Letter from Germany: The World Cup - Exportweltmeister- the Hartz Reforms

In the first of his ‘Letters from Germany’, Michael Burda ponders Germany’s transition from post-unification ‘sick-man’ to ‘export world master’.

For many years, this column was written by Ray Rees. It’s a delight and an honor for me to step into his very large shoes. But is the RES showing their desperation by choosing me, a Yank, to take over? I don’t have a UK passport and I haven’t been to a RES meeting in more than a decade (shame on me). I would guess that Ray’s reason for the ‘Letter from Germany’ was his wonderful vantage position as a prominent professor at one of Germany’s best universities — and his conviction that academics provide a powerful medium for furthering international relations. I share that view. Although a US citizen, I’ve been living in Europe for 25 years now, five in Fontainebleau at INSEAD and twenty in Berlin. My mother is from Liverpool and was raised there. She also remembered the war as a child which has always made it a little difficult to deal with the fact that her son lives in Berlin. I’m also serving my last year as president of the Verein für Socialpolitik, the RES’s German-speaking sister organization (slightly older than the RES by the way). So I guess I have marginal street-creds as a wannabe European. I hope to share some of my economic perceptions of life in Germany in these interesting times.

The great labor market success
Let’s turn our attention very briefly to football, a sport roundly scoffed at by most Americans (but not by me!) The relative success of the Germans in the World Cup (as opposed to England) has been a theme this summer all over Europe, raising the perennial fear of German dominance. (Witness recent Economist and Financial Times editorials concerning the Cameron-Merkel showdown over the Presidency). While it’s too early to know how well the soccer team will have done, at the time of this writing,1 the German record in the labor market has indeed been stunning. Since 2003, unemployment fell from 9.8 per cent to 5.3 per cent (national definition), employment grew by a phenomenal 13.2 per cent to an all-time high of 41 million, while the population shrank by almost 2 million over the same period! All boats seem to be rising, so that while wage inequality has edged upward, family income hasn’t, meaning that modest GDP growth has managed to reach most workers’ families. This is not simply a good run, but represents more than a complete business cycle encompassing the Great Recession, when German GDP fell from peak to trough by more than six per cent.

It turns out that the eight year winning streak in the labor market, which began in 2006 or two World Cups ago, may be coming to an end. The narrative in Germany seems to be shifting: The vaunted Hartz reforms introduced in 2003, in which Social Democratic Chancellor Gerhard Schröder rolled back, Thatcher-like, central German aquis sociales in the labor market, had long been accepted as a necessary element of the German labor market success story. Now it seems that Germany is determined — in grand Continental style — to roll back its own success. There are plans to put a minimum wage in place from 2015 which will be universally binding after 2017. The retirement age, which was lifted from 65 to 67 with much internal strife, will be relaxed for workers with 40 years or more of ‘continuing service’ (which will include time spent in unemployment up until two years before retirement). This will paid for by the pension funds, which are currently flush with contributions related to the favorable labor market. Furthermore there are plans to grant pension benefits to mothers who stayed at home in earlier decades to raise their children. The economic justification for this revisionist charge has been informed by a recent paper in the Journal of Economic Perspectives by Christian Dustmann, Bernd Fitzenberger, Uta Schönberg and Alexandra Spitz-Oener, which shifts the narrative of the labor market success from the Hartz reforms (2003-2005) to the flexibility of German collective bargaining over the past two decades. This is a crucial debate with central ramifications for macro and labor policy in southern Europe. After up to five years of austerity, Southern Europe is getting impatient. The Dustmann et al revisionist argument — that the social system need not have been dismantled to resuscitate Teutonic labor markets — has been picked up not only by southern Europeans and Britons but also by a large component of the German political class as well. The argument is subtle but not easily dismissed: Germany’s labor institutions are simply hard to beat — strong industrial unions which bargain across occupations and tasks in (not surprisingly) Stackelberg fashion across geographic regions; an well-oiled, finely-tuned apprenticeship system which takes human capital formation seriously; a system of short time working that manages (in a fashion which I still cannot fathom) to target and subsidize companies suffering from business cycle loss in custom; generous but disciplined access to unemployment benefits with an increasingly tough search-based means test. Overall, industrial relations are based on strong — some Anglo-Saxon-US analysts would say cartelized — employers’ associations which are absent in most continental European and the UK. These institutions are designed to deliver skilled labor to stable industries in established trades in an orderly way. In the past fifteen years, they were well-poised to supply the goods the newly industrializing economies of the world wanted.

Sharing the benefits
Despite this impressive run, the public perception is that the fruits of the labor market miracle have not been shared fairly, and that those at the lowest end of the distribution deserve more. As a result, the ‘grand coalition’ of conservative (CSU/CSU) and Social Democrat (SPD) parties has agreed to a number of measures designed to win general public support and serve loyal clienteles. First and foremost, the government will introduce Germany’s first statutory minimum wage of €8.50/hour starting in 2015 and applying to all workers in 2017. In doing so they recognized massive public support of more than 70 per cent for the idea. The possibility of a global minimum pay rate in the EU’s largest economy has Belgian and French meatpackers rubbing their hands in delight that it might raise those German unit labor costs — which have been falling secularly since the 1990s. It may well create some extra demand from credit-constrained German households and help bring down those outsized trade surpluses. By estimates of the Essen-based institute RWI, this statutory minimum (from which there are still are no exceptions for youth, the aged, long term unemployed, etc.) would put Germany well ahead of the UK on the Kaitz index metric, ahead of Belgium, Hungary and Ireland and just behind Greece. Naturally, the whole distribution will adjust but all the same, the minimum wage ‘bite’ to UK levels, the general wage level needs to rise by about 8 per cent!

