Just a Recovery Is Not Enough

Op-ed in the Financial Times Deutschland

August 29, 2005

The English are famous for damning with faint praise.  Last week, London's Economist magazine gave a cover to touting the surprising German economy.  Much to an Anglo audience's shock, there has been reform-real labor market reform-in Germany.  In recent months, profits have gone up, for large exporting companies at least, and unemployment has actually gone down (slightly).  And, wonder of wonders, unit labor costs have declined relative to France and Italy.  Could it be that Germany might actually grow more than 1 percent over the next year?


Intentionally or not, the Economist's breathy tone for describing such limited prospects, not to mention the Chancellor's and others response of pride to such a description, only makes clear just how far the German economy has fallen.  That a limited and far from assured cyclical recovery should be greeted with elation indicates how unbelievably low expectations for the German economy have become-unbelievably and unacceptably low.  Germany can attain far better, and the possibly coming "upside surprise" on growth is not an indication that much or even enough has been fundamentally changed.


It is understandable that after years of the financial press vastly exaggerating Germany's problems, and significantly underestimating the reforms undertaken by the Red-Green government, that they would wake up to reality with a jolt.  Certainly, the accomplishments of the Schröder government in the areas of labor incentives, pension sustainability, health care co-payments, and tax cuts are significant, and in many quarters (even in Germany) underappreciated.  And certainly, the positive impact of the changes in labor incentives in particular will only be widely seen and felt in the next economic upswing, and the upswing will be the stronger for it.  Thus, one should tell a positive tale linking 2003's reforms to improved economic prospects in 2006.


But no one should be quite so excited about, let alone satisfied by, that tale.  First, let us keep the magnitudes in perspective.  Total employment has continued to decline in Germany, and even a recovery stronger than consensus forecasts is unlikely to create on net even half so many jobs as those lost in recent years.  Germany thus will still be subject to hysteresis, where each recovery leaves employment at a lower plateau than in the previous cycle.  Exports have still been the primary source of growth, with investment only recently picking up, but domestic consumption remains weak-and also remains roughly two-thirds of the economy. 


Most importantly of all, an upside surprise in Germany would mean growth at a rate of at most 1.5 percent in real GDP year-over-year in the second half of 2005 or 2006.  That is a rate below the rate of productivity growth in most OECD and even eurozone countries.  And that paltry performance would be coming out of a recession when one would normally expect some above-trend growth as idle resources are put back to work.


Second, as that subpar trend even on the upside implies, today's German growth is coming from a less than compelling source: relative wage deflation.  It is true that German labor had become overpriced in some internationally competitive sectors, as measured relative to its productivity.  Had Germany raised its rate of productivity growth rather than cutting the cost of its labor, this gain in competitiveness would have lasting benefits, and could be continued.  By raising its competitiveness through wage restraint, however, Germany did little more than what an exchange rate depreciation would have done, with greater pain.  And there are political as well as economic limits to how much further such a strategy can go.


Third, it is almost inevitable that modern economies recover eventually from recessions-in fact, it takes extraordinary policy mistakes and/or series of shocks to keep an economy down.  Given that macroeconomic policy has not been extraordinarily misguided, for all the pressure the European Central Bank and Stability and Growth Pact have put on Germany of late, and given that the euro has not (yet) stayed up against the dollar, and the US economy has not (yet) slowed its imports, the only surprise would be if Germany has not recovered somewhat.  So the mere fact of this recovery itself indicates almost nothing about the German economy's underlying state.


Here's the real point: if this weak recovery buys the next government in Berlin (of whichever color) enough political Spielraum to push through the remaining needed reforms, it will be a wonderful and welcome surprise truly worth many a magazine cover.