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Germanys Economic Dilemma

To Save or To Spend1?
Keynes always maintained that a big part of economics was psychology (animal spirits and all that) so the stake
of psychological play in Germany is of no little importance at the moment2.
Psychology can be a brake on growth, or it can be a spur to growth. There is a big risk that in Germany, it will
remain a significant brake. We must all work together.
Hans Eichel, German Finance Minister3

The German economy is the worlds third largest, and IT alone accounts for more or less one-fourth of the European
Unions GDP. With regard to world trade it is second in the world4 . It is the biggest trading partner of U.K., France and
Italy, Europes second-, third- and fourth-largest economies, respectively5 . From the 1948 currency reform until the
early 1970s, West Germany experienced almost continuous economic expansion, but real GDP growth slowed down
and even declined from the mid-1970s through the recession of the early 1980s. The economy then experienced eight
consecutive years of growth that ended with a downturn beginning in the late 1992 (Annexure 1). Since reunification
in 1991, Germany has seen annual average real growth of only about 1.4% and stubbornly high unemployment6 . The
best performance since reunification was registered in 2000, when real growth reached 3.0% on account of global
economic recovery and domestic private consumption (Annexure 2)7 .
German unification has not been a qualified success in terms of economic integration and GDP growth8 . Private
consumption, which accounts for more than 60% of the GDP, rose by 46% for the period 1991-2003. This was insufficient
to offset the decline in government consumption and the volatility of exports. Since 2000, even private consumption
has been declining due to consumers not so optimistic expectation of the economy9 and their increasing propensity to
save. This was partly due to the rise in unemployment and uncertainty of the sustainability of socio-welfare schemes.
Helmet Kohl, who was preoccupied with the unification to the detriment of economic growth, was given marching
orders and was replaced with Gerhard Schrder (Schrder) on October 27th 1998. As promised in the election campaign,
Schrder tried to kick-start the economy with the tax reforms, an exercise with a little success. Subsequently in his
second term, he sought to revive the economy by implementing comprehensive economic reforms, titled Agenda


Spend refers to consumer spending and investment by companies.
Between 1991 and 2002, the German trade surplus soared. From 11 billion in 1991 it increased to around 84 billion in 2002. Imports totaling 665 billion were offset by the export of goods
and services totaling 749 billion. The year before, the trade surplus had reached a record 87 billion.
Since 2001, unemployment has been consistently above 4 million mark.
Reunification with East Germany has been colossally expensive, costing 1.25 trillion since 1990, and still consuming 4% of GDP in transfers ( as of 2004), with the added burden of 20%
unemployment in the region. The Economist
As measured by the Munich based IFOs business confidence index.

This case study was written by CAnanda Prasad under the guidance of G Srikanth, IBSCDC. It is intended to be used as the basis for class
discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from
published sources.
2004, IBSCDC.
No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without
the permission of the copyright owner.

Germanys Economic Dilemma To Save or To Spend?

Policy experts believed that Agenda 2010 could be a success only if consumers dilemma to save or to spend,
was settled boosting consumer spending10 . Schrder had to achieve this without resorting to too much of Keynesian
economics as his fiscal and monetary policy maneuverability was constrained by the euro areas stability and growth
pact(SGP) and European Central Banks monetary policy decisions.

