Honey, I shrunk the German VAT shock

Ever since the end of the German coalition negotiation between Christian Democrats and Social Democrats in late 2005, the standard forecast for 2007 has been full of gloom. Following the increase of the standard VAT rate from 16 to 19 percent, most economists had been projecting a sharp slow-down in growth in 2007, if not an outright end of the economic recovery. Deutsche Bank even forecasted an outright fall of GDP in 2007 compared to this year. Papers in Germany were full of articles lamenting “the largest tax increase in history” with commentators claiming that the upswing would be extremely short-lived.

Recently, the attitude towards the VAT hike has changed markedly. A number of important banks have revised up sharply their forecast for Germany for 2007. Citigroup now projects a GDP growth of 1.7 percent, up from 1.1 percent. Morgan Stanley corrected it forecast from 0.7 to 1.5 percent. Yesterday, the OECD revised it forecast for 2007 to 1.8 percent. Moreover, both current GDP details as well as business surveys hint that growth will not take as much of a beating as has been feared: Last week, the Ifo index rose the second consecutive month, with both the sub-index for current conditions as well as for the business outlook increasing sharply. Obviously, the companies do not believe that the VAT increase will derail the economy. This might well turn out to become a self-fulfilling prophecy: With businesses expecting continuing brisk growth in 2007, they will continue to increase capacities and to hire new employees, thus providing disposable incomes to consumers who in turn can continue to shop even when the VAT increases.

Behind this shift in attitude are two reasons: First, the upswing has gained more momentum than many had thought possible. Especially fixed investment, both in machinery and construction, has recovered strongly. According to the KfW, business investment should rise by 7.9 percent this year, roughly the same amount as in the boom year 2000. Since the beginning of the year, in seasonally adjusted terms, more than 300,000 new regular jobs have been created. In Q3, even consumption contributed strongly to growth, with the fall in inventories pointing to strong production going forward.

Second, the grand coalition has relatively stealthily increased the planned cut in social security contribution, offsetting much of the VAT hike. For example, it is now planned that contributions for the unemployment insurance are cut from 6.5 to 4.2 percent in January, more than originally envisioned. While there will still be some 20 bn Euro in net increase in tax and social security contribution burden, the relief will be big enough that government revenue, measured as share of GDP, will roughly remain constant in 2007 according to most current estimates (see here for example the EU commission’s forecast which predicts a marginal increase from 43.5 to 43.6 percent). A “tax shock” as many had dubbed the VAT increase surely looks different.

This puts German budget consolidation into stark contrast with the Italian policy which relies much more heavily on increased revenues that the German consolidation. In Italy, the share of government revenue in GDP is projected to rise from 44.9 to 45.7 percent in 2006, after an increase from 44.0 to 44.9 percent this year (see figure).

The brighter outlook for Germany is not a merely national issue, but has positive consequences for the rest of the eurozone. Just as the German economy has dragged down the rest of the region for a number of years, it now provides a welcome boost at a moment that the US economy is slowing. Due to its brighter outlook for the German economy, Morgan Stanley has also revised upwards its Eurozone forecast (from 1.5 to 2 percent for 2007).

What might be more important, however, is that the German upswing might provide necessary breathing space for countries such as Italy which have lost competitiveness in the past years. Not all of Italy’s slow export performance can be attributed to the country’s poor unit labour cost developments. Much seems to have been a consequence of poor consumption demand at one of its main trading partners, Germany. If now internal demand in Germany is recovering, so should Italy’s exports, making divergences in the Eurozone less of an issue – at least until the recovery in Germany comes to an end.

Goodhart warns of political miscalculations in the Euro exit debate

A few weeks ago, Eurozone Watch had a little curtain raiser on a conference from the Institut für Makroökonomie und Konjunkturforschung on “European integration in crisis”. Though it has been two weeks since that conference, I would still like to give a short account of that conference.

It was really interesting to see that one of the hottest topics on the conference was the question of divergences in the eurozone and how they could be dealt with (even though the actual title of the conference was much broader). Hardly any of the sessions failed to mention this problem.

Charles Goodhart gave a very interesting presentation on divergences and the possibility of an EMU break-up (I later conducted an interview with him for the Financial Times Deutschland in which he became even more specific). He argued that the costs for leaving EMU might well be underestimated. While he agreed that a country such as Italy could in principle de-lirafy debt contracts and then devalue, he reminded us that the case would be much complicated by the fact that Italy is not only member of the EU, but also home for a number of multinational companies.

Costs of leaving EMU might be higher than thought

Being member of the EU, he argued, would mean that any law changing the denomination of Italian debt contracts in which one of the parties would come from another EU country would most likely be challenged in the Europan Court of Justice. He concluded that the only viable alternative would be leaving EMU and EU together.

As for the multinational companies from Italy, he argued that they would become targets for court action from creditors in all countries where they have subsidiaries, with the possible consequence that assets may be seized and business activity badly disrupted.

However expensive leaving EMU in real terms might be, Goodhart however warned that single government might well underestimate these costs. According to him, therefore there might be a real possibility that a country might leave EMU in the coming decade. Specifically, he warned that even playing publicly with the idea of leaving EMU might lead to capital flows which in the end force a country out of monetary union.

Using seignorage profits for stabilisation

Goodhart again called for a more centralised fiscal policy (and I learned that he had already called for both a transnational stabilisation fund and a European corporate tax in the early 1990s – an idea Daniela and I took up lately without knowing Goodhart’s earlier work). He also made the interesting proposal that money made from seignorage (basically the euro system’s profits) could be used for a eurozone-wide stabilisation fund.

The idea of European fiscal policy was repeatedly mentioned, which might not be too much of a surprise, given the Keynesian provenance of most of the participants, while it was criticised by one ECB economist who also took part in the conference. According to him, the single member states could do much more against divergence than they are doing now. It was a little sad to see that the two camps (more centralised fiscal policy vs. national policy action) did not really come closer together. To me it seems evident that we need a two-handed approach with countries like Spain fighting their housing bubble with national instruments, countries like Portugal reforming their labour market so that unit labour costs do not continue to rise excessively and a second pillar which creates a fiscal stabilisation mechanism which deals with those divergences which cannot be dealt with nationally.

Apart from Goodhart’s presentation, there was a lot of discussion about how bad the situation of single EMU countries really has become. While most participants agreed that the situation for poor little Portugal is really dire, there was more disagreement for the other problem cases: Some economists argued that the situation in Spain is not as bad as often thought since fixed capital formation is high (though I might carefully add that it has been to a large extent investment in housing). Italy’s case was also careful examined, with some economists providing further evidence for Ulrich Fritsche’s and my finding that the situation might be overly dramatized (by the way, Eric Chaney from Morgan Stanley has published a note with a similar direction), while others defended the view that Italy’s competitiveness situation is indeed very problematic.

What was really positive about the conference is to know that the most pressing problems of EMU governance now seem to be widely discussed. Maybe this puts us a step into the right direction of – at some time in the future – acutally changing institutions to make EMU work.