Is Germany the model to follow?

Daniel Gros
6 March 2013

en years ago Germany was considered to be the sick man of Europe. Its economy was mired in recession while the rest of Europe was recovering. Germanys unemployment rate was higher than the euro area average, it was violating European rules on excessive deficits and its financial system was in crisis. Today, however, Germany is held up as a model for other countries to follow. In considering this turnaround one has to distinguish between what can be done by a government and what remains the responsibility of the social partners and society at large. The one area where the government is clearly in charge is that of public finance. In 2003 Germany ran a fiscal deficit of close to 4% of GDP. This does not seem high by todays standards, but back then it was higher than the EU average. Today, the country has a balanced budget whereas most of the rest of the euro area still has deficits higher than those of Germany ten years ago. The turnaround in public finances was mostly due to a reduction in expenditure. In 2003 general government expenditure amounted to almost 46% of GDP, above the euro area average. But expenditure was cut by five percentage points of GDP over the next five years. As a result, on the eve of the great recession, Germany had one of the lowest expenditure ratios in Europe. But the government could not really do much about Germanys main problem, namely its perceived lack of competitiveness. It is hard to imagine today, but during the first years of the euro Germany was generally thought to be uncompetitive because of its high wage costs. When the euro was introduced it was widely feared that this problem could not be resolved because Germany could no longer adjust its exchange rate. But, as we now know, Germany did become competitive again. Today the country is even viewed as having become too competitive due to a combination of wage restraint and productivity-enhancing structural reforms. But a closer look at the data reveals that the former was decisive, not the latter. Wage restraint was the key element, but it could not be imposed by the German government. It happened essentially because the German labour market was working. Persistently high unemployment between 2000 and 2008 forced workers to accept lower wages and longer working hours, while wages continued to increase by 2-3% p.a. in the booming peripheral countries. It is thus not surprising that until 2008 unit labour costs in Germany fell relative to those in the rest of the euro zone.

Daniel Gros is Director of the Centre for European Policy Studies. An earlier version of this Commentary was first published by Project Syndicate on 5 March 2013, and disseminated to newspapers and journals worldwide. It is republished here with the kind permission of Project Syndicate. CEPS Commentaries offer concise, policy-oriented insights into topical issues in European affairs. The views expressed are attributable only to the author in a personal capacity and not to any institution with which he is associated. Available for free downloading from the CEPS website (www.ceps.eu) CEPS 2013 Centre for European Policy Studies Place du Congrs 1 B-1000 Brussels Tel: (32.2) 229.39.11 www.ceps.eu

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Figure 1. Unemploym ment rates

12 11 10 9 8 7 6 5
19 995 1996 1997 1998 1999 20 000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2 7 2010 2011 2012 2

EA17 Source: A Ameco, 2012.

Germ many

But what about pr roductivity and reform A num ms? mber of imp portant labo market reforms our were in ndeed enacted about ten year ago, but apparent t rs tly they h had no im mpact on product tivity. All a available d data show t that Germa any had on of the lo ne owest prod ductivity growth rates over t last ten years. This is not surp the s prising if on considers that there were no ne s reforms at all in th service s s he sector, whi is widel seen as o ich ly over regula ated and pr rotected. Product tivity grow rates we higher in manufac wth ere cturing because it was subject to intense s o internat tional comp petition, but even in th sector Germanys performanc was not the best his G ce among t large eu area cou the uro untries. Even in Germany t service s n the sector rema ains twice as big as the industrial s s sector. Deep service p sector re eforms wou therefor be necess uld re sary to gene erate meanin ngful produ uctivity gain in the ns German economy. But this di not happ n id pen, even in 2003, beca n ause all atte ention was focused on inter rnational co ompetitiveness and ind dustry. nnual change in hourly la e abour produc ctivity Figure 2. Average an

M Manufact turingse ector, 200 012010

3.0% 2.0% 1.0% 0.0% 1.0% Germany S Spain Italy y France 2.0% 1.5% 1.0% 0.5% 0.0%

Service esector,2 2002 2011

Germany

Spain

Ita aly

France e

Source: A Ameco, 2012.

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The overall conclusion is that there are certainly some elements of the German model that are useful for the embattled peripheral countries of the euro area today. In the first instance, long-term fiscal consolidation requires expenditure restraint, and labour market reforms can, over time, bring marginal groups into employment. But the biggest challenge for countries such as Italy or Spain remains competitiveness. The periphery can grow again only if it succeeds in exporting more. Wages are already falling under the weight of extremely high unemployment rates. But this is the most painful way out of the crisis and generates intense opposition. A much better way to reduce labour costs would be to increase productivity. Unfortunately, Germany is no model in this respect. Fortunately, however, some peripheral countries are now being forced by their creditors to undertake drastic reforms, not only of their labour markets, but also of their service sectors. The reforms, even if initially implemented only under duress, actually represent the strongest grounds for optimism. Over time they should foster productivity and flexibility and the countries that implement them thoroughly will gradually become more productive and more competitive. The one lesson to emerge from the reversal of fortunes that has taken place within the euro area over the last ten years is that one should not extrapolate from the difficulties of the moment. The reforms undertaken in some peripheral countries are much deeper than those undertaken by Germany when it was facing problems. Those peripheral countries that persist with these reforms could well emerge much leaner and more competitive. Those that do not (Italy appears to be heading in this direction) will be stuck in a low-growth trap for a very long time. Where individual countries will end up in ten years time is highly uncertain, but Germanys pole position is not guaranteed forever. The pecking order within Europes economy could change at any time.