Germany: Supply-side homework unfinished

After almost a decade of slump, the German economy is finally moving again. Growth this year will probably exceed 2.5%, and comes on the heels of the longest slump since the 1950s. Germany, long considered one of the “sick man of Europe,” logged less than a third of EU’s overall rate of GDP increase over the past ten years. Many are relieved that this central engine of Euroland is firing properly again. The question is: How long? How sustainable is this faster economic growth in Germany?

The Teutonic turnaround is noteworthy for three important reasons. First, it was led by a significant upturn in equity values. The DAX index started rising already in March 2003, and has increased by more than 250% since then. Previous German recoveries were seldom accompanied by such a strong run-up in stock prices. Just to put things in perspective, DAX outperformed the French CAC-40 index by roughly 100%, and the Italian MIBTel by about than 125% over the same period. Investment, both domestic and inward FDI have increased sharply in the aftermath.

Second, the recovery has been accompanied by massive increases in both exports and imports, both rising by about 33% in real terms since 2003. Germany is opening up to international trade in an unprecedented fashion. If there was a demand effect behind that export growth, it was certainly offset by above-average import growth; Germany may well be an “Export-Weltmeister” but it it has become a leading Import-Weltmeister as well. At the same time, consumption spending, a traditional engine of recovery in OECD economies, only turned upward in 2006.

Third, unemployment has declined more sharply than than in any other recovery since the early 1960s. For the first time, since the 1970s, a recovery has made significant inroads into an upward-drifting trend of joblessness, especially long-term unemployment. This has occurred despite a labor market reform which reclassified half a million able-bodied Germans as unemployed in January 2005. Even in the depressed eastern part of the country, the unemployment rate has fallen significantly.

Those who would argue that this recovery is simply Germany free-riding on the aggregate demand of a booming world economy are ignoring the evidence. Indeed, it it is intellectually challenging not to attribute a large part of the dramatic drop in German joblessness to the supply-side and especially labor market reforms implemented over the past three years. My interpretation starts with those stock prices, which started rising in March 2003, the same month that chancellor Gerhard Schröder announced the Agenda 2010, and which ultimately led to the Hartz legislation. Similar spectacular stock market increases can be found in the years subsequent to both the Thatcher reforms in the UK and the Wassenaar consensus in the Netherlands in the 1980s. Any informed assessment must conclude that the country has begun to adjust to competitive pressures normal in a monetary union with a free internal market. German industry has exploited a long period of moderate real wage growth to restructure, increase productivity and restore competitiveness in a tough world market, partly by aggressive outsourcing of low value added abroad. Unit labor costs in Germany have fallen by about 10% and German inflation has been the lowest of all Eurosystem countries since the launch of the monetary union in 1999. By virtue of a disciplined internal devaluation, Germany can now compete again inside and outside Europe.

You would think that German policymakers and politicians would be falling over themselves to take credit for this recovery. Far from it: in fact, a wave of discontent shaken the country in recent weeks, and there is a real danger that much of the hard work of recent years may be cast to the wind. The Social Democrats, partners in the grand coalition, are still smarting from backlash they received from their traditional clienteles when ex-chancellor Schröder introduced the Agenda 2010 and the Hartz reforms; public approval ratings are at all-time lows. In a transparent attempt to buy back alienated voters, SPD party leader Kurt Beck has now proposed to “share the fruits of the recovery” and increase the duration of unemployment benefits and backslide on increasing the retirement age. His argument: With growth strong and tax revenues rising, the welfare state can afford to be more social. Even more striking are the public opinion polls: more than 80% of Germans support the SPD leader’s initiative.

