Abstract
The paper provides a discussion of two economically diverse nations, England and Germany. It is a discussion on the models used and other externalities that the countries have experienced up to the present and how it has affected the success or failure of its capital markets. In March 1990 the first free elections in East Germany since 1932 brought to power a conservative, market-friendly government allied with then-Chancellor Helmut Kohl. The election of a government favoring rapid reunification reduced uncertainty about the future, and the economic, social, and monetary union of July 1, 1990, ushered in the key economic changes. Ten years after East Germany came in from the cold, the success of the transition from socialism cannot easily be summarized. By 2000, GDP per capita in the eastern states (Lander) of the reunited Germany including Berlin had risen to 65.3 percent of that in the western states (if Berlin is excluded, the figure is 60.6 percent). That is an impressive accomplishment by the yardstick of economists’ more pessimistic forecasts a decade ago. Thanks to generous transfers from the west, consumption per capita has converged even more. On the other hand, although the United Kingdom has experienced a considerable rate of recession, the advent of the liberalization of the European Economic Community’s internal market it was thought that such a study would have special interest at the present time. Britain’s financial capital industries might currently be in a position to clean up’ at the expense of continental competitors. The United Kingdom is among the economies that exude strength wit its capital markets. This is in accordance with its political and economic philosophy, UK’s government has a noticeable presence in the economy through government-linked companies. This involvement allows the government to control strategically important industries, to assume a leadership role in sectors that it deems important yet where the private sector has not taken any initiatives, and to direct the economy based on its assessment of future economic developments.
The study constitutes a description of the two countries and a discussion on the reasons of the success or collapse of their capital markets. Consequently, the author shall provide forecasts based on the discussions stated in the two preceding sections.
Description of Germany and UK
The global capital markets have been a significant determinant of an economy’s strength and potential to compete in the aggressive contemporary global market. This study will provide a description on the current attributes of the capital markets of two countries, United Kingdom and Germany. Particularly, the latter’s pursuit to the perfection of its capital market shall be the fundamental purpose of this paper. The former country on the other hand shall be viewed as a model for the latter with regards to its capital market’s disposition.
Markets and ownership are abstract regulatory media (Parsons 1978:393), which perform their function only within the framework of concrete institutions. These institutions vary according to the cultural and political context in which they are embedded (Granovetter 1985). This part of the paper will be discussing the description of the environment that created the current disposition of the countries’ market capital. The first to be discussed is the environment of Germany. The country’s history and current market shall be discussed. Consequently, a description of the United Kingdom’s capital market situation will be presented.
Germany
The Berlin Wall was irrevocably breached on November 9, 1989. (Akerlof et al, 1991; Sinn and Sinn, 1991) In March 1990 the first free elections in East Germany since 1932 brought to power a conservative, market-friendly government allied with then-Chancellor Helmut Kohl. The election of a government favoring rapid reunification reduced uncertainty about the future, and the economic, social, and monetary union of July 1, 1990, ushered in the key economic changes. The decision to exchange ostmarks for deutsche marks at a rate of one for one was a source of controversy. Political unification occurred on October 3, 1990, bringing the eastern states of Berlin, Brandenburg, Mecklenburg-Western Pomerania, Saxony, Saxony-Anhalt, and Thuringia into the Federal Republic of Germany. Already by the spring of 1990 it had become evident that the East German economy was in shambles, belying even the most pessimistic estimates of the Central Intelligence Agency and other U.S. intelligence sources. Economic and monetary union meant instant trade integration: not only could curious easterners visit the west, but also they could buy goods from enterprising western German traders. Domestic demand and foreign demand from other former communist countries slumped. Industrial production in the east fell by two-thirds within eighteen months of the Wall’s opening, (Siebert, 1992) even though much unprofitable production was propped up by a combination of subsidies to involuntary part-time employment and to money-losing enterprises. Unemployment rose quickly. Those who kept their jobs benefited from rapid wage increases bargained by the western German labor unions. Others obtained large wage increases simply by moving to the west: more than 1 million people (6 percent of the eastern population) did so in the period 1989-91.
