Upon unification, it became clear that most firms in the Eastern Lander (as the ex-German Democratic Republic is now known) were just not competitive. Many had to be closed in part or in total, and the others needed new and more modern equipment. It soon became obvious that transition would require large increases in government spending on new infrastructure, on cleaning up environmental damage, on unemployment benefits to workers who had lost their jobs, and on government subsidies to firms to keep them operating until they turned around.
Faced with this large increase in spending, the German government decided to rely partly on increased taxes and partly on a larger deficit. Table I gives basic numbers for some of the major macroeconomic variables from 1988 to 1991 (for West Germany only).
The numbers show that, even before unification. Germany was experiencing a strong expansion. GDP growth in 1988 and 1989 was close to 4 per cent. Investment was booming. And, because tax revenues
Table 1 Selected macroeconomic variables for West Germany. 1988-91
1988 1989 1990 1991
GDP growth (%) 3.7 3.8 4.5 3.1
Investment growth (%) 5.9 8.5 10.5 6.7
Budget surplus (% of GDP)
(minus sign = deficit) -2.1 0.2 -1.8 -2.9
Interest rate (short term) 4.3 7.1 8.5 9.2
SOURCE © OECD Economic Outlook. June 1992.'Investment' refers to non-residential investment.
depend on economic activity, the strong growth in GDP was the source of high government revenues in 1989, leading to a fiscal surplus of 0.2 per cent of GDP in 1989.
The effects of unification were to increase demand further. In 1990, investment increased even faster than it had in 1989. And. because of the increase in spending and transfers due to unification. West Germany's fiscal position went from a budget surplus in 1989 to a budget deficit of 1.8 per cent of GDP in 1990. In terms of the IS-LM model. 1990 was thus characterised by a sharp increase in investment and government spending, a large shift of the IS curve to the right, from IS to IS' in Figure I.
Seeing these developments, the Bundesbank (the German central bank) worried that growth was too strong, that the economy was operating at too high a level of activity, and that the result would be inflation (a mechanism explored in the next four chapters). It concluded that output growth should be slowed. Even though the interest rate had already increased from 4.3 per cent in 1988 to 7.1 per cent in 1989, the Bundesbank decided on a policy of even tighter money; it let the interest rate go even higher, to 9.2 per cent in 1991. In terms of the IS-LM diagram in Figure I, the central bank decided to shift the LM curve up, to slow down economic activity.
GOODS AND IINANCIAL MARKETS: THE IS LM MODE.
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у у
Output, У
Figure I The monetary- fiscal policy mix in post-unification Germany
The recent experience ol the US economy shows how the government and the central hank can appear to cooperate initially and then deviate. Thc locus box The US recession of 2001 explains how the US government and the central hank (the fed eased fiscal and monetary policy to get the economy out of recession. However, as 2006 approached, liscal policy was slill very expansionary, and the fed had substantially tightened monetary policy.
THE US RECESSION OF 2001
In 1992, the US economy embarked on a long expansion. For the rest of the decade, GDP growth was positive and high. In 2000, however, signs appeared that the expansion might be coming to an end. And it did, with a recession starting in March 2001 and ending in December 2001. You saw this during our brief tour of the United States in Chapter I—have a look at Table 1.2 again. In the two figures below, the period of the recession is shaded.
The result was fast growth (from the fiscal expansion) and high interest rates (from tight money). These high interest rates had important implications not only for Germany but for all of Europe. Indeed, some economists argue that the high interest rates were one of the main causes of the recession in the rest of Europe in the early 1990s. We will discuss this argument in more detail in Chapter 20.
What triggered the recession was not. as in 1990-91, a decrease in consumption demand but a sharp decline in investment demand. Non-residential investment—the demand for plants and equipment by firms— decreased by 4.5 per cent in 2001.The cause was the end of what Alan Greenspan had dubbed a period of 'irrational exuberance'. During the second part of the 1990s, firms had been extremely optimistic about the future, and the rate of investment had been very high.The average yearly growth rate of investment from 1995 to 2000 exceeded 10 per cent.This is very high. In 2001. however, it became clear to firms that they had been over-optimistic and had invested too much.This led them to cut back on investment, leading to a decrease in demand and. through the multiplier, a decrease in GDP.
