How the economy would react to September 11 and the war in Afghanistan was at first a matter of speculation, because, although the danger of an economic downturn was obvious, the evidence was lacking. Time was needed to see how some of the regularly compiled economic indicators would react. Even the German economic research institutes in their recent economic analysis and forecast had to rely largely on plausible suppositions.

Now, week after week, the "hard" facts are emerging, and they do not bode well. In the US, the Consumer Confidence Index registered its lowest reading since 1994, the unemployment rate rose from 4.9 to 5.4% from September to October and the survey of existing home sales showed the strongest plunge from August to September since the the index was recorded. In the third quarter the American economy failed to grow for the first time in years. The UK CBI economic indicator showed the strongest decline in 17 years. Similar downturns have been recently reported in Sweden, Belgium and Italy. For Germany the results of the Ifo Business Survey of 7000 German firms, conducted during the first half of October, are now available. The indicator took the biggest one-month drop since the first oil crisis in 1973.

The bad news is indicative of a storm that is brewing. The silver lining on the horizon that could be seen - with some imagination - in various economic indicators last summer, has totally disappeared. In their autumn forecast the German economic research institutes see Germany already on the brink of recession, and they forecast economic growth of just 0.7% this year and 1.3% in 2002. In the meantime, the dangers have become even greater.

Especially at risk is the German manufacturing industry. After 6.4% growth in 2000, only 0.8% is expected for this year. Besides weak demand, rapidly increasing inventory pressure makes a quick turnaround in production unlikely. Especially hard hit are the sectors close to construction. Construction spending will decline by 5% this year and by more than 1% in 2002. An end to the downturn is not likely until 2003.

Signs of a looming recession have grown so clearly that politicians must now respond energetically. In the United States demand-stimulating measures have been taken that will lead to a budget deficit of about 1.5% of GDP. German tax reform was implemented just in time, since it will allow the deficit-to-GDP ratio to increase from the 1.5% called for in the Stability Programme to 2.5% this year and from 1% to 2% in 2002. This, however, will not eliminate the danger of recession.

For this reason, the economic research institutes have recommended that the government advance the next phase of tax reform by one year. This is easily done, if the German Länder agree, and will not exceed the 3% limit of the deficit-to-GDP ratio established in the Stability Pact. It would raise the budget deficit for 2002 by an additional 0.3% of GDP, and by stimulating consumption would raise growth by an additional 0.5%.

During the next boom, even more energetic efforts should be made to reduce the deficit. The risk of not eliminating the budget deficit by 2006, as called for in the Stability Pact, is not great. In all probability, an economic upswing will set in before, that will allow the state to intensify its consolidation efforts.

The government could of course argue that it should continue to gather more information before taking steps to stimulate the economy, and of course the indicators will calm down somewhat in the weeks ahead. But further hesitation will cost the economy dearly since production once lost can never be recovered. The time for demand-supporting measures has come. Consumers and investors need encouraging, forward-looking signals.

The European Central Bank's failure to lower interest rates at its last meeting, although US rates are now below those in Europe, was very disappointing. Is the boom in Ireland and Finland so important for Europe that it prevents battling recession in the heart of the Continent? Where is the much-touted responsibility of every individual member of the Central Bank for the whole, for the sake of which Germany contented itself with only half of the voting strength of these two countries even though it is nine times as large?

And why has the German government taken cover? What good is Chancellor Schröder's "steady hand" metaphor when energetic action is needed? Is the American government displaying a "shaky hand" in implementing a massive Keynesian economic programme?

The time has also come to apply the 1967 Stability and Growth Act, the Magna Charta of stability policies. This law obligates the federal and Länder governments to take the requirements of macroeconomic balance into consideration in their economic and fiscal-policy measures. Accordingly they must not be guided solely by the goal of rapid budget consolidation, since balancing the economy is not less important than balancing the books of the Ministry of Finance.

Since economic balance is now clearly upset by a demand deficiency, the federal and Länder governments should implement the measures for stimulating demand that are contained in the Stability and Growth Act. This includes the granting of an investment premium of 7.5% to private investors and municipalities as well as lowering the income tax by up to 10%. These measures could be implemented immediately by a simple executive order, since the measures were designed for rapid deployment in emergency situations. The emergency is upon us.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

German original published as "Des Kanzlers ruhige Hand muss zupacken" in Handelsblatt (5 November 2001, p. 10).