Structural Reforms and the German Growth Recovery

I am delighted to get so much response to my first blog. I especially appreciate the comment from a reader who called for calm, rational discussion of the issue. In Germany, reforming social safety nets is hazardous business and people can get pretty upset! And especially when Wolfgang Münchau claims what I claim is nonsense, I simply have to respond!

Any economist knows that both blades of Marshall’s scissors – demand and supply – need to be working for a recovery to occur, either in the market for vegetables or for the output of a nation. Demand alone is insufficient as is supply. And behold: During the booming world economy of this decade, German exports were booming; yet from 2000-2004, economic growth was positively anemic. This is because imports also rose at a breathtaking rate. Demand was abundant, but domestic supply was not. Rather than dismissing this as a Bazaar economy, I’d prefer to see it as the natural consequence of sensible specialization and gains from trade. And it’s not sufficient evidence to establish that the current German recovery is just like every other in the post-war era. Far from it.

The stock market: it is about as close to an indicator of expectations – rational or otherwise – that one can find. Markets were seriously shocked – as I was – by Gerhard Schröder’s Agenda 2010 in March 2003, because most political animals understand that this type of reform effort is equivalent of hara-kiri – suicide. Obviously the chancellor was driven by something very fundamental. And the fact that the other markets rose is a no-brainer – when Germany moves, so does Europe. No one denies that demand is important. What’s more important is how far demand can induce more output at low inflation – and that’s an issue for the supply side to settle.

How could the Hartz reforms have created jobs? First it is important to state clearly that the Hartz laws were hardly an outcome of careful or rational economic policy discussion. They resulted from backroom dealings between the SPD-Green government and a nasty opposition – the CDU imposed conditions on the reforms which might be interpreted as time bombs waiting to go off later. Moreover, not a single economist sat on the Hartz commission and public finance and labor economists weren’t involved in formulating reforms of the unemployment benefit system either. In many respects the new laws cut inframarginal benefits but left marginal work disincentives little changed – hardly what an economist would have recommended. Nevertheless, they applied the medicine where it was needed; the cut in the duration of benefit in the insurance program (Arbeitslosengeld) and more important a reduction in the benefit levels and qualification for the the follow-up needs-based program (Arbeitslosenhilfe) were revolutionary. And contrary to what my critics say, these medicines have been recognized by prestigious analysts like Richard Layard and Steve Nickell as a central explanation for the long-term reduction of unemployment in OECD countries. People also forget the deregulation of the temporary help sector and the liberalization of marginal employment and most importantly the modernization of labor offices and the institution of stricter work requirements.

I am reminded of the story of Henrico Frank, an unemployed man who achieved national attention by confronting SPD party leader Beck at a political rally and criticizing the Hartz reforms as heartless. Beck’s tough response to the disheveled Frank was “take a bath and shave, and you’ll get a job.” In the aftermath Frank promptly received eight job offers, but turned down all of them! Only after the local labor office threatened to cut his unemployment benefits did the young man take a job. Without the Hartz reforms this pressure would not have occurred.

All anecdotes aside: the Hartz reforms were designed to increase labor supply. Increasing labor supply generally implies lower wages, increasing labor demand, and more output, especially for an open economy like Germany with an export exposure now well over 40%. And evidence now emerges – both direct and indirect – that the Hartz programs have indeed increased labor supply. Temporary help agency employment, the bane of the trade unions, has soared in the past recovery. Part-time and casual work (minijobs), as distasteful as that may be to some, grew rapidly until the government decided to remove its tax-favored status. A recent paper by Rene Fahr and Uwe Sunde  demonstrates econometrically, for example, that the Hartz I, II and III laws significantly increased outflow rates out of unemployment. The claim that “no jobs were ever created by the Hartz reforms” is simply wrong. In a two-sided market, the decision of an employer to create and advertise a vacancy is predicated on a reasonable expectation that it can be filled. There are many well-articulated economic models – the most prominent of them formulated by Dale Mortensen and Christopher Pissarides, which predict that the supply of vacancies (i.e. the demand for labor) responds positively to a reduction in the fall-back position of workers in wage bargaining. While aggregate demand is a necessary condition for an increase in employment, it is certainly not sufficient.

6 Responses to "Structural Reforms and the German Growth Recovery"

  1. interested reader   October 27, 2007 at 5:08 pm

    Professor Burda, the points you make make perfect sense to me and clarify the debate enormously! But there’s one thing I still find very puzzling: How can we explain to the layman (including me) that 10% or so long-term unemployment is in fact a sign of under- and not oversupply of labor? My second question: If additional jobs are available only at lower wages on average, does that not mean that the marginal productivity of these additional jobs is lower too? When looking at the experiences of Spain and Italy and also the Netherlands, the introduction of part-time and flexible labor did in fact reduce unemployment a lot but so was the aggregate effect on labor productivity. Any hints anyone? Thanks.

  2. Guest   October 29, 2007 at 8:46 am

    Prof. Burda, a most excellent reply to the arguments made by Dr. Dullien and others in this blog. I tend to agree with your points.

  3. Ulrich Fritsche   October 31, 2007 at 3:33 am

    Well written post. Michael Burda calls for a calm and rational discussion, a position I would completely agree with. The high unemployment rate in Germany is a problem which can not be taken seriously enough. And I completeley agree with the argument, that one has to look at demand and supply schedules simultanously to investigate the issue. However, scepticism with regard to conventional wisdom arguments remains justified. I will outline the arguments which may justify some scepticism in a future post.

  4. JOM   November 1, 2007 at 4:33 pm

    “Well written post”? “An excellent reply”? I cannot see how to justify these appraisals. Burda is arguing like the tabloids: Look, Henrico Frank did not want to work but due to Hartz 4, he was finally forced to do so. Is this science? Or ideology? The market for labour is not like a market for goods. Prices, i.e. wages cannot fall without an end, since workers have to pay for their living costs. If people really chose to stay at home (which is far from being the case for all the 4 million unemployed workers), then this is not because unemployment benefits are too high, but because wages are too low!There is only one serious economic argument in this post: Hartz 4 has increased pressure on trade unions, thus lowering wages and boosting exports. But real wages have been falling for one decade already. Why should Hartz 4 be then the decisive measure leading to the recent recovery? And who discusses the link between Germany’s wage policy and the European imbalances? I’m looking forward to a really well written post..

  5. Guest   December 21, 2007 at 3:00 pm

    The Role of Labour‐Market Changes In the Slowdown of European Productivity GrowthIan Dew‐Becker (Harvard University)/ Robert J. Gordon (Northwestern University, NBER, CEPR)”Throughout the postwar era until 1995 labor productivity grew faster in Europe than in the United States. But since 1995, productivity growth in the EU‐15 has slowed while that in the United States has accelerated. But Europe’s productivity growth slowdown was largely offset by faster growth in employment per capita, leaving little difference in growth of output per capita between the EU and US going back to 1980. This paper is about the strong negative tradeoff between productivity and employment growth. We document this tradeoff in the raw data, in regressions that control for the two‐way causation between productivity and employment growth, and we show that there is a robust negative correlation between productivity and employment growth across countries and time.