The recession could have been much worse. But it was met by a strong macroeconomic policy response, which certainly limited the depth and the length of the recession.
Take monetary policy first. Starting in early 2001. the Fed. feeling that the economy was slowing down, aggressively decreased the federal funds rate. (Figure I shows the behaviour of the federal funds rate from 1998:3 to 2008:2.) It continued to do this throughout that year. The funds rate, which was 6.5 per cent in January, stood at less than 2 per cent at the end of the year, a very low level by historical standards. (It went even lower until as late as June 2004. after which it was raised in small increments to 5.25 per cent. After 2007. it came right down again to 1.5 per cent in October 2008. with the Fed under Governor Bernanke worrying about the risk of a recession in 2009.)
Turr to fiscal policy. During the 2000 presidential campaign, the then candidate George Bush had run on a platform of lower taxes.The argument was that the federal budget was in surplus, and so there was room to reduce tax rates while keeping the budget in balance. When President Bush took office in 2001 and it became clear that the economy was slowing down, he had an additional rationale to cut tax rates—namely, the use of lower taxes to increase demand and fight the recession. Both the 2001 and the 2002 budgets included substantial reductions in tax rates. On the spending side, the events of 11 September 2001 led to an increase in spending, mostly on defence and homeland security.
Figure 2 shows the evolution of US federal government revenues and spending during 1998:3 to 2008:2. both expressed as ratios to GDP. Note the dramatic decrease in revenues starting in the third quarter of 2001. Even without decreases in tax rates, revenues would have gone down during the recession: lower output and lower income mechanically imply lower tax revenues. But. because of the tax cuts, the decrease in revenues in 2001 and 2002 was much larger than can be explained by the recession. Note also the smaller but steady increase in spending, starting around the same time. As a result, the budget surplus—the difference between revenues and spending—went from positive up until 2000 to negative in 2001 and. much more so. in 2002 and 2003. (Since then, the budget deficit (a negative surplus) has improved, but it was still large at the
Figure I 7-
The US federal funds rate,
1998-2008
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
SOURCE.
GOODS AND IINANCIAL ИЛИЙ TS: ГЩ !.S LM MODEL
chapter 5
Figure 2
US federal government revenues and spending (as ratios to GDP), 1998-2008
i i i i i i i i i
1998 1999 2000
2001
2002
i i ) i i l l i l l
2004 2005 2006
2007
LM Drop in
investment tLM'
Monetary expansion
IS
Figure 3
The US recession of 2001
SOURCE;
As a result of the decrease in investment demand and of the two policy responses, the economy in 2001 ended up at point A", with a decrease in output and a much lower interest rate. Let's end by taking up three questions you are probably asking at this point:
• Why weren't monetary policy and fiscal policy used to avoid, rather than just to limit, the recession? The reason is that changes in policy affect demand and output only over time (more on this in Section 5.5).
Thus, by the time it became clear that the US economy was entering a recession, it was already too late to use policy to avoid it. What the policy did was to reduce both the depth and the length of the recession.
• Weren't the terrorism events of 11 September 2001 also a cause of the recession?
The answer, in short, is no. As we have seen, the recession started long before September 11, and ended soon after. Indeed. GDP growth was positive in the last quarter of 2001. One might have expected—and, indeed, most economists did expect—September 11 to have large adverse effects on output, leading, in particular, consumers and firms to delay spending decisions until the outlook was clearer. In fact, the drop in spending was short and limited. Decreases in the federal funds rate after September 11—and large discounts by motor vehicle producers in the last quarter of 2001—are believed to have been crucial in maintaining consumer confidence and consumer spending during that period.
• Was the monetary-fiscal mix used to fight the recession a textbook example of how policy should be conducted?
On this, economists differ. Most economists give high marks to the Fed for strongly decreasing interest rates as soon as the economy slowed down. But most economists remain worried that the tax cuts introduced in 2001 and 2002 led to large and persistent budget deficits.They argue that the tax cuts should have been temporary, helping the US economy get out of the recession but stopping thereafter. Instead, the tax cuts were permanent, and despite the fact that the economy went through a strong expansion in 2005, budget deficits were still large and are projected to remain large at least for the rest of the decade.This, they argue, will create very serious problems in the future. We will return to this issue in depth in Chapter 27.
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