Germany Outperforms....Moldova

Hans-Werner Sinn
The Wall Street Journal Europe, 24.03.2005, S. 11

State of the Union / By Hans-Werner Sinn

Germany is moving. Last week, Chancellor Gerhard Schröder and the conservative opposition leaders Angela Merkel and Edmund Stoiber agreed to jointly carry out some fundamental reforms of the German economy.

Germany is moving because it has to. Although some commentators tend to play down the country's problems an joke about seemingly unfounded German angst, the economy is in fact in deep trouble. Since 1995 the German economy has been growing at a slower pace than any other European country-except Moldova. And this year, Germany will again be the laggard.

This, however, is not due to German unification as Berlin likes to argue. Even though it just successfully used this argument to effectively eliminate the eurozone budget rules, the real reasons for Germany's malaise lie elsewhere.

It is correct, though, to say that the East German experiment has failed. The two parts of the country have been drifting apart since 1997 despite or maybe because of the €85 billion of annual transfers. East German GDP per person of working age, which peaked at 61% of the West German level in 1996, has fallen to 59%. There are regions with unemployment levels of 30%, breeding extremism and violence.

But even if we took the East out of the equation, the hard truth is that the West German economy has also been growing slower than any other country in Western and Central Europe.

Statists argue that Germany is a saturated economy and that stagnation is the flip side of its past success-the logical consequence of the fact that it has supposedly already arrived where others want to go. Nothing could be further from the truth.

Recently, Germany's per capita income has been overtaken by the U.K., France, Austria, the Netherlands and Ireland, to name only a few. Germany's public finances arc also in free fall. By the end of this year, Germany will have violated the Stability and Growth Pact for four years in a row. But, as already said, Berlin took care of that problem by killing the pact.

It is true that the country is the world's vice champion in terms of exports. But it is worth taking a closer look at some of those numbers. About 40% of German exports are based on imports of intermediate goods from other countries. Moreover, Germany's domestic investment is so miserably low that the excess of savings over investment, which, by necessity, is being exported, represents 5% of GDP.

Net investment as a share of GNP is the second lowest among all OECD countries. In 2004, when the world economy experienced its biggest boom in 25 years, German gross fixed capital for nation, which could have been expected to grow by about 8%, actually fell by 0.9%.

Unemployment is at a post-war record level. From 1995 to 2004, Germany's manufacturing sector lost the equivalent of nearly 1.3 million full-time jobs while at the same time the total number of man-hours worked in the rest of the economy remained unchanged. No doubt, Germany is currently facing one of its most severe peacetime crises in history.

Without reforms this will be Berlin's only success

The government and opposition seem to agree on a number of important reform proposals. The most remarkable change could be a move toward a social system similar to the U.S. earned income tax credit. President Horst Köhler also recommended it, using the term "activating social aid," which characterizes a reform proposal developed by Ifo. If the proposal is taken seriously, the unskilled will receive subsidies in addition to their earned income, which should he creating jobs in the low wage sector.

The parties also agreed to cut the corporate tax rate from 25% to 19%, Slovakia's magic number. However, since Germany's local profit tax comes on top of that, the effective corporate tax burden is about 30%. Still, this is a courageous move in the right direction.

Mr. Schröder also asked the Council of Economic Advisors to develop a comprehensive tax reform. The Council previously suggested adopting the dual income tax system found in the Nordic countries. If it sticks to its proposal, this could turn out to be a major reform for Germany. Further measures include waiving the inheritance tax for family businesses and a €2 billion program for infrastructure investments.

Unfortunately, Mr. Schröder did not say how he plans to finance his proposals. The fear is that he may want to increase the debt further. But Ms. Merkel and Mr. Stoiber unequivocally said that they will not accept any deficit spending. There will be a lot of political hassling before a compromise may be reached about the financial side of the proposals. The hard part of the negotiations is yet to come.

While the program does move Germany forward, it is not the big break through. Mr. Schröder has yet to challenge the power of the unions.

Germany's wage-bargaining system is based on industry-wide contracts that are binding for individual firms. Such contracts allow unions to form effective cartels against the employers and the rest of the economy, leading to particularly aggressive wage policies. Small wonder that, next to Norway, Germany has the highest hourly labor costs in the entire world, and that unemployment has increased along a linear trend over the last 35 years.

Ms. Merkel and Mr. Stoiber called for a reform of the bargaining system by giving individual companies the right to deviate from union wages if two-thirds of their employees agree. This would effectively destroy the cartels.

The opposition leaders also proposed scrapping significant parts of job tenure rules to make the labor market more flexible. This would weaken the unions further because their clientele would lose the protection against the negative employment effects of their overblown wage demands.

Sadly, Mr. Schröder is unlikely to follow such proposals. He would not risk losing his support from the unions and the left wing of his Social Democratic Party. So, much water will have to flow down the Rhine before Germany will really be ready for globalization.

Mr. Sinn is president of Ifo, one of Germany's leading economic institutes, and the author of 'Can Germany Still Be Saved?"