Germany’s substantial trade surplus with its southern neighbours is in the spotlight (Wyplosz 2010). Many economists argue that Germany’s trade imbalance with its southern Eurozone neighbours has contributed to their woes. German industry has boosted the competitiveness of its exports over the past decade by keeping wages flat.
As a result, German wage restraint has led to a real depreciation of Germany’s fixed nominal exchange rate vis-à-vis its Eurozone members, helping Germany to win market shares at the expense of Southern Europe. The numbers give support to this argument. In fact, Germany’s real effective devaluation in terms of relative unit labour costs compared with the EU27 during 1994-2009 is about 20%. This is indeed substantial.
But the argument hides another powerful way by which Germany lowered its relative unit labour costs. German firms’ offshored part of production to the new member states in Eastern Europe, Russia and Ukraine.
At first, Germany was slow in exploiting the opportunities offered by the opening up of Eastern Europe after the fall of communism compared to its neighbour, Austria. In 1999 Austria’s outgoing foreign direct investment to Eastern Europe accounted for almost 90% of total investment leaving the country, Germany invested a meagre 4% in Eastern Europe. As a result, offshoring as measured by the share of trade between German parent firms and their subsidiaries in Eastern Europe – also called intra-firm trade – accounted for only about 20% of total German imports from Eastern Europe, while it reached almost 70% of total Austrian imports from the same region (Marin 2009).
In the second half of the 1990s Germany shifted its strategy and started to invest heavily in Eastern Europe. Its share of outgoing foreign investment to the region increased to almost 30% in 2004-2006.
This new way of organising production by slicing up the value chain has been more important for Germany’s lower unit labour costs than German workers’ wage restraint. According to estimates, German offshoring to Eastern Europe boosted not only the productivity of its subsidiaries in Eastern Europe by almost threefold compared to local firms, but it also increased the productivity of the parent companies in Germany by more than 20% (Hansen 2010 and Marin 2010).
As a result, relocating production to Eastern Europe made globally competing German firms leaner and more efficient helping them to win market shares in a growingly competitive world market. The efficiency gains from reorganising production were particularly pronounced after 2004 leading to a sharp fall in Germany’s relative unit labour costs from 2004 to 2008.
Productivity gains from offshoring are also the main reasons why Germany and Austria experienced only minor job losses as a result of the opening up of Eastern Europe. By finding this new way of producing, German and Austrian firms were able to cut costs and to take advantage of the pool of skilled workers available there. It seems that the fall of communism and the opening up of Eastern Europe happened just at the right time. It allowed German firms to cut costs at the time when globalisation intensified competition and it allowed Germany to cope with the scarcity of human capital which became particularly pronounced in the 1990s.
Due to Germany’s skill shortage, offshoring to Eastern Europe has led also to lower wages for skilled workers in Germany. German firms offshored the skill intensive part of the value chain to exploit the low cost skilled labour available in Eastern Europe. As a result, the demand for this type of labour in Germany was lower, putting downward pressure on skilled wages in Germany. Hence, offshoring improved Germany’s competitiveness by increasing German firms’ productivity and by lowering its skilled wages.
What follows from this for southern Europe?
Germany and Austria adjusted to eastern enlargement by changing the way they do business. It is often argued that the Eurozone’s problem is that, contrary to the US, it lacks labour mobility and fiscal centralisation. But the evidence for Austria and Germany suggests that Europe has invented a new adjustment mechanism based on firms’ slicing up of the value chain. As a result, while country boundaries have become less important for the competitiveness of Europe as a whole, firm boundaries are now more important.
Thorsten Hansen (2010), “Tariff Rates, Offshoring and Productivity: Evidence from German and Austrian Firm-Level Data”, Munich Discussion Paper 2010-21, University of Munich.
Dalia Marin (2009), “The New Corporation in Europe”, BRUEGEL Policy Brief, Brussels, September.
Dalia Marin (2010), “The Opening Up of Eastern Europe at 20: Jobs, Skills, and ‘Reverse Maquiladoras’ in Austria and Germany”, Munich Discussion Paper 2010-14, University of Munich.
Wyplosz, Charles (2010), “Germany, current accounts and competitiveness”, VoxEU.org, 31 March.
Originally published at VoxEu.org and reproduced here with permission.