Posted by: Dirk | December 3, 2008

The debate on economic policy in Germany

The current debate on economic policy in Germany is frustrating. There are mainly two reasons why this is so. First, there is no real discussion on what is wrong in the economy. Two, everybody says what he or she always says when it comes to economic policy, which is fiscal policy in these days. Let me elaborate.

Some days ago, chancellor Merkel criticized banks for not putting out enough loans. Also, demand seems to fall. Solutions: (1) give more money to banks (to increase loans) and (2) more money to consumers (to increase demand) by cutting taxes and that is it: problem solved. Is it really that simple?

So, the discussion on what went wrong in the economy has treated only the symptoms, not the real causes. The solutions to cure the symptoms seem straightforward and sound so good to almost everyone, it seems, that no discussion on economic theory is deemed necessary. Self confidence is only shaken slightly by other (European) countries announcements of expansionary fiscal policies. So, why might Germans have to think about economic policy harder than they normally do?

First of all, we are in a position where monetary policy does not work anymore. To boost the economy, it used to be enough to increase money supply, thereby lower the interest rate, which boosts investment, which finally boosts employment and output, end of story. Apparently, somewhere in this chain there is a problem. Banks are reluctant to lend and enterprises reluctant to invest. What about consumers? They spend less. The reason is probably not that income taxes are too high (they have been only lowered since 2000), unemployment is rising (which is actually still falling) or consumers are debt-laden (this still is Germany). So it’s not a problem of income, one would think. It’s more a problem of people wanting to save more.

A tax cut for consumers will probably not help in this situation. Consumers cut their spending, not because they had to, but because they wanted to. A fiscal stimulus will probably end up in outright savings, payback of debt, or, worst of all, the money is stuffed under the bed. The US stimulus in May made in dent in consumption, but it was too small to solve the problem. Which brings us to the next problem: even if the tax cut increases spending, who guarantees that it is enough? Demand has to be pushed up, to increase the expectations of entrepreneurs (so that they invest again) and to banish the specter of deflation (which would be horrible for entrepreneurs).

I would argue that the goal of economic policy is not just to add a little demand, but to make sure that entrepreneurs know (1) there will be demand for their goods and services and (2) there will not be deflation, which would harm those that buy now and sell later (yes, entrepreneurs again). Private investment, which has fallen to a coordination failure, has to pick up again, everything else is secondary. The solution might be plain government spending, since only this guarantees that the money is spent. Also, at current low interest rates (and maybe the ECB can lower them some more), debt-financing is a cheap option in the short run. And this is all about the short run. But since there is no discussion, I rest my case. For now.

UPDATE 04/12/2008: Sebastian Dullien at RGE thinks that German economists are partly to blame for Mrs Merkel’s slow reaction. I agree.

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