AICGS: ANALYSES : Germano-pessimism: Just How Troubled Is Germany's Economic Future?

In 1970, German unemployment stood at less than 200,000. Three decades later, it has reached more than four million officially, and substantially more under the most comprehensive calculations. Over the same period, income per capita relative to many of Germany's European neighbors steadily declined as Germany morphed from locomotive to brake-van of the European economy. The fiscal accounts, strained by rising unemployment, slow growth, and the costs of unification have notably worsened; the Federal Audit Court, ordinarily occupied with detecting wasteful agency spending, criticized the latest budget as "utterly alarming."

The outlook appears equally grim. Unfunded liabilities and the demographic transition will place increasing pressures on public finances on all levels, with no easy offsetting revenue sources in sight. Responding to high labor costs, high taxes, and a restrictive regulatory climate, even mid-sized firms have turned to outward Foreign Direct Investment (FDI), a move that does not bode well for manufacturing employment trends. Taken together, weak domestic investment, slow productivity growth, and the demographic trends look set to constrain growth; few observers bet on a medium-term trend growth rate much above 1.5 percent. Consumers, coming to grips with the new reality, are responding by keeping their wallets firmly closed, further depressing demand.

Short Run Challenges: Agenda 2010 and the Solvable Unemployment Problem

It has taken a while for the prospect of reduced circumstances to percolate into public consciousness. Once it did, Germans set about exploring the challenges with accustomed thoroughness. Nary a week passes without talk shows and editorials exploring the latest crisis and reform proposals. Members of the Economic Council have become bona fide media stars. Germano-pessimism seems firmly entrenched. Justly so?

Chancellor Schröder, facing a precipitous decline in public support following his narrow re-election, has devoted his second term to structural reforms, notably of the labor markets. While the Nixon to China strategy proved rough going, Germany over the last two years has begun to reverse course. Labor markets for skilled workers have become more flexible, partly through legal reforms, but mostly through increased negotiation flexibility on the part of both employers and unions, the occasionally fiery rhetoric notwithstanding. Labor markets for unskilled workers remain more problematic, but even here the Hartz reforms are begin to chisel away at the structural and incentive problems contributing to the high unemployment in this group. Labor market efforts have been complemented by initial reforms in the health and pension systems.

Public reception of these efforts has been mixed at best. While the need for reform is widely embraced on the abstract level, spirited opposition has greeted many of the concrete steps. As the halfway-point of the government?s term approaches, many Germans seem unhappy with the reform process and distrustful of the outcome. Communication is part of the problem. No modern equivalent to Ludwig Erhard, personifying reforms and exuding confidence, is to be found. While the government struggles to convince voters that its actions are driven by an over-arching strategy rather than the latest crisis, the opposition has been distracted by internal struggles.

Yet beyond personalities and political struggles lurks a deeper, more fundamental uncertainty about the future of "Rhineland Capitalism," and with it Germany's economic identity. Can the consensus system of cozy coexistence that was so instrumental in Germany's postwar growth be modified for the twenty-first century? Or is Rhineland Capitalism a relic of the past?

The public debate has often emphasized the extremes, a choice between wholesale dismantling of the social safety net or defense of the status quo. As usual, there is a middle ground, as a casual look across Germany's borders readily reveals. To the south, Austria has abandoned "alpine socialism" to re-invent herself as a low-cost gateway to the East, with remarkable results. To the north, Denmark provides a lesson in how unemployment can be addressed through a combination of incentives and targeted help. To the west, the Dutch Polder model stands as a model of forging consensus among the interest groups. While both Denmark and the Netherlands have recently experienced setbacks, their standardized unemployment rates remain far below those of Germany. These experiences of successful reform, to which one could add Finland, Ireland, and Slovakia, among others, demonstrate the reservoirs of dynamism in the European economy and establish the viable middle road. While both Austria and Denmark re-thought and fine-tuned their social benefit systems, one would be hard pressed to argue that either country had abandoned their commitment to the social welfare system.

There is no reason why this happy middle ground cannot be found in Germany as well, with the same positive effects on employment as enjoyed in neighboring states. With Agenda 2010 Germany has already embarked on this process. Reforms famously follow a J curve: the pain comes first, the hoped-for gains later. Germany may now be near the nadir. Rhetoric and political posturing aside, the fundamentals are not all that bad. Provided that unions and employers continue their recent more cooperative and problem-oriented approach, the 2006 election might yet be fought against a backdrop of rising employment if the external environment remains supportive.

On the fiscal side, a look across the borders likewise yields grounds for optimism. Ireland has moved from one of the highest debt to GDP ratios to one of the lowest over the last two decades. Finland, hit by a major shock in the early 1990s, has returned to fiscal health. A number of countries, including Denmark, Sweden, and the United Kingdom, have seen their fiscal prospects improve markedly. Comparisons are tricky of course, as tax structures, expenditures (including unification in Germany) and policy options differ. That said, the experiences in other European countries demonstrate that a return to a healthier fiscal situation does not require wholesale cuts in entitlements. It is not unreasonable to imagine an optimistic scenario in Germany, in which serious action on the long list of subsidies combines with falling unemployment (bringing the double fiscal gain of reduced unemployment benefits and higher tax revenues) to provide some fiscal breathing room.

