The German Economy: Back to Full Strength?
By Eckhard Wurzel

German economic activity has strengthened recently. In the first half of this year the gross domestic product (GDP) grew at rates above the OECD's estimate of Germany's potential growth rate of 1 œ percent annually. Does this indicate that the country has left behind more than ten years of very weak economic growth? Did the economy finally adjust to domestic and global economic challenges and are politicians now in the comfortable position that cumbersome reform policies do not need to be continued?

In the first quarters of the year German exports expanded vigorously, at double-digit rates. But some analysts are warning that considering high export rates alone gives a misleading impression about the true strength of the German export sector as a driver of economic growth. They argue that an increasing share of German exports consists of imported intermediary products -- produced not in Germany itself but in other parts of the world. Hence, so the argument, production within Germany is eroding, and this, in turn, implies that the present upswing will remain shallow.

Indeed, the import content of German exports increased from about 30 percent in the middle of the 1990s to around 40 percent at present. Hence, the "value added" produced within Germany of each dollar of German exports is significantly smaller today than it was some fifteen years ago. By the same token, the impact of each dollar of German exports on economic growth within Germany is also smaller than it used to be.

But does this observation imply that the contribution of total exports to German economic growth has faded? Closer inspection of the data shows that this is not the case. The sheer increase in German export volumes over-compensated by a wide margin for the effect of rising import contents on export-induced value added. The impulse for GDP growth emanating from exports net of intermediary imports is much larger in the present phase of recovery than it was during the episodes following the previous troughs of the business cycle in 1993 and 1995/96 -- despite the higher import content. The fact that German exporters successfully established themselves as major trading partners in regions with high economic growth, such as the middle and eastern European transition countries and China, explains an important part of this development. Also, while German competitiveness vis-à-vis other EU countries deteriorated in the first half of the 1990s, it improved more recently owing to comparatively low German inflation rates and more moderate wage settlements.

Unfortunately, however, the fact that Germany's export sector is functioning well as the motor of economic growth is only part of the story. The complementary -- and quantitatively more important -- part is that economic activity that is not export-oriented has remained extremely sluggish. Private consumption and fixed investment, which receded over the last two and three years, respectively, did not contribute to the strengthening of output growth that occurred over the last quarters. Indeed, the present episode of the business cycle illustrates once more the economy's low capacity to generate employment and internal demand, observed over more than a decade. As a consequence of this weakness economic activity became over-dependent on the export sector, and the economy's resilience to adverse external shocks is low, as recent empirical work confirms.

Overall, the current data point once more to Germany's competitive export sector being able to reap the benefits of an upswing in world trade. But the German economy is far away from operating at its old strength. The weak response of total domestic demand to the large demand stimulus generated by buoyant net exports adds another piece of evidence that structural reform is indispensable for the adaptability of the economy to be increased and growth and employment to be lifted in a sustainable way. This is not the time for policy makers to rest

........................................................................................................................

To see the OECD's Economic Survey - Germany 2004, go to OECD.

This essay appeared in the December 3, 2004, AICGS Advisor.

The views expressed in this publication are those of the author(s) alone. They do not necessarily reflect the views of the American Institute for Contemporary German Studies.