Letter from Germany - Three Economists Two Opinions

At a time when the EU’s proposed Constitution has come in for considerable criticism and been rejected (in some quarters at least) as being too ‘Anglo-Saxon’ in its economic orientation, Ray Rees, Professor of Economics at the University of Munich, provides this timely review of three books on the problems facing the German economy.

In Anglo-Saxon economics there is a great tradition of leading academic economists writing on economic affairs for the ‘educated layman’. In a sense, most of classical economics was of that kind, but more recently economists such as Keynes, Friedman, Galbraith and Krugman have been leading contributors to the genre. In German economics there is no such tradition. The leading academic economists have written for their fellow professionals, leaving the field of popular economic debate by and large to journalists and politicians. It is perhaps a measure of the intensity of the debate that is currently taking place in Germany over the country’s mediocre economic growth and seemingly irreversible high unemployment levels, that in the past year or so no fewer than three books have been published by leading academic economists, addressed to the general reader: Hans-Werner Sinn’s ‘Can Germany Still Be Rescued?’ (Ist Deutschland Noch Zu Retten?); Horst Siebert’s ‘Beyond the Social Market: A Necessary Reorientation of German Policy’ (Jenseits des Sozialen Marktes: Eine notwendige Neuorientierung der deutschen Politik); and Peter Bofinger’s ‘We Are Better than We Think We Are’ (Wir Sind Besser Als Wir Glauben). In fact the three books represent the two sides of the debate, Sinn and Siebert on the one side, Bofinger on the other.

Raising the standard of debate
The first two reflect the overwhelmingly dominant consensus among academic economists about what the problems are and how to solve them. Bofinger’s book, on the other hand, as the title suggests, tries to argue that the reality is not nearly as black as the picture the critics paint, and his policy proposals reflect his closeness to the German trades unions and their representatives in the German ruling party, the SPD. Altogether, they give a comprehensive (if somewhat wordy, about 1400 pages in all) account of the problems and possible solutions. Since each is written with that air of unassailable authority and omniscience that economists typically adopt when writing this kind of book, with (Siebert’s book excepted) no lack of side-swipes and put-downs directed at the other side, the ‘educated layman’ may well be left in the end wondering who is right, and will probably choose according to his initial political preferences and position in the economy as a gainer or loser under the various policies proposed. Nonetheless, the books do a great service in clarifying the economic arguments and informing the reader, and should at least help to raise the level of the debate, which, in particular in the last few months, has often been abysmal. And at least the number of opinions is smaller than the number of economists.

Costs of the welfare state...
The historical picture presented at some length by Siebert, more concisely by Sinn, has as its core the idea that the seeds of stagnation were sown at the peak of success. Throughout the 1950’s and 60’s, helped by low wages and social security contributions and an undervalued but stable D-Mark, (West) Germany rebuilt its economy, society and physical infrastructure after the terrible devastation of the Second World War, and re-emerged as one of the world’s strongest economies. GDP and productivity growth were at levels now associated with the Asian tigers. However, the socialist-liberal coalition which ruled Germany in the 1970’s, confident in the strength and prosperity of the German economy, put in place a Welfare State (Sozialstaat) which with its subsequent extensions, Siebert and Sinn argue, has become a major cause of high unemployment and slow growth. At the same time, the system of labour laws and labour market regulation, and the corporatist tendencies of German politics, always very strong, allowed the German trade unions far too much power in setting wage rates, hours and working conditions across the entire economy. As a result wages grew steadily at a faster rate than productivity, hours worked fell, and employment protection grew. Decade by decade, beginning in the seventies, growth rates of output and productivity fell steadily, numbers unemployed grew inexorably, at a trend rate of about a million per decade, and unit labour costs soared, to become just about the highest of any developed country in the world. Now the modest bursts of GDP growth seem insufficient, when they occur, to make a dent in unemployment, and Germany is characterised as the Sick Man of Europe, that status originally assigned to Turkey, but equally disparagingly applied to Britain in its time of similar travail in the 1960’s and 1970’s.

