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German recovery – it’s the supply-side but not government labour market and welfare state reforms

Private supply-side reforms in Germany are what caused the recovery – not government labour market and welfare state reforms. Further real wage cuts, generic labour and welfare reforms, or radical changes in corporate governance might not help. Future reform should focus on the functioning of the labour market without undermining the core labour system.

There is no consensus about the roots of the current German economic recovery. By contrast, two years ago in July 2005, there was unanimity amongst over 240 leading German academic economists who were signatories of a diagnosis and policy prescription. The state of the German economy was characterised as a deep, structural crisis and the demand was for drastic and painful reforms. The only way forward for the German economy was to reduce labour costs, especially for poorly qualified workers; to adopt a stability-oriented financial policy involving cuts in public expenditure and to implement institutional changes as in Britain, Finland and Ireland.

Some of those signatories now argue that the current recovery is ephemeral and that continued wage cuts and deep welfare state reforms are required (see e.g. Sinn ‘Can Germany be Saved?’). Others attribute the recovery to the success of the supply-side policies judged as so inadequate two years ago (e.g. Burda ‘German Recovery: It’s the Supply Side’). Outside observers are equally split. In a forthcoming book Adam Posen of the Peterson Institute for International Economics in Washington argues that Germany’s problem does not reside with structural problems in the labour market but with its protected and pampered companies: he calls for deep reforms in corporate governance and company ownership along Anglo-American lines. He attributes the recovery to a misguided obsession of policy-makers with export success (and with securing a reduction in real wages). Although these commentators disagree about why the recovery has happened, they share a common premise that more supply-side reforms toward Anglo-American norms – whether in labour markets, the welfare state or corporate governance – are required.

For an account of the current recovery to be convincing, it must also explain the long period of stagnation and high unemployment since the early 1990s. Moreover, it must be consistent with the performance of other comparator countries. In this spirit, we offer a different explanation of why German performance was so poor, why it has improved and the role that has been played by government policy. In doing so, we draw an explicit comparison with the experience over this period of the British economy: why was British economic performance so good, how was it maintained and what role was played by government policy.

Differences between Germany & the UK in job creation: consumption, housing & government-related sectors

The first step is to compare the patterns of job creation in Germany and the UK. Job creation was far superior in the UK as Table 1 demonstrates – the ratio of employment to the population of working age increased by 7percentage points in the UK and only 2 in Germany. But where were these new jobs created? The success of Britain in business services and finance is well-known as is the run-down of manufacturing and mining employment. Table 1 shows that the contraction of employment in the ‘goods’ producing sectors was indeed slightly less in Germany than the UK; more surprising is the fact that employment in finance and business services increased by just as much (3 percentage points) in Germany as in the UK. The real differences lie elsewhere – in distribution, construction and government employment.

Industry Germany UK
1      Agriculture, forestry & fishing -0.4 -0.3
Mining and energy -0.3 -0.2
3 Manufacturing -1.3 -1.5
4 Construction -1.7 0.5
5 Distribution 0.9 1.7
6 Transport & communications -0.1 0.5
7 Finance, business services 3.1 3.0
8 Public administration, health, education 1.2 2.2
9 Other services 0.7 1.0
10 Total 2.0 7.0
  Consumption, housing & government booms in the UK … not in Germany

The second step is to show that these employment patterns are associated with dramatically different structures of aggregate demand growth in Germany and the UK over the last 15 years. Employment growth in distribution, construction, and public administration, health & education were associated with booms in private consumption, housing and government spending in the UK and their absence in Germany. Figure 1 illustrates how the contributions to the growth of aggregate demand have evolved in each of these economies.

Figure 1. Comparison between Germany and UK in contributions to growth of aggregate demand, 1993-2005 (3 year moving average)

For shifts in aggregate demand to have more than a transitory cyclical impact on employment and growth, their implications for the supply-side have to be accounted for: the standard New Keynesian macro model predicts that aggregate demand shocks affect unemployment only until rising or falling inflation allows adjustment back to the (supply-side) equilibrium. One mechanism that seems to have allowed booms in private and public consumption in the UK and corresponding slumps in Germany to have a sustained impact on activity rather than on inflation relates to the real exchange rate. The appreciation of sterling associated with the consumption boom of the late 1990s in Britain reduced import prices and boosted real wages, allowing unemployment to fall without the emergence of wage pressure. In the opposite case, a fall in aggregate demand produces a short-run fall in activity. Once wages and prices respond, inflation falls and in the canonical macro model, this prompts the monetary policy-maker to reduce the interest rate. In an open economy, this may not happen (even if the country has its own monetary policy): falling inflation at home raises the real cost of imports and reduces real wages, which permits a new supply-side equilibrium to emerge at higher unemployment. In Germany, wage-setters appear to have targeted a fairly constant or depreciated real exchange rate through the 1990s and early 2000s. If the above mechanism is at work (reinforced in the German case by the limited response of ECB monetary policy to German disinflation), then a prolonged depression of aggregate demand is reflected in the medium term in employment. This points to a major gap in our understanding, namely of the drivers of aggregate demand over this period.

