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Germany: Europe's engine

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Germany: Europe's engine

A special report on Germany

Why Germany needs to change, both for its own sake and for others

Mar 11th 2010 | From The Economist print edition

ELSEWHERE in the world, Europe is widely regarded as a continent whose economy is rigid and sclerotic, whose people are work-shy and welfare-dependent, and whose industrial base is antiquated and declining—the broken cogs and levers that condemn the old world to a gloomy future. As with most clichés, there is some truth in it. Yet as our special report in this week’s issue shows, the achievements of Germany, Europe’s biggest economy, tell a rather different story.

A decade ago Germany was the sick man of Europe, plagued by slow growth and high unemployment, with big manufacturers moving out in a desperate search for lower costs. Now, despite the recession, unemployment is lower than it was five years ago. Although Germany recently ceded its place as the world’s biggest exporter to China, its exporting prowess remains undimmed. As a share of GDP, its current-account surplus this year will be bigger than China’s.

This feat gives the lie to the picture, common in America and Asia, of Europe as a washed-up continent incapable of change. And, for the rest of Europe, there is a lot to be said for having a strong economy at the continent’s geographical and political centre. Yet Germany’s success is paradoxically also causing problems for its neighbours—problems which they, and Germany, need to address.

The old and the new

Germany’s impressive flexibility is the consequence of old virtues combined with new ones. The old consensus-building management system helped employers keep unions on side when costs needed to be held down. The famous Mittelstand (small and medium-sized firms, often family-owned) went through its operations, step by step, judging what to do in Germany, what to send abroad and what to outsource.

At the same time, economic policy took a new, liberalising, direction. The Schröder government introduced reforms to the labour market and welfare systems in 2003-04; spurred on by those, and by competitive pressures from Europe’s single currency, German business ruthlessly held down real wages. Unit labour costs fell by an annual average of 1.4% in 2000-08 in Germany, compared with a decline of 0.7% in America and rises of 0.8% and 0.9% in France and Britain respectively. Although last year’s recession hit Germany hard, its economy is in much better shape now than it was a decade ago—a point that should be noted in France, where President Nicolas Sarkozy has taken to railing against outsourcing, and in southern Europe, which bends over backwards to preserve overgenerous wages and restricted labour markets.

Germany is rightly proud of its ability to control costs and keep on exporting. But it also needs to recognise that its success has been won in part at the expense of its European neighbours. Germans like to believe that they made a huge sacrifice in giving up their beloved D-mark ten years ago, but they have in truth benefited more than anyone else from the euro. Almost half of Germany’s exports go to other euro-area countries that can no longer resort to devaluation to counter German competitiveness.

While Anglo-Saxons were throwing money around, Germans kept saving. Domestic investment has not kept pace. The result of Germans’ prowess at exporting, combined with their reluctance to spend and invest, has been huge trade surpluses. Germany’s excess savings have been funnelled abroad—often into subprime assets in America and government bonds in such countries as Greece. It would be absurd to maintain that a prudent Germany is responsible for Greece’s profligacy or Spain’s property bubble (though a few heroic economists have argued this). But it is true that, within a single-currency zone, habitual surplus countries tend to be matched by habitual deficit ones.

Give spending a chance

Imbalances cannot be sustained for ever, whether they are deficits or surpluses. Yet surplus countries tend to see themselves as virtuous and deficit countries as venal—the implication being that the burden of adjustment should fall on the borrowers. Germany’s response to the troubles of Greece, Spain and other euro-area countries has followed just such a line. A bail-out for Greece, once taboo, is now being debated—and German ministers have even come out in favour of a putative European Monetary Fund (see article). But the idea that Germany should itself seek to adjust, through lower saving and higher consumption and investment, still seems unacceptable to Angela Merkel’s government.

It is certainly true that Germany’s neighbours have a great deal of work to do. France, Italy and Spain need to follow Germany in loosening up their labour markets; Italy, Spain and Greece need to tighten their public finances. But Germany also needs to push ahead with liberalisation. Its web of regulations is too constricting; its job protection is too rigid; its health, welfare and education systems still need big doses of change; its service sector is underdeveloped. You do not have to be a free-market zealot to think that it is too hard to start a new business in Germany, or to worry that a fat tax “wedge” to pay for health care and welfare reduces low-paid service jobs. Nor do all the changes Germany needs to make mean cutting government back. Too few women are in full-time work, partly because child-care support is lacking. The country’s demographic prospects are dire.

A bold programme of German structural reforms would do much to boost consumption and investment—and, in turn, to raise Germany’s GDP growth, which remains disturbingly feeble. Germany can also afford growth-boosting tax cuts without ruining its public finances. If only Germany would lift its head, it would see that this is in its own wider interest, both because it would be good for German consumers and because it would help the euro area to which it is hitched. Europe’s single currency, like the European Union itself, owes much to past German leadership. When that goes missing, both the currency and the club tend to suffer—and Germany is foremost among the losers.

