Reforms or cycle? Some comments on the German debate

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.

6 Responses to "Reforms or cycle? Some comments on the German debate"

  1. Guest   October 19, 2007 at 9:17 am

    Bottom line: the ECB should play its part too, but how if other EMU members are overheating at the same time?

  2. Guest   October 19, 2007 at 4:49 pm

    A good ecumenical compromise btw the views of Burda and those of Dullien/Fritsche!

  3. James   October 19, 2007 at 4:52 pm

    Any role that can be played by monetary and fiscal policy in fostering further reforms? The idea of EMU was that without the monetary tool and with the fiscal tool being constrained by the Growth and Stability Pact structural reform would accelerate. But maybe we need the grease of stimulative monetary and fiscal policies to induce the difficult political economy of further structural reforms. You need carrots and sticks as the benefits of those reforms occur only in the medium to long run.

  4. Guest   October 19, 2007 at 5:09 pm

    The argument is not whether the reforms were “good” or not but whether they are responsible for growth in various metrics.

    The one side argues that the metrics prove the reforms were good because they improved because of the reforms(?!?). The other side argues convincingly that it is doubtful the performance improvements seen were due to the reforms.

    No you say that the reforms would have been better because the performance would have been better if the reforms had been supported by measure to improve performance.

    “We all think we know what should be done but have neither the moral authority, nor clarity of reasoning, to get it done because if we did we would not be here”

  5. Ulrich Fritsche   October 20, 2007 at 3:19 am

    Thank you, David, for this clear definition of your position. Our little blog series (part III will appear soon) is to some extent — at least in my point view — about identifying and uncovering ideology in the German debate and to disentangle this from economics. As you clearly state, you are one of those economists who always was in favor of certain reforms. Fine, this is a clear position. But the bulk of those economists who are claiming to find the reason of the German turnaround in the reforms found the reforms useless or even harmful some years ago. Our blog posts are misread if someone would claim that structural reforms have to be useless. In contrast, in a series of papers, Sebastian and I claim that functioning institutions and markets are neccessary to achieve smooth adjustment in the currency union. This clearly includes functioning labor markets and in the case of market failure appropriate institutions to deal with this issue. In contrast, we would not claim that the Hartz reform is a value in itself (as some colleagues seem to do).

  6. David F. Milleker   October 20, 2007 at 5:31 am

    Ulrich, Thanks for your comment. I don’t think we are very far apart from each other. Indeed, I found the main thrust of Michael Burda’s reasoning simply bogus – using a flawed metric for stock markets for example. And you are right about the ideology in a lot of many economists’ reasoning. Thing for me is really that Hartz IV is very much to my liking as labour market insitutions are concerned, in effect it goes a long way in establishing a negative income tax. To top this up, I’d favour going in the direction of tax rather than contributions financed systems for health and care provisions to untie labour costs and social provisions. So please don’t take my position as a whole-hearted critique of Sebastian’s position and yours. It is not meant to be this way.