************* Already Stumbling, Germany Now Faces Threat of Deflation
As Prices Slide, Consumers Just Wait for a Better Deal
By G. THOMAS SIMS Staff Reporter of THE WALL STREET JOURNAL
PFULLENDORF, Germany -- The price of a nice kitchen cabinet has been falling for months. But German consumers aren't buying. That is dire news for a supplier called Alno AG, its hometown here -- and the rest of the world's third-largest economy.
Last year, Alno, one of Germany's biggest makers of made-to-order kitchen cabinets, cut prices by 11% to celebrate its 75th anniversary. Sales dropped 9%. In the past year, it has trimmed 28% of its staff, or more than 450 workers -- a huge blow to a town of 14,000.
Alno management gloomily doubts that further price cuts will boost sales, as customers say price cuts only whet their appetite for more cuts -- a deadly downward spiral that is the hallmark of deflation.
"In the ads, you see only 'rebate,' 'rebate,' 'rebate,' " says Alno's chairman, Frank Gebert. "We can see consumer goods are under heavy price pressure, but people don't buy. That's a trend to deflation."
The phenomenon of deflation -- defined as a sustained period of falling prices -- has in recent years ravaged Japan, plunging the world's second-largest economy after the U.S. into 13 years of slump. Now it is beginning to gnaw at Germany. Consumer prices rose by just over 1% in Germany last year and in May they fell 0.2% from the month before. For the state of Baden-Wuerttemberg, which includes Pfullendorf, prices of a broad basket of consumer goods fell 0.1% in May from April. Household-goods prices were down 0.2%, restaurants and hotels were off 0.2%, and clothing and shoes fell 0.3%. Last month, the International Monetary Fund warned that Germany was the industrialized country most vulnerable to deflation.
The grim scenario under way in Germany offers insight into just why the specter of deflation unsettles American policy makers. Federal Reserve Chairman Alan Greenspan describes the chance of deflation in the U.S. as small. But he says the consequences of deflation are so dangerous that the Fed will do all it can to prevent it. The Fed is expected this week to cut short-term rates to their lowest level in more than 45 years.
Playing Down Risks
In Germany, government and central-bank officials play down the risks of deflation, perhaps out of fear that the problem could become self-fulfilling. Those who admit a risk promise deflation won't be as pronounced as in Japan. "Mild deflation is fairly likely to take hold in Germany," Ernst Welteke, president of the German central bank, said in a recent speech. "It is highly unlikely that Germany will experience pernicious deflation."
Optimists say a pickup in the global economy later this year will help keep Germany from falling into the downward spiral. They point out that powerful unions will keep wages up, and that real-estate prices haven't crashed, as they did in Japan, where prices have been falling for five years in a row.
But deflation is dangerous because it is so hard to stop. And its effects can cripple economic activity: Consumers delay purchases until goods become even less expensive, causing a vicious circle. Companies have a harder time paying off debts. Profitability in the banking sector weakens, which in turn reduces lending and strangles the flow of capital. Central banks lose the power of their interest-rate tool because rates can only go so low. As prices continue to fall, real interest rates -- or inflation-adjusted rates -- rise, making it harder to pay back debt and further entrenching the problem.
Even mild deflation could have ripple effects beyond Germany's borders. If Germany slides into deflation, then two of the top three economies are lamed, making a global recovery that much harder. And as the motor of Europe, accounting for a third of output among the 12 nations that have adopted the euro, Germany could drag its smaller neighbors into deflation as well, some economists fear. About $1 of every $6 in U.S. exports goes to the euro zone.
Since World War II, one key economic lesson has been ingrained in the mind of every German policy maker and pundit alike: avoid inflation. Hyperinflation helped do in Germany's last democracy, the Weimar Republic, which ended in 1933 with the Nazis' rise to power. Learning the lessons of the past, West Germany set up a strong, independent central bank that remained in place when East and West unified in 1990. It also insisted that its neighbors adopt such a system when the euro was launched.
That has made the euro something of a success -- in just a few years it has surpassed the yen to become the world's second-biggest currency after the dollar. In large measure, that is due to the European Central Bank's exclusive focus on fighting inflation. Unlike the U.S. Federal Reserve, the ECB's mission has been to hold down inflation, not promote growth -- even if its biggest economy is in recession and heading toward deflation. The ECB has begun taking steps to modify this stance, saying it would aim to keep annual inflation rates "below but close to 2%," compared with a previous range of between zero and 2%. That tough stance is still the most ambitious inflation-fighting goal of any major central bank.
Germany's historic fear of inflation also led it to insist that the European Union adopt strict budget rules for countries that join the euro. With Germany already violating those limits, it has no room to cut taxes or boost spending. That has helped push the country into a second recession in two years and driven up unemployment to 11%, further weakening consumer confidence.