Germanys Economy Under Gerhard Schrder

Germanys economic system could be described as a social market economy11 . The Government had been
providing an extensive range of social services. Although it intervenes in the economy through the provision of subsidies
to selected sectors and the ownership of some segments of the economy, competition and free enterprise have been
promoted as a matter of policy. The economy is heavily export-oriented, with exports accounting for more than onethird of national output. As a result, exports traditionally have been a key element in the macroeconomic expansion.
Germany has been a strong advocate of closer European economic integration, and its economic and commercial
policies have increasingly been determined by agreements among the European Union (EU) members. Like other EU
members, Germany uses the common European currency, the Euro, and the European Central Bank sets its monetary
More than a decade after the unification of the two German states, great progress has been made in raising the
standard of living in eastern Germany, by the introduction of a market economy and improvement of infrastructure. At
the same time, the process of convergence between East and West has been taking longer than originally expected
and, on some measures, has stagnated since the mid-1990s. Since 2001, Eastern economic growth rates have been
slower than in the West, unemployment twice as high, prompting many skilled easterners to seek work in the West,
and productivity continues to lag. Eastern consumption levels are dependent on public net financial transfers from
West to East totaling about $65 billion per year, or over 4% of the GDP of western Germany. In addition to social
assistance payments, the government plans to extend funds to promote eastern economic development until about
2010. However, there is discontent in the more populous West Germany that East Germany has been a drag on the
German economy.
Germans are regularly asked in surveys about how they assess the economic situation. In September 1998, only
35% of the respondents considered the economic situation to be good or very good12 . The popular discontent was
expressed at the September 1998 polls, ousting Helmut Kohl and handing a strong mandate to the new Chancellor
Schrder. His main task was to lift the moribund economy to a healthy level and thus reduce unemployment from
10.6% (4.1m people)13 to acceptable levels. The roots of the economic troubles were very clear: wages, taxes, socialsecurity deductions and state subsidies were all too high, the labor market too inflexible. Lafontaine14 , the finance
minister argued that higher public investment was necessary to stimulate consumer demand and thus economic
growth. However, the leading employers federations criticized the governments economic course15 and finally Lafontaine
resigned in March 1999. Sensing the peoples psychology16 Schrder replaced Lafontaine with Hans Eichel, who
focused on a gradual reduction of the budget deficit through cuts in public expenditure. In early July 1999, two SPD
minister-presidents Kurt Beck and Wolfgang Clement demanded real wage freezes, i.e., linking nominal wage increases
to inflation, for the next two years in order to reduce unemployment. Apart from budget cuts, Schrder introduced tax
reforms17 (Annexure 3) to revive the economy and reduce unemployment. He believed that a 10% tax cut would
produce a stimulus to consumer spending of a similar scale. However, according to economic commentators, the
figure could be just 1.7%18 .




Consumer spending accounts for more than half of GDP.

The Social Market Economy concept had two central aspects: 1) Decontrol to a certain degree of market processes, and 2) an institutional framework of government Ordnungspolitik, an
orderly structure of rules for the economy, designed to steer market powers and compensate for undesirable effects of liberalization. Although the original concept of Social Market Economy
speaks of all social forces as order-giving potentials, the government has, over the course of time, turned into a monopoly of Ordnungspolitik. The overall aim of German economic policy is to
secure stable prices, a high rate of employment and a balanced foreign trade along with steady economic growth. The central task of economic policy is to limit unemployment.,10155.23403/rede/Address-given-by-Chancellor-Ge.htm
Gerhard Schrders task October 1st 1998, The Economist,
He is an enthusiastic supporter of Keynesian demand management and expansive fiscal policy and a favorite of the left wing of the SPD as well as of the trade unions.
The German weekly Der Spiegel asked for the whereabouts of Schrder and called for the chancellor to put Lafontaine in his place.
Nearly 70% of Germans believed the country needs far-reaching reform to cope with globalization, according to a poll by Berlins Forsa Institute. Labor unions agreed to wages of 3% or less,
in line with productivity and inflation, and signed longer, two-year contracts that made it easier for companies to plan and to hold down costs. -Gerhard Schrder: The Accidental Reformer May
1st 2000, BusinessWeek,
(Read tax cuts)
Chancellors cash crisis, July 14th 2003 -,12498,997949,00.html

Germanys Economic Dilemma To Save or To Spend?

