 1992.51 The Federal Government has also largely completed its privatization program.52

In contrast to the improvements on the revenue side, however, only limited progress has been made in the area of expenditure. Subsidies, in particular, fell only moderately in relation to output in the period 1980–89 (Tables A17A18).53 While some further progress was made in 1990 with the phasing out of a number of tax exemptions, plans to subsidize investment and support the restructuring of enterprises in the eastern part of Germany are likely to put upward pressure on subsidy expenditure.

Some steps have been taken in the area of deregulation. A reform of the postal system, decided in 1989, went into full effect in 1990; although the reform involved some opening up of the telecommunications sector to private suppliers, a considerable part of the telecommunications market remains under the monopoly of the Deutsche Bundespost.54 There has been a limited liberalization of shop opening hours: Shops may now remain open on Thursday evenings provided they cut opening hours on Saturday afternoon (Saturday afternoon opening is allowed once a month) so that the total weekly opening time does not change. There have also been some reforms in the area of financial markets (see above), but altogether deregulation seems not to have gained any noticeable momentum. The long-awaited report of the Deregulation Commission is now scheduled to be released in 1991, although the Commission has recently published recommendations on the deregulation of the insurance and transportation industries.55

In the area of competition policy, the Cartel Law has been revised. The major changes, which went into effect in early 1990, were (1) stricter competition rules in the retail sector with a view to providing small and medium-sized companies better protection against large companies; (2) extension of the Cartel Law to cover previously excluded areas, for example, the banking, insurance, transportation, and utilities sectors; and (3) stricter control of mergers and acquisitions.

Appendix: Statistical Tables

Table A1.

Federal Republic of Germany: Aggregate Demand

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Sources: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen; and Deutsche Bundesbank, Monthly Report, Supplement 4.

Seasonally adjusted, but not annualized.

Data for stockbuilding and the foreign balance are contributions to real GNP growth in percentage points.

Table A2.

Federal Republic of Germany: Distribution of Income

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Source: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen.

In percent.

Figures fluctuate around small bases, giving rise to extreme growth rates.

Includes unrecorded tax payments, social contributions of the self-employed, net casualty insurance payments, and international private transfers.

Table A3.

Federal Republic of Germany: Household Income and Consumption

(Percent change from previous year)

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Sources: Deutsche Bundesbank, Monthly Report; and Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen.

Nominal yield on outstanding public bonds with a remaining maturity of more than three years, in percent per annum.

In percent of total labor force, based on microcensus data.

Household saving as a percent of household disposable income, national accounts definition.

Table A4.

Federal Republic of Germany: Balance of Payments Summary

(In billions of deutsche mark)

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Source: Deutsche Bundesbank, Monthly Report, Supplement 3.

Excluding supplementary trade items.

At transactions values.

Table A5.

Federal Republic of Germany: Regional Breakdown of Foreign Trade1

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Source: Deutsche Bundesbank, Monthly Report, Supplement 3.

Excluding supplementary trade items.

Including trade with unspecified countries.

Table A6.

Federal Republic of Germany: Services Account

(In billions of deutsche mark)

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Source: Deutsche Bundesbank, Monthly Report, Supplement 3.

Balance on payments among official institutions which are not included elsewhere in the balance of payments accounts; reflects mainly receipts of the German Government for deliveries of goods and services to foreign military posts in Germany.

Table A7.

Federal Republic of Germany: Earnings, Employment, and Productivity

(Percent change from previous year)

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Sources: Statistisches Bundesamt, Volkswirtschaftliche Gesamtrechnungen; and Deutsche Bundesbank, Monthly Report.

Unemployment in percent of the total labor force excluding the armed forces, based on microcensus data.

Tariff wages and salaries on an hourly basis. Actual earnings differed owing to wage drift.

Real GDP per hour worked.

Based on actual earnings and thus there are discrepancies with calculations based on hourly earnings reported above.

Table A8.

Federal Republic of Germany: Growth of the Main Monetary Aggregates1

(Period averages)2

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Source: Deutsche Bundesbank, Monthly Report, and Monthly Report, Supplement 4.

From December 1985, the published data are not comparable with earlier data because of extended coverage; to construct this table, the pre-December and post-December 1985 series have been spliced together based on the December 1985 values under the old and new coverage.

For series other than central bank money and the quarterly data for M3, data are averages of end-of-month levels.

Seasonally adjusted.

Currency held by nonbanks plus minimum reserve requirements on domestic bank liabilities (at constant reserve ratios of January 1974).

Other than bank holdings.

Up to one year.

Table A9.

Federal Republic of Germany: Interest Rates

(In percent a year)

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Sources: Deutsche Bundesbank, Monthly Report, and Monthly Report, Supplement 2; and International Monetary Fund, Data Fund.

End of period for the discount rate and the Lombard rate; period average for the rate on securities repurchase transactions.

Period average. After June 1990, reflects a change in the definition of the series.

Unweighted average of rates during the period; for American style tenders, calculated on the basis of the low rate accepted.

Interest rate on special Lombard loans during the suspension of the general Lombard facility, from February 20, 1981 to May 6, 1982.

Average yield on public authority bonds with remaining maturities of three years or more.

Average yield on public authority bonds with remaining maturities of nine—ten years.

No transactions.

Averages of end-of-month rates for the discount rate and the Lombard rate.

Table A10.

Federal Republic of Germany: Exchange Rates

(Percent change from end of previous period)1

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Sources: Deutsche Bundesbank, Monthly Report; and International Monetary Fund, Data Fund.

Unless otherwise noted; based on monthly average data. Positive figures indicate appreciation of the deutsche mark.

Annual average percent change.

Based on exchange rates vis-à-vis 16 other industrial countries.

As calculated by Bundesbank for countries participating in the ERM. Calculations for 1989 and 1990 include Spain, which joined the ERM on June 19, 1989. Calculations for 1985–88 exclude Spain.

Based on normalized unit labor costs (ULC) in manufacturing and exchange rates vis-à-vis 16 other industrial countries.

The consumer price based index uses a wider range of countries in its weighting scheme—35 other countries, compared with 16 other countries used for the unit labor cost based calculation.

Units of foreign currency per deutsche mark.