Saturday, November 22, 2014

Learning from Germany

BRUSSELS – Ten years ago, Germany was considered the sick man of Europe. Its economy was mired in recession, while the rest of Europe was recovering; its unemployment rate was higher than the eurozone average; it was violating the European budget rules by running excessive deficits; and its financial system was in crisis. A decade later, Germany is considered a role model for everyone else. But should it be?

In considering which lessons of Germany’s turnaround should be applied to other eurozone countries, one must distinguish between what government can do and what remains the responsibility of business, workers, and society at large.

The one area in which government clearly is in charge is public finance. In 2003, Germany ran a fiscal deficit that was close to 4% of GDP – perhaps not high by today’s standards, but higher than the EU average at the time. Today, Germany has a balanced budget, whereas most other eurozone countries are running deficits that are higher than Germany’s ten years ago.

The turnaround in Germany’s public finances was due mostly to a reduction in expenditure. In 2003, general government expenditure amounted to 48.5% of GDP, above the eurozone average. But expenditure was cut by five percentage points of GDP during the next five years. As a result, on the eve of the Great Recession that began in 2008, Germany had one of the lowest expenditure ratios in Europe.

But the government could not really do much about Germany’s key problem, namely its perceived lack of competitiveness. It is difficult to imagine today, but during the euro’s first years, Germany was widely considered uncompetitive, owing to its high wage costs.

When the euro was introduced, it was widely feared that Germany’s competitiveness problem could not be resolved, because the authorities would no longer be able to adjust the exchange rate. But, as we now know, Germany did become competitive again – too competitive, according to some, owing to a combination of wage restraint and productivity-enhancing structural reforms.

In fact, that analysis is only half right. On one hand, wage restraint was the key element, though the government could not impose it. Persistently high unemployment forced workers to accept lower wages and longer working hours, while wages continued to increase by 2-3% per year in the eurozone’s booming peripheral countries.

On the other hand, while the German government did enact important labor-market reforms a decade or so ago, those measures apparently had no impact on productivity. All of the available data show that Germany had one of Europe’s lowest rates of productivity growth over the last ten years.

That is not surprising, given the absence of any reforms whatsoever in the service sector, which is widely regarded as over-regulated and protected. Manufacturing productivity increased somewhat, owing to intense international competition. But, even in Germany, the service sector remains twice as large as the industrial branches.

Deep service-sector reforms would thus be necessary to generate meaningful productivity gains in the German economy. But this did not happen even in 2003, because all the attention was focused on international competitiveness and manufacturing.

Nonetheless, the German model does hold some useful lessons for the eurozone’s embattled peripheral countries today. Long-term fiscal consolidation requires, in the first instance, expenditure restraint; and labor-market reforms can, over time, bring marginal groups into employment.

But the biggest challenge for countries such as Italy or Spain remains competitiveness. The periphery can grow again only if it succeeds in exporting more. Wages are already falling under the weight of extremely high unemployment rates. But this is the most painful way out, and it generates intense social and political instability. A much better way to reduce labor costs would be to increase productivity – and Germany is no model in this respect.

Fortunately, however, some peripheral countries are now being forced by their creditors to undertake drastic reforms not only of their labor markets, but also of their service sectors. The reforms, even if initially implemented under duress, represent the strongest grounds for optimism. Over time, they will foster productivity and flexibility, and the countries that implement them thoroughly should thus become more competitive.

The most important lesson that has emerged from the reversal of fortunes within the eurozone over the last ten years is that one should not extrapolate from the difficulties of the moment. The reforms undertaken in some peripheral countries are much deeper than those undertaken by Germany a decade ago. Those countries that persist with these reform efforts could well emerge leaner and more competitive.

Those that do not (Italy appears to be heading in this direction) will be stuck in a low-growth trap for a long time, while Germany’s top position is not guaranteed forever. Indeed, where individual countries will end up in ten years is highly uncertain, and the current pecking order within the European economy could change quickly.

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    1. CommentedKai Wagner

      I can't contribute anything to the "mechanics" of competitiveness, since I'm still learning, so thank you for that. But I think you should indicate in your article, from which institution's perspective you are writing. It seems like you do this either from a capitalist's point of view, or from a goverment's point of view that doesn't have any influence on European politics i.e. a potential collective fiscal policy. In your analysis it sounds like the country' SHOULD speed up in undercutting each other's socialsystems. One could call it actually quite cynical to denote competitivenes with "health", that is connected with the cutting of public spending, i.e. including in some cases actual public health systems. To cut along story short: The possibilities you include and exclude in your analysis always imply fundamentally the standpoint of a particular institution. I think it would add a lot analytic power here, if it was more explicit which these are.

    2. CommentedMarco Cattaneo

      The problem with Gros' analysis is that it took 10 years to Germany to build a 20% cost advantage over Southern Europe and this was made under favourable world economic conditions. Now the South should do that in a couple of years which is impossible - you only collapse internal demand and go into depression. Reforming the european monetary system is the only avenue.

    3. CommentedTomas Kurian

      Internal devaluation (ID) is in essence the same strategy as currency war.We know where currency wars lead - knowhere. It will be just emulated by other countries. The same applies to (ID), but there is the additional suffering of high unemployment, social unrest. It does not seem to me that result of such strategy (ID) will bring any equilibrium at all Europe wide.

      Besides, rising productivity of Germany is more of increasing output and exports than lowering the wages. It is not possible to do it for all. If for example France started producing same volumes as Germany and exporting it there, German market would be obliterated the same way as France is today. And then what ?

      My point is that the most dangerous thing is to give Germany as an example. What they did to succeed cannot be emulated by all. Driving nations through (ID) is dragging them towards internal "currency war" without end but endless depression.

      Or, should the end be China´s average wages for Europe nations ?

    4. CommentedProcyon Mukherjee

      Daniel Gross is raising two important points, one that Germany has shown resilience to deal with adverse conditions given its competitive position at the time of introduction of the Euro and second that it had to deal with its public finances from a rather difficult position.

      Much of this could be emulated, specially the unwavering resolve to not let the wage escalation happen, much against the chastisement it received; such prudence in the wake of the next crisis would go a long way if others could follow as Germany had a three way sharing of the joblessness burden (one third shared by the management, workers and the government), when the output gap was too high in the period 2008-2009.

    5. CommentedJohnny (MoneyWonk)

      I agree with you on the fact that the internal devaluation in Europe is painful and causing social unrest. That's why I favor Soros' suggestion: Germany should either lead or leave the Euro.

      If Germany wants to keep the Euro together, then it must be more decisive and accept that the Southern countries sent capital north during the boom times. Now to restore competitiveness, Germany can either commit to transfer payment to align unit labor costs or accept higher inflation.

      If, however, Germany does not want to tolerate either or both actions, then it should leave the Euro. With Germany gone, the ECB can pursue the necessary monetary stimulus to get Southern Europe more competitive. Then, Germany can go back to the Deutche Mark at the appreciated value that their country deserves.

    6. CommentedCarol Maczinsky

      In the current situation it may be appropriate for Germany to invest in infrastructure projects, e.g. the Elster-Saale Channel, as a fiscal means to keep balance in the eurozone.