Much of the argument about Germany’s early recovery from the economic crisis has focused on the country’s currency policy and less so on the performance of its manufacturing sector. Calls for restraint and austerity measures miss the point that those policies were underpinned by an industrial base which is not and cannot be replicated across the Eurozone, writes John Ryan.
From a German standpoint, the Euro has a number of attractions. It prevents, for example, Germany’s principal trading partners from making their products more competitive against German ones by devaluing their currencies against the Deutschmark like they were able to do in the time before the introduction of the Euro.
Germany has been among the biggest economic beneficiaries of the Euro creation in 1999.
However, assertions that Germany’s competitive recovery is mostly due to the loss of nominal exchange rate flexibility in the Eurozone, a related German policy of wage moderation and real exchange rate suppression is taking too narrow a view at the country’s economy.
The neo-mercantilist view of Germany in the Eurozone generally attributes far too much importance to the role of exchange rates in external competitiveness and export performance, while ignoring equally important microeconomic effects of domestic structural economic reforms and the ongoing corporate restructuring in the German manufacturing sector.
German wage restraint was complemented by the Gerhard Schröder government’s implementation of the Agenda 2010 and the Hartz labour market reforms, which significantly strengthened work incentives and job matching, and phased out early retirement options in Germany.
German wage restraint was real from 2003 to 2008, but it was not the whole story, and when the rest of the story is considered, German economic policies since 1999 cannot credibly be dismissed as merely mercantilist. Instead, in addition to the wage restraint policies, relative German economic performance versus the rest of the Eurozone since 1999 combines the delayed domestic adjustment from the country’s own formative economic shock of German unification in the early 1990s with the unsustainable booms in the periphery from the one-off real interest rate shock from the Euro introduction, and significant German structural reforms and corporate restructuring after 2002.
Much of the analysis of Eurozone competitiveness and real exchange rate movements is rooted in the diverging unit labour cost trends between Germany and the Eurozone periphery after the Euro introduction in 1999, together with the diverging current account balances between Germany and the Eurozone periphery after 1999. Germany’s unit labour costs until 2008 grew considerably slower than the Eurozone average, while those of the periphery grew much faster. Germany has run persistent current account surpluses, while the periphery until the crisis had run large deficits.
The most striking single macro-economic feature of the Euro introduction was the near total convergence of risk-free government bond rates among the Eurozone members from the late 1990s, when the Euro introduction became politically inevitable, until the global financial crisis struck in late 2008 and especially the Eurozone sovereign debt crisis in the spring of 2010.
Wage restraint negatively affected domestic German private consumption, facilitating the development of the private consumption gap between Germany and the rest of the Eurozone. But it is hardly surprising that German private consumption grew much slower than the rest of the Eurozone after 1999, as Germany saw no real interest rate shock from the introduction of the Euro and thus had no subsequent real estate boom and associated wealth effects to temporarily boost domestic consumption.
The Euro’s introduction meant that Germany’s external economic environment was transformed with its closest trading partners no longer able to nominally devalue. A part of the capital inflows from Germany’s improving external balance following the Euro introduction were channelled back to the Eurozone periphery through rapidly expanding credit provisions by private German banks to Spain and Ireland in particular.
Germany’s economic success is a product of a combination of nominal wage restraint, supported by labour market reforms that have put downward pressure on wages, and severe spending restraints on public investment as well as on research and development and education. The reluctance to spend on research and development and education lowers potential growth rates not only in Germany, but through the existence of spillover effects also in the rest of Europe as the overall technological progress slows. This effect would be amplified if everyone acted similarly. Finally, weak spending on public infrastructure lowers the potential for productivity increases at home.
If other Eurozone countries emulated Germany’s deflationary wage policy, it will reduce aggregate demand. The nominal wage restraint bears elements of a beggar-thy- neighbour policy which could even turn into a negative-sum game if followed by all European countries. Rather than copying the German approach, European leaders should carefully examine which elements of the reforms introduced in Germany in the last decade could actually increase productivity, output, and employment without a detrimental effect on others in Europe or on long-term growth.
Professor John Ryan is Research Associate at the Von Hügel Institute of St Edmund’s College, University of Cambridge