Germany’s Five Shocks (Fünf Schocks, die Deutschland zum Schlusslicht machten)

Hans-Werner Sinn
Project Syndicate, July 2005

Over the last decade, Germany has been the slowest growing economy in the European Union, and Europe has been the slowest growing continent in the world. From 1995 to 2005, Germany will have grown by only 14.6%, while the old EU on average will have grown by 24%, the US by 39.9%, and the world economy by 45.6%. Why has Germany performed so badly?

One theory, endorsed by the head of Germany’s ruling Social Democratic Party, Franz Müntefering, is that Germany is already where the others still want to be. Slow German growth, he maintains, is a sign of natural convergence.

But this theory is not convincing. Germany has recently been overtaken in terms of per capita income by several EU countries, including Ireland, the UK, the Netherlands, and France, and is still growing more slowly than all of them.

Another, more plausible 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 over-regulated labor market, Germany was unable to react to these shocks and ran into trouble. This theory recalls that of the British historian Arnold Toynbee, according to which empires collapse because they are unable to react to external challenges.

The first shock was intensified globalization, which brought a lot of new low-wage competition. Although globalization is a gradual process, it gained momentum when China decided to play the game. China is ten times the size of Japan, and Japan was not easy to deal with, either. German precision instruments and optical equipment, for example, lost their competitive edge when Japan entered the game.

The second shock was EU integration, including the northern and southern enlargements. The dismantling of the EU’s internal borders boosted each country’s market size and brought about the predicted economies of scale. But this helped Europe’s small countries more than the big ones, and it implied more competition for Germany, Europe’s biggest economy.

Think of Nokia, the mobile phone maker. Due to the economies of scale that the common market made possible, Nokia was able to exploit its inventions fully, while Germany’s Siemens recently decided to give up on the mobile phone market.

The third shock was the euro, which has induced a rapid convergence of long-term interest rates, which in some countries had been five to seven percentage points above the German level. Freed from exchange-rate risk, international investors no longer demanded a risk premium from these countries and were willing to provide funds to all of them under the same favorable conditions that previously had been reserved for Germany.

This is good for Europe, because it helps improve the allocation of capital and stimulates 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, which has brought extraordinary chances for trade and investment in the east, but has also brought massive low-wage competition. On average, wage costs in the ten countries that joined the EU in 2004 are only 14% of the West German level. Low-wage competition has led to substantial outsourcing and off-shoring activities that have kept German firms competitive by reducing their demand for domestic labor. As neither Germany’s unions nor its welfare state would accept falling wages, the result was higher unemployment and slower growth.

The fifth shock was German unification, which is a failure in economic terms. GDP per working-age person in East Germany had been 61% of the West German level in 1996, but it is now only 59%. The slow growth of the eastern part of the country has pulled down the Germany-wide average, while the enormous demand for public funds in the east has increased public debt. The weak fiscal position has in turn undermined investors’ confidence, with obvious implications for economic growth.

All five shocks constitute historical developments that are good for the world as a whole, but problematic for Germany. In order for the country to meet the challenges and to continue to grow, it would have to make its labor markets flexible. Only if wages adjust downward to accommodate the new international environment can German workers become competitive again, so that the country returns to a higher employment level, exploiting its human capital up to the capacity constraint.

The new government that voters will most likely elect in September will be confronted with the difficult task of confronting Germans with reality and pushing through the necessary reforms. Only then will we know whether Germany can meet the Toynbeean challenge it is facing.

Project Syndicate, 2005.