German recovery: it’s the supply side

Michael Burda, 23 July 2007



After almost a decade of slump, the German economy is finally growing again. Between 1995 and 2005, annual real growth averaged a meagre 1.4%, compared with 3.2% in the US, 2.9% in the UK, 2.1% in France and Denmark and 2.7% in the Netherlands. Clearly the “sick man of Europe,” Germany logged less than a third of EU’s overall cumulative rate of GDP increase over the same period. Now things look different: Growth in 2007 might top 3% in 2007, and many now expect the recovery to persist for several years. The sick man may finally get out of the hospital, and Europe is breathing a sigh of relief that one of its key engines is firing properly again.

The Teutonic turnaround has already caught the attention of academics and policymakers alike. In many respects, the current upswing is not simply a run-of-the-mill recovery. Indeed, there is a lot that German policymakers, advisers and journalists in this country could learn from it, and there are good reasons to do so. Policymakers in Italy and France might also do well to pay close attention.

The recovery is robust

First of all, it is robust in comparison to past German recoveries of the past quarter century. The stock market, a standard precursor of economic upturns, saw this train coming. In fact, the DAX index started rising in March 2003, and has increased by more than 250% since then. Moreover, previous recoveries were seldom accompanied by such a strong run-up in equity values. Because stock markets mirror medium run fundamentals of new capital projects, it is no surprise to economists that investment spending is soaring. Just to put things in perspective, DAX outperformed the French CAC-40 index by roughly 100%, and the Italian MIBTel by about than 125% over the same period.
Second, consumption in Germany is rising again – and despite still modest real wage growth – and after years of stagnation. Forward-looking, rational households are more confident about future earnings and employment prospects than they have been in many many years. Far from being automatons spending hand to mouth, German consumers needed to be convinced that the recovery was not a flash in the pan.

Job creation and productivity growth

Third, true to form, job creation, a lagging indicator of the business cycle in OECD countries, is now growing robustly. Over the past twelve months, German unemployment has declined faster than in any other period since the late 1950s. For the first time, a recovery has made significant inroads into the ever upward-drifting trend of joblessness. This came despite a labour market reform which reclassified half a million able-bodied Germans as unemployed in January 2005. Even in the depressed eastern part of the country, the unemployment rate has fallen significantly. The commentators who bemoan the stagnant labour productivity numbers might do well to take a refresher economics course; it is difficult to organize an above-average expansion of employment – especially drawn from the ranks of long-term unemployed – and expect labour productivity to rise at the same time.

In Germany a silly debate is raging over who gets credit for the recovery. Modern macroeconomics teaches that cyclical fluctuations are the culmination of random influences – a run of good luck, but possibly one associated with surprising and positive policy decisions.

Hartz reforms

Against the backdrop of previous expansions, it is intellectually challenging not to attribute a large part of the dramatic drop in German joblessness to the Hartz reforms implemented 2-3 years ago. A key to this interpretation lies in stock prices, which began to rise in March 2003, the same month that then-chancellor Gerhard Schröder announced the Agenda 2010, which ultimately led to the Hartz laws and other labour market reforms. Similar spectacular stock market increases are evident in the years subsequent to both the Thatcher reforms in the UK and the Wassenaar consensus in the Netherlands in the 1980s.

Those who claim that this recovery is simply Germany free-riding on the aggregate demand of a booming world economy are simply ignoring the evidence. Over the period 1995-2004, real German exports rose by more than 90%, while output grew by a paltry 20%. If there was a demand effect behind those exports, it was certainly offset by above average import growth – indeed, by more than 65%%! Germany may well be an “Export-Weltmeister” but it has become a leading Import-Weltmeister as well.

Sector turbulence, restructuring and the euro

A more reasoned view is that Germany has begun to adjust to competitive pressures normal in a monetary union with a free internal market, specializing in the upper end of final production and final stages of value added, while outsourcing the less profitable bits. German industry has used this opportunity to restructure, reduce costs and restore competitiveness in a tough world market. The period of stagnation was a time of massive restructuring: my student Ronald Bachmann and I find that turbulence – the unevenness of sectoral expansion and contraction of economic activity rose dramatically in West Germany during the 1990s. As a response to these new circumstances, unit labour costs in Germany have fallen by about 10% and German inflation has been the lowest of all Eurosystem countries since the launch of the monetary union in 1999. By virtue of a disciplined internal devaluation, Germany can now compete again inside and outside Europe.

Yet Germany is not yet where it should, or could be. Two years have passed without further significant labour and product market reforms – a missed opportunity for deeper change when it is easiest: when the economy is growing. Vacancies are at an all-time high, labour shortages are beginning to emerge and, at an official unemployment rate of around 8.5%, unions are striking for higher pay in the railroad, construction and other sectors; wages are rising again. The equilibrium rate of unemployment has not fallen as much as it has in the Netherlands, Denmark, Ireland, and the UK over the past two decades, but Germany does seem to have finally gotten aboard the train of labour market, supply-side oriented reforms initiated by Europe’s success stories. Italy and France would do well to follow suit.

To paraphrase (or abuse!) Karl Marx, economists have interpreted the recent slump in many different ways, the point is to change the way we think about it. To me, the facts are fairly unconvertible in their support for a supply-side interpretation of the recovery. Naturally, many journalists, labour unionists and policymakers in Germany will want to read the tea-leaves differently; no one can deny them this right, just as one shouldn’t ban creationism or even saying that the world is flat. Wasn’t it Keynes himself who warned that persons "who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist." Well let’s hope that in just this one case, both Marx and Keynes were both right.

Topics: Europe's nations and regions
Tags: Germany, growth, job creation, productivity

Professor of Economics at Humboldt University Berlin and CEPR Research Fellow