Older and wiser

For all its stolid reputation, Germany has become surprisingly flexible, says Brooke Unger (interviewed here). But it needs to keep working at it

Mar 11th 2010 | From The Economist print edition

ULM, like many German towns, is arrayed around a central church like an expectant congregation. Its Gothic spire is the tallest in the world. The city is also famous for being the birthplace of Albert Einstein. But Ulmers do not live in the past. They are too busy making things, or working out how to make them better, and dispatching them to the rest of the world. The family-owned Mittelstand firms that cluster in and around this modest town alongside the Danube river were among the prime beneficiaries of Germany’s export boom, the main source of growth until the world economy slumped in late 2008.

That disaster has not shaken Ulm’s self-confidence. Since the financial crisis Germany’s economy has shrunk more than most, by around 5% in 2009 (see chart 1). That of Baden-Württemberg, Ulm’s home state, dived by as much as 8%. But the region around Ulm itself held up better than the rest of the state because its economy is diversified, reckons Otto Sälzle, managing director of the region’s chamber of industry and commerce. Some local firms are in hard-hit industries like cars and machine tools but many are not: Ulm also makes pharmaceuticals and James Bond’s favourite firearm, the Walther PPK. The region’s unemployment rate rose from 3.3% to 4.6%, still well below the national rate. “We are the strongest region in Germany,” crows Mr Sälzle.

Feistiness is an all-German trait these days, bolstered rather than subdued by the crisis. Although Germany’s economy has plunged, its unemployment rate has so far barely budged, a “German miracle”, economists proclaim (see chart 2). As the global economy recovers, Germany’s will do better than the rest by selling cars, chemicals and capital goods to markets such as China, India and Brazil. “Germany is still outfitter to the world,” says Bert Rürup, a former head of the government’s council of economic “wise men”.

The crisis seemed to discredit the “Anglo-Saxon model” of growth based on financial wizardry and property bubbles—and vindicate the German one, in which workers co-operate with bosses, managers invest for the long term and manufacturing holds pride of place over services. The chancellor, Angela Merkel, is promoting a “charter for international economic management” based on Germany’s “social-market” principles. Crisis-prone members of the euro zone could cure their woes by becoming more like Germany, many Germans think. Its hottest export could be the German model itself.

Repeat after me

Germany does have some important lessons to teach the world, as this special report will explain. But the idea that Germany has got everything worked out requires some big qualifications. It has an ageing population, a growing share of which is either of non-German origin or poorly educated, or both. And Germany’s towering export surpluses are at risk because its trading partners cannot sustain deficits for ever. Strikingly, too, the German model is no longer all that German. Over the past decade the country has rewritten its recipe for success, incorporating many foreign ingredients, including some from the much-maligned Anglo-Saxons.

Ulm shows that a springy economy makes the challenges easier to tackle but does not remove them. People with a “migration background”—immigrants, their children and grandchildren (including ethnic Germans who arrived after the fall of the Berlin Wall)—account for 37% of the city’s 116,000 inhabitants and a majority of its children under ten. Those who came as “guest workers” in the 1950s and 1960s quickly adopted Swabian habits of thrift and hard work, says Ulm’s mayor, Ivo Gönner, but “the kids have problems.” Many are unsure where they belong; some have not mastered German.

Ulm and Neu Ulm, its Bavarian sibling across the river, became briefly notorious in 2007 when police captured would-be terrorists who were on the verge of blowing up American installations in Germany. Two of the suspects, one a convert to Islam, belonged to radical outfits in the twin towns. These have nothing to do with the established immigrant community, Mr Gönner insists. But foreigners are often associated with the threat of terrorism.

A bigger worry is what will happen as ageing Swabians retire. By 2025 a quarter of the workforce will be older than 55, compared with 15% now, and the number of school-leavers will shrink by a third. Within ten years the region will be short of 60,000 workers, 7,500 of them engineers, the soul of the Mittelstand. Mr Sälzle wonders whether the next generation is ready to step in. “We’ve imported the educational problems of Turkey and Italy,” he says. Integrating young immigrants into the workforce is the “biggest challenge by far”.

Much therefore depends on how gracefully Germany becomes greyer and browner. Other countries have even fewer babies, but none “has such long-term experience in low fertility”, notes Reiner Klingholz of the Berlin Institute for Population and Development. The number of children per woman dropped below the replacement rate of 2.1 in the 1970s. The women born then in relatively small numbers are in turn having small families. Until 2002 Germany let in enough immigrants to stave off demographic decline, but the influx has slowed. In 2008, for the first time in a quarter-century, more people left the country than came in.

