Germany’s Imbalances: Don’t Weaken our Strengths

Germany’s Imbalances: Don’t Weaken our Strengths

The “sick man” of Europe has become the powerhouse of the world economy. Within less than ten years Germany has turned from a sclerotic society into a European center of gravity, economically but also politically. Even if The Economist sees Germany as a reluctant hegemon, nothing goes without a German yes and nobody else has the financial power to stabilize the still weak European economy.

German growth rates are still modest. The real Gross Domestic Product (GDP) has grown by 0.5% this year and the forecast for 2014 is by about 1.5%, which is weaker than U.S. growth. The true strength of the German economy can be seen in the labor market development. More people than ever in the reunified nation have a job and fewer than ever are unemployed. And the future looks even more promising. Full employment might be reached by the end of the decade. A mixture of several ingredients is responsible for this success:

  • In the last decade, structural reforms under the label “Agenda 2010” have modernized labor market regulations. As a result, mobility and flexibility have increased.
  • The trade unions and the employers’ associations long ago agreed on a deal which assures strong job security but moderate wage increases. As a consequence, labor costs have risen only slightly between 2000 and 2010, and strikes have become an exception and definitely not the rule.
  • The small and medium sized firms have proved to be very innovative. They have changed their strategies from cost minimizers to technology leaders. This has secured rather good sales and high profit margins.
  • Altogether, unit labor costs were able to be kept more or less constant from the beginning of the century until 2011.

The German success story contrasts with the failures of most of the other member states of the Euro area. There unit labor costs have increased. Consequently, German firms have gained competitiveness. Because within the Euro area the common currency renders the devaluation of national currencies impossible, improved competitiveness has led to an increase of German market shares.

On one hand, German firms were able to export significantly more to the other Euro member states. On the other, products from abroad have lost attractiveness in the German market. As a result of these two developments, the trade balance became very uneven. Germany recorded high trade surpluses, while most other Euro member states ended with high trade deficits. And due to simple balance laws, the capital balance mirrored the trade balance. Germany became a creditor, the others became debtors. And for both sides this situation has had nasty consequences. For Germany, the risk of losing parts of its investments rose. And for most other Euro members, the high liabilities led to higher risk premiums for new credit. This again pushed a self-propelling vicious circle. Increased interest rates increased the costs and further decreased the competitiveness of the firms in the already weaker Euro member states.

With this analysis of the European imbalances in mind, the solution seems simple. To stop the vicious cycle of a German core becoming more and more competitive and a European periphery falling more and more behind, the gap of productivity and unit labor costs has to narrow. This could be reached from either side: either the weak become stronger or the strong become weaker. The latter strategy is well known in the economic literature under the concept of “raising rivals’ costs.” The problem with this concept is that raising the German unit labor costs, for example by paying higher wages to the employees, would not really help the Southern European economies. It might lead to a kind of convergence within the Euro area. However, the Euro area is not the bench mark. The bench mark is defined by the world market. European countries do not compete for the European championship. They have to go for the World Cup or they will lose the game and exit the market.

Thus, only the second option is a valid one. The weaker European economies have to become stronger. They have to increase their competitiveness. How this has to be done can be seen from the German example in the last decade: Implement structural reforms, increase mobility and flexibility, accept only moderate wage increases and invest more in education to improve the quality of skills and knowledge and as a consequence to speed up innovation. This is an ambitious program. It needs time and strong political will to go this hard way, and not the easy way of asking for more financial support from the Germans – or even to assert that German firms, and not the ones in Southern Europe, have to change and reduce their productivity and competitiveness.

History provides clear empirical evidence. Germany’s strength is not the result of the implementation of the Euro 14 years ago. Nor is the weakness in many member states the fault of Germany’s strength. Rather, it is the consequence of sclerotic structures, uptown tastes and exaggerated expectations that are not covered by productivity or unit labor costs. Consequently, the remedy of “raising rivals’ costs” is misleading.

To urge Real Madrid to side-line Christiano Ronaldo would not help Malaga win the European Champions League. It would weaken the Spanish soccer league as a whole and would give the teams from other countries a better chance to win the tournament. Even if it was not President Lincoln but Reverend Boetcker who is responsible for an old saying, the insight is still valid: “You cannot strengthen the weak by weakening the strong.” The truth is that for an improvement of the standard of living for everybody, everybody has to contribute: the strong and the weak. The weak Europeans have to become stronger. And only a strong Germany has the financial strength to support the weaker Euro member states on their long and hard path to becoming more competitive.