Germany’s economy: Back to new strength?

Economics Department

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The picture of the German economy seems brighter than for quite some years. Should we feel confident?

Several indicators point to relatively strong economic growth in Germany in 2006. Activity accelerated in the first quarter of the year, business expectations have reached their highest levels for more than a decade and order books are filling up.

Furthermore, over several years German export performance turned out to be considerably stronger than that of the OECD overall. Indeed, Germany has recovered its position as the world’s leading exporter of goods, benefiting from strong demand for investment goods in particular.

Even more importantly, since the middle of the 1990s, there has been a marked improvement in the economy’s external competitiveness, as measured by the depreciation of the real effective exchange rate vis-à-vis Germany’s main trading partners.

So, does this mark Germany’s return as one of the OECD’s most robust economic performers? Perhaps not quite yet. After all, let’s not skip the other side of the story. Over the last 15 years German GDP growth potential decelerated to just 1.5% annually, according to the OECD’s estimates. The economy remains bedevilled by a persistent dichotomy between relatively strong exports and very weak domestic demand, and the volume of employment–as measured by the total number of hours worked–has trended down since the beginning of the 1990s, undercutting the level that prevailed in the 1993 recession by 6%. How do these apparently diverse observations about the external and domestic sides fit together, and what are the policy implications?

Our analysis suggests that since the beginning of the 1990s, the evolution of aggregate demand relative to trading partners was the main driver of Germany’s international competitiveness, rather than events on the supply side of the economy or monetary developments. At the beginning of the last decade a temporary boost in demand, largely thanks to massive transfers to eastern Germany and lively wage increases, combined with rising interest rates to trigger a real appreciation of the German Mark. This loss in competitiveness was associated with a swing in the current account from a sizeable surplus into deficit.

After this unification-induced boom, retrenchment on the demand side of the economy has played a dominant role in re-establishing Germany’s competitiveness on external markets, through a deceleration in wages and prices as well as cuts in employment. Several other events impinging on the domestic economy, such as the transition to European economic and monetary union, added to the pressure to adjust. In recent years, positive supply-side effects on external competitiveness have also emerged, reflecting corporate restructuring and international sourcing of inputs at lower cost abroad.

The output and employment foregone can be considerable during a prolonged period of retrenchment, particularly if prices and wages have difficulty adjusting to a changing environment and productivity growth remains subdued. By contrast, structural change can become the vehicle that generates higher income and employment if the regulatory environment fosters a reallocation of resources into new areas of activity. That may also include channelling any savings from off-shoring into the development of new lines of production at home, for instance.

Fortunately, the previous federal government started reforms in a number of fields to help overcome the rigidities impairing Germany’s economic performance. More efficient activation policies for the unemployed, measures to put the pension system on a more sustainable footing, and raising competition in the crafts sector are some examples. However, there is scope for the new government to deepen and extend regulatory reform in various areas and so raise the economy’s capacity to generate employment and increase productivity growth. For instance, disincentives that weigh against older employees and spouses in the labour force still need to be reduced, such as channels to early retirement or shortages in the supply of childcare services.

On the pay front, though determining wages and work conditions between employers and employees has become a more flexible process over the years, wage rigidities by qualification have to be softened further to fight unemployment of low qualified job seekers. Employment protection legislation needs further tuning in favour of more flexible contracts, though at the same time avoiding segregating the labour market into highly protected regular employment on the one hand and marginal jobs on the other.

Competition is another area requiring attention, both for innovation and productivity growth. Germany’s outward policies are traditionally open, and the general competition and enforcement framework is in most respects a success story. However, much more can be done to foster competition in specific sectors, notably in services and in network industries, and to lighten the administrative burdens on entrepreneurship. Legislation being prepared to reduce the overhead costs of doing business is a step in this direction.

In short, there is no single policy path for the government to follow. Indeed, it must take a comprehensive approach by exploiting synergies between different measures. Efforts to generate new employment, for instance, would be more effective if they looked beyond labour market reform to include other regulatory measures, such as reducing barriers to entry for new firms and impediments to the growth of enterprises. In the same vein, more competition in product markets ultimately favours consumers by forcing down prices. This, in turn, contributes to strengthening domestic demand and can enhance the public acceptability of reforms in other areas, notably the labour market.

Fiscal consolidation will have to rank highly on the German policy agenda, not least in view of the stress a rapidly ageing society implies for public sector budgets further ahead. While an increase in the standard VAT rate by three percentage points has been scheduled for 2007, the bulk of future fiscal adjustment will need to fall on the spending side of the general government budget, including the elimination of distorting tax expenditures. This is important for potential growth prospects to be preserved. Reform in federal fiscal relations, healthcare and the pension systems, as well as the education system, including at tertiary level, are all important areas where public sector action could generate large benefits. Legislation is being prepared in some areas, and first steps have been made to cut distorting tax expenditures, such as subsidies for residential construction.

Several other major industrialised countries have been through periods of intense structural and fiscal changes that were triggered by economic underperformance. Germany’s new government will need to firmly anchor and broaden the path of regulatory reforms that it has recently embarked on. If it does that, then we might soon be able to say with greater confidence that the German economy is indeed on the way back.

References

  • OECD (2006), Economic Survey of Germany, May (see www.oecd.org/germany for extended summaries)
  • OECD (2004), Economic Survey of Germany, Paris.
  • Wörgotter, Andreas and Wurzel, Eckhard (2004),“Ist Deutschland Europas kranker Mann?”, in Internationale Politik No. 5/59, May.
  • Wurzel, Eckhard (2005), “Why Germany Needs Structural Reform”, CESifo Forum 4/2005.
  • Wurzel, Eckhard (2003), “Germany: The case for reform”, in OECD Observer, No. 237, May.

More OECD Observer articles by Eckhard Würzel can be found via the search site facility on the top left of this page.

©OECD Observer No. 255, May 2006



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