Hello, is there an economist in the house? Evidently, those currently in power missed a key opportunity to explain to voters why tough labor market reforms in Germany – significant cuts in both the level and duration of unemployment benefits, increased pressure to take up work, combined with deregulation of the temporary help service and part-time job markets – were sorely needed to raise the sustainable path of output, and not simply self-flagellation. Instead, two years have passed without further action – a missed opportunity to organize majorities for deeper reform while the economy is growing. Vacancies are at an all-time high, labor shortages are beginning to emerge and, at an official unemployment rate of around 8.5%, wage growth is picking up and unions are striking again for more. Eyeball econometrics suggests that the equilibrium rate of unemployment has not fallen as much in Germany as it has over the past two decades in the Netherlands, Denmark, Ireland, and the UK . Unlike those successful reformer countries, Germany started, but has not yet finished its supply side homework. If it backslides now, it and the rest of Europe will pay the price when the next downturn comes.

15 Responses to "Germany: Supply-side homework unfinished"

  1. Nouriel Roubini   October 12, 2007 at 1:10 pm

    Mike, many congrats for this very first and excellent contribution to the new RGE Europe EconoMonitor. The press has been full recently of press items and op-eds about the risks of a reversal of structural reforms in Germany given the ongoing political backlash against them. Thus, your contribution is most timely and interesting.
    At RGE we have covered this debate in one of our spotlight coverages (Will the End of Hartz IV in Germany Also Be the End of Supply Side Reforms in Europe?) at:
    http://www.rgemonitor.com/385?cluster_id=2181

  2. Guest   October 12, 2007 at 1:27 pm

    Are you as pessimistic as Wolfgang Munchau who has spoken of the “Death of Hartz IV”?

    See http://www.eurointelligence.com/Article.620+M5bad2e90dd6.0.html

  3. eparisi   October 12, 2007 at 4:56 pm

    The structural rigidities explanation for high unemployment and low growth in Europe is increasingly being challenged in the literature as well:

    David Blanchflower (2007), MPC member at the Bank of England [http://www.bankofengland.co.uk/publications/speeches/2007/speech323.pdf]

    and Olivier Blanchard (2006)
    [http://econ-www.mit.edu/files/711]

    among others point to the limited empirical support to date.

    Blanchard: “The [structural rigidities] story is plausible, and I believe, largely right. The problem with it is that available measures of labor market institutions do not show the sharp deterioration of labor market institutions implied by the story.”

    Blanchflower: “it is difficult to show any significant relationships between rigidity variables and levels and changes in unemployment even in the raw data” with respect to benefit duration, employment protection, trade unions, and labor market deregulation, with the exception of replacement rates.

    Rather, Prof. Blanchflower finds that unemployment is positively correlated with changes in rates of home ownership (lagged 2 or more years), presumably because it reduces labor market mobility.

    “Of the major industrial nations Spain has the highest unemployment and the highest rate of home ownership and Switzerland the lowest unemployment and the lowest rate of home ownership. During the 1990s there were three European countries with unemployment rates close to 20% and these three had the highest home ownership rates (Ireland, Spain and Finland). In the 1950s and 1960s the United States had the highest unemployment and the highest rate of home ownership. This pattern also holds within US states: for example, Michigan has both a high unemployment rate (6.9% in 2006) and a high home ownership rate (77.4%), while California has a low unemployment rate (4.9% in 2006) and a low homeownership rate (60.2%).”

  4. Richard Bauer   October 12, 2007 at 6:40 pm

    Here is the FT Column by Munchau. It seems that you and Munchau agree on a lot.
    Do you see any hope of a revival of the reform process in Germany? What about the rest of the EU?

    08.10.2007
    Europe’s decade of economic reform draws to a close

    By: Wolfgang Münchau

    Gerhard Schröder lost his job as German chancellor in 2005 largely because of unpopular and badly implemented welfare reforms. Now Kurt Beck, his successor as chairman of the Social Democratic party, has proposed to undo one critical element of those reforms. He wants to exempt older workers from the full force of the welfare cuts.

    Mr Beck’s proposals have caused outrage among pro-reformers in Germany. Yet they are extremely popular: 82 per cent of the public supports him, according to a poll. It looks as though he is going to prevail within the grand coalition.