...and of reunification
German reunification could have restored the necessary dynamic to the German economy. A new frontier was opened up, with a population of over 16 million eager to make a rapid transition in living standards to those of the West. Unfortunately, in terms of economic policy, the integration of the two economies was incredibly badly handled. I remember the late John Flemming, who at the time, late 1990, was chief economist at the EBRD, telling me at a dinner at Nuffield College that east Germany was going to be a disaster, and I just could not believe him. What he knew, and I did not, was that the wage levels that were being negotiated for East German workers were such that the only way in which East Germans were going to be able to increase their living standards substantially would be through massive transfers from the west, rather than by self-generated economic growth. And so it has turned out. Moreover, the burden of the continued flow of transfers to and persistent lack of growth of the East German economy continue to be serious problems for growth in Germany as a whole. Indeed, Bofinger makes this, rather than the Welfare State and the problems with the labour market, a major source of Germany’s present problems, along with deficient aggregate demand. But both Sinn and Siebert show convincingly that the problems of slow growth and growing unemployment had set in well before this time in West Germany, and certainly cannot be explained historically by deficient aggregate demand. Indeed, the consumption boom of 1990, generated by reunification and the associated transfers, postponed the recession in Germany by about a year or so, but this seems only to have increased its intensity and duration when it did arrive.

Poor economic literacy
A subtext of all three books, though given more explicit prominence in Sinn’s, is the generally poor quality of German economic policy making by all governments, from the 1970’s right down to the present day. Leading politicians, from the Prime Minister, (Kanzler) and his ministers for finance and economics, right down to the senior civil servants that staff the relevant ministries, seem to have an abysmally poor understanding of economics, and often reveal this in public statements (some of which Sinn uses at the head of his chapters. This is very unlikely to make him popular with the powers that be, though they perhaps are less of a problem with the powers that are about to be). This is as true of the present incumbents as of their immediate predecessors.

In Britain in the 1960’s there was a collective loss of confidence of the ruling caste, in the face of the apparently insurmountable economic problems faced by the UK economy at the time, as it reeled from crisis to crisis. It became accepted that a first in classics or history from Oxford or Cambridge, though undoubtedly a signal of high intellectual ability, was an insufficient background to deal with the complex economic problems of the time. The contributions of the Economics Section of the Treasury and of the great economists who had worked in it pointed the way to a solution. There was a major recruitment of economists into the public service, as well as a large-scale attempt to teach economics to new and existing high-level civil servants (in which I participated), first at the Treasury Centre for Administrative Studies, then at the Civil Service College.

In Germany, hardly any properly-trained economists are employed in the major economic ministries. Senior civil servants are typically trained as lawyers. Junior ministers, depending on the party in power, may be trades union functionaries (about 75 per cent of SPD members of parliament are trade union officials, some still in position with their unions), lawyers or career politicians. Each ministry has its committee of economic advisers, consisting of outside academics, but nobody really knows what happens to their reports. There is a Council of ‘Five Wise Men’ (though recently one of the positions has been taken by a woman), the Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung, to which both Bofinger and Siebert belong, and this publishes voluminous and detailed annual reports on Germany’s economic problems and proposes solutions. Siebert in his book draws extensively on these on the whole very good reports, and they represent the mainstream of academic opinion to which Sinn and Siebert both belong. Bofinger, a recent SPD-appointee, is something of an unreconstructed Keynesian outsider in this group. In any case, when the reports of this Council are distasteful to the Government, it ignores them or even publicly dismisses them, the label ‘neoliberalism’, by which is to be understood anything which stresses the importance of market forces, being a favourite term of abuse. Germany badly needs more economists at all levels in its public service.