German reunification is paradigmatic of the economic integration of any two neighboring regions at different levels of economic development. The mixed success of the transition shows the difficulty of development even under the most auspicious circumstances. The former East Germany was immediately able to import sound institutions, including political, legal, monetary, banking, and industrial relations systems, from its more developed partner. At a minimum, these have enabled eastern Germany to avoid the anarchic equilibrium in which Russia finds itself today. Furthermore, eastern Germany has benefited from the largesse, labor market, and expertise of a rich neighbor sharing a culture and language. Its experience serves as a crucible for understanding the ramifications of other, larger-scale regional integration projects. The milestone achievement of German monetary, economic, and social union now stands as a benchmark (and perhaps as a foil) not only for the economic integration of the rest of central and Eastern Europe with the European Union, but also for the immediate consequences of European Monetary Union. Although the eastern German transition has attracted the continuous attention of economists, the issues have changed. The one-for-one conversion of East German ostmarks for deutsche marks, the privatization and restructuring of state enterprises, and the striking initial jump in real wages are no longer matters of policy debate, although they may have left their mark on the economy. We take the position that the ultimate measure of the economic success of German reunification is no longer the introduction of a market economy, but rather the attainment of an efficient production pattern made possible by the union of the two regions. This must be accomplished by growth in eastern GDP per capita, which is by definition the sum of growth in labor productivity and the employment rate.
Ten years after East Germany came in from the cold, the success of the transition from socialism cannot easily be summarized. By 2000, GDP per capita in the eastern states (Lander) of the reunited Germany including Berlin had risen to 65.3 percent of that in the western states (if Berlin is excluded, the figure is 60.6 percent). That is an impressive accomplishment by the yardstick of economists’ more pessimistic forecasts a decade ago. Thanks to generous transfers from the west, consumption per capita has converged even more. Reports state that 81 percent of easterners have seen their incomes rise during the transition. (Benblo et al, 2001) However, convergence in productivity has slowed sharply, implying the need for continuing transfers, and the labor market has yet to recover from the initial shock. Even the unemployment rate cannot easily be summarized, since, again, it depends on whether people in make-work and training programs are included. The eastern unemployment rate based on registered unemployed was 18.8 percent in 2000, more than twice the rate in the west; it was 27 percent in 1997 if hidden unemployment is included. Measures based on survey data, taking search and availability into account; show that the unemployment rate averaged 13 percent from 1994 to 1999. The employed share of the eastern working-age population (those aged eighteen to sixty-five) declined from 83 percent in 1990 to 65.2 percent in 1999, compared with a steady 73 percent in the west over the same period.
Currently, Germany is considered as a central actor in European integration, regarded as the locomotive for major economic and, increasingly, political developments. (Benblo et al, 2001) Political leaders consistently justified the country’s provision of around 60 percent or more of net transfers to the European Union (EU)–while disposing of disproportionately low voting shares in EU institutions (Sielbert, 1992)–by reference to a consolidation of peace and security in Europe and to Germany’s export dependence and volume of trade with EU states. This article examines Germany’s relationship to the EU’s enlargement, now in the preaccession stage, to include up to ten Central and Eastern European candidate states. It analyzes benefits and costs and the political dynamics of Germany’s evolving position. Until relatively recently, German elites supported integration and expansion and accepted the consequences, imprecise as they were, without serious challenge to basic policy directions or the provision of financial support. Scholarly accounts tend to concur, if often favoring further and faster integration and enlargement. (Sinn and Sinn, 1991)
United Kingdom
After a sustained expansion of output which began in the second half of 1981, the UK economy experienced a decline in real GDP starting in the second quarter of 1990, which continued into the first quarter of 1992. The cumulative fall in output over the two years amounted to more than 3 1/2 per cent, in contrast to the 1979-81 recession, when output declined by about 4 1/2 per cent over a period of 6 quarters. The obvious contenders that could qualify as possible proximate causes of the recession in 1990 are changes in the stance of fiscal policy; shocks arising from the external sector; the stance of monetary policy preceding the recession; and shocks to individual demand components.
