Ifo Viewpoint No. 67: The Five Shocks: Why Germany is Lagging Behind

Hans-Werner Sinn
Munich, August 4, 2005

During the last ten years, Germany has been the slowest growing country of the European Union, and Europe has been the slowest growing continent in the world. From 1995 to 2005 Germany will only have grown by 14.6%, while the old EU on average will have grown by 24.0%, the U.S. will have grown by 39.9% and the world will have grown by 45.6%. Why has Germany performed so badly?

One theory, which has been endorsed by the head of Germany’s leading party, Franz Müntefering, is that Germany is already where the others yet want to arrive. The slow German growth, he maintained, is just a sign of natural convergence. But this theory is not convincing, as Germany has recently been overtaken in terms of per capita income by quite a number of countries in Europe, including Ireland, the UK, the Netherlands and France, for example, and is still growing more slowly than these.

Another theory is that over the past fifteen years there have been various external challenges or shocks that have hit the country simultaneously. Rigid as it was, with an extensive welfare system and an overregulated labour market, the country was unable to react to these shocks and ran into trouble. This has a touch of Toynbee’s theory according to which history’s empires collapsed because they were unable to react to external challenges.

The first shock was intensified globalisation which brought a lot of new low-wage competition. Although globalisation is a gradual process, it gained momentum when China decided to participate in the market game. China is ten times Japan, and Japan was not easy either. German precision instruments and optical industry, for example, had gone astray when that country entered the game.

The second shock was EU integration including its northern and southern enlargements. The dismantling of the EU’s internal borders has enlarged each country’s market size and has brought about the scale economies that the Cecchini report had predicted. However, this has helped the small countries more than the big ones, and it has provided more competition for Germany, which is Europe’s biggest economy. Think of Nokia, the mobile phone maker. Due to the economies of scale which the common market made possible, that company was able to fully exploit its inventions, while Siemens, the German mobile phone maker, recently decided to give up that market.

The third shock was the euro. The euro has induced a rapid convergence of long-term interest rates in Euroland which in some countries had been 5 to 7 percentage points above the German level. Freed from exchange-rate risks, international investors no longer demanded a risk premium from the countries outside the deutschmark zone and were willing to provide their funds to all of them under the same favourable conditions that previously had been reserved for Germany. This is good for Europe, since it helps improve the allocation of capital and stimulate growth by transporting German savings to the remote and previously disadvantaged regions of the euro- zone, but it is of doubtful benefit to German workers who also would have liked to cooperate with that capital.

The fourth shock was eastern EU enlargement. This has brought extraordinary chances for trade and investment in the east, but it has also brought massive low-wage competition. On average, the wage costs of the ten accession countries that joined the EU in 2004, are only 14% of west German wage costs. The low-wage competition has led to substantial outsourcing and offshoring activities that have kept German firms competitive by reducing their demand for domestic labour. However, as neither the unions nor the welfare state accepted falling wages, unemployment and slow growth resulted.

The fifth shock was German unification, which has turned out a failure in economic terms. GDP per person of working age had been 61% of the west German level in 1996, but now it is only 59%. The low growth of the eastern part of the country has pulled down the German average and, what is more, the enormous demand for public funds in the east has increased the public debt, which has made the country violate the criteria of Europe’s stability and growth pact. The unsound financial situation in turn has contributed to making investors hesitant to bury their money in this country with obvious implications for economic growth.

All five shocks or challenges are historical developments that are good for the world as a whole, but they have created problems for Germany. In order for the country to meet the challenges and to continue to grow, it would have to make its labour markets flexible. Only if wages adjust downwards to accommodate the new international environment of the country, could German workers become competitive again so that the country could return to a better employment level, exploiting its human capital up to the capacity constraint. The new government, which the Germans will, in all likelihood, elect in September, will face the difficult task of confronting Germans with reality and to push through the necessary reforms of the labour market. It will have to decide whether Germany will make the effort to meet the Toynbeean challenge it is facing.

Hans-Werner Sinn
Professor für Nationalökonomie und Finanzwissenschaft
Präsident des ifo Instituts

Published as "Germany's Five Shocks", Project Syndicate, July 2005. Published in German under the title "Gut für die Welt“, Die Welt, No. 179, August 3, 2005, p. 9; also published in Les Echos (Mali), Business World (Philippines), The Straits Times (Singapore), Taipei Times (Taiwan), Ekonom (Czech Republic), Aripaev and Molodez Estonii (Estonia), Vilaggazdasag (Hungary), Logos Press (Moldova), Rzeczpospolita (Poland), Dilema Veche (Romania), Danas (Serbia), Finance (Slovenia), Ultima Hora (Paraguay), Jordan Times (Jordan), Der Standard (Austria), L'Echo (Belgium), Financial Mirror (Cyprus), Le Figaro (France), L'Agefi and Berner Zeitung (Switzerland).