On the basis of gross aggregate labor share in GDP as reported by the OECD as a crude metric for unit labor costs and competitiveness, the argument that nominal wage moderation (in particular the growth of fringe benefits) has been significant since the mid-1990s is compelling. Since 1993 the wage share in Germany fell from 55.4 per cent to 50.9 per cent, implying an overall decline in unit labor costs of 8.1 per cent. Yet in the Netherlands the reduction was greater, from 70.9 per cent to 64.7 per cent (8.7 per cent), and unit labor costs fell in the US on this metric by only 2.6 per cent over the same period. The lion's share of the story is manufacturing, where the decline has been much larger, since the outset of monetary union and is due to accelerated outsourcing of low productivity services in that sector. That outsourcing really took off after 1990 and gained further speed after eastern EU enlargement.

Low and declining labor shares may indicate high profits which can be redistributed, yet before drawing hasty conclusions we need to remember where Germany came from. Unification was an enormously expensive affair, costing taxpayers upwards of EUR 2 trillion over 20 years. Much of this was the cost of social insurance for Easterners — funding unemployment benefits, pensions, disability and health insurance — who had no real economy to speak of at the outset. Those who are old enough will remember that Chancellor Kohl promised no new taxes to finance reunification, borrowing instead and raising the social contribution rates on current Western workers (Germans don’t consider these to be taxes, but never mind!). Indeed the social contribution rate (the share of gross wages paid to social insurance funds as a fraction of the gross wage bill) rose in Germany from under 30 per cent in 1990 to almost 37 per cent in 1998. The wage share was already high in West Germany in the 1980s and rose even further after unification as a result.

But East Germans are back to work and their unemployment rate has fallen to levels not seen since the early 1990s. More importantly, overall labor force participation and employment ratios are up, close to Dutch levels, and for older people are higher than they ever were. Exports continue to boom and the German current account surplus does not seem to want to go away. So undoing the Hartz reforms could be interpreted as part of a multi-pronged strategy of the Grand Coalition to roll back huge German balance of payments imbalances in the monetary union which have been the source of much tension and misinformed rhetoric both inside and outside Germany. Throttling Germany’s überperformance in this particular way is more likely a part of the survival strategy of the Social Democrats, who paid a high price for Chancellor Schröder’s reforms a decade ago and got little credit for it.

Explaining labor market performance
I don’t share Dustmann et al.’s view that Germany’s Weltmeister labor market performance is only due to flexible wage setting, because they don’t really prove the point in their paper. When my students ask me how to explain the German labor market miracle I say ‘it’s all in Marshall’ and it is: labor demand and labor supply. It's not enough for unions to agree to lower wages and fringes and to eliminate paid overtime. Wage moderation doesn't help if workers aren’t willing to work at those wages. While one decisive element of the Hartz IV reform — reducing generosity and duration of unemployment benefits and follow-up assistance — certainly incentivized unemployed workers to accept job offers more rapidly, another (Hartz III) was about better monitoring of job search, placement assistance, and information exchange. In standard models of search these measures will lead to lower reservation wages for unemployed and increase job acceptance, and indeed empirical evidence shows an uptick in exits from unemployment following the reforms.

Chris Pissarides notes that the Beveridge curve in Germany shifted inward after 2008, consistent with an increase in matching efficiency and increased job search. Looking at Dustmann et al.’s Figure 2 (reproduced above), the big decline in indexed wage growth for the 15th percentile starts in 2004, the year reforms were put into effect. Yet collective bargaining institutions have existed for decades. Labor supply must be a part of any account of the German labor market miracle.

Academic economists are still in disagreement about many of these issues, but there might be better ways to slow down runaway German competitiveness and Weltmeister-export surpluses than undoing the Hartz reforms — and it does not make a good impression on southern Europe who are poster children for inflexible labor markets. Clearly a fiscal expansion — e.g. a wage increase for the public sector or an infrastructure improvement campaign would also lift wages, benefit neighboring economies and reduce the Target 2 imbalances, although it’s not clear how important these are if the Eurozone doesn’t break up. The minimum wage will hurt low-productivity manufacturing but mostly services, and disproportionately so in the East. A better long-term strategy towards smooth regional adjustment within a monetary union will need deeper reforms to guarantee smooth financial adjustment across national boundaries. The Eurozone could move to the next level of monetary and financial integration, abolishing national central banks completely, adopting the Fed model with less politicized rediscounting, securitization and haircut policies. It is time to start valuing national debt on bank balance sheets in a risk-adjusted way if it wants to avoid another crisis like the one in 2010. Maybe I’ll talk about these issues in more detail in my next ‘Letter from Germany’.

Best regards from Berlin!

Note:

1. But not, alas, too early to know that it will be better than England (ed.)

Reference:

Christian Dustmann, Bernd Fitzenberger, Uta Schoenberg and Alexandra Spitz-Oener, 2014. ‘From Sick Man of Europe to Economic Superstar: Germany’s Resurgent Economy’, Journal of Economic Perspectives, American Economic Association, vol. 28(1), pp. 167-88, Winter.

From issue no. 166, July 2014, pp. 3-5

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