Like Japan, Germany is not only a high savings country, but a country whose savers increasingly put their money into bank accounts even as returns decline. Germany's deposit-to-GDP ratio is the highest in Europe. Total deposits have grown sevenfold in the last twenty years, while the economy itself only grew by about 60 percent. During these two decades, average interest paid on deposits declined from 4 to 2 percent. A growing (and now the largest) share of these ample loanable funds--four times the amount lent in 1980--have been put to work by German banks in loans to the non-financial services sector, a low productivity set of small- and medium-enterprises whose loans, as in Japan, are secured mainly by real estate collateral. Reminiscent of Japan, too, this lending growth has occurred while Germany's more stable and profitable export-oriented manufacturing sector has steadily raised a greater share of its funds by going directly to foreign markets with securities on offer. The profitability of German banks' loan portfolios has fallen, and the riskiness of its loans has risen as a result. Germany's tough labor laws restricting the firing of workers limit the ability of the banks to improve profitability internally, much as the Japanese banks feel bound to retain their "lifetime employment" workforces.

The number of German banks, however, has not declined to restore profitability--just as in Japan. There are still over 300 commercial banks of various sizes and over 530 Sparkassen (public savings banks). Only the number of credit unions has been shrinking. As in Japan, public banks and special credit entities--including the Sparkassen, their clearing banks (the state-owned Landesbanken), and the Kreditanstalt für Wiederaufbau (the one-time Marshall Plan funds bank that is now a means for the federal government to pursue chosen projects off-budget)--play a significant role in the financial system. These public banks carry as advantages a state guarantee, and therefore a lower cost of funds, as well as non-profit criteria for lending. This puts them into unfair competition with Germany's private banks, further eroding the latter's profitability. The EU has recognized that this system is anti-competitive, and it has legislated that the Landesbanken lose their state guarantees by 2005. But that means at least another two years of eroding private bank capital.

Not surprisingly, then, visible adverse selection has begun to emerge in the German financial system. A credit crunch for new borrowers is developing as asset prices fall, collateral and balance sheets of borrowers are impaired, and banks reduce lending. A standard marker of credit conditions is the spread between government bonds and corporate bonds of equivalent maturity--when this spread widens, borrowers have greater trouble getting loans. In Germany, the spread between ten-year government bonds and highly-rated corporate bonds averaged 0.3 percent between January 1980 and May 1998, and rarely went above 0.7 percent for more than a month, even during recessions. Since June 1998, when German banks began to incur losses from the Asian financial crisis and then the Russian default, the risk spread has been steadily rising. As of September 2002, the spread was a hefty 1.7 percent, having averaged 1.3 percent in the preceding year.

This increase can be credibly linked to declining German bank capital. The national average bank financial strength rating, removing the effect of government guarantees, is now below C+ according to Moody's rating agency--in other words, sub-investment grade. Every other EU country's banking system except that of Greece has a higher average rating. Provisioning for the coming losses on non-performing loans in a time of declining profits will further erode German banks' capital base. Germany today, like Japan circa 1992, has too many banks with too little capital, but no significant exit of savers or public sector competitors.

In the past four years, German macroeconomic policy, the second indicator to watch, has taken on frightening parallels to that of Japan, as well. Until 1999, German monetary policy was quite flexible and stabilizing of the real economy, while German fiscal policy was well within G-7 norms for counter-cyclicality. Since European monetary unification at the start of 1999, however, German monetary policy has been set by the European Central Bank (ECB), and German fiscal policy has been constrained by the eurozone's Stability and Growth Pact. Since then, Germany has suffered from an excessively tight monetary policy. While the German inflation rate averaged 1.5 percent annually since January 1, 1999, and has fallen just below zero percent over the past six months, the ECB refuses to cut interest rates. Meanwhile, on the fiscal side, the Schröder government has raised taxes during the current recession in hopes of bringing the budget deficit back down to the Stability and Growth Pact target of 3 percent of GDP.

As it happens, the EU's Stability and Growth Pact has a built-in destabilizing bias: the larger a recession, the more likely an economy is to breach the 3 percent cap on deficits; and the more likely it is to exceed the deficit cap, the more tax increases or spending cuts must be pursued. Recent proposals to measure the deficit on a cyclically-adjusted basis would offset this bias somewhat. But as long as the rule remains in place mandating a rapid return to below 3 percent deficits, fiscal policy will choke off recovery by tightening credit as soon as growth and tax revenues pick up--repeating almost exactly Japan's mistake of 1997.

Some countries, like France, have defied the Pact and simply put off meeting the deficit targets. The German government, however, has explicitly abjured such measures since its politicians were the ones who insisted upon having public debt and deficit limits built into the Maastricht Treaty and the EMU in the first place. They did so in order to prevent (in their minds) fiscal indiscipline from subverting the stability of the euro. The German government has thus painted itself into a corner of austerity, for it has itself characterized any greater fiscal flexibility as an indication that markets should discount the euro's stability.

Magnifying even further the Japan-like course of increasing austerity in a time of recession is the fact that Germany has the fourth-oldest, and one of the most rapidly aging, societies in the world (Japan's is the oldest society). This will make public debt burdens less and less sustainable over time.

While monetary policy has been too tight in the eurozone since the euro was introduced, it has been particularly harmful to Germany. The ECB came into being as a new and newly independent successor to the revered Bundesbank, extremely concerned about establishing its credibility for toughness on inflation. As a result, it has been even more reluctant to ease credit than the Bundesbank would have been under similar economic conditions. The ECB has pursued an inflation target of 2 percent or less for a weighted average of eurozone economies, a strategy with three inherent difficulties.

First, the "or less" target, rather than a symmetrical one of around 2 percent, imparts an additional deflationary bias, leading the ECB to be more aggressive in offsetting price rises than declines. Second, the target is too low for a eurowide average. The smaller and the structurally-reforming EU economies should be experiencing higher inflation as they adapt, and the large and developed economies (like Germany) would therefore have to average less than 2 percent (which in practice is actually deflation, given the positive bias of all inflation measures). Third, given the lack of synchronization between the eurozone economies' business cycles and of fiscal transfers among the economies, some countries will always suffer from significant divergences between ECB policy and their own cyclical needs. When some countries--like Ireland, Denmark, Spain, and (to a lesser degree) France--are on sustained trends of growth improvement, while other countries--like Germany and Italy--are on secular growth downtrends, monetary policy will not simply balance out over time. It will be chronically too tight for the slower economies, and will reinforce their slowdown. Moreover, now that Germany is in a currency bloc with the majority of its trading partners, it cannot loosen its monetary policy "in effect" by adjusting its exchange rate to make up for excessively high interest rates.

Perhaps the most chilling parallel between post-EMU Germany and post-1992 Japan on macroeconomic policy is in the lack of coordination between fiscal and monetary policymakers in the eurozone. As with the Bank of Japan, the ECB refuses to loosen monetary policy sufficiently or to believe that stronger growth is sustainable without inflation until elected governments pursue structural reforms. And the ECB is on record that it will view any loosening of or non-adherence to the Stability and Growth Pact as undermining monetary stability, and will tighten policy in response. In the eurozone, however, the ECB is playing chicken with not just one but twelve sets of politicians and bureaucrats. And the German Ministry of Finance, alone among those dozen national fiscal authorities, feels the need to self-impose austerity in order to set an example--even though its fiscal discipline alone will be insufficient to convince the ECB to ease policy in return.