GERMANY: Dire straits
Europe's biggest economy is in dire straits and its government is locked into the mindset that created the mess to begin with, writes Martin Wolf
Oskar Lafontaine, Germany's former finance minister, had a gift for making enemies. He irritated the Americans by demanding exchange rate target zones; he infuriated the European Central Bank by calling for lower interest rates; and he enraged German business with plans for higher taxes. In the process, he made the German government unworkable. He had to go.
Gerhard Schröder, the chancellor, now has a chance to start afresh, but has also lost his best excuse for failure. Hitherto, however, he has shown few signs of knowing how to inject dynamism into the economy or deliver more jobs to the people. He and his new team will need to show far more imagination.
Germany has two complementary weaknesses: growth is too slow; and what growth there is generates too few jobs. Even France is doing better, on both fronts. French gross domestic product rose by 14.3 per cent between the trough of the cycle in the first quarter of 1993 and the last quarter of 1998, while Germany's output expanded only 11.4 per cent over the same period. Moreover, in the fourth quarter of last year, German GDP shrank by 0.4 per cent, while French GDP rose 0.7 per cent. France is also generating more jobs per unit of output. Between 1992 and the last quarter of last year, the number of people employed in Germany per unit of GDP fell 13 per cent; over the same period it fell only 8.5 per cent in France. Since early 1993, French employment rose 5 per cent, while German employment shrank 4 per cent.
How can even France be doing better than Germany? On recent growth, one answer is that Germany is more exposed to shocks in emerging markets than France: exports to Asia and Russia accounting for 2.5 per cent of German GDP last year, but only 1.6 per cent of French GDP. On growth since 1993, Germany had much less excess capacity after its post-unification boom than France did at that time. But, on the more fundamental topic of jobs, the truth is that the relative flexibility of the French labour market has improved.
There are two possible responses. The first is to note that Germany's rapid increases in labour productivity show it needs faster growth in aggregate demand than France, to compensate. This helps explain the urgency of Mr Lafontaine's calls for lower interest rates. But with its "one size fits all" monetary policy, there is little reason to expect the ECB to respond.
The second and more illuminating response is to recognise how inappropriate - but revealing - Germany's rapid productivity growth is. Remember that the most important event in Germany's recent economic history was unification. This brought in many new workers but little useful capital equipment. Very roughly, the ratio of the potential labour force to the useable capital stock rose by up to a quarter.
A sudden increase in the labour force is both a great opportunity and a great challenge. It is an opportunity because it permits faster economic growth. It is a challenge because that growth will only follow changes in relative prices. In particular, the real cost of labour should be driven down by the excess supply of labour and the return on capital correspondingly rise. These changes should, in turn, generate an investment boom and substitution of labour for capital. Not only should the rate of growth rise, but the growth in labour productivity should fall, as output becomes more employment-intensive.
This is a superb description of what has not happened in Germany: according to the Organisation for Economic Co-operation and Development, labour productivity growth, far from being slower than before unification, has risen from 1.2 per cent a year to over 1.6 per cent, since 1992; far from there being a sustained post-unification boom, investment has been weaker in the post-1992 recovery than in the two previous cycles; and far from an improvement in economic growth, it has been lower since 1992 than in the 1980s.
The overall outcome has been an appreciable reduction in the number of people employed, not just in eastern Germany, but in both parts of Germany: in the last quarter of 1998, the number of people employed in west Germany was more than 1m less than in early 1991; in east Germany it was down 1.7m. This is a textbook account of how not to adjust to a big increase in the labour supply.
Why has Germany done such a miserable job of adjusting to unification? The best answer is provided by Mancur Olson's book on economic growth*. His argument is that stable societies will, over time, throw up a crop of growth-destroying distributional coalitions. Olson says the UK's slow post-war growth is explained by the persistence of pre-war coalitions. For Germany, by contrast, defeat was a coalition-destroying shock - one that Ludwig Erhard's reforms then exploited*.
Now, however, Germany has powerful interest groups aligned against change. Allowing the labour market adjustment to work through the economy would have sharply reduced the real wages of west Germans. It would also have allowed producers located in east Germany to undercut those in west Germany. These possible sources of competition were eliminated by the cartelisation of west German labour markets and the direct introduction of west German regulations and social partners into the east German economy.
What has this to do with Mr Schröder? The answer is simple. The government he heads represents the distributional coalitions against adjustment. It is hardly surprising therefore that his government has rolled back even the modest structural reforms of its predecessor.
Thus, the government has reversed the easing of employment protection and the tightening of sick pay provisions; it has extended the law forbidding the sending of construction workers to Germany at other than German pay rates; and it has made the compulsory extension of wage agreements in construction easier. But reversal has happened in many other areas, from health reform to deregulation. Moreover, by putting forward tax changes that big business loathes, the government has damaged confidence, so threatening investment.
The question is whether such a government can turn the post-unification disaster around. This is not a problem the ECB will try to solve. It is far from clear it could. There must be a micro-economic response as well. Broadly speaking there are two possible solutions. One is agreement among the "social partners". The second is liberalisation and increased competition.
Under the former, corporatist approach, real wages would, by agreement among the social partners, rise very slowly over a long period. This would make growth more employment-intensive and induce more investment. But, quite apart from the huge domestic obstacles to reaching such an agreement, the government cannot depend on the ECB's responding with lower interest rates.
Under the liberalising alternative, a left of centre German government would introduce even more radical reforms than those it has already reversed. This will not happen. It is all very well for Tony Blair to suggest it should. But even his government is merely the beneficiary of its predecessor's efforts.
Mr Lafontaine's departure has solved nothing. Germany's difficulties are not of his making, but reflect the inability of an evolved welfare state to make the adjustments demanded by unification. The present government represents the coalition against that adjustment. There is no reason to suppose Mr Schröder has a better answer than Mr Lafontaine to the dilemmas it consequently confronts.
*The Rise and Decline of Nations (Yale University Press, 1982).
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