Nevertheless, with the advent of the liberalization of the European Economic Community’s internal market it was thought that such a study would have special interest at the present time. Britain’s financial capital industries might currently be in a position to clean up’ at the expense of continental competitors. The United Kingdom is among the economies that exude strength wit its capital markets. This is in accordance with its political and economic philosophy, UK’s government has a noticeable presence in the economy through government-linked companies. This involvement allows the government to control strategically important industries, to assume a leadership role in sectors that it deems important yet where the private sector has not taken any initiatives, and to direct the economy based on its assessment of future economic developments. At the same time, the government interferes only minimally with government-linked companies, as they are run on corporate principles and established to make money.
The government has also created an economic environment that allows the free market to function and encourages foreign investment. While there are some restrictions on foreign ownership in such sectors as local banking, airlines, shipping, public utilities and the defense industry, for the most part, UK has a free market economy with most industries open to foreign investors. However, relevant government departments or statutory boards must approve all foreign investments. This process serves to direct investment to the appropriate sectors rather than to limit foreign capital. The government further provides tax incentives to attract local and foreign investment without differentiating between the two sources of capital. UK imposes no capital gains tax.
Moreover, the current position of the UK economy is improving in an uncharacteristically smooth manner. However, it should be stressed that this is an improvement from a very difficult position of deep recession, combined with severe balance sheet problems for many firms and households as well as the public sector. High levels of unemployment have depressed earnings and the indebtedness of the personal and public sectors has reduced their expenditure relative to what it would otherwise have been. The difficulties associated with large scale unemployment and indebtedness remain and there is a long way to go before they are alleviated fully. It is partly because of pressures exerted by these problems inherited from the recession that we anticipate that the recovery can continue smoothly over the next two years and beyond. While some have suggested that the UK economy might be enjoying an economic miracle in successfully combining fast growth and low inflation, we would argue that the current very healthy conjuncture represents the response that might be expected in the recovery from a deep recession where balance sheet difficulties were prevalent.
Consequently, when markets boom like this, it is generally supposed to be beneficial for industry, since the rise in stock prices is the result of more money going into the stock market and hence more money being available to industry for productive investment. In fact, capital market inflation is a much more complex process of financial flows and balance-sheet changes in the economy. First of all, it does not affect all stocks or securities equally. Bonds have the amount of money that will be returned to their owner on maturity written into their certificates. They therefore rarely trade “above par,” that is, at prices in excess of their repayment amount, although growing demand for bonds has made trading above par quite common today. However, shares, or common stocks, have no maturity and hence no fixed future value. Stock market inflation therefore affects such shares most of all. The resulting capital gains make these stocks the most desirable financial investments in a boom.
For companies, a shift toward equity or share financing offers a way of raising money cheaply. This is because the capital gain part of the return that investors obtain is paid not by the company but by other investors’ buying the shares from their existing owner at a higher price. In the extreme case of some recently issued information technology stocks, this capital gain is the only real prospective return for investors, because the companies issuing the stocks have yet to make any profit or to pay any dividends. Moreover, the money obtained by issuing shares in this way is commonly used to repay debts rather than for productive investment. When debt is repaid, the interest that no longer has to be paid is added to a company’s pretax profits. This approach is a far more effective way of increasing profits than tying up corporate liquidity in fixed capital investment of uncertain profitability.
When a company has repaid its debts, it can continue to levitate its profits in this way by taking over an indebted company and repaying its debts. In any case, companies also can cash in on the capital gains in a rising stock market by buying other companies and selling them later at a higher price. In this way, takeovers and mergers are not the “capital market discipline” on corporate managers that they are reputed to be. Rather, take-over booms are symptoms of the way in which capital market inflation redirects corporate management away from production arid investment and toward corporate restructuring. Most of the money raised in the London Stock Exchange since its long boom started in the 1970s did not go into productive investment. Instead it went into the coffers of the government in the form of privatization receipts and into the repayment of company bank debt. More worrying for the health of the economy is the recent trend toward share buybacks. The fashion for rewarding senior executives with share options is now motivating many of them to buy back shares, often with borrowed money. A system in which shares are issued to repay debt, then rise in value, and then are bought back to keep the share price high is a system for increasing corporate debt without any corresponding increase in the companies’ capacity to generate sales or income.
