The German Economy: Shifting Gears or Spinning Wheels?
By Stephen Silvia

The gauges on the dashboard of the German economy have been pointing in contradictory directions of late.  The major indices of economic expectations are running in opposite directions.  On the one hand, the GfK Group's measure of consumer sentiment has soared to its highest level since November 2001 and the ifo index of business confidence has reached heights not seen since the initial heady days of German unification in 1991.  On the other hand, the ZEW indicator of economic sentiment has fallen sharply for six straight months from an extremely bullish position to neutral.  Word of an up-tick in domestic investment abounds, but is nowhere to be found in the data.  Productivity growth remains anemic.  Unemployment has dropped noticeably over the past few months, but it is too soon to tell whether this is a turning point or an aberration.  German policy-makers are getting positively giddy over predicted growth rates approaching two percent for 2006, even though such results would be considered disappointing in most other parts of the world and are likely to fall back toward one percent in 2007.  What is going on?

The new German government has pursued a three-pronged economic strategy in its attempt at creating growth: short-term stimulation, long-term budgetary consolidation, and performing triage on existing programs that are hemorrhaging cash.  It is striking, however, that German policymakers have no strategy at all to raise the growth potential of the German economy.  As a result, Germany is likely to remain an economic laggard for some time to come.  The lack of long-term objectives and strategies goes a long way toward explaining the contradictory indicators within the German economy.

The stated purpose of the short-term portion of the German government's economic policy is to provide some kindling to get the economy going.  It consists of a €25 billion economic-stimulus package that includes accelerated depreciation, a value-added-tax (VAT) waiver for selected items, and tax credits for research and development, home renovation, and childcare.  This hodgepodge of relatively narrowly-targeted programs has proved ill-suited to stimulating a broad-based recovery.  Strong export sales have so far remained the principal fuel for the German economy, rather than the stimulus package.  Consumer sales are likely to help push the recovery along in the latter half of 2006 because of the impending three-percent VAT increase scheduled for January 1, 2007, but consumer expenditures are unlikely to last.  Much of the 2006 sales will be purchases that have been shifted forward.  As a result, consumer demand will be especially weak in 2007.  The recent collective bargaining settlements in the metals and public service sectors will be of little help.  The wage increase in the metals sector actually costs out to 2.6 percent, which will hardly boost domestic demand.  Employees in the public sector will be working longer hours for the same weekly pay.  Most of the other sectors of the German economy remain locked into wage agreements that range between one and two percent annual increases.  Government offices tout corporate tax reform as a means to increase investment.  This reform, which has not yet been passed, would cut the nominal corporate tax rate from 39.7 to 40 percent.  Other proposed changes, however, such as ending the deductibility of interest payments from taxable profits, would dampen investment instead of stimulating it.  Additional measures, such as the just-passed health care reform and changes to the Hartz employment laws, are simply stopgap measures designed to staunch the unexpectedly high costs of these programs rather than serious efforts to revise these programs to enhance the performance of the German economy.

German policymakers hope that the economy will pick up enough speed in 2006 to be able to absorb the three percent VAT increase in 2007.   Macroeconomic models of the German economy show it sliding back to a growth rate of one percent in 2007, however.

Most striking, however, is the absence of a discussion within the German government about a strategy to raise the growth potential of the German economy.  Sluggish productivity growth, particularly in the service sector, is not being addressed.  The 2006 OECD economic survey of Germany stressed the urgent need for product market deregulation, but the government has so far shrugged off this recommendation.  The problems with the German educational system are routinely reduced to a discussion about foreigners, which effectively evades the deeper structural problems at all levels.  Only the German Federal President, Horst Köhler, is taking the problem seriously.  He has given several speeches in recent months in which he has demanded more comprehensive economic reforms to accelerate growth and employment.  So far, Köhler has been a voice in the wilderness.

The reforms undertaken since 2001 have been substantive, but many have been like half of a bridge: they have not fully spanned the problem, so they have not yielded results.  The numerous flaws in the Hartz labor-market reforms have been debilitating, since they have demoralized policymakers and discredited additional reforms.  As a result, Germans find themselves standing on the edge of a half-finished bridge trying to figure out what to do next.

A recent OECD study, a follow up on the famous OECD employment study of the 1990s, is instructive in this regard.  The study surveys a decade's worth of experience and concludes that there are two successful roads to higher employment: the Anglo-Saxon and Scandinavian approaches.  Britain has relied on a highly deregulated labor market, while Denmark has combined comprehensive retraining with strict rules regarding the right to refuse a new job to bring down unemployment.  Others, such as France, Germany, and Italy, have not found the wherewithal to choose one of these approaches and have therefore languished in the middle of the road where, as the Texas saying goes, there's only a yellow stripe and dead armadillos.  Germany needs to choose.  The reluctance to do so has led to millions languishing in unemployment for fifteen years to the detriment of not only the unemployed, but also Germany's trading partners, some of whom are now accusing Germany of pursuing beggar-thy-neighbor economic policies.
 
Three reforms would help to raise employment and the economic performance of the German economy.  They are comprehensive product-market deregulation, a liberalization of dismissal protection, and a deep cut in payroll taxes to reduce labor costs.  Each of these reforms is politically difficult; combined, however, they spread the pain.  Product market deregulation is difficult for small business, but dismissal protection and a cut in payroll taxes should compensate.  The trade unions adamantly resist liberalization of dismissal protection, but most workers would benefit from product market deregulation and all would profit from payroll tax reduction.  Lowering the payroll tax does not have to mean that benefits need to be cut.  It could instead be achieved by paying for social programs out of general funds, which is common practice in Scandinavia.

Economic reform in Germany has always been at best an incremental process.  Still, establishing the overall objective of increasing the growth potential of the German economy would provide both coherence to the process and a measure against which to assess progress.   Otherwise, the German economy will simply continue to spin its wheels.

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Stephen J. Silvia is a Political Scientist at American University, a member of the AICGS Senior Advisory Council, and a former AICGS/DaimlerChrysler Fellow.

The author would like to thank the Atlantic Council, and in particular Fran Burwell, Director of the Program on Transatlantic Relations, for including him on a research trip to Germany in June 2006 as a part of the "German-American Dialogue on Transatlantic Economic Policy and Global Leadership."  Much of the information and observations found in this contribution were developed on that trip.

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This essay appeared in the July 6, 2006 AICGS Advisor.

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Want to know more? Check out these links:

OECD (Organisation for Economic Co-operation and Development) Website.

Ifo Business Climate - Germany.