WHATEVER the final shape of the government to emerge from yesterday’s German election, one forecast can be made with confidence. This election will not mark the “brave confident morning” that was widely expected for the German economy and for the broader cause of European economic reform.

The reason for pessimism is not just that the new government’s economic plans are bound to be constrained by coalition politics. Much more significant is that the economic plans presented in the election by all Germany’s parties were fundamentally flawed. Add the fact that the global economic environment — recently very favourable to Germany — is likely to deteriorate in the next year or two and the picture that emerges is hard to reconcile with the enthusiasm of German businessmen and commentators before the poll.

The problem is that all Germany’s “respectable” parties, from the Greens on the Left to the Free Democrats on the Right, were proposing a variety of broadly sensible policies to boost the supply of goods and labour in the economy, and none at all to address Germany’s most immediate problem: the chronic deficiency of demand. Meanwhile, the outcasts of German politics, the post-communist Left Party, had a broadly sensible policy to boost the economy’s demand-side, but none at all to improve supply. So the only coalition that could conceivably offer a balanced, coherent prescription for Germany’s economic malaise would be a coalition of the post-communists and the conservatives — a possibility not worth discussing any further.

Looking at the realistic options for political realignment, Germany’s economic performance seems bound to get worse, not better, in the year ahead. This is because the policies that all Germany’s establishment politicians seem most firmly to believe in are the ones that will do the greatest damage to economic activity, employment and consumer demand. The worst of these policies is the 2 per cent rise in VAT identified by Angela Merkel as her top economic priority. In a country suffering from the world’s slowest consumption growth, this is almost literally an insane proposal, hardly mitigated by the plan to spend half the proceeds on cuts in employers’ social security contributions, which are designed to lower labour costs. These social security reductions may be desirable in principle, but their first-round effect simply will be to increase already very ample profits and they will contribute nothing at all to the growth of demand.

Overall, after taking account of all sorts of other anti- consumption measures, such as ending tax relief on housing and commuter fares, the Merkel macroeconomic plan implies a tightening of fiscal policy of 1 per cent of GDP. In an economy that has struggled to grow at 1 per cent a year since the start of the decade and faces weaker consumer demand in its main export markets — Britain, America and China — these measures suggest that an all-out recession is now more or less guaranteed.

The worst part, however, is that the new German government’s deflationary macroeconomic policies will sabotage potentially favourable results of supply-side reforms. The need for mutual support between pro-competitive supply-side reforms and expansionary macroeconomic policies should be obvious to anyone with an understanding of Keynesian economics. It has been amply demonstrated in practice — positively by the success of the US and UK economies since the mid-1980s and negatively by the consistent forecasting failures of the pre-Keynesian economic flat-earthers of the European Central Bank (see chart). Despite this consistent failure to meet economic targets, German politicians still treat anyone who criticises the ECB or points to the obvious symbiotic relationship between supply-side reforms and expansionary monetary policies rather as the Vatican treated Galileo when he suggested the Earth revolved around the Sun.

The whole eurozone, in fact, is in denial about one of the clearest lessons of modern economic experience, which is that tough structural reforms of the kind promoted by Germany’s new government will work only amid rapidly expanding demand. This was the lesson of the Thatcher and Reagan eras, when tough labour market policy began to be successful — and politically acceptable — only from 1985 onwards, when interest rates collapsed, the pound and dollar were devalued and economic growth and consumer spending moved from bust to boom.

However, the link between expansionary monetary management and structural reform was not just an isolated experience of the 1980s, as demonstrated by a fascinating study published in the summer by the OECD (The Effects of EMU on Structural Reforms, OECD Economics Department Working Paper No 438, July 2005). This study looked at more than 100 episodes of major economic reforms in OECD countries and tried to assess the interaction between reform processes and constraints on monetary policy independence. Although the econometric research could not, by its nature, be definitive, the balance of evidence suggested a clear conclusion: “The absence of monetary autonomy seems to be associated with lower reform activity.”

The study reached three further conclusions that make good sense to me, although they would have never, to my knowledge, even be considered by any policymaker in any country in Europe. First, preparation for monetary union encouraged structural reforms in several of the relatively backward EU countries, such as Italy and Greece, but the pressure for change was drastically reduced, or even reversed, once these countries actually joined the euro. Secondly, labour market deregulation, the main type of structural reform required in Europe, is the most difficult to implement in an environment of monetary restriction. A third interesting conclusion was that small open economies, such as the Netherlands and Belgium, were far more likely to undertake reform within a monetary union because they never enjoyed substantial monetary independence; for big economies such as Germany and France, by contrast, the absence of monetary independence and impossibility of currency adjustment was probably an impediment to structural reform.

Given the diplomatic constraints on OECD officials, these are very strong conclusions. Anyone interested in this issue is advised to view the full paper at www.oecd.org.

The symbiotic relationship of liberal supply-side reforms and expansionary monetary policy is something that Ronald Reagan and Margaret Thatcher instinctively understood from the mid-1980s on, and the success of the US and UK economies ever since has been largely because of skilful application of policies for expansion of supply and demand at the same time.

However, in continental Europe — and especially Germany — politicians, businessmen and central bankers still seem to be light years from understanding that supply-side reforms can work only amid rapid demand-side growth. Supply-side reforms of the kind advocated by all the “respectable” German politicians may be necessary to revive economic growth, but are far from sufficient.

Without supportive macroeconomic policies, pro-market structural reforms will only depress demand and make Germany’s economy even weaker than it is. If German politicians refuse to understand this, they could set back by years, if not decades, the hopes of pro- market European reform.

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