This description on the capital market of UK is reflected in the sound public finances and the control of inflation remain at the top of the government’s macroeconomic policy agenda, through the recent change in its political complexion. The Chancellor in his Mansion House speech completed the new arrangements for monetary policy, in which the Bank of England is given operational responsibility for setting interest rates, on 12 June 1997. He reasserted a target inflation rate of 2.5 per cent, and added a requirement that the Bank should report publicly on its actions whenever inflation deviates from this target by more than one percentage point in either direction. Similar precision with respect to the fiscal objective is lacking, however, whether or not the government were to adopt the Maastricht Treaty’s targets for the size of the general government financial deficit and the volume of debt, as proportions of GDP. (Bank of England, 1997) That the apparent exactitude of these targets is spurious is clear from the debate in several European countries about the specific accounting conventions to be applied. Nevertheless both objectives condition the outlook of macroeconomic policy analysts and forecasters, and they are also reflected in the models that provide the quantitative framework for such analysis.
Causes of Collapse or Victory
The capital market of both countries has significantly changed from the past years. With Germany’s unification and UK releasing several colonies, its market is thus affected. This part of the paper shall discuss the reasons of effectiveness and failure of both countries.
Germany
The increasing globalization of financial markets has been spurred by the liberalization of financial markets in both source and recipient countries. In recent years, many developing countries, such as Germany, have not only removed restrictions on payments for current account transactions but have also lifted controls on cross-border financial flows, especially controls on foreign inflows. In fact, by the end of 1995 about 35 developing countries had fully opened their capital accounts. And although many countries still retain some restrictions on capital account transactions, the magnitude of gross capital flows, particularly to the emerging market countries, shows a substantial increase in the openness of developing countries to both current and capital account transactions. Greater openness of these financial markets, and the associated decline in transactions costs, has allowed industrial country investors to diversify their investment portfolios, enabling them not only to share in the relatively high returns offered on many emerging stock markets but also to reduce their portfolio risk by taking advantage of the relatively low correlation between returns in emerging markets and industrial countries. Although external financial liberalization and the increased openness of domestic financial markets have contributed to greater capital market integration, the recent pattern of growth in capital flows has undoubtedly been influenced by the pattern of improvements in underlying economic fundamentals.
Moreover, the liberalization of trade and exchange systems and structural reforms to promote private sector activity have resulted in strong expansion of exports and have helped to sustain rapid output growth in most emerging market countries. Capital flows to these countries seem likely to be sustained at relatively high levels in the medium term, given the prospect of their continuing rapid economic growth, associated high rates of return on foreign direct investment and portfolio equity investment flows, and their rising shares of world output. The increased scale of private capital flows has eased the financing constraints on recipient countries and increased the potential payoffs to them from sound policies. At the same time, given the volatility of portfolio investment flows, it has also increased the need for caution and self-discipline in macroeconomic policy. Similarly, the country’s large net private capital inflows have tended to reduce domestic interest rates, raise aggregate expenditures, increase inflationary pressures, and widen current account deficits in all the major recipient countries. These consequences are attributable in part to exchange market policies that have attempted – with varying degrees of success – to limit the nominal appreciation of domestic currencies because of concern about the adverse effects of real exchange rate appreciations on external competitiveness. These pressures and concerns have presented many recipient countries with similar policy dilemmas.
Furthermore, the increasing openness of the German financial market and the large increase in foreign inflows intermediated through domestic banks have underscored the importance of banking and financial system soundness for maintaining financial and macroeconomic stability in these countries. Weaknesses in the banking system, which is the predominant source of finance in most developing countries, are not only costly because of their wider repercussions on the real sector, but they also impair the effectiveness of monetary policy. Thus, when macroeconomic stabilization or the need to preserve external confidence calls for monetary policy to be tightened, concern about the effect of higher interest rates and reduced liquidity on the cost of funds and the loan portfolios of weak banks may delay – and be expected to delay – policy action, and thereby exacerbate the risk of sudden reversals of capital flows, which may precipitate a more serious banking crisis. Indeed, banking crises have often occurred following periods of rapid expansion in economic activity and the associated emergence of macroeconomic imbalances.
The effects of banking sector difficulties in developing countries can be particularly pervasive because their financial systems tend to be dominated by banks to a larger extent than in industrial countries. A fragile banking system, such as that of present in Germany, may also magnify the amplitude of business cycles. Banks that face capital shortages and have inadequate reserves to cover non-performing loans may be forced to call other loans or sell assets and collateral in declining markets, further exacerbating a cyclical downturn. Moreover, even in countries where the ill health of the banking system is not the main factor precipitating a financial crisis, a weak banking system may contribute to or prolong a financial crisis and jeopardize economic recovery.
