What Germany's Recovery Means for Germany's Future

Op-ed in Welt am Sonntag

May 27, 2007

The good news on the German economy just keeps on coming. GDP growth in 2006 and the first half of 2007 has exceeded everyone's expectations (including my own) by far. Unemployment has fallen further and faster than even the heartiest advocates of labor market reform hoped. Germany's six economic institutes have now started competing over who can raise their economic forecasts the most instead of who can be the gloomiest. And all this has come at a most fortuitous time for the world economy, when the US growth rate (and thus imports from the rest of the world) was finally slowing, and the world needed another growth engine to carry the load. It seems a far cry from just two years ago when books about Germany's economic malaise or decline or even crisis dominated the country's bestseller lists.

While the benefits of German economic recovery are real and welcome, the lasting meaning of today's German economic recovery is far from clear. Should we now expect German real per capita GDP-the measure that most closely tracks economic welfare-to keep growing annually at rates well above 2.0 percent? That is what Germany will average over the course of 2006-08 and would put Germany among the leaders of comparable economies. Does the recent growth surge mean that the German economy has changed a great deal for the better? Or does it mean that all the diagnoses of doom and gloom were misplaced?

Unfortunately, the answers to the first two of these questions still appears to be no, even taking into account the latest positive data; the mainstream negative assessment of the German economy's long-term prospects remains correct, albeit for different reasons than those usually cited. This is the theme of a new book, Aufschwung fuer Deutschland-Plaedoyer international renommierter Oekonomen fuer eine neue Wirtschaftspolitik (Dietz-Verlag), to which I contributed along with Nobel Laureate Robert Solow, Harvard University's Richard Freeman, and others. And lest you think this negative assessment is just Anglo-Saxon free-market ideology blindly at work, I would note that all the contributing authors are considered solidly on the left in their home countries, and the project was initiated by the Friedrich Ebert Stiftung.

So, no, German real potential growth has not risen and is still only around 1.5 percent per capita, and that is the rate at which we would expect Germany to grow on average including even these boom years. Remember, Germany over 1991-2005 averaged only 1.4 percent per capita growth, despite first the post-unification boom at home and then the growing world economy of the late 1990s. Similarly, the current already peaked cyclical recovery will not bring the long-run trend up very much and is not in itself evidence of a structural change.

As Solow points out, "Potential [per capita] output increases as…[a country's] skills are improved by education and training, as technological progress occurs, and as investment adds to the stock of capital and enables it to absorb new technology." And we know that investment has been low in Germany for years, investment growth has lagged the current recovery, and education and training in Germany have declined in both quality and quantity. Regulatory and political barriers have blocked the widespread adoption of information technology (IT) and other new technologies in Germany where they would require significant changes in business and labor practices. In the United Kingdom, Japan, and the United States, recent sustained rises in growth rates were preceded by investment and technological adoption. The reverse sequence in Germany at present is a fundamental reason to be suspicious that the current recovery is only cyclical in nature and will not last.

The good news about the rapid decline in unemployment in Germany also raises doubts about the sustainability of Germany's higher growth rate. If an increase in a country's growth rate is due to an increase in potential output rather than just absorption of slack, it usually shows up in an increase in productivity growth. The economy starts producing more with the same number of workers and other inputs, and that in turn leads to demand growth (through higher wages and profits), and then to greater use of labor as the economy expands.

In Germany at present, again the sequence was wrong if the potential has improved. As soon as the economy started to pick up, companies had to add a lot of workers, i.e., labor input, to generate a small increase in production, which is the very opposite of productivity growth. Put another way, mainstream economists usually examine so-called Okun coefficients of how much unemployment changes when an economy is growing faster or slower than at its potential rate-and the coefficient for Germany has risen in this recovery, meaning that Germany has not only been growing well above potential (to cause such a drop in unemployment) but needs to add more workers to increase growth than it used to. Part of this rise in employment certainly reflects the labor reforms to date, irrespective of the productivity aspect, but in a sense that is the point.

Thus, no one should be confused or satisfied by the current cyclical recovery, welcome though it is. Germany's potential growth rate and thus its long term prospects remain poor, as the mainstream view had it. But people also should recognize where the current upswing demonstrates that common economic policy beliefs in Germany are mistaken: A meaningful share of German unemployment and slow growth in recent years was due to insufficient demand, that is due to excessively tight wage settlements and fiscal and (to a much lesser degree) monetary policies, so there is a role for "Keynesian activism" in macroeconomic policy. Labor market reforms alone, which already had a major impact in Germany, do not generate sustained productivity growth, so labor costs cannot be the main source of German low potential. And the real structural reform agenda, which is about increasing efficiency in the German corporate and financial sectors, remains to be tackled, so recent business and export success should not be used an excuse to do nothing.