    Mr Beck’s U-turn is an important milestone. It probably marks an end to Europe’s decade of reform. In Germany, the welfare reforms have turned out to be so unpopular that the SPD’s poll ratings have dropped to between 25 and 27 per cent.

    Is this really just a case of a victory of political expedience over economic necessity, as it is portrayed by the pro-reformers? The answer is no: from an economic perspective, these reforms were marginal. Politically, they were a disaster.

    The first of these judgments stands in contrast to frequent claims that these reforms have contributed to the strong economic recovery. That is nonsense. But it would have been a nice story. You reform the economy and, bang, the next upswing is going to be stronger and longer.

    What really led to an acceleration of exports and domestic investment was a combination of strong growth in Germany’s export markets and wage moderation at home. The latter was the result mostly of external competitive pressures. Of course, it may also have been caused by a rise in the domestic labour supply, and that could be attributed to the reforms. In fact, that argument is not entirely wrong. We know that some discouraged workers have re-entered the labour market. But crucially, long-term unemployment still accounts for about 40 per cent of all unemployment. The proportion may still fall in the future, which is why the economic effect of these reforms cannot be fully judged at this point. But it would be folly to claim that Germany is already a reformed economy as a result.

    A British political consultant once made an astute observation to me about the differences between the SPD and New Labour. He compared the German pro-reformers with what he called “Labour brutalists” of the 1970s, such as Denis, now Lord, Healey. The German pro-reform Social Democrats are old-fashioned cost-cutters. They are not creative reformers.

    It is often said that New Labour had the advantage that someone else had done the dirty work for it, while the SPD had to do it all by itself. But that is not entirely true. When the SPD returned to power in 1998, the government undid the few labour market reforms of the previous administration, instead of building on them. New Labour, by contrast, had a well laid-out reform agenda in 1997.

    Mr Schröder wasted the upswing, and was bounced into his reform agenda only when the economy went into recession. When it finally came, the programme lacked strategic direction. The welfare reforms were not reinforced by reforms in other areas, such as an opening of the markets for services. It could have included the privatisation of state-owned banks, the creation of a more effective capital market or the liberalisation of corporate governance.

    The timing of the welfare reforms was wrong too. That should have come at the end of a reform cycle so that the economy would have been in a position to create new jobs, as welfare participants re-enter the labour market.

    As a strategic exercise, economic reform is akin to planning a war. The works of Carl von Clausewitz, the Prussian military theorist, would be more useful to a pro-reform politician than the latest finger-wagging report from the Organisation for Economic Co-operation and Development. You need to plan for different political and economic scenarios. You need to know when you can retreat and when to stand firm. You need solid public support, not only at the beginning but throughout the process. And you need a viable exit strategy. The public needs to know when you are finished. Permanent reform is as nonsensical as permanent war.

    The failure of economic reforms in Germany has mirror images in other large European countries. In France, the last government tried, and failed, to liberalise labour contracts, and it remains to be seen whether the new administration is better at providing a more strategic focus. In Italy, successive governments have been reforming different parts of the economy, but nobody has dared tackle the inefficient public sector. The European Union’s reform programme, the Lisbon agenda, is also too diffuse.

    In all these years, I have yet to meet a single politician in a large continental country with a plausible economic reform strategy. I suspect most European voters have not met one either. The electorates have regrettably, but logically, concluded that parties advocating economic reforms cannot be trusted. Do not blame the voters. The idea that voters are incapable of grasping what is good for them is plainly absurd.

    The small countries have fared better, but their successes hold few lessons as their political economy is so different from that of large countries. It is now time for a new approach, something strategic, and something that does not call itself “agenda” or “reform”. Both words, and the politicians who use them, are associated with failure.