The newcomers are not as well educated as the native Germans, but they have more babies. Ulm is not unusual. In some towns in the Ruhr region the share of under-fives with migrant backgrounds tops 60%. Overall, they account for a third of the youngest children. By mid-century half the population will have non-German origins, says Klaus Bade, head of the Expert Council for Integration and Migration in Berlin.

By then Germany will be a different sort of place. It will have 8m-14m fewer people than it does now, and perhaps a smaller population than Britain and France. If Turkey joins the European Union Germany could be pushed into fourth place, the spot Italy occupies now. Germany’s economy will shrink relative to that of its neighbours. If it is not careful, so will its living standards. It will have more pensioners and fewer workers. One possible future is that it will become less innovative and less productive, and indeed less German in ways it would not welcome. But that is not inevitable.

The great thaw

Germany strikes people as being set in its ways. Revolutions, whether of the Thatcherite sort in Britain or the spasms of discontent in France, hold little appeal. From history’s convulsions Germany has learnt to prize a quiet life. The fall of the Berlin Wall in 1989 and unification a year later was excitement enough for a while. Change, if it must happen, is painstakingly negotiated by everyone concerned, from political parties to the governments of the 16 Länder (states) to the “social partners” (trade unions and employers’ representatives).

Yet the country has spent the past decade smashing its own taboos. In 1999 it sent its armed forces into battle for the first time since the second world war as part of a NATO operation to protect Kosovo from Yugoslavia. In the same year Germany reluctantly surrendered the D-mark, an anchor of its post-war identity, in favour of the euro, with notes and coins appearing in 2002. In 2000 the government changed the definition of what it is to be German, which had been based on bloodlines since imperial days, by giving non-ethnic Germans born in the country a right to citizenship. Meanwhile “Deutschland AG”, the clannish system of cross-shareholdings among banks and enterprises, was killed off by Anglo-Saxon notions, and no one wants it back. That brought “more shareholder democracy into the real economy”, says Frank Mattern, who heads the German operation of McKinsey, a consultancy.

More contentious than all of these was a series of economic reforms prompted by stubbornly high unemployment and intimations of demographic decline. Agenda 2010, the handiwork of a left-wing coalition of Social Democrats and Greens in 1998-2005 led by Gerhard Schröder, tried to tackle many of Germany’s economic maladies. It made joblessness more painful but provided more support for jobseekers. That, along with buoyant world trade, seemed to help. Unemployment dropped from 5m in 2005 to 3m in 2008; in the last two years of the upswing long-term unemployment fell by 40%.

But Agenda 2010 both symbolised and contributed to changes in economic and social relations that Germans find unsettling. New forms of work and welfare spread: “mini-jobs”, temporary employment and, most menacingly, Hartz IV, the handout that awaits anyone who does not find a job quickly. Workers in western Germany were already scrambling to compete with more flexible eastern Germans and cheap labour on Germany’s doorstep in central Europe, and Agenda 2010 increased the pressure. This did wonders for competitiveness, sharpening Germany’s dependence on exports, but wages stagnated and the middle class shrank even as high-income earners enjoyed a tax cut. Germany’s income distribution was fast becoming less equal.

Punishing the messenger

In the 2005 election voters evicted Mr Schröder from power and demoted his Social Democratic Party (SPD) to second fiddle in a grand coalition led by Mrs Merkel’s conservative Christian Democratic Union (CDU). Disgruntlement with Mr Schröder’s reforms fuelled the rise of the ex-communist Left Party, largely at the SPD’s expense. Mrs Merkel proved to be more social democratic than her combative predecessor. She avoided giving offence, sought consensus, inched reform forward when she could and back when she thought she had to. In last September’s elections she was rewarded with a victory that allowed her to boot out the SPD from her government and form a more coherent, supposedly more reform-minded coalition with her preferred partner, the liberal Free Democratic Party (FDP).

Germany may not need another abrupt shake-up. It no longer suffers from an arthritic labour market, an obese state or a suffocating tax burden. As the labour force shrinks, the number of jobs is likely to become less of a worry than the number and quality of people available to fill them. But this special report will show that plenty of problems remain to be solved. Between 2000 and 2009 the share of Germans who considered society unfair jumped from 54% to 71%. The state is better at supporting idle citizens than preparing them for today’s world of work. Social welfare is not yet ready for the coming demographic storm. The economic recovery is still shaky and, if it lasts, will be followed by years of fiscal belt-tightening. Unless export surpluses keep rising, Germany will need to find new sources of growth. Mrs Merkel’s job is not to haul Germany out of a ditch but to retune the engines of its success—in some ways a harder task.

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