Ernst Welteke

President
of the Deutsche Bundesbank

Toward a New European Economy

Lecture held 
at the Center for German and European Studies, University of Wisconsin, Madison

on April 14, 2000

Ladies and Gentlemen,

  I

Thank you for the warm greeting. It is a pleasure, indeed, to be in Madison again. There is a special sister-state relationship between Wisconsin and Hesse which dates back to 1976. One of the earliest focal points of our relationship was education. In the many years of our school-system exchanges, hundreds of teachers and thousands of students spent time in their sister-state. Only recently - on my initiative - we established a new group, the "Freundeskreis Hessen - Wisconsin". It certainly will bring new ideas, new programs and new exchanges to both states. So you can almost call me a Wisconsinite.

I was a bit surprised to notice that there is no question mark behind today's topic, bearing in mind that economists are still debating whether the notion of a New Economy fits even the US economy. I hope that your somewhat daring forecast of a "new and vital European economy" will indeed come true.

I do not want to go as far as the famous English economist Thomas Robert Malthus (1766-1834), whose economic ideas caused some people to believe that economics is a "dismal science". But the fact that economics has its weaknesses was also evident to one of the greatest scientists ever.

When Albert Einstein was waiting at the gate of heaven he met three men whom he asked about their IQ. "190" said the first one. "Wonderful" Einstein replied "we can discuss my theory of relativity." The second man said "150". "Good" said Einstein "why don't we discuss the prospects for world peace?" The third mumbled: "50". Einstein thought carefully for a while and then replied "Now, what is your forecast for the economy next year?"

But joking aside, and considering that there are, indeed, some developments in the USA that do not fit past patterns, it may be worth asking whether there may be something of a New Economy developing in Europe, too.

I would like to concentrate my remarks on four aspects which are usually mentioned when discussing the "New Economy" of the United States. These four aspects are: first, the labor market and inflation; second, growth and productivity; third, fiscal policy; and fourth, the financial markets. As a German central banker, it may be appropriate for me to concentrate on the German economy and not on Europe as a whole.

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II

With regard to the labor market and inflation, it is initially striking that the development of inflation in Germany over the last decade has been fairly similar to that in the United States. However, there was a certain time-lag in Germany.

In the early nineties, the German inflation rate was still around 5 % owing to tight capacity utilization. Since then, it has fallen continuously. Since 1995 the inflation rate has been well below 2 %. It is thus within a range that is consistent with price stability, according to the ECB's definition.

In contrast to inflation, labor market trends in Germany during the nineties have been fundamentally different from those in the United States. Whereas the US unemployment rate has continued to decline, the unemployment rate in Germany rose significantly for a long time after the cyclical slump in 1992-3. And this rise was accompanied by a continuous decline in employment, despite an active labor-market policy and the creation of early retirement schemes. The German labor market is, so to speak, a classic element of an "old economy".

The causes of the German labor-market problems are primarily structural. This is also suggested by the comparatively large number of long-term unemployed.

From the current perspective, it remains an open question whether the establishment of European monetary union will ultimately also lead to a reduction in labor-market rigidities. However, I should add that we are witnessing a gradual erosion of industry-wide wage bargaining, at least in eastern Germany. And we are also seeing working hours becoming more flexible. However, further steps will have to follow, so that a wage policy that is in line with market requirements can help to stimulate employment-friendly growth.

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III

When I now come to the second area of my comments, "Growth and Productivity", I do not have to tell you about the US economy's success story in the nineties. It is well known to you.

In Germany, the GDP growth rate in the nineties was almost 1 ½ percentage points below the corresponding US figure. Currently, the difference in trend growth is likely to be slightly more than one percentage point.

If the different pace of economic growth is examined more closely, it becomes apparent that US output growth is driven by a sharp increase in both employment and labor productivity. This is a strong indication that a balanced growth process exists, in which labor and capital complement each other in terms of their contribution to output.

With an average growth rate of 2 %, labor productivity in Germany was quite close to the US figures in the nineties. When analyzing that development, however, it has to be remembered that the productivity gains in Germany also owed something to a fall in employment. The contrasting developments in labor productivity and employment point to an extensive replacement of labor by capital.

It is, of course, not enough to look only at the highly aggregated level. The OECD comes to the conclusion that development towards a services society has also made considerable advances in Germany: in a comparative study, it puts the share of "knowledge-based industries" in the United States and Germany at just over 50 % in each case. And in the category of investment, as in the United States, investment in software shows by far the highest growth rate in Germany.

What do these findings now imply for future growth prospects? Most of the currently available forecasts agree that an economic recovery is to be expected in Germany over the next few years, whereas the pace of expansion in the United States is likely to decelerate, leading to a soft landing. To that extent, a certain convergence of cyclical growth can be expected. However, from the perspective of the debate on the "New Economy", the key question is whether the anticipated upswing in Germany will be more than cyclical in character and lead to a trend shift in the path of growth - in much the same way as in the United States during the nineties. I believe this is possible if the willingness to undertake reforms is followed by action to match.

What is of paramount importance to me in this connection is to point out that the integration of the European goods and factor markets inherent in the EU's single market program is being accelerated by the single monetary policy in the euro area. The resultant intensification of competition may act as a sustained boost to productivity. The changes in the telecom sector are an example of how the deregulation of markets can make further progress in Germany as well. With the intensified competition, especially in an increasingly globalized competitive environment, this development will not only put a damper on prices. It is also likely to lead to further surges of modernization, in which new globally available technologies will be employed.

