Ifo Viewpoint No. 50: Bazaar Economy

Hans-Werner Sinn
Munich, 18 December 2003

Even if the economy is now recovering, the deep structural change in the German industrial landscape observable since the mid-1990s will continue at an alarming scale. Outsourcing and offshoring remain the options for offsetting Germany’s competitive disadvantages. German big industry has been engaged in Asia for some time, to benefit from low labour costs and to supply the international markets from Asia. Now German mid-sized businesses are establishing ties with Eastern Europe. These firms did not dare to venture into Asia but are now willing to risk involvement in Eastern Europe because the start-up costs are very much lower there. Eastern Europe also offers very low wages, but lies at Germany’s doorstep and is part of our cultural area. In addition, the former Communist countries have overcome their transformation crises, have established stable legal systems, and a majority will join the EU in a few months.

The list of firms migranting to the East is long and reads like a Who’s Who of the Mittelstand, the mid-sized German companies that are the backbone of German industry. Sixty percent of enterprises with fewer than 5.000 employees surveyed by the Cologne Institute for Economic Research (IW) have already established locations outside the EU. These firms have not completely pulled up their stakes in Germany since they still plan to supply their worldwide customers from Germany. But they are increasingly shifting larger parts of their intermediate product chain to Eastern Europe. Either they have invested there themselves or they buy their inputs from other firms that have production sites there.

The low wages of the Eastern Europeans are too tempting to resist, especially since many competitors in Asia and other parts of the world pay lower wages. The hourly wages of industrial workers in the accession countries range from a third (Slovenia) to one tenth (Estonia) of west German wages. The largest country in the group, Poland, has hourly wages that are approximately a quarter of east German and a fifth of west German labour costs. These wage differentials will not change quickly. Even if we assume an annual convergence rate of two percent, which is double the rate observed in Western Europe in past decades, Polish hourly industrial wages would only amount to a third of west German wages in 2010 and less than half in 2020. No wonder that German enterprises are taking advantage of shifting production sites abroad to reduce costs. According to a Bundesbank study, they had created no less than 2.4 million jobs abroad by 2000.

Businesses that do not play that game risk extinction. The number of German bankruptcies continues to set new records. In Germany today, there are three times as many bankruptcies as ten years ago and five times as many as twenty-five years ago. Because of these bankruptcies, the big German banks now face a major crisis that will be very difficult to overcome.

The industrial statistics clearly show how enormous the incentive is to avoid Germany’s competitive disadvantages by outsourcing. Although German industrial production increased by fifteen percent between 1995 and 2003, real value added of German industry increased by only 5 percent in the same period. In the past both of these figures ran more or less parallel to each other. Two thirds of the increase of German industrial production since the mid-1990s presumably stem from outsourcing to low-wage countries and only one third is due to an increase of domestic value added.

This throws a bad light on the competitiveness and export strength of the German economy, because we must obviously distinguish between the competitiveness of German industry and the competitiveness of German workers. German enterprises will remain competitive on international markets thanks to their Eastern European hinterland, but German workers have already lost their competitiveness. Industrial employment decreased by ten percent in the same period without new jobs having been created to offset these losses. A total of four and a half million Germans were unemployed in 2003. Four and a half million Germans are no longer competitive.

Competitiveness can no longer be measured in terms of German exports. Because of outsourcing to Eastern Europe German industry can still shine on the international markets with its products and can point with pride to its export statistics. An Audi whose engine is produced in Hungary is counted at its full value in the German export statistics. However, “Made in Germany” is increasingly becoming a false label. Only the final assembly takes place in Germany. The value-added components are coming more and more from Eastern Europe.

Germany is becoming a bazaar economy that sells the world economical, high-quality products that were not produced in the country.

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

Published as "4,5 Millionen Verlierer", Die Zeit, December 28, 2003, p. 28.