Long Run Challenges: The Second Demographic Transition

Alas, behind the solvable unemployment and short-term fiscal problems lurks the more difficult challenge of the second demographic transition that will take place over the next decades. Once upon a time, the two-child family was the bedrock of the demographic structure. This is no more. Children are becoming increasingly scarce. The potential consequences in terms of population size and age structure are dramatic. If current trends are extrapolated over the next century (which of course, one should never do) the German population will be almost half of what it is today and individuals sixty and older will outnumber the traditional working age population within a few decades.

A rising retiree/worker ratio within an aging society poses a number of transitional problems. Some of these are widely appreciated, others are not. The alarming implications for financing pay-as-you-go retirement systems have (belatedly) caused much hand wringing and led to a few modest reform steps. Maintaining solvency of the system will entail a combination of a later retirement age, higher contributions, more contributors, and lower benefits. The exact choices will be a central issue in German politics going forward. In the most likely scenario, public pensions will continue to insure against old age poverty but will not suffice to maintain accustomed living standards for most retirees, requiring an increased reliance on supplemental private retirement savings, the focus of much of the recent pension reforms.

While the demographic impact on pensions and health has received the most attention, the dual trends of an aging and shrinking population will have profound effects on most areas of economic and social life. Books can (and have) been written on the myriad challenges; here are three brief examples taken from different areas to illustrate the breadth of effects:

Training . An aging workforce in a period of rapid technological change requires a vigorous embrace of continuous lifelong learning and on changes in specialization. The apprentice system, world-renowned for its combination of classroom and practical education, focuses on providing school-leavers with a skill for their working lives. Can it be adapted to allow a 40-year-old unemployed coal miner to re-qualify as a plumber? Efforts are under way, often as joint employer-union initiatives. Their success will determine whether the German labor force retains its technological edge.

Demand. Older households demand more personal services, driving up the demand for doctors, nurses, personal-care givers, but also for delivery van drivers and a whole range of other labor-intensive services. Who will fill these positions as the labor force shrinks? What wages will be required to shift more workers into these (outsourcing-safe!) jobs?

Real estate. Burned by two monetary crises in the twentieth century, Germans have developed a strong liking for saving in real assets, notably houses. How will the real estate market respond to a shrinking population and a greater share of urban singles?

Outlook

Looking back from 2050, will the turn of the century be seen as the time Germany lost its way and began a long, if comfortable, slide down the economic ladder? Or will the 1990s be seen as a blip on a sustained long-term growth trajectory?

It is too early to tell. The ingredients for sustained malaise are certainly present. German public discourse remains inward looking, focused more on the allocation of blame and the perceived justice of burden sharing than on forward looking solutions. Psychology matters: faced with relentless Germano-pessimism, both investors and consumers are keeping their wallets firmly closed, reinforcing the stagnation.

Yet, on an objective level, the problems are not insurmountable, as a look across Germany?s borders illustrates. In the end, Germany suffers "only" from high labor costs, structural rigidities, and a failure to aggressively deal with looming fiscal challenges. In contrast, Germany possesses all the "soft" institutional fundamentals for sustained growth: an educated labor force, good physical infrastructure, a central location in the largest integrated market in the world, and a quality reputation in global markets. There are worse starting points.

The next years will decide whether the positives win. Much will depend on the success of labor market reforms, on the continuing constructive cooperation between unions and employers, and on the creation of a business climate that is more favorable to creating and running small-scale firms, the source of most job creation. If a vigorous effort in this direction expands the labor force, both the fiscal and the demographic challenges will be eased. The experience of Germany's neighbors speaks eloquently to the underlying strength of the European economy, and illustrates that full employment and growth is compatible with a comprehensive social safety net if incentives are set right.

There is, to be sure, a less rosy scenario, in which failure to follow through with the reforms, to tackle the fiscal problems, and to deal with the innovation challenge pushes Germany (and perhaps Europe) into an unenviable position between a technologically dominant United States pulling away, and the emerging economies increasingly catching up from below. Protectionism and further decline might well be the political answer in this scenario.

In conclusion, it may be worth remembering that a few decades ago, economic and business bestsellers predicted the decline of American manufacturing and the emergence of Japan as the dominant economic power of the twenty-first century. As Niels Bohr once remarked, prediction is very hard ... particularly of the future. Germano-pessimism, too, needs to be viewed with a healthy skepticism.

Holger Wolf is Associate Professor at the BMW Center for German and European Studies, School of Foreign Service, Georgetown University, and a frequent participant in AICGS workshops and seminars.

This essay appeared in the August 12, 2004 AICGS Advisor.

AICGS is grateful to The German Marshall Fund of the United States for its generous support of this essay series.

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