The tax cuts cheered companies and consumers alike19 . Germanys business leaders hailed the governments
deficit reduction package as a breakthrough for economic reform. The government reformed corporate tax law with a
view to creating an internationally competitive tax system Corporate tax was cut from 40% to 25% effective from
2001. Moreover, the government spending cuts amounted to DM30bn ($15.9bn). Most of these cuts came from the
labor and social security budget. The rest was spread evenly throughout other government departments. A big chunk
of savings came from linking the annual rise in pension payments to the rate of inflation, as opposed to average
earnings20 . These measures were supposed to strengthen private consumption and facilitate the financing of
investments, both of which are prerequisites for more growth and employment. In the wake of the world economic
recovery in 1999 and 2000, German economy also seemed to recover. In September 2000, 60% of the respondents of
the economy survey said that economic situation looked good or very good21 . However, Germanys economy, which
was dependent on exports, remained vulnerable to external shocks22 . The September 11th 2001 terrorist attack on
World Trade Center shook investor confidence not only in United States but also in Germany along with that in many
industrialized nations. In this context, German employers who needed flexible hire and fire policy failed to get adequate
support from the government authorities, to keep their going concerns going. Budget cuts and tax reforms neither did
address the concerns of international investors nor that of German companies for that matter. As a result corporates
consistently criticized the structural rigidities in the economy, the high and rising cost of labor and the poor mix of fiscal
and monetary policy since German unification.
Corporate tax reform has been a stop-start process, leaving companies uncertain about future tax bills and benefits.
The level of basic corporate tax is still the highest in Western Europe, at 38.7%, compared with 35.4% in France, 34%
in Austria (falling to 25% next year) and 12.5% in Ireland. Though there are ways for companies to reduce this burden,
they tend to favor the larger firms. According to Lorenz Jarass, an economics professor at Wiesbaden University, the
top 30 listed companies tend to get more credits back from the government than they pay in tax. For example, in 2002,
DaimlerChrysler reclaimed a net 1.2 billion ($1.5 billion), while the tax payments of Thyssen Krupp and Lufthansa
netted out at zero23 . That sort of favoritism nags the smaller, Mittelstand companies, which insist they are the backbone
of the German economy, employing 70% of the workforce, accounting for 46% of investment and creating 70% of all
new jobs. There are fewer ways open for them to reduce their tax bills24 .
Apart from employers, employees have also been unhappy about the way the tax cuts were structured. Between
1991 and 1997, the cost of employing German workers went up by 11%. And, since 1999, tax cuts put more money in
the hands of consumers. Consequently consumer demand was supposed to pick up and lift the economic growth rate.
Despite the rise in wage costs, net incomes remained virtually flat because of increases in tax and social security
contributions. Income taxes were reduced only marginally and the social security contributions, which amounted to
40% of wage costs, only came down by a fraction. Since Germany had been a country with high income tax rates, but
relatively generous tax write-offs the combined result was an effective tax increase for many middle - and highincome earners, who drive the consumer demand up (Annexure 4). Moreover, unemployment continued to increase
since 2001, making people pessimistic in their outlook. In May 2002, IFOs25 report mentioned that its business
confidence index fell to 96 from 96.3 in April 2002, according to the median of 38 forecasts in a Bloomberg News
survey26 . A separate survey of economists showed that household spending failed to increase. GDP rose 0.25% in the
months of April, May and June, barely above the 0.2% rise in the first three months of 2002. Unemployment in
Germany rose to a three-year high; business confidence among top companies faded and the countrys leading stocks
markets index, the Xetra Dax, fell by almost 30% further hampering consumer and business confidence27 .
In the backdrop of rising unemployment and poor economic growth, Schrder was expected to lose in the September
2002 elections. However, he was reelected28 . He understood that tax reforms and budget cuts would fail to take the
economy much further and that his country needed the long delayed structural reforms to revive the economy. So, on
March 14th 2003, he announced comprehensive structural reforms labeled Agenda 2010 (Annexure 5). He indicated


Tax cuts put extra money in the hands of employers and consumers.
German Business Climate darkens July 25th 2002,
Companies generate almost a third of their profits through exports, and almost one in four jobs are dependent on foreign trade.,
How to pep up Germanys Economy May 6th 2004, The Economist
IFO Institute is one of the largest economic research institutes in Germany. It is a service-based research organisation with a three-fold orientation: conducts economic research, offers advice
to economic policy-makers and provides services for the research and business communities.
opcit - German Business Climate darkens
German economy barely grew August 19th 2002,
His re-election in September 2002 was by a tiny margin, based in large part on his opposition to American foreign policy and his response to the preceding summers floods, not on a mandate
for economic change. -

Germanys Economic Dilemma To Save or To Spend?

