1. After a decade of difficult adjustment, Germany now has the opportunity to put behind it a stretch of low growth. During the past decade, the economy largely absorbed the enormous costs of reunification while sustaining an impressive convergence of eastern to western income levels. Also, Germany emerged as a leader within Europe in product market deregulation, firms kept up spending on research and development, and a program for rolling back high taxes was started. Nevertheless, GDP growth rates were on average low, reflecting a long cooling off after the boom of the early 1990s, the fiscal strains from reunification, and structural constraints in the labor market. Excessive wage increases early in the decade, together with weak incentives for the unemployed to seek work and hindrances to firms' demand for labor, left Germany with one of the lowest employment growth rates in Europe. Looking forward, with the largest costs of reunification behind it and the benefits of tax and product market reforms ahead, Germany is well-placed to tackle high unemployment, complete fiscal consolidation, and press ahead with market liberalization. Such efforts would likely be rewarded with a revival of strong growth.

2. We accord a particularly important role to labor market policies—the next frontier for structural reform. There have already been promising signs of increased work-time flexibility and wage moderation. As a result, in the latest downturn, unemployment did not ratchet up to nearly the extent as in previous cycles. But if this year's strikes and higher wage settlements signal a shift toward more job-neutral wage growth, progress may come to an end. In any case, unless institutional obstacles are addressed, reducing high structural unemployment is likely to be a drawn out process.

3. We are heartened that labor market reform has moved to center stage of the policy debate. Ideally, this debate would produce a comprehensive package that moves toward a more flexible wage structure and employment practices as well as stronger incentives to work. This would provide the most effective signal to employers and workers about the orientation of policies and would reap the highest response in terms of investment and job creation. But if building a consensus for change takes time, a more selective approach may be necessary. Such an approach would best address two critical problems: the low employment rate of older workers and the high unemployment rate of the low-skilled. Particularly for these groups, improving incentives to work and training opportunities would appear to be priorities.

4. Such focused reforms should center on problems of labor supply, but be supported by measures to facilitate job matching and strengthen labor demand. For the jobless, the first requirement is raising the payoff to work. This could be achieved by introducing an administratively simple earned income tax credit for low-income earners, perhaps even targeted specifically to older workers. However, such a scheme could result in costly failure if incentives for the jobless to accept work were not also strengthened through reform of the benefit system. One element would be to unify the duration of unemployment benefits at 12 months. Proposals under discussion to merge unemployment assistance and social assistance also represent a promising avenue, but would only be effective if assistance is restricted to the truly needy. At the same time, those who saw their level of assistance reduced could be given the opportunity to earn supplements by taking on training and performing socially useful work. Such work should substitute for many of the current, ineffective active labor market policy schemes and could be intermediated by private placement agencies. To help raise labor demand, thought could be given to reducing social security contributions of employers of older workers, funded by savings from reform of welfare and the Federal Labor Office.

5. With the economy poised to recover after two years of low growth, the environment for reforms and for completing the important task of fiscal consolidation is improving. Recent indicators and surveys of business confidence suggest that growth will pick up in the second half of this year. As exporters continue to benefit from the improved external environment, first the inventory cycle, and then consumers enjoying greater purchasing power, should boost domestic demand. However, growth momentum in 2003 is likely to be tempered by tight macroeconomic policy conditions: the planned fiscal consolidation will dampen domestic demand growth; low bank profitability will prompt more selective lending; and the recent euro appreciation, if sustained, will restrain exports. Taking these factors into account, we project growth of 2.3 percent in 2003, following 0.8 percent in 2002. We expect inflation to remain around its current low level.

6. Fiscal consolidation is necessary, even if, at the envisaged pace, it will be a drag on the nascent recovery. Stability Program commitments provide useful discipline, and getting close to balance by 2004 will afford needed room to react to adverse economic shocks in the future. But the even harder fiscal task for Germany—preparing for the costs of population aging—must be kept in focus. Eliminating the budget deficit in the next few years would be the minimum down-payment in addressing this problem.

7. Even if deficit reduction is implemented in a flexible manner, it will be demanding. Assuming that tax revenues revive along with the economy in the second half of the year and that expenditures at both the federal and local levels are tightly controlled, we expect the general government deficit in 2002 to be below 3 percent of GDP. Getting close to balance in 2004 will be more difficult, especially if growth over 2003-04 were on average to fall short of the government's 2½ percent target. In our view, the cyclically adjusted general government deficit needs to be reduced by about ¾ percent of GDP a year to keep underlying consolidation on track; allowing the operation of automatic stabilizers should provide an element of flexibility in nominal deficit adjustment. As the still-high tax burden, particularly on labor, should not be raised, general government expenditure growth will need to be contained to 1½ percent a year, regardless of the strength of recovery. If growth turns out to be more buoyant than expected, discipline would be needed to avoid past problems with spending abundant tax receipts in good times. We see no room for tax relief other than that already factored into current plans.

