Germany Faces Growing Deficit, Inflation Fears

ON the windy Baltic coast in the German city of Rostock, residents are shivering through this winter in apartments set at 50 degrees F. Rostock, once home to East Germany's massive shipbuilding industry, is broke. The contracts to build ships have evaporated, unemployment is skyrocketing, and the city can't afford to heat block after block of communist-style high-rises. Bonn, say local officials, has to do something.

The severity of the economic problems in eastern Germany is just now being more fully recognized in the German capital, nestled comfortably on the banks of the Rhine and far removed from the hardship to the east.

``We underestimated the problems,'' Economics Minister J"urgen M"ollemann said last week, when he introduced a three-year, 30 billion marks (US$20.5 billion) program to revitalize the east German economy. Supporting the five new German states is now ``the primary domestic goal,'' said Dieter Vogel, the government spokesman.

How Bonn handles this economic crisis is not just an issue of domestic importance, however. ``We're not living in isolation,'' says economist Peter Pietsch at Commerzbank. Germany's economy is the anchor for Europe, and the fiscal and monetary decisions made here ripple through the European Community.

Troubles in eastern states

The economic situation in eastern Germany is dire. About 2.6 million east Germans are unemployed or working reduced hours, out of a work force of roughly 8 million. Trade with the Soviet Union, the former East Germany's largest market, is at a standstill. Western investment has been slower than expected. Cities and local governments have an inadequate tax base for revenues. Many cities, such as Leipzig, say they are near insolvency.

The fiscal challenge is how to pay for east Germany's revival.

Because of reunification, this year's deficit is expected to be about 140 billion marks, about 4 percent of Germany's gross national product (GNP) - a worse ratio than the United States had during the later Reagan years. This could easily grow if the economic turnaround in eastern Germany is delayed until next year, as some economists predict. In addition, Germany has earmarked 15.6 billion marks for the Gulf war, with further payments possible if the war drags on.

Tax increase likely

Germany can control its deficit by raising taxes, cutting costs, or both. Finance Minister Theo Waigel is to present tomorrow the draft budget for 1991 - which will not include a tax increase. Instead, Mr. Waigel wants to wait until spring to assess needs. But he has already announced the likelihood of a tax hike, probably by July 1 and probably on oil, gasoline, or other consumer goods. Chancellor Helmut Kohl says higher taxes will be needed to pay for the Gulf war.

Norbert Walter, chief economist at Deutsche Bank, warns that raising taxes will have a dampening effect on the economy, ``exactly at a time when we don't need it.'' Germany, he says, ``is an overtaxed country. To increase taxes doesn't help.''

Although Waigel's budget is expected to cut spending by 35 billion marks, Mr. Walter believes more could be shaved. Regional subsidies should be cut and inefficient, state-owned industries - such as the telecommunications giant, the Bundespost - should be privatized, he says.

The Bundesbank, the independent central bank that controls the money supply in Germany, is also concerned that Bonn show fiscal responsibility and not let borrowing and the deficit get out of hand. The Bundesbank would prefer the government to pursue spending cuts, but is not averse to a tax increase, a bank spokesman says.

The Bundesbank is far more concerned about another aspect of the economy: the robust growth in western Germany and its inflationary potential.

In contrast to east Germany, the economy in western Germany is booming. Real growth in this part of the country was a phenomenal 4.6 percent last year. The financial woes of eastern Germany, though serious to those affected, are relatively small economically in a country were western Germany accounts for 90 percent of GNP.

Because of the boom, unions are demanding a 10 percent increase in wages. West German manufacturers, producing at a frenzied pace to fill shelves in east Germany, are close to capacity. If the brakes aren't applied, the inflation-wary Bundesbank maintains, there will not be enough goods to meet demand and prices will go up.

Germany's inflation rate is only 2.9 percent. But the Bundesbank raised interest rates two weeks ago - mostly for technical reasons, but also to halt the threat of inflation, a spokesman says.

The move caused anger on the part of Germany's partners in the European Monetary System, where currencies are linked to each other. Both France and Britain have been wanting to drop rates to revive their sagging economies. To keep their currencies in line with the deutsche mark, these countries would either have to raise interest rates or devalue their currencies.

Interest rate controversy

``We are rather critical of the Bundesbank's move,'' says Mr. Pietsch, at Commerzbank. ``It was very difficult for our neighbors'' and the inflationary threat was not so drastic, he says.

In retrospect, some economists say the interest rate hike has not been that damaging. Long-term interest rates in Germany have actually come down since then. Countries that wanted to lower their rates, such as the US and Britain, have done so, despite the German move in the opposite direction. Even the related shift in foreign exchange rates is not yet detrimental, they say.

German industry, which depends heavily on exports, has indeed seen the stronger mark take its toll on exports. But much of the business has been made up by the ``export'' market to east Germany. Economists add that Germany needs a strong mark to attract foreign capital to help pay for east German recovery.