    Send your comments to munchau@eurointelligence.com

    © The Financial Times Limited 2007

  5. Guest   October 12, 2007 at 6:43 pm

    Both SPD and CDU dont want more reforms while you argue they are necessary. So what is wrong with democracy? The majority of Germans are totally wrong on what is good for them. Or what is the political economy of this bad equilibrium with stalled reforms. And to break this stall? Any ideas?

  6. Guest   October 13, 2007 at 3:29 am

    Michael Burda’s comment is not in line with Wolfgang Munchau, but completely opposed to him. Wolfgang writes in his FT column:

    “The first of these judgments stands in contrast to frequent claims that these reforms have contributed to the strong economic recovery. That is nonsense.”

    In his German language column in FT Deutschland he went even further, writing:

    “Today, no serious economist claims that the Hartz reforms have contributed to the upswing…”

  7. Guest   October 13, 2007 at 2:40 pm

    So who is right Burda or Munchau on the structural reforms?

  8. Guest   October 13, 2007 at 2:40 pm

    So who is right Burda or Munchau on the structural reforms?

  9. koteli   October 13, 2007 at 10:08 pm

    Time will say, guest.

    One thing is their opinion, and another the reality and social aswer.

    Be patient!

    PS: Losts of hanks Dr. Roubini for thins new section RGE. I read and fight in bsetser section, everyday. I read your’s one, but there are lots of noise here. Anyway, this website is the best! And I hope that this new EU section won’t be too noisy.

  10. Nouriel   October 14, 2007 at 8:57 am

    Koteli, thanks. The goal is to keep the noise to a minimum in this new blog and have intelligent and thought provoking debates. Thanks Nouriel

  11. Anonymous   October 14, 2007 at 9:00 am

    Here is the FT take on the debate on structural reforms in Germany. Closer to the views of Burda on reforme than to Munchau’s but realizing the political economy fatigue of reform in Germany.

    An altered zeitgeist
    By Bertrand Benoit in Berlin

    Published: October 11 2007 03:00 | Last updated: October 11 2007 03:00

    Science and other disciplines have the Nobel prize; German politics has the Quadriga awards. So when Gerhard Schröder was given the honour this month, it would have been tempting to believe that the country had finally made peace with the ex-chancellor’s far-reaching but highly controversial economic reforms.

    Yet the jury’s choice of Kurt Beck, Mr Schröder’s successor as chairman of the centre-left Social Democratic party, to hand over the award suggests a different message: far from having come to terms with Mr Schröder’s legacy, German politicians are joining forces to give it a first-class funeral.

    In recent weeks, Mr Beck has been busy unstitching Mr Schröder’s handiwork. Mr Beck’s latest initiative, a proposal to increase unemployment benefits for older jobseekers, is symbolic. Across Germany’s political parties and deep within its government, the voices calling for a “reform of the reforms” are growing louder.

    Most of the policies being pondered in Berlin by chancellor Angela Merkel’s coalition government, composed of the SPD and her centre-right Christian Democrats, add up to a general dismantling of Mr Schröder’s entire Agenda 2010, the most far-reaching package of structural reforms imposed on the country since its postwar reconstruction. “There is a shift under way,” Karl-Rudolf Korte, professor of political science at Tübingen university, says of the changing political zeitgeist. “Reformists are still high in the hierarchy of the main government parties but they are losing the fight. They are on the defensive. Right now, the dominant feeling is that Agenda 2010 should be reversed.”

    Launched in 2003, the package was aimed at rationalising Germany’s bloated and underfinanced welfare state and injecting incentives for the unemployed to get back to work. More than that, it was a radical break with decades of political denial about the need for a radical overhaul of Germany’s social security architecture.

    Reviled by opponents as the start of a race to the bottom by a government happy to ditch its social responsibilities, for most economists the reforms instead marked the moment German politicians finally acknowledged the burden that years of legislative accretion had put on the economy and did something to address it.