In the eyes of people such as Mr. Gebert of cabinetmaker Alno, political paralysis at home is also to blame. The vast safety net that makes workers feel secure is also helping to pull Germany down, in his view: Companies shy away from hiring because regulations make firing difficult even if the economy slumps. The federal government in Berlin recently approved a spate of reforms -- widely considered the most significant in decades -- such as cutting the nation's generous unemployment benefits and liberalizing restrictions on store-opening hours. But it has also flip-flopped on tax breaks. So far, he says, the reforms have stirred caution, rather than optimism, both among companies and consumers.
"In the U.S., there are ups and downs in the economy but there's always light at the end of the tunnel," Mr. Gebert says. "But in Germany, let's face it, we've been in a downturn four, five, six years. I don't see any perspective where we can say the structural problems will be solved."
Longer-term forces such as globalization are also at work. Pfullendorf doesn't even have its own rail connection, but the town is feeling the effects of China's two-decade-long export push that is driving down prices around the world. Consumers benefit because companies are forced to cut prices, but it may also bring countries such as Germany a notch closer to deflation. From January through March, imports to Germany from China rose 20.2% from the year-earlier period, double the average increase in the volume of imports from other countries. Mr. Gebert has visited China several times in recent months as he considers setting up production there or founding a joint venture. "They fight for the business," Mr. Gebert says of the Chinese.
Already, the effects of deflation are becoming apparent in Pfullendorf. Situated in southern Germany just a few miles from Lake Constance on the Swiss border, the town's picturesque streets, lined with 16th-century half-timbered houses, offer an idyllic setting for tourists.
A closer look at the town's landmark, a watchtower built in 1505, tells another story. On one side, neat rows of marigolds are a reminder that Pfullendorf is a finalist in the national "Our City is Blooming" contest. On the other side of the tower, a foot-high patch of weeds and dandelions attest to the financial problems of the town as it cuts back on maintenance costs. Water dribbles out of the mouths of two cherubs in a fountain onto an empty package of cigarettes. "Sex" is scribbled in red lipstick on the tower.
Manfred Moll, Pfullendorf's deputy mayor, knows the watchtower needs renovation. But, as he pores over tax receipts, he sees few options. "We are really taking a hit," Mr. Moll says in his airy town-hall office overlooking the main square.
Pfullendorf raked in more than $12 million in corporate tax in 1995. This year, corporate tax receipts are expected to come in at less than half of that, and the reduction is primarily linked to the economy, Mr. Moll says. The city slashed the maintenance budget to less than $1 million, half of the level in 2000. The city has also cut its work force, to 156 from 170 people. Mr. Moll still doesn't know where the town will get nearly $1 million to fill this year's budget hole.
To blame are depressed consumers, fears of further job cuts, bankruptcies and troubles at those retailers still holding their heads above water. "We feel that prices are declining," Mr. Moll says.
Across the street from the watchtower, Horst Spoo built up a business of five taxis and two buses. But now he's planning to cut back.
"Alno doesn't have any work for me anymore," he says. Businessmen visiting the cabinetmaker used to spend more than $2,000 on his taxi service each month. His taxis would drive executives to airports as far away as Zurich and Frankfurt, racking up fares as long as three hours. "I'm missing it," he says.
Geberit AG, a big bathroom-equipment maker, has also cut staff. There are fears that a nearby military base will close.
At the Angel Inn off Pfullendorf's main square, a golden angel with an iris in hand perches on an eave. But a "closed" sign has replaced the menu out front. Four clothing stores, including Sabrina's boutique, and two shoe stores have gone out of business. Unemployment in this once-prosperous region is now 7.5%, below the German average but up from 6.7% three years ago.
Banks are often the first to feel the effects of deflation and Volksbank Pfullendorf EG is no exception. Werner Gross, the bank's chairman, flips through a booklet outlining its 100-year history. The Volksbank was one of the few banks in the town to survive the hyperinflation of the early 1920s, when Mr. Gross's grandmother found that a week's salary bought nothing more than a cup of coffee. It was the town's only bank to survive the Great Depression. It also outlasted the Third Reich and managed the devaluation after World War II.
Better times came with the Wirtschaftswunder, or economic miracle, of the 1950s and '60s. But now for the first time in the past 50 years, the bank's existence is growing insecure. Last fall, Mr. Gross trimmed a quarter percentage point off rates for new mortgages and advertised the new rates for a month. He got no takers. The volume of new loans fell 3.2% last year and continues to decline this year, he says. The last time loan volume fell was in 1974 during the global oil crisis. "It can't go on forever," says Mr. Gross.
Volksbank's caution has caused him not to offer full-time jobs to the bank's two apprentices -- the first time in Mr. Gross's 20 years at the bank that it has made such a move.
Across from a Volksbank branch on Pfullendorf's Main Street sits an optical shop -- in a building vacated by one of the banks that went belly up during hyperinflation in 1925.
Inside, a poster advertises "Contact Lens Solution: Super Cheap." Owner Egbert Kurb says that no matter what he offers in the way of discounts or promotions customers are buying inexpensive frames or bringing their old ones in for new lenses. "The will to spend is just not there," he says.
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Write to G. Thomas Sims at tom.sims at wsj.com4
URL for this article: http://online.wsj.com/article/0,,SB105631749845407700,00.htm
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