Freeing up market forces
The policy proposals of Sinn and Siebert for solving Germany’s problem are also very reminiscent of the UK debate in the seventies. The Thatcherite terms ‘rolling back the welfare state’ and ‘breaking the power of the unions’, although they have not been used by the authors, summarise the proposed measures quite well. Of the two books, Siebert’s is the tougher read. The ‘educated layman’ is required to have a good ability to read tables of statistics, follow a fairly dense discussion of them in the text, and have a good dictionary of economics at his side so that he can translate terms such as ‘diminishing marginal productivity of capital’, ‘Harberger triangle’and ‘moral hazard’ into everyday language. The plentiful graphics are in black and white, sometimes easy to follow and sometimes not. The extreme detail in description of the problems is matched by generality in the discussion of their solution. ‘Social market’ is a term coined in Germany in the 1950’s to express the idea that although the economy should function essentially as a market system, with free trade, unregulated markets, private ownership and so on, economic policy should be concerned with ensuring that the possible casualties of this system are looked after and that the prosperity that it generates is distributed fairly. There is to most economists located between the extremes of left and right nothing objectionable in that. However, over time, starting in the 1970’s, the ‘social state’ has in fact extended the system of social insurance and regulation of labour markets to the point at which the economy has lost its dynamic. Siebert argues basically that Germans are over-protected from market forces, over-insured (by expensive state systems), under-worked and over-paid. The solution is the restoration of individual responsibility and the freeing-up of market forces, particularly in the labour market.

While Siebert’s book would be a good textbook for an undergraduate course in economic policy, the best-selling book by Hans-Werner Sinn is a brilliant polemic. Written in a clear, lively and provocative style, it is scathing in its criticism of policy makers and graphic in its portrayal of the country’s problems. Though on the whole its diagnosis of the latter is not that different to Siebert’s, it is much more specific and detailed in its proposed solutions. For example, it does an excellent job of spelling out the poverty trap created at low gross incomes by the way in which social benefits are withdrawn as earned income increases, and proposes in detail a form of earned income tax credit, of the kind long familiar in the USA and UK, as an attempt to overcome this. The problem of the lack of incentive to become re-employed, created by a generous system of unemployment insurance and social welfare, is portrayed as the Welfare State competing for workers with the real economy, adding to the competition the latter also faces from low wage countries abroad.

The unions and reduction of labour supply
Its most scathing attack is however directed at the trades unions. Sinn uses a song written by Ernst Busch, a communist singer of the 1950’s, to portray the German unions as a cynical and wasteful labour market cartel. In his song Busch satirises the capitalist system, by describing how in Brazil coffee beans were poured into the Rio Grande to maintain high prices, and how in the USA potatoes were dosed with petrol for the same reason (this was before the CAP made similar measures a commonplace in Europe). Sinn argues that the unemployment, the destruction of labour supply, that has been created by the German unions, in part through wage negotiations and in part by their pressure for a generous Welfare State, is precisely the same phenomenon. The unemployed outsiders are the victims of the unionised insiders. At many points, as at this one, the basic ideas put forward by Sinn, if expressed in academic language, would hardly turn a hair, but his choice of words often seems designed to provoke not just thought but rage in those he criticises. I would say that this reflects his sense of the gravity of Germany's economic situation and of the urgency of the need for fundamental reform, tinged with despair at the absence of this up until now. Certainly, the recent Hartz IV labour market ‘reforms’ for example seem to show little sign that the policy makers in the ministries have understood his exposition of the poverty trap.

A more optimistic view
Bofinger’s book is intended as a refutation of the arguments that Siebert and especially Sinn put forward. As an academic he is matched here above his weight, but nevertheless scores points. Some of these are quite easy. Anyone who relies heavily on international comparisons, as Sinn does, must not complain when these are used to some effect against him. A persistent theme of Sinn’s is that Germany is bottom of the international league table, but it is always possible to find other comparisons that place Germany in a less unfavourable light. Two points however are more substantial.