    The measures look all the more radical with hindsight. Armed with blood-and-tears rhetoric, Mr Schröder cut unemployment benefits and introduced means-testing for recipients and financial sanctions for those unwilling to seek work. He pushed through the first cut in retirement payments in Germany’s postwar history and trimmed the healthcare scheme.

    The measures enjoyed broad support: the then opposition CDU-CSU, Germany’s conservative bloc, helped pass the reforms through the upper house it controlled. As its leader, Ms Merkel proceeded to develop a ruthlessly reformist platform that went even beyond Agenda 2010. Reformists across Europe began to see Mr Schröder’s Germany as proof that old industrial nations, even those with unwieldy political systems reliant on cross-party consensus, could be radically restructured.

    But the price was high. The SPD suffered a rapid fall in membership in the wake of Agenda 2010 and lost a string of regional elections, forcing Mr Schröder to call an early general election. Ms Merkel was punished, too. After seeing her lead collapse during the campaign, she barely scraped into the chancellery and then only as head of a national unity government together with a weakened SPD. Voters had issued their verdict on structural reforms – and the lesson was that toughness did not sell.

    After the September 2005 election, Ms Merkel’s “grand coalition” of CDU and SPD, while passing a few more reforms, began to move away from the path charted by Mr Schröder and Agenda 2010. The steps adopted since and the government’s plans for the future underline the shift in Germany’s political debate away from economic reforms.

    Elga Bartsch, economist at Morgan Stanley, says the centre of gravity of German politics is moving leftwards. “To an extent, this reflects the state of public opinion. But from an economic point of view, it is deeply worrisome. If we turn back the clock right now, when the economy is doing relatively well, next time we hit a major downturn we will have to start from scratch all over again.”

    Where Mr Schröder cut welfare provisions, Ms Merkel’s grand coalition has created a “parental allowance” for childrearing professionals. Where he deregulated the labour market, Ms Merkel has imposed minimum wages in several sectors. Her government is now reviewing a flat-rate €347 ($491, £241) basic monthly benefit for the long-term unemployed, created by Mr Schröder, with a view to increasing payments. Ursula van der Leyen, family minister, wants to quadruple the number of jobseekers eligible for extra child benefits. Social conservatives even managed to secure a handout for mothers who raise their children at home.

    At its August retreat, the cabinet embarked on a series of expensive projects, with subsidies to promote employee share ownership, top-up benefits for half a million low earners and tax incentives for people who hire household help, not to mention a €1bn package to combat climate change. The message, it seems, is that the state is on the rise again, acting as a protective shield between its citizens and environmental damage, terrorism, international speculators, globalisation and poverty.

    The rediscovery of a social conscience is all the more remarkable in that it runs through both the SPD and the CDU. Mr Beck’s latest proposal – to double the time for which older jobseekers can draw unemployment benefits – strikingly resembles a motion adopted by the CDU at its party conference last November. “The speed at which the intellectual climate has changed is staggering,” says Holger Schmieding, economist at Bank of America. “Two years ago, every new idea being proposed was a structural improvement. Today, every suggestion is a step backwards. My most optimistic scenario right now would be for politicians to keep talking and do nothing.”

    Some argue that the leftward shift in German politics, as Mr Schmieding suggests, is all talk. Since the country’s politicians are inclined towards preserving the status quo, they say, most of the ideas being bandied around will never make it into law. Mr Beck, so the theory goes, is mainly aiming to polish the SPD’s social profile ahead of a party conference this month. Likewise, the CDU’s motion calling for higher jobless benefits was largely designed to defuse a dispute between its social wing and its reformist camp – though neither expects it to become policy.

    Yet there are two reasons to think that the general leftward shift could translate into action. One is the de facto alliance that has formed between CDU and SPD “leftwingers”, who have coalesced into an ad hoc but vast parliamentary bloc. When the SPD’s Franz Müntefering, vicechancellor, protested against Mr Beck’s social drift last week, neither Peer Steinbrück nor Frank-Walter Steinmeier, the finance and foreign ministers who are among the SPD’s most prominent reformists, raised a finger in his support. The CDU’s loudest reformist voices have gone quiet too. Stefan Müller, a CDU MP and labour expert, says there is much sympathy in the CDU parliamentary group for Mr Beck’s proposals. “This is less a question of money than one of justice.”

