In Case You Hadn’t Noticed
By John Starrels

Nothing, as they say, succeeds like success, and "success" is the appropriate adjective for German economic performance this past year. The International Monetary Fund's annual Article IV Report on the German economy explains what has happened: "From the economic doldrums early in the decade [2000s] Germany has staged a remarkable and enviable recovery. GDP growth has been strong, employment gains have been substantial, the share of longer-term jobs with social security benefits has risen, and the fiscal position is in the best shape since unification." Gross National Product is estimated to be 2.5 percent in 2007, a result, in part, of a pick-up in domestic consumption. Meanwhile so-called "core inflation" (everything minus food and energy) will likely remain within the range of 2.2 percent. And, as usual, German trade performance last year was impressive, thanks to robust hard goods exports to rapidly growing developing countries and further gains in rationalizing, and regionalizing, export product markets within the country.

Having worked at the IMF, I was not surprised to find - as usual - that these generous compliments were partially counter-balanced with the inevitable "on the other hand" warnings. For the Fund, the chief concern about Germany is a justified worry that recent economic gains might eventually be undermined by political actions that could erode the gains of reform. "A pause in the reform process would... be premature... and reversals risk undermining the gains achieved." In non-Fund language, this translates into a thinly veiled warning to the Merkel government to resist pressures to increase spending and slow down labor market reforms in an ultimately futile effort to maintain the status quo of high wages, generous leave polices, and, by U.S. standards at least, an all-too inclusive welfare state. In sum: not too bad, but watch your step.

Once again, some perspective on Germany's near and longer- term economic prospects is in order. By almost any conceivable yardstick, Germany has registered impressive performance since the end of World War II. Indeed, for the first two decades of its existence, the western half of the divided country was hailed as an "Economic Wonder" by a supportive, if at times envious, international community. Powered by the Marshall Plan, robust export growth and a healthy social environment stressing close collaboration between business, government, and labor, the Federal Republic of Germany's integration into the global trade and payments system was strikingly smooth. And then came the oil shocks, labor unrest, international financial turmoil, and, finally, the financial burdens accompanying unification. From the vantage point of 2008, however, the issue is no longer whether these events have sent shock waves throughout Germany's economy, but - if only in retrospect - how relatively easy it has been for the country to effectively absorb them. Re-enter the IMF's new report.

A call for caution: Germany, warns the IMF, cannot afford to rest on its hard-won, still tenuous, gains. The IMF sets forth two broad sets of policy challenges facing Germany over the coming years. The first, and least amenable to immediate resolution, is the "sharper-than-projected economic deceleration in the U.S." economy "that would further weaken German growth" that has, in turn, been exacerbated, if not directly caused, by the sub- prime mortgage crisis. Along the same front - and perhaps in reaction to the first trend - these unfolding external developments have encouraged German banks to hoard large amounts of liquidity to "insure themselves against the possibility of renewed financial market turmoil." Up to a point, says the Fund, these cautionary steps by Germany's banking community make sense. "Another wave of financial market turbulence, however, could negatively impact asset valuations and capital levels at some banks - with adverse consequences for credit availability and growth" throughout the German economy, warns the Fund.

The second cluster of concerns cited by the IMF focus more exclusively on domestic, micro-economic concerns. Chief among these worries: lagging productivity in the service sector, unjustifiably high wages in some parts of the public sector, and labor market difficulties. On productivity, the IMF observes, "the current cycle does not provide clear evidence of a step-up in productivity growth. While the export sector has experienced cyclical gains, most service (nontraded) sectors have recorded weak, and even declining, productivity growth rates." New and somewhat perplexing labor market trends will also require serious attention: "while vacancies have increased, especially in skilled occupations, the inflow of immigrants to fill these positions has remained subdued [while] highly-trained Germans have chosen to seek employment abroad" because they can expect "higher returns to expertise, and more robust economic opportunities." For an economy that earned plaudits for the dynamism and flexibility of its labor markets, this last observation merits particular attention.

John Starrels is a non-resident Senior Fellow at AICGS.

This essay appeared in the January 25, 2008, AICGS Advisor.