A problem for anyone who wants to argue that the German economy is systemically and fundamentally in a mess has to confront the fact that Germany is a world leader in exports. The strength of Germany’s export sector is undeniable, closely rivalling that of the US in terms of world share. Sinn’s resolution of this problem lies in his introduction of the term ‘bazaar economy’. Through the transfer of production facilities abroad, these German ‘exports’ are no longer to any substantial extent produced in Germany. The end stage of assembly takes place here, and they receive the stamp ‘Made in Germany’, but the value added is generated abroad. Essentially, the German exporters are simply merchants who import the goods and then re-export them.

The term ‘bazaar economy’ has somewhat controversial overtones, suggesting as it does oriental practices of haggling and dealing rather than the solid German virtues of high quality engineering and high technology production. Decline and decadence seem to be the message. But in his desire to be graphic, Sinn here has I think taken a step too far. Of course there has been substantial foreign investment and outsourcing by German firms to take advantage of lower wages abroad, and the share of German value added in exports has fallen from around 70 per cent in 1995 to about 61 per cent in 2002. But according to a study by the Federal Office of Statistics, overall export growth raised the share in aggregate value added accounted for by the export sector from about 16 per cent in 1995 to just about 21 per cent in 2002. A rational response to globalisation and the increasing integration of the world economy is being used to reinforce a picture of decline, but here the case is overstated.

The point is that Germany’s export success is largely based on four traditional medium to high technology sectors: mechanical engineering; vehicles; electronic engineering; and chemicals. Germany has somehow missed out on the more recent technological growth sectors such as computers, biotechnology, consumer electronics and communications technology. Its success in its traditional export sectors has been insufficient to generate much growth in the economy overall or to reduce unemployment, in fact they have scaled down their employment. In the last three decades, Germany, as other countries like the UK and US, has undergone a significant process of deindustrialisation, with a large transfer of the labour force from manufacturing to services. In 1970, 48 per cent of the workforce were in manufacturing, energy and mining, with 38 per cent in services, while in 2003 the proportions were 28 per cent and 70 per cent respectively. This process has not brought with it the growth in employment and exports of services that has characterised for example the UK and US. From a fast-growing manufacturing economy Germany has become a slow-growing service economy. The term ‘bazaar economy’ has little to do with this development. Indeed one might wish a little more of the bazaar in Germany’s service sector.

A second point concerns the burden of Germany’s welfare state. Sinn accurately and clearly demonstrates the harmful effects on employment created by the heavy burden of social security contributions, essentially payroll taxes, required to finance unemployment and health insurance and pensions. His and Siebert’s solution is to cut benefits and move to funding, i.e. privatisation, of the pension system. Now the issue of funding pensions should be discussed on its own merits, and there is much to say against it, for example in terms of increases in transactions costs and risk. But this aside, Bofinger makes the valid point that Germany’s overall value of social security expenditures is not particularly high by international standards. What is very high is the extent to which they are financed by payroll taxes rather than by general taxation. In other words, much more thought should be given to ways of financing the social security system that have less direct and harmful effects on the labour market.

Finally, all three authors have a blind spot when it comes to the household. A major root cause of the problem of financing social security is declining fertility. But if they are not having as many children, what are these women doing? They are not going into the labour market, at least to nothing like the extent they do in other economies with, incidentally, significantly higher fertility rates. The reasons are not ‘cultural’, but have to do with the ways in which the German tax and social security system treats working married women, as well as with the extreme shortage of pre-school child care and the half-day school system. In my view there is a significant growth potential there which only needs some appropriate policy changes to be realised.

So now we have four authors and three opinions. Still not enough to justify the old canard. Hans-Werner Sinn's book will shortly be appearing in English, and I recommend it most strongly to all economists as a lively, informative and stimulating read. Horst Siebert’s book already exists in English, as The German Economy: Beyond the Social Market, Princeton University Press, 2005, and I would thoroughly recommend it for a detailed study of the German economy. It is very likely that the next German elections, most probably brought forward to September this year, will result in Germany’s first woman Prime Minister. Neither in personality nor in ideology is Angela Merkel a Margaret Thatcher, but I expect very strongly that one of the authors I have been discussing will play an important role in advising her government on economic policy, and in the end the results may turn out to be much the same.

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