    Another, perhaps more crucial, reason why the dismantling of Agenda 2010 could become reality lies in the state of the German economy, which has equipped proponents of a more generous social policy with a powerful argument. As Germany’s export- and investment-led recovery is beginning to lose steam, they argue, the country badly needs a rebound in consumption. What better way to kick-start that than by shovelling state money into consumers’ pockets and reassuring them about the future?

    After two years of economic recovery, Germany faces a challenging environment. Slowing US growth, higher interest rates and energy prices and the soaring euro are expected to hamper its exporting prowess. At the same time, despite a big drop in unemployment, German consumers are stubbornly refusing to part with their savings. Consumption has plunged since the beginning of the year after a 3 percentage point rise in value added tax, even though the economy has been growing.

    Declining exports without a rebound in consumption could spell a swift end to Germany’s second economic miracle. Hence, say Mr Beck’s supporters, the need to put an end to the personal sacrifices the reforms have imposed on the German people. An economic adviser to the government who asks not to be named says: “I would not be surprised if we had falling consumption in 2008. Disposable income has stagnated for most people despite the recovery. I have a lot of sympathy for reassuring measures at this stage.”

    That most Germans have seen the economic rebound pass them by is indisputable. The dramatic im-provement in corporate competitiveness that lies behind the country’s export performance was built largely on wage restraint. This and the hefty rise in social security contributions over the past 15 years mean real disposable income has hardly risen in the period. Data from the Federal Statistical Office show that the average west German is no better off.

    Given the VAT increase and recent food and energy price rises, many Germans rightly feel poorer now than they did a year ago. An alternative consumer price index developed by Hans Wolfgang Brachinger, a Swiss academic, and based on the most frequently purchased items showed “perceived” annual inflation at 5.2 per cent in August.

    Still, the vast majority of economists disagree with the notion that more state spending and wage protection can tackle the problem. “This is wrong in the medium term,” says Dirk Schumacher, economist at Goldman Sachs. “If there is money to spare, you should cut taxes and social security contributions. Right now, gross wages are growing faster than net wages. It is the government that is taking money away from the people.”

    Although opponents of Agenda 2010 seem to have the upper hand in both ruling parties, the outcome of the battle between pro- and anti-reformists may ultimately depend on the position of Ms Merkel, who so far has acquiesced in silence as her coalition has drifted leftwards. If she fails to back her weakening pro-market allies, economists warn, Agenda 2010 will turn out to be not the political gamble that set an enduring economic restructuring in motion but a one-off political accident in Germany’s postwar history.

  12. Jess   October 14, 2007 at 11:05 pm

    I find more convincing the Burda arguments – that supply side reforms explain the recent economic growth recovery of Germany – than the opposite arguments of Munchau that such reforms did not matter. That is why the backlash against such reforms is worrisome.

  13. Guest   October 15, 2007 at 6:47 am

    Are structural reform on the retreat throughout the EU? It looks like the case even if France’s Sarko claims to want to be a serious reformer. If there is reform fatigue throughout the EU why is that the case? And if the best performer – Germany – is retreating what are the prospects for reforms for countries that have not performed – growth wise and competitiveness-wise – as well as Germany? From a political economy point of vie, does low growth slow the reform drive or enhance the need for it?

  14. Guest   October 15, 2007 at 3:38 pm

    I and some of world’s central banks also took a very large “dump” in and around March 2003. Does the absence of a smell now mean that I perfumed the globe?

  15. Guest   October 15, 2007 at 3:49 pm

    Oh come on Germany, just get back to being fat and happy. Everyone is doing it! Some with your money!

    Let someone else have a chance!!