that the objective of the program was to make structural improvements that would save 45 billion euros in federal
budget expenditure29 . The program was aimed at cutting spending on health, pensions and social welfare, streamlining
the job market, relaxing employment legislation, encouraging people back to work and lowering taxes to boost consumer
spending. The chancellors most controversial reform was aimed at the long-term unemployed, who comprised twothirds of the jobless. Under his proposals, those who remained out of work for six months or more receive lower
benefits, paid out over a shorter period 12 months, rather than 32. Furthermore, if they are offered a job and refuse
to take it, they may lose their benefits altogether. The labor market reforms, part of Agenda 2010, made it easier for
firms to hire and fire employees. Moreover, Schrder and Wolfgang Clement, the Economics & Labor Minister, brought
changes in working hours30 , pushed back retirement age and reduced holidays31 . This was supposed to absorb the
shocks in both the demand and supply side of labor and in turn boost consumer spending. However, the German
consumers seemed to remain in a state of suspended animation unable to decide to save or spend.

To Save or To Spend?
Germany is willing to undergo change. Germany is moving forward. Schrder used these words in a policy
statement delivered on July 3rd 2003, to describe a new mode of thinking brought about by the Agenda 2010 reform
program32 . However, his decision in mid-December 2003, to bring forward the tax reform evidently failed to have the
desired effect on consumers of removing their dilemma to save or to spend. The uncertainty resulting from the continued
controversy regarding tax, social security and pension reforms impacted on the mood and consequently, all consumer
climate indicators were down in January 2004.
The survey carried out by GfK33 in January 2004, showed that the bad mood among German consumers deteriorated
further. It was in direct opposition to the optimism felt by companies (IFO) and the financial analysts (Zentrum fr
Europische Wirtschaftsforschung). According to the IFO business climate index and ZEW, companies and financial
experts continue to be positive about the future. The recent consumer low is attributable to the unresolved political
debate surrounding the tax, pensions and healthcare reforms. The consumer climate indicator, which had been rising
slowly but surely since May 2003, is slightly down for the first time in the recent months.
At the end of 2003/beginning of 2004, German consumers were once again pessimistic about an economic upturn,
following several months of optimism in 2003. With a value of -1.6 points in December 2003, the economic outlook
indicator decreased by a further 4.2 points in January 2004 to stand at -5.8. Consumers did not share the positive
expectations of companies, financial and economic experts with regard to the economy34 . Income expectations were
down again. The indicator lost 2 points in December 2003 and a further 6 points in January 2004. The sobering
development was the manifestation of consumer irritation as to their future financial situation. In the consumers
minds, the fear of potential financial burdens outweighed any possible benefits resulting from the healthcare reform.
Pensioners, in particular, were worried about having to get by on less money at the beginning of 2004. From January
2004 onwards, pensioners had to pay the full healthcare contribution on company pensions. Even the IFO Business
Climate index of manufacturing, construction, retailing and wholesaling in Germany continued its downward slide
during the months of January, February and March 2004. It slightly rose in April only to fall again in May35 (Annexure 5).
In manufacturing, both the appraisals of the business situation as well as the expectations improved slightly. In
retailing the business climate index remained largely unchanged; whereas the assessments of the current business
situation worsened, the business expectations for the coming six months improved. In construction and wholesaling,
however, both components of the business climate index weakened.
The slight decline in the business climate was a result of a worsening in East Germany, but in West Germany the
climate indicator rose a fraction. The latest survey results, especially the nearly unchanged business expectations,
speak for an ongoing, moderate economic recovery in Germany in the later part of 2004. May be Germany was willing
to undergo change. And Germany was moving forward.




Schrder: Germany Open To Reducing Subsidies 11th July 2003,

Analysts say just an hour more work per week would cut production costs by three percent, and have noted that 0.6 percentage points of the 1.7 percent economic growth forecast for Germany
in 2004 would come alone from the fact that five national holidays fall on weekends.
Germanys comparatively short work week, as well as the numerous holidays and vacation days that drive up labor costs compared to the international market, contribute considerably to the
desperate economic situation.
The GfK Group, the No. 5 market research organization worldwide, is active in five business divisions, Consumer Tracking, HealthCare, Non-Food Tracking, Media and Ad Hoc Research. In
addition to 15 German subsidiaries, the company has over 120 subsidiaries and affiliates located in 50 countries.
Ifo business climate in industry and trade -

Germanys Economic Dilemma To Save or To Spend?

Annexure 1


Germanys Economic Dilemma To Save or To Spend?