8. Expenditure savings need to be sustainable and secure to the extent possible structural improvements.Getting close to balance in 2004 would be a transitory accomplishment if pent up spending demands could no longer be contained. Thus, while it is essential that public sector wage moderation continues, consolidation plans should not rely on unrealistic pay compression. And squeezing public investment—an option under consideration by local governments—would be shortsighted given that public investment is low by the standards of other European countries and infrastructure needs in the new Länder remain substantial. Instead, it would be better to target a more aggressive elimination of industrial and agricultural subsidies than planned and scale back entitlement spending, for example on health care and labor market programs. If measures are not put in place to rein in the growth of entitlements, spending on other budget items would need to continue shrinking in real terms for several years.

9. In any case, longer-term considerations suggest that further reform of entitlements is essential. We estimate that implementation of the Stability Program, along with the effects of the pension reform, could defuse about one third of the long-term demographic pressures on the public finances. One strategy to address the remaining pressures would be to run fiscal surpluses in the medium term with the aim of building a net asset position for the government. However, the small surpluses planned for the end of the decade would be not only insufficient, but also unrealistic if they relied on continuing shrinkage of the relatively small base of public spending not tied to entitlements. And without a substantial period of large surpluses, punitive increases in social contribution rates could be avoided in the future only if the generosity of entitlements is reduced. In the area of pensions, which will account for the bulk of ageing costs, the options largely boil down to raising the retirement age and lowering the replacement ratio. In the area of health care, higher patient co-payments could generate direct budgetary savings and reduce health service demand. Moreover, selective waivers to co-payments could be used to steer patients to cost-effective providers and prevention. Although demographic pressures are not expected to bite for a decade or so, the process of building consensus for reforms needs to be intensified now.

10. Recent strains in the banking sector are prompting the adoption of improved risk management practices and discussions about faster consolidation. A weak economy, a high level of company insolvencies, and a declining stock market have led to increased bank provisioning adding to long-term cost and profitability problems. The future phasing out of guarantees to public sector banks and the expected introduction of Basel II standards are welcome developments and will ultimately lead to a stronger banking system. These changes, together with banks' efforts to raise profitability, are already driving the processes of improving risk management and of bank consolidation. Allowing the latter to continue unhindered will be important to the future health of the banking system. Nonetheless, the present confluence of cyclical and structural weaknesses will require supervisors to be particularly attentive. It is essential, therefore, that the new Law on Integrated Financial Services Supervision be implemented to ensure the latitude and resources of the BaFin are sufficient to keep abreast of the situation as well as to prepare it for the increasing challenges posed by cross-sector and cross-border linkages among financial institutions. The upcoming Financial Sector Assessment Program (FSAP) presents a timely opportunity for supervisors to review the lines of defense against financial sector vulnerabilities.

11. To meet the challenges of intensified global competition and improve productivity growth, Germany must remain firmly committed to product market reform and competition.Much attention has been focused recently on the developments in the Mittelstand, which has been affected by the cyclical downturn and improvements in banks' lending standards. But ultimately if the Mittelstand is to remain the engine of growth in the economy, it should not receive special treatment or subsidies. This would only divert resources away from more efficient uses and make the Mittelstand a less dynamic force than it has been traditionally. On the network industries, Germany has been at the forefront of the EU in pursuing liberalization. The benefits—most visibly in lower prices for consumers but also in the pace of change for all Europe—have been important. While the difficulties of different speeds of market opening in Europe due to national interests are recognized, Germany needs to remain a leader. Emphasis should continue to be given to ensuring sufficient competition in the network sectors, as well as the right balance of regulation. Corporate governance is rightly coming under scrutiny in Germany. The new voluntary corporate governance standards are a welcome start.

12. Official statistics still need to be strengthened in some respects. For the most part, Germany's statistics are timely and of high quality. To improve cross-country comparisons, we encourage the authorities to adopt price deflators that better adjust for changes in product quality. The poor quality of data on inventories should also be addressed.

13. We encourage the government to raise spending on official development assistance, which amounts to less than 0.3 percent of GDP. Germany's support for multilateral trade liberalization and the elimination of trade barriers for poor countries is highly welcome.* * *

We would like to thank our many interlocutors for the interesting discussions and warm hospitality.