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IV

Although fiscal policy is not at the actual center of the New Economy controversy, I think it is a very important player in the macro­economic setting.

In Germany, reunification confronted fiscal policy with its most difficult task since the period of reconstruction following World War II. The restructuring of the corporate sector in eastern Germany in keeping with the social welfare system, the enormous task of modernizing the public infrastructure and the adoption of the west German social security system required huge transfer payments to the east, the bulk of which were covered by public borrowing.

Overall, there has been a significant increase in the public sector's recourse to the resources of the economy as a whole.

The unhealthy developments in public sector finances made a reversal increasingly inevitable. Moreover, the convergence criteria of the Maastricht Treaty had to be met. Since 1997, the deficit ratio has been declining as a result of increased consolidation efforts.

The decisions taken since summer 1999 warrant the hope that major changes in the economy as a whole will also be supported by fiscal policy. However, the picture is very complex in this area.

It has to be regarded as favorable for the future development of the economy that the German Federal Government is committed to pursuing a strict policy of consolidation. What is gratifying is that this course is not just being pursued in theory but has already been implemented by measures which will have a rapid impact. The savings package envisages savings of DM 30 billion for 2000 and around DM 50 billion for 2003. Hence the public sector's recourse to GDP is likely to fall. The consolidation course is to be accompanied by tax reductions on a quite impressive scale.

The twin-track approach of tax cuts and a restrictive spending policy has paved the way for a sustained reduction of the public sector burden on the capital markets, and hence the creation of greater scope for private investment.

The government's plan for a reform of business taxation now aims to grant relief to enterprises, and thus create conditions that are more favourable to growth via the supply side. This reorientation will be accompanied by a further two-stage reduction in income tax in 2003 and 2005, which will also include the top rates.

The cut in the corporate tax rate to a uniform level of 25 % will enhance Germany's attraction as an industrial location. The planned tax exemption of corporations' profits from the sale of equity interests will facilitate corporate restructuring. Germany is likely to become more attractive as a location for holding companies.

In all, the tax plans are an important and welcome beginning which should be followed by further steps.

Whereas approaches to a solution are emerging in the field of fiscal policy, the same cannot be said of the severe structural problem of the statutory system of old-age provision. Above all, what is needed is a curb on the rate of pension growth. That would create room for supplementary privately-funded pensions. It would also benefit the capital markets. And, in mentioning the capital markets, I have now arrived at the last topic of my presentation.

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V

Undoubtedly, the "New Economy" is closely connected with developments in the financial markets. For example, the sharp growth in the supply of venture capital in the United States suggests that the momentum of the real economy is being underpinned by flexible, innovative forms of financing in the capital market.

The German financial system has traditionally been characterized by the dominant role of the banks. Such more "bank-based" structures should by no means be equated with backwardness, however. On the contrary, credit institutions' intermediation may in some cases actually be superior to a market-based financial system. Just to give one, particularly important, example: the corporate landscape in Germany has traditionally been characterized by small and medium-sized enterprises. Long-standing, strong business relationships with specific banks are particularly suited to meeting the financing requirements of such enterprises at reasonable cost even in periods of economic difficulty.

However, from the point of view of the New Economy, market-based financing is especially important. It is precisely young, innovative enterprises with uncertain earnings prospects that often have to rely on financing sources outside the banking system.

In this connection I would like to draw your attention to the rapidly increasing significance of the stock market in Germany. In 1999 alone, domestic enterprises issued shares with a market value of E 36 billion. This is an increase of almost 50 % compared with 1998, and three times the 1997 figure. Particularly noteworthy is the large share of initial public offerings in what is known as the "New Market", the market for young and innovative enterprises. More than 200 companies are now listed in this sector, which has thus become an engine for financing innovative enterprises in Germany.

However, the New Market is only appropriate for firms which have already established themselves in the market. Hence it is of particular importance that, alongside the success of the New Market, venture-capital business has simultaneously undergone a rapid upswing. The amount of venture capital invested rose by DM 5 billion in Germany in 1999. At the same time, the structure of venture-capital investment changed radically. Whereas it used to be more traditional sectors that attracted venture capital in the past, such investment now focuses on telecommunications, biotechnology and computing.

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VI

Ladies and gentlemen, let me finally return to my initial question: "Is there a New Economy in Germany?" This question cannot be answered with a sweeping yes or no. There are certain signs of a New Economy.

First, there are movements in Germany which are simultaneously beneficial to growth and price stability.

Second, the new technologies are available globally.

Third, the German financial system seems well equipped not only to accommodate the changes in the real sector, but also to support them. I cannot, and do not want, to comment on the movement of equity prices in the New Market in Germany. But I do believe that traces of a New Economy can be found in this market segment. On top of that, ever-increasing competition and technological advances are leading to a far-reaching renewal of the financial sector.

Fourth, Germany has a highly qualified labor force capable of implementing new technologies.

Fifth, the economic policy decisions taken since the summer of 1999 suggest that an upswing in the economy as a whole is being supported by the fiscal framework. What is especially positive is the commitment to a strict consolidation course which is being reinforced by concrete savings measures.

And last, but by no means least, monetary union in Europe and the completion of the single market are promoting corporate restructuring, which is improving the efficiency of the economy. No one should underestimate the stimulating effects of the euro.

A combination of technological change and structural reforms will make possible not only better use, but also a widening, of the potential for growth in Germany, and thereby play a crucial role in revitalizing the European economy.

So, will there be a New Economy in Europe? We shall see. Economics is really like science before Newton. "A few things will stand the test of time, but the rest is meaningless."

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