Luxemburg’s prime minister once opined on structural reforms: „We (Europe’s politicians) all know what has to be done, yet we also know that we are politically dead, if we do it“.
With respect to this, the discussion in this blog started by Michael Burda on the one hand and Sebastian Dullien and Ulrich Fritsche on the other on the causes of the German economic recovery is most important. Especially now that there is currently a debate raging in Germany about „modifying“, i.e. scaling back, the labour market reforms introduced by the Schroeder government since 2003.
My opinion on this is that both Burda and Dullien/Fritsche are both missing an important point due to the fact that they completely ignore the factor of time in their analysis. Michael Burda’s argument that the announcement of Agenda 2010 in March 2003 kick-started the German recovery is flawed for economic indicators started to improve only in May/June 2005, i.e. more than two years later. Incidentally, that was right at a time when Germany’s structural reform process stopped dead in its tracks – first with the call for an early election and second a rather disappointing electoral showing for the rather radical reform platform of Angela Merkel’s Christian Democrats.
Dullien and Fritsche are absolutely right that the economic upswing since has all the hallmarks of a typical cyclical recovery. I.e. corporate order books swelling, new investment plans to meet demand being made, new jobs created…
It would be wrong, however, to imply that structural reforms are useless. The (ignored) link between both positions is that any upswing needs in Joseph Schumpeter’s line of thinking some sector willing to make a bet on a better future and start to deficit-spend. Uncertainty – also of the political kind – is a killer for such forward-looking behaviour. Schroeder’s sudden and rather unpredictable reform style has most likely contributed to delaying rather than speeding up Germany’s economic recovery.
This does not mean though, that the reforms in themselves were wrong. I do side in this respect with Michael Burda: If anything, they were too timid and not coherent enough.
How do I reconcile those two positions? Quite simply a more flexible economic structure will profoundly alter the shape of the economic cycle and help to prolong the upswing phases and helping to overcome recessions more quickly.
As I argued at the time of Agenda 2010 (April 3, 2003) together with Ekkehard Ernst in an op-ed piece in FT Deutschland (Zeit für einen Strategiewechsel – Das Wachstumskonzept der Regierung reicht nicht aus) the basic problem of Schroeder’s Agenda 2010 was not to be accompanied by a set of proper, in this case expansionary, macroeconomic policies which would help to overcome shortfalls in aggregate demand due to heightened uncertainty in the initial phases of the reform process.
Furthermore, the Schroeder government focussed its efforts almost exclusively on the labour market but failed to address product market deregulation. Any traditional macroeconomic model where wage setting is a mark-up on prices and prices are set as a mark-up on unit labour costs does suggest that this kind of reform will result in a major shift in the functional income distribution from wages to profits with no or at best negligible effects on output. Sebastian Dullien and Ulrich Fritsche have shown that this result has indeed come about in the end.
Bottom line: Schroeder’s Agenda 2010 was the right thing to do but badly wanting both in its lack of being embedded into a proper macroeconomic framework and of addressing product market deregulation.