What can account for the prolonged buoyancy of household expenditure and its supplementation by government spending in the 2000s in the UK and the opposite pattern in Germany? We offer some suggestions (discussed at greater length in CEPR Discussion Paper No. 6415) that the explanation may lie with differences in the supply side in these two economies – but the differences we emphasise are at odds with the conventional wisdom. Our argument is also consistent with the successful performance of the German export sector in this period.

Supply-side restructuring by the private sector in Germany

Unlike the UK’s deregulated labour market, Germany has two different labour systems – one in the core export-oriented economy and the other operating in the rest of the economy. Over the past decade or so, key changes have taken place in the export-oriented labour system. These have occurred outside the remit of government policy and have resulted from cooperation between company managers and their employees, through the medium of works councils. A major restructuring in organisation, training and in employment conditions has been negotiated. The result has been reflected in the strong performance of German companies in international markets based on improved price and non-price competitiveness.

The profitability of German firms has improved and this is reflected in the national accounts where the net profit share in both manufacturing and non-manufacturing business has staged a very impressive recovery. The deep disruption to the private sector of the German economy caused by unification has been overcome. The net profit share in manufacturing is now back to levels recorded in the early 1970s.

Unintended consequences of Germany’s generic labour market & welfare state reforms

How has private sector-led restructuring interacted with government labour market reforms in Germany and what has been the impact on macroeconomic performance? In the export-oriented labour system, mid-career labour markets are very thin. In order for workers to invest in the deep company- and industry-specific skills associated with these sectors, insurance has to be provided. Traditionally generous state unemployment benefits and limited pressure to take a lower level job in the event of unemployment have provided this. However it is probable that the adoption by the German government of generic labour market reforms to increase the cost of unemployment has had the unintended consequence of raising precautionary savings in the core work-force as self-insurance has substituted for expected lower state insurance. This is likely to be part of the explanation for weak consumption growth even as the export sectors employing these workers boomed. A second effect has occurred as a consequence of the wage restraint that originated in the core labour system: whilst the real depreciation played some role in boosting net exports, its wider effects in a large fairly closed economy reinforced the weakness of consumption by keeping real income growth low.

Why does the deregulated UK labour market produce different outcomes? Investment by workers and firms in specific training in the UK is very low as compared with Germany. There is no core labour market where workers are involved with firms in making co-specific investments and where as a consequence the mid-career labour market is very thin. Job turnover is higher in the UK and labour market reforms raising the cost of job loss do not affect the expectations of life-time income in the same way as in Germany. (The substantial role of the house-price boom in fuelling and sustaining consumption expenditure in the UK is also absent in Germany, where house prices declined over this period. The explanation for this difference rests on a combination of a tightly regulated planning system in the UK that restricts housing supply and a deregulated financial system that has permitted households to borrow an increasing fraction of their current income.)

The deregulated British labour market also plays a role in permitting counter-cyclical fiscal policy. There is growing evidence that countries divide into clear groups according to whether activist-stabilising fiscal policy is observed. Countercyclical fiscal policy is observed in Anglo-Saxon economies and in those small economies which still have encompassing consensual wage-setting institutions. It is absent in the large continental economies with large wage-setters. One explanation is in terms of political economy: a non-discretionary fiscal policy is likely to emerge in order to provide incentives for large wage-setters to exercise wage restraint. Where labour markets are deregulated, the prospect of non-discretionary fiscal policy has no effect on wages.

Reform design should complement a successful private sector

In the absence of stabilising macroeconomic policy, the current recovery of growth in Germany has rested on spillovers from the export boom. Investment is now high, reflecting strong profitability of production in Germany and consumption demand is recovering. The origins of the recovery lie with the changes on the supply side in Germany made by the private sector (by firms in conjunction with workers), making the vocational training system and coordinated wage bargaining more efficient. Government labour market and welfare state reforms may if anything have delayed the recovery by encouraging precautionary saving and keeping domestic demand depressed. Calls for further real wage cuts, further generic labour market and welfare state reforms and radical changes to ownership and corporate governance of German firms should be scrutinised carefully. Reform efforts should instead be turned to policies that improve the functioning of the labour market without undermining the core labour system. For example, policies to encourage women’s labour market participation, allowing them to combine child-rearing and employment, would seem a priority.

Success should be measured by improvements in the employment rate and in productivity, which will be reflected in GDP per capita. Success is not measured by a growing current account surplus. Nevertheless Germany’s comparative advantage is in high value-added exports and reforms should be designed to be compatible with the institutions that support its flexibility and innovativeness. The other European success stories have implemented a variety of reform packages: where institutional endowments and specialisation differ across countries, so should reforms – the more so, the more globalised are product and capital markets.

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