Angela Merkel was supposed to bring a breath of fresh free market air into the increasingly statist and creaking German economy. Sadly, she’s well on her way to making things far worse:
The new German Government is launching one of the boldest experiments ever undertaken in the history of economics â€” or rather anti-economics. Germany in the past three years has been the worldâ€™s most depressed economy, with the weakest growth in economic activity and consumption. The coalition partners â€” representing, as they do, the opposite ends of the political spectrum â€” found it hard to find common ground on most issues, but on one point they could emphatically and enthusiastically agree: the way to stimulate an economy suffering from mass unemployment and stagnant consumption is to increase tax.
Germanyâ€™s plan to cure its self-confessed economic failure by doing exactly the opposite to what modern economics would suggest is certainly a bold and novel idea. Jim Oâ€™Neill, the chief international economist of Goldman Sachs, remarked on television last week that German politicians are acting as if they had never seen an economics textbook, much less understood one.
Germany has been called a “tax hell” – and for good reason. Germany has some of the most punitive tax policies in the EU. Even worse, the German labor market is horrendously ossified, meaning that unemployment has been in the double digits for some time. Even if the economy were to pick up, German firms wouldn’t engage in a rounds of hiring for fear that the next contraction would leave them with payrolls they couldn’t afford – so they simply don’t hire new workers. Germany is caught in an economic catch-22 – their economy can’t recover without jobs, but employers aren’t willing to hire with all the economic uncertainty.
Merkel’s new “grand coalition” has taken the least popular approaches of both the Christian Democrats and the Social Democrats. They’re hiking the top tax rates from 42% to 45%, while simultaneously increasing consumption taxes and eliminating deductions. In essence, everyone will see a higher tax bill as Germany tries to tax its way out of its massive structural debts. That plan is one that is absolutely doomed to failure:
Germany’s booming industrial exports have made it the world’s largest exporter but the sullen refusal of its own consumers to open their wallets has thwarted hopes across the continent of a revival in Europe’s dominant economy.
The German Institute of Labour and Economics said the coalition negotiators had displayed “economic illiteracy” by ignoring the importance of consumer spending and deciding to rein in the government’s budget deficit at the risk of tipping the economy into recession.
As Anatole Kaletsky notes in the Times piece, this is exactly the kind of strategy that brought the Japanese economy into recession:
Experience suggests success in stimulating the economy through higher taxes is very unlikely, but not entirely impossible. Let me begin with the bad news. The closest analogy for what Germany is now attempting is the rise in consumption-tax imposed by the Hashimoto Government on Japan in 1997. The Japanese economy had already been depressed for five years before this tax increase (just as the German economy has been depressed since 2001), but still Japanese consumption grew by an average of 2.3 per cent annually from 1991 to 1996. In the year following the tax increase, Japanese consumption collapsed by 3 per cent and consumption growth in the following five-year period averaged a meagre 0.2 per cent.
This collapse in Japanese consumption from 1997 onwards triggered the Asian financial crisis and the huge economic dislocations that went with it. In other words, the 1997 tax increase was arguably the most disastrous economic measure imposed by any major government since the Smoot-Hawley tariff of 1931.
The German tax hikes have the potential to be much worse. If the ECB would adjust interest rates downwards, it would give Germany a chance to gain some valuable liquidity that would at least soften their economic crash. However, the ECB has signaled that they may raise interest rates in the near future.
Merkel’s disastrous economic plan is a recipe for 1970s-style stagflation which could easily spread economic chaos throughout the Eurozone and beyond. A financial crash like the Asian flu of 1997 in Europe would have an even more devastating effect on the world’s markets.