In countries such as Germany where the monetary authorities are concerned about protecting weak banks, the operation of monetary policy may be asymmetric: central banks may be more reluctant to tighten policy than to ease monetary conditions. In these countries, it may appear preferable for central banks to curb credit growth in the economy through moral suasion and direct controls on bank lending until the underlying weaknesses in the banking system are resolved. In some cases, direct controls may be necessary in the short term because domestic markets for treasury bills and other central bank securities are relatively small compared with the liquidity surges associated with inflows of foreign capital. Direct controls on bank lending, however, lose their effectiveness over the longer term: in countries where they have been applied, controls on banks have increased disintermediation and spurred the growth of nonbank credit and financial institutions.
Nevertheless, Germany has also experienced major banking calamities. Most major banking crises have been preceded by deterioration in macroeconomic imbalances and in some cases, inadequate policy responses to macroeconomic shocks. But conversely, the effects of macroeconomic shocks have in many countries been exacerbated by structural weaknesses in the banking system. Moreover, the disinflationary policies of the recently reunified country also exposed the underlying weaknesses in bank balance sheets and thereby trigger banking crises. In some cases, banks may experience difficulties during the transition to a low inflation environment because interest rates that banks pay to obtain funds may rise more during a monetary contraction than the yields on bank assets, partly because banks may be hesitant to pass on interest rate increases to their borrowers to ease repayment difficulties. Policymakers can help to moderate such adjustment difficulties by avoiding sharp monetary contractions that entail steep rises in interest rates. The trade-off between macroeconomic stabilization and the avoidance of banking sector crises may therefore be a particularly acute dilemma in countries where banks were previously accustomed to operating in a high-inflation environment. Banks’ income in high-inflation countries is often derived from indexed lending rates, from relatively large transitory balances stemming from the incentive for banks to delay payments, from foreign exchange speculation, and from the inflation tax on underremunerated demand deposits. A decline in inflation will deprive banks of such inflation-dependent income, as well as expose fundamental weaknesses in bank portfolios.
United Kingdom
It has been described earlier the current disposition of the capital market of UK. One of the causes of this success is its monetary policy. At present there is a very clear framework describing the operation of monetary policy in the UK. The authorities have set a target range for inflation of 1 to 4% as defined by the retail price index excluding mortgage interest payments, with a commitment to aim for the lower half of this range by the end of the present parliament. If this target were fully credible then forward nominal interest rates now would reflect the forward real interest rate plus an inflation premium of close to 2 ½%. It is difficult to imagine that this need be higher than 8%. Of course, if the inflation target is overly ambitious and likely to go the way of many other monetary targets in the UK, then the current set of forward nominal interest rates, which are low by the standards of historical experience since the early-1970s, appear to offer cheap fixed rate borrowing. It is clear that the markets are basing their expectations on a weighting of the outcome the authorities hope for and the one that the markets fear.
Another factor is the paradigm used by the country to deal with is capital interests. The leading paradigm among both policy analyst-advisers and macroeconometric modellers in many OECD economies is one in which a broadly neo-classical view of macroeconomic equilibrium coexists with a new Keynesian view of short-to-medium term adjustment. Thus, at least in respect of the long-run equilibrium, the level of real activity is independent of the steady-state inflation rate, whereas in the short run, adjustment costs and contractual arrangements imply that markets do not clear instantaneously and there is a relatively slow process of dynamic adjustment to equilibrium. The potential persistence in output and employment disequilibria may then leave considerable scope for fiscal policy whose effects, strictly speaking, are nevertheless only temporary. Moreover, the model used prevalently includes four models.
One is the model of Her Majesty’s Treasury (HMT), while four receive support from the ESRC Macroeconomic Modeling Consortium. These are the London Business School (LBS) and the National Institute of Economic and Social Research (NIESR), together with the `COMPACT’ model group led by Simon Wren-Lewis of the University of Exeter and a new entrant known as `CUSUM’–the Cambridge University Small UK Model–directed by Sean Holly. In four models the monetary policy rule sets the nominal short-term interest rate as a function of the deviation of inflation from its target. In the NIESR model this simply relates the change in the interest rate directly to the inflation deviation, and we implement a rule of the same form in the CUSUM model. In the LBS model additional terms in the change and rate of change of the inflation rate are included, in order to prevent instability in the model. In the COMPACT model an additional term involves the deviation of the price level from its base-run value.
