Ifo Viewpoint No. 89: How the Upswing Came About – Six Hypotheses

Hans-Werner Sinn
Munich, 15 November 2007

In the recent forecast of the economic research institutes, the German upswing will continue next year but will clearly weaken. The soft American economy is casting its long shadows.

The weakening of the German upswing raises the question of how this upswing came about in the first place. If we know the cause, we can perhaps keep the upswing forces going a little longer. Six hypotheses present themselves.

Hypothesis 1: The upswing is the work of Chancellor Merkel. This hypothesis is manifestly wrong, because Angela Merkel has completely reduced its budget deficit and has not pursued a supply-side policy. Whereas the deficit stood at 3.4 percent of GDP the year she assumed office, this year we expect a small surplus of 0.1 percent. The government has curbed the upswing, in other words. This, however, was the correct anti-cyclical policy, precisely as set out in the textbooks. The burden on future generations was not enlarged, and the government is in a position to respond when the next downturn comes.

Hypothesis 2: The trade unions displayed reserve, which led to the creation of new jobs. In fact, increases in nominal unit labour costs in recent years are clearly behind the rises in other countries. While the German unit labour costs increased from 1999 to 2006 by only 0.6 percent, the unit labour costs of the other euro countries increased by 15.9 percent, on average, which meant a relative lowering of labour costs in Germany of 13.2 percent. This has improved the competitiveness somewhat of the still very expensive German worker. However, credit for this is due less to the trade unions than to generally low inflation and to Agenda 2010. This leads us to the next two hypotheses.

Hypothesis 3: Germany has had a lower rate of inflation than the other euro countries and has become more competitive overall. Economists call this a real devaluation. In fact, measured in terms of the GDP price index in the euro area from 1999 to 2006, Germany experienced a devaluation of around 11.4 percent (10.9 percent on a trade-weighted basis). This is the main reason for the slow increase in German unit labour costs. It also means that only about 2 percentage points of the advantage from a decrease in unit labour costs vis-à-vis the other euro countries (13.2 percent) is explained by real wage restraints.

Hypothesis 4: Agenda 2010 is working. Schroeder eliminated Germany’s second-tier unemployment assistance for one million people in the west and another million in the east, making the people essentially into social welfare recipients. In addition he reduced the duration of the first tier unemployment benefit for older employees from 32 to 18 months. This all lowered the implicit wage claims that were defined by wage replacements and brought some movement into the wage front, which also contributed to the job miracle of the past two years. We still cannot quantify the effects. An indication for the correctness of the hypothesis, however, is that employment of employees over fifty increased by 4.9 percent in 2006, whereas for all working-age groups the increase only amounted to 1.6 percent.

Hypothesis 5: The economy is driven by investment replacement cycles. This hypothesis is irrefutable if we look at the trend path of GDP demand components: Investments are the cycle makers. They fluctuate much more strongly than other components of macroeconomic demand and generate the cyclical ups and downs. The German investment cycle has been about ten years long up to now but seems to have shortened. This explains a good portion of economic activity. That the economic cycle is driven by investments holds not only for Germany but for the whole world. This brings us to the last hypothesis.

Hypothesis 6: German economic activity parallels world economic activity because we export a lot. This hypothesis is also doubtlessly correct since the world economy has been expanding at a nearly unprecedented pace. This year for the fourth time in succession the world economy has grown at a pace of about five percent. This has not happened since the 1950s. Usually, in good times growth rates of 5 percent or more have only occurred for a maximum of three years.

There is no contradiction between hypothesis 6 and hypothesis 5, since the level of world economic activity is also explained by the investment cycle. In the German case, the two hypotheses complement themselves very well, since Germany has specialized in capital goods exports. Germany thus profits more from the upswing of the world economy than the other Euro-area countries did and exchanged its laggard status in the country growth rankings for a medium-range position. For the same reason, however, Germany could be more strongly hit by an economic downturn. The decades in which all efforts were focussed on exports to the neglect of the domestic sector has made Germany particularly vulnerable to cyclical change. During a boom Germany receives a stronger boost than the other euro countries, but it suffers all the more when the economy is sluggish. For this reason it is important to further strengthen the forces that emanate from Agenda 2010, as stated in Hypothesis 4. In the long term they will contribute to an expansion of the more service-intensive domestic sector and thus reduce the cyclical dependency of the German economy.

Hans-Werner Sinn
Professor of Economics and Finance, University of Munich
President of the Ifo Institute

Revised version. Published as “Wo der Aufschwung herkam – sechs Hypothesen", WirtschaftsWoche, no. 44, October 29, 2007, p. 186; additionally published in EurActiv.com, 2007 (Belgium).