No reason to copy the fading German miracle

'Rising costs and an expensive currency have resulted in a poor export performance. This has been only partly compensated by the fact that import growth has been held down by the tight domestic monetary policies followed by the Bundesbank'

For as long as most people can remember, we in Britain have been casting envious glances at the Germans, wishing that our economic performance could be more like their's. Recently, this tendency has taken a new twist, with Tony Blair's adoption of the stakeholder principle - a principle that was clearly at the heart of the German success in the 30 years after the war. But ironically an unprecedented degree of pessimism is erupting in Germany itself about its own economic future. It would be going much too far to say that Germans have started to cast envious glances in our direction, but with their economy teetering on the brink of a recession which seems to have had no obvious short-term trigger, there is certainly a realisation that much in their system may need to be changed.

For the "locomotive" economy of Europe, Germany's recent economic performance has been dire. In the four years from 1992-95, GDP growth averaged only 1 per cent per annum in the western sector. The pan-German unemployment rate is touching 10 per cent, compared with only 6 per cent before unification (and only 8 per cent in the UK today). Furthermore, the growth in labour productivity in the business sector in Germany since 1979 has been a puny 0.9 per cent a year, less than half that in the UK, and the third-worst record in the OECD.

Not only has productivity growth been sclerotic, but job creation has been anaemic as well, an unusually unpleasant combination. Two sectors have been primarily responsible for job creation in developed economies in the last decade - business and financial services, and self-employment. In the first, Germany's record is the worst in the OECD. In the second, it has managed no growth at all, compared with almost 6 per cent per annum in the UK.

Increasingly, this dismal performance seems due to an over-regulated economy, and a labour market that is pricing workers out of jobs. During the 1980s, the increase in real wages for low-paid workers in Germany - the group most at risk from unemployment - averaged 2.6 per cent per annum, the highest rate of increase in the developed countries. In the US, the same group saw real wages dropping by 1.3 per cent per annum, while in the UK the increase was only 0.9 per cent per annum. The result was much less job creation in Germany than in the Anglo-Saxon economies.

In addition, the tax and social security burden on top of wages is unusually high in Germany. Together, these extra burdens represent 41 per cent of German labour costs, against 28 per cent in the UK and 29 per cent in the US. Although German workers remain much more productive than most other OECD workers, mainly because of higher levels of plant and machinery at their elbows, it is becoming increasingly difficult for them to compensate for the burden imposed on them by the federal government.

For many years, German entrepreneurs have reacted to these problems by voting with their feet, and leaving the country. To a larger extent than in other comparable economies, German firms have been building up plant and equipment in foreign countries, rather than at home. Direct foreign investment has averaged about 1 per cent of GDP each year in the past decade, and last year it reached a record of around DM40bn, equivalent to over 5 per cent of domestic investment.

Ignoring the effects of capital depreciation, the past decade of foreign investment has, on its own, reduced the sustainable level of GDP by over 3 per cent. And many projects cancelled because of lack of profitability in Germany have disappeared, so the build-up in foreign investment probably understates the true "hollowing out" problem by a wide margin.

How can we be sure that the rise in foreign investment reflects problems within Germany rather than the intrinsic attractiveness of investment opportunities in emerging economies? The accompanying graph shows that those countries which have invested most abroad tend to have the highest levels of domestic wage costs, measured in a common currency (dollars). Furthermore, for any given level of wage costs, those countries with stringent regulatory standards in the labour market have a higher leakage of investment overseas than those with flexible labour standards. So there is some evidence that entrepreneurs are responding rationally to the incentives offered to them by labour market conditions in various economies.

In Germany's case, though, a persistent over-valuation in the exchange rate has added to the problem of excess labour costs, and a rigid labour market, at home. In nine of the last 10 years, German export deliveries have grown less rapidly than export markets, a record of lost market share unparalleled elsewhere in the OECD (except in the even more chronically overvalued Japan). Although the visible trade balance has managed to remain in surplus (largely because the domestic economy has been thrown into imbalance, with unemployment embarking on a persistently rising trend) the current account of the balance of payments has deteriorated alarmingly. In the mid-1980s, it was in surplus by around 4 per cent of GDP; now it is in deficit by 1 per cent of GDP, and widening.

Essentially, rising costs and an expensive currency have resulted in a poor export performance. This has been only partly compensated by the fact that import growth has been held down by the tight domestic monetary policies followed by the Bundesbank. Without these tight policies, inflation in Germany would have risen - instead, the exchange rate has been pushed up, the economy has been deflated, and the underlying problems are seen in rising unemployment.

Although these problems have been around for a long time, they have only recently been fully recognised inside Germany. The sudden collapse in economic growth last autumn was no doubt precipitated partly by the rise in the mark against the dollar and the lira earlier in the year, and by the fact that excess inventories had been accumulated during 1994. But these short-term factors do not seem sufficient to explain the full severity of the collapse in business confidence in recent months, and at last the government seems to be waking up to the need for structural reform. Even the Bundesbank has changed its spots, and seems desperate to push the mark at least 10 per cent lower against the dollar. Yet the Kohl government has often in the past promised much more than it has delivered when it comes to reducing taxation and regulatory burdens. Last week's "structural" package promises tax cuts of DM16bn next year (0.5 per cent of GDP). This combined with the current burst of monetary easing is likely to induce some recovery in economic growth in the months ahead. But it will take much more dramatic action to put the locomotive economy fully back on its tracks, and that seems as far away as ever.

Many aspects of the stakeholder system, such as the long-termism it breeds in industry, are still attractive. But, taken overall, the social market economy in Germany is no longer producing the goods, and has as much to learn from us as we have from it.

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