Furthermore, the fiscal closure rules ensure the sustainability of policy, in particular ruling out the possibility of an explosion of government debt. In principle any government income or expenditure variable could be altered to achieve a desired fiscal adjustment or, perhaps more realistically, a package of changes in taxation and expenditure could be constructed, but in practice the models use the direct tax rate as the policy instrument, following earlier work on fiscal closure rules on the IMF’s MULTIMOD model (Masson et al, 1990). In the LBS and NIESR models the basic rate of income tax is adjusted whenever the PSBR/GDP ratio deviates from its target value, and we implement a similar rule in the CUSUM model; in the COMPACT model the target variable is the debt/GDP ratio.
The Future of Germany and UK
Germany’s situation today is marked by two challenges which affect and influence each other economically and politically. Because they developed fully independently of each other, their chance crossing at the beginning of this last decade of the twentieth century is too rarely noted. Yet, it makes all the more imperative a fresh analysis of Germany’s situation, one that departs from all the more conventional accounts that emphasize only how much unification is costing the nation, why the process is so substantially more arduous than predicted by politicians in or out of government. The first challenge, growing out of the reestablishment of Germany’s unity after forty years of division, requires that comparable living conditions and equal opportunities be afforded all who today live in Germany. The second challenge, much less commented on, requires that Germany pay close attention to its economic productivity, understanding that it is the only way for the country to maintain its prosperity, to be able to compete internationally. Following on reunification, rifts in Germany’s social fabric have become visible again. The vision of Germany’s role as a partner in the world needs to be defined anew. The Germans are being closely observed from abroad, sometimes mistrustfully. It has once again become difficult to be German. What many believed had been overcome through forty years of West German good conduct is once again being debated. What was put aside and laid to rest in the status quo produced by the Cold War has been stirred up again. The fear of uncertainty is felt both at home and abroad. The dream of not upsetting the status quo through good conduct, with the wish to appear exclusively as a stable element of European and Atlantic integration, has been rendered less important through unanticipated developments in all of Europe. No appropriate new political vision has emerged in Germany, either for the country or for the continent. In the public mind, there is no separation of the problems created by reunification and those that became increasingly characteristic of the economic system of the former Federal Republic. Both, in fact, developed independently, though their effects coincide. Only when they are seen as two distinct phenomena will there be a basis for restructuring the system. Until then, severe cuts in social benefits in Germany cannot possibly gain consensus; they will be viewed as the unacceptable price brought on by reunification alone.
On the other hand, the United Kingdom possesses the potential and the power to compete among its adversaries in the global setting. Based on the discussions above, the country has found several models that could address the development of the country’s capital market. Despite current economic weakness, and the downside risks that remain to the global recovery and consumer expenditure growth, there are grounds for optimism ahead. Nevertheless, adverse effects of global crisis such as the war in Iraq is unlikely to have been of major economic consequence, the uncertainty that loomed in advance of the war, leading to further turbulence in equity markets and a sharp increase in the price of oil, no doubt contributed to the economic weakness at the beginning of the year. While much uncertainty about the global economic outlook remains, the rapid conclusion of the war in Iraq is likely to have removed some uncertainty, allowing investment decisions to proceed. We expect a gradual recovery to business investment in the second half of the year, gathering pace next year.
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Akerlof, George A., and others. 1991. “East Germany in from the Cold: The Economic Aftermath of Currency Union.” BPEA, 1:1991, 1-87.
Bank of England (1997), The interest rate transmission mechanism in the United Kingdom and overseas’, Bank of England Quarterly Bulletin, 30, pp. 198-214
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Masson, P.R., S. Symansky and G. Meredith (1990), `MULTIMOD Mark II: A revised and extended model’, Occasional Paper no. 71, International Monetary Fund, Washington DC.
Parsons, T. 1978. Action theory and the human condition. New York: Free Press.
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