Germanys Economic Dilemma To Save or To Spend?

Annexure 2a

Economic Growth(% GDP in 1995 prices) in Germany 1992-2003













Compiled from:

Annexure 2b: Growth, Inflation and Unemployment



Unemployment rate (RHS)

Growth (LHS)


Inflation (LHS)











Germanys Economic Dilemma To Save or To Spend?

Annexure 3
Highlights of Tax Reforms
A) Highlights of the Tax Reform 2000

The rate of corporate income tax was reduced from 30 percent 40 percent down to 25 percent.
The tax imputation system was abolished. Inter-company dividends between German corporations are
exempt from tax. Individual shareholders are only taxed on 50 percent of the dividends received from
A national participation exemption was introduced. All capital gains realized directly or indirectly by a German
corporation from the sale of shares in a German subsidiary are exempt from tax. (Previously, such exemption
was available only in a sale of shares in a non-German subsidiary).
German thin-capitalization rules for foreign investors were tightened.
The depreciation of assets was restricted.
The conversion model, which enabled a step up in basis upon a conversion of a corporation into a
partnership, was abolished.
The quota for a material holding in a corporation was reduced from 10 percent to one percent. Consequently,
the gain resulting from the sale of shares in corporations is tax exempt if the seller owns less than one
percent of the corporation (previously less than 10 percent).

B) Highlights of the Tax Reform 2001

The requirements for a fiscal unity for trade tax purposes have been adapted to the requirements for a
fiscal unity for corporate tax purposes.
The transfer of assets between partnerships and partners and vice versa is tax neutral under certain
Partnerships and sole proprietorships are entitled to a tax free rollover of capital gains up to 500,000 from
the disposal of corporations if such capital gains are utilized for the investment in another corporation.
No tax relief is available for the disposal of only a part of a partnership interest by individuals.
Portfolio dividends (participation of less than 10 percent) are subject to trade tax. Expenses connected to
such dividends are deductible for trade tax purposes.
Capital gains by corporations from the disposal of partnership interests are subject to trade tax.
Dividends and capital gains are defined as active income in the context of CFC-regulations.
Dividends and capital gains are tax exempt if the income of a CFC was subject to tax.

Annexure 3b: Agenda 2010 Overview

Healthcare Reform
On September 26, 2003 Germanys parliament, the Bundestag, passed a law that would reduce monthly premium
payments for the national healthcare system from 14.3% of an employees income to 13.6% next year and 12.15% by
2006. As health insurance payments are split by employers and employees, the reduced premium is aimed at
lowering Germanys staggering non-wage labor costs. To finance the cuts, the public health fund will no longer
finance dentures or replacement teeth and will require patient co-pay for doctor visits and prescriptions. The reforms
are expected to save insurance companies up to 20 billion.
Labor Market Reform
A second reform bill passed on September 26, 2003 seeks to make Germanys heavily regulated labor market more
flexible. It reduces to 12 months the maximum duration a person can receive unemployment benefits after losing a
job and also makes it easier for companies to hire and fire employees. Older employees, however, could receive
unemployment benefits for up to 18 months.

Germanys Economic Dilemma To Save or To Spend?


