Germany has fallen behind in terms of economic growth and exports. Vis-à-vis the EU average of the past seven years, Germany has lost a good 6% of growth, and Germany's share of world exports has fallen from 10% at the beginning of the 1990s to only about 8%. This slippage has both internal and external causes. The internal causes have been operating for some time. They are the same factors that have led to an uninterrupted upward trend in unemployment since about 1970.

The increase in wages and wage-related expenses is the most important factor, since it has hindered job-creating investment. Real hourly labour costs in manufacturing increased by more than 40% in West Germany in the last twenty years. In the Netherlands, where a policy of moderate wage increases began in 1982 with the Wassenaar Agreement, the rise was only a little more than 20%, and in the United States it was about 8%. The result was that the number of working hours increased in the US by more than 40% and in Holland by around 20%, while West Germany only managed an increase of about 5%. The rule of thumb established in numerous econometric studies, that a one percent moderation in wage agreements leads in the long run to a at least one percent increase in jobs, is confirmed by a comparison of these countries.

The expansion of the welfare state contributed significantly to the rise in labour costs. On the one hand, it increased minimum wages through the expansion of wage replacement payments, and on the other hand, it increased the tax burden placed on the factor labour. At more than 65%, the marginal tax burden on value added that an average employee generates as the result of a qualification measure or more work in west Germany is by far the highest rate in the world. The next stages of tax reform will do nothing to change this because tax progression will offset the effects of the reform. Joblessness in Germany is becoming increasingly more lucrative, and holding a job increasingly more unattractive. It is no wonder that fewer people are employed and that growth is sluggish.

German unification also explains part of the weak economic growth. In economic terms, unification was a failure because it aroused the desire for harmonised wages before a convergence in aggregate productivity had been achieved. While GDP per person of working age in the former GDR is only 58% of that of former West Germany, labour costs have reached a level of more than 70 percent and average net household incomes a level of about 85%. Pensions, on average, are even ten percent higher than in the west. The result of the anticipatory income convergence and the associated high-wage policies is that east Germany never had the chance to become a competitive location. The forces that could have induced a convergence in aggregate productivity were weakened from the very beginning. Since 1997 the two parts of Germany have been drifting apart, as measured by their GDP gap, instead of growing together. Employment continues to decrease in east Germany at a pace of more than two percent a year.

The weak growth in the east contributes arithmetically to the low level of aggregate German economic growth. Further, it adds to the weak growth in west Germany because it necessitates permanent public transfers to east Germany and signals to investors that they must reckon with high burdens if they choose Germany as an investment location. The deficit on current account in east Germany is about 45% of GDP. The greater part of this deficit is financed through public transfers. The smaller part is covered by private capital imports. Never before in history has there been a region depending to such a great extent on resource flows from another region. Even Israel, Portugal and the Italian Mezzogiorno, three more classical transfer economies, lie far below, with values of 12-13%.

In addition to these internal, longer-term factors, a major external reason for weak economic growth is the intensification of competition following the fall of the Iron Curtain and European integration.

The euro in particular has led to the creation of a common capital market and to a dramatic convergence in interest rates. This has accelerated growth in the peripheral areas of Europe and has advanced economic convergence, but it has not helped Germany. Only seven years ago, interest rates in major EU countries were around five to six percentage points above German rates because high risk premia had to be paid to international investors as a result of exchange rate uncertainty. The interest-rate differences began to fade with the announcement of the euro, and by now they have practically disappeared. The euro has robbed German industry of its competitive advantage in the form of lower interest rates and led to the strengthening of growth forces in other European countries.

In order to speed up growth again, market forces, especially on the labour market, must be activated. If idle labour resources are mobilised, the national product will increase. The belief that growth creates jobs no longer applies in Germany. The opposite is the case: new jobs create growth.

The reforms should start with the welfare state, to reduce the impact that welfare has on the labour market in the form of high minimum wages. This can be achieved without dismantling the welfare state by paying wage supplements to the lesser qualified instead of wage replacement. This would eliminate the minimum wage level that is currently imposed by social welfare and it would induce the unions to accept lower wages. At lower wages additional jobs, which would normally not have been created, would become profitable. With the proper design, the new system would be less expensive for the state than the present welfare system, and at the same time the numbers whose earnings are above current social welfare would increase.

In addition collective bargaining and labour law must be fundamentally reformed. It is an absurdity that the unions can refuse to let employees of a firm accept lower wages to save their jobs. The case of Philipp Holzmann where the workers had made such offers but were stopped by the unions speaks volumes. Industry-wide collective agreements should in future only function as wage guidelines that a company can choose not to follow if the majority of its employees agree. The favourability principle in labour law must be interpreted such that the creation of jobs can be included among the measures that are "favourable" to employees. Laws offering protection against dismissal should be loosened to allow new jobs to be created, which is prevented by current rules. Protection against dismissal only safeguards jobs in the short term. In the long term it causes unemployment and job insecurity. Co-partnership for employees is better. If co-partnership is offered to employees in return for wage moderation, considerable mobilisation effects can be achieved.

A new pension reform is just as necessary as an extensive privatisation of health insurance and a fundamental reorientation of policies for east Germany that would increase self-responsibility.

Last but not least, education must be improved to lay the long-term foundation for a new surge in innovation. This is widely accepted, but it will not be enough. German economic growth will continue to lag behind its European partners unless the more difficult reforms are implemented, too.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

German original published as "Warum Deutschland Schlußlicht ist" in Frankfurter Allgemeine Zeitung (No. 112, 16 May 2002, p. 14).