Labor Office Reorganization

A crucial component in the governments reform package, passed in an effort to reduce unemployment, is a massive
reorganization of the Federal Labor Office. The office will be modelled after a private placement agency and
rechristened as the Federal Job Agency, with responsibility for managing unemployment benefits and finding
placements for jobless. The law also requires companies to immediately inform the office if an employee has been
given notice and to free up employees for job hunting so they can find other work before they become unemployed.
The office would also have the ability to dock benefits for people who refuse to take employment.
Merging Unemployment and Welfare
The Hartz IV Law calls for unemployment and welfare benefits to be merged and spur those without a job into action.
Under the plan, unemployed persons capable of working would be given what the government is describing as
Unemployment Benefit II after their eligibility for unemployment runs out. Unlike the current benefit for the long-term
unemployed, which pays out as much as 57% of a persons last regular net income, the new benefit would be capped
at 345 in western Germany and 331 in the East. A person may not be eligible to receive this second unemployment
benefit if they have a working spouse or has assets exceeding 13,000.
Tax Cut
The third phase of a previously approved German tax reform would be bumped up to 2004 from its originally planned
implementation in 2005. The reform will change the countrys progressive tax rate from 19.9% to 15% at the lowest
level and from 48.5 to 42% at the highest level. The cut is expected to save taxpayers a total of 21.8 billion.
Chancellor Gerhard Schrder is hoping the cut will spur consumer spending and provide a needed boost to the
countrys ailing retail sector. The government plans to finance the tax cut by slashing federal subsidies and privatizing
government-held properties.
Communal Financing
German cities are running at a record deficit this year, with a 10 billion shortfall in funding. The governments plan
seeks to increase the percentage received by communities of the local business tax from 2.2 to 3.6%. The tax would
also be extended to previously excluded freelancers, doctors and lawyers as well as to any interest a company earns
or any rent or licensing fees it pays. The government says that the plan would put 4.5 billion in additional funds into
city coffers by 2004 and 5 billion the year after. The merger of unemployment and welfare benefits is also supposed
to save the cities several billion euros.
Reform of Master Craftsmen Law
Under a controversial plan approved by the government earlier this year, mandatory apprenticeships and master
craftsmans diplomas would be eliminated in 65 skilled trades, allowing ambitious journeymen to set up shop without
the prestigious qualification. The changes would only apply to less dangerous work like tile-laying, tailors or
goldsmiths. More high-risk jobs, like electricians and opticians, would still be required to go through the lengthy and
expensive certification apprenticeships.
Social Insurance Reforms
Earlier this year, the government commissioned a panel led by Bert Rrup to issue an advisory plan for saving a
social system threatened with collapse by a fast-growing German population. The key provision of the Rrup
Commission plan, released in August, is to increase the age of pension eligibility from the current 65 to 67. It would
also reduce pension levels from 48 to 40.1% of a recipients former income. Workers would not be eligible for early
retirement before the age of 64, and the annual cost-of-living increase would be reduced by 0.5%. The government
is considering the commissions work as it drafts its own bill for reforming the pension system. The first reading is
expected in November or December.
Meanwhile, a commission appointed by the conservative opposition Christian Democrats and led by former German
President Roman Herzog has also called for the retirement age to be increased to 67, a proposal that has split the
Christian Democratic Union internally and led to a rift with its Bavarian sister party, the Christian Social Union. The
Herzog Commission has also called for a flat monthly health insurance premium of 264 for all Germans, a move it
says would save the public health fund 27 billion.

Germanys Economic Dilemma To Save or To Spend?

Annexure 4

Annexure 5 a



Germanys Economic Dilemma To Save or To Spend?


Germany (Index, 2000=100, seasonally adjusted)

5/03 6/03 7/03 8/03 9/03 10/03 11/03 12/03 1/04 2/04 3/04 4/04 5/04

89.4 90.6 91.7 92.8 93.0 95.3 96.2 97.0 97.5 96.4 95.4 96.3 96.1


87.1 88.1 88.2 89.5 88.3 91.0 91.8 91.9 92.5 92.6 92.2 94.9 94.4

Expectations 91.8 93.2 95.2 96.3 97.9 99.7 100.9 102.4 102.8 100.3 98.8 97.7 97.8
Source: Ifo Business Survey

Annexure 5b



Germanys Economic Dilemma To Save or To Spend?


Germany (Index, 2000=100, seasonally adjusted)

5/03 6/03 7/03 8/03 9/03 10/03 11/03 12/03 1/04 2/04 3/04 4/04 5/04

Trade and Industry -21.9 -19.6 -17.5 -15.2 -14.8 -10.3


-6.9 -5.8 -8.1 -10.0 -8.2 -8.7


-14.6 -12.9 -9.7 -5.9 -5.4




-44.0 -40.6 -43.5 -42.0 -45.4 -45.2 -41.8 -39.8 -39.2 -39.8 -37.8 -39.5 -41.4


-30.9 -29.0 -25.5 -17.9 -20.3 -15.1 -14.6 -12.9 -12.7 -18.0 -15.6 -14.3 -18.1


-22.2 -18.0 -17.1 -25.0 -19.0 -17.6 -23.6 -23.1 -25.1 -24.3 -31.7 -21.7 -21.9

Source: Ifo Business Survey