in cooperation with Ulrich Fritsche
Last Thursday, the leading German economic research institutes have published their semi-annual diagnosis of the state of the German economy. Similarly to Michael Burda’s post on RGE Monitor, they warn that the Grand Coalition must not fall into a “reform pause”. Just like Michael Burda, they credit part of the German turnaround to the Agenda 2010 reforms (never mind that they did not see any significant growth impact from them when they were passed – see this comment by Thomas Fricke at FT Deutschland’s website).
We have already criticised this view in two former posts. First, if the proposition of an supply-side stimulated turnaround triggered by increased incentives for the long-term unemployed to seek employment is right, we would expect long-term unemployment to have fallen strongly and we would also expect that decreasing market power of trade unions will enforce wage moderation after the reform. As we have shown in the first post, there is little sign that the Hartz reforms initiated a dramatic decline in long-term unemployment or fostered further wage moderation. Instead, wage moderation is a much older phenonemon in Germany.
Second, we showed in a another post that the story of a expection driven turnaround – measurable in the stock index – is far from convincing. Over a period of ten years, inspite of the Agenda 2010, there is no sign that German stocks have outperformed other countries with comparable rigidities in the labour market.
So, if the Agenda 2010 was not the reason for the turnaround in Germany which has until 2005 experiences several years of quasi-stagnation before growth accelerated above one percent in 2006? We will argue that the change in the outlook of the German economy is mainly the result of a number of retarding moments which have been pulling down German growth for a number of years but which have endogenously disappeared. A very important point is in our views that Germany has entered EMU with an overvalued exchange rate and an already overly expanded construction sector. Given the absence of a national monetary policy in EMU, these factors needed to be corrected in the painful way: By wage deflation and slow shifting resources from the construction sector to other sectors. This process has taken several years and has in the meanwhile depressed growth. Only after the correction came a sufficient way to provide (together with the booming world economy) a large enough stimulus for the German economy, growth was able to turn around.
First of all, let’s have a look at indicators of external competitiveness. Figure 1 shows a competiveness index, calculated by the German Bundesbank (source) over the last 25 years.
Figure 1: Competitiveness index
As the index impressively shows, Germany went through a decade of strong changes in competitiveness. Wheras in the late 1980s the case of Germany’s competitiveness was discussed under the headings of “World export championship” and a reasonable amount of economists claimed Germany would run a “beggar-thy-neighbour” stragegy of an undervalued exchange rate – exactly as the Chinese seem to do in recent times.
The picture changed in the early 1990s. The fall of the iron curtain and the German reunification in 1989/1990 led to a huge surge in demand with economic growth in Western Germany topping 5 percent for several years in a row. Unemployment fell to 5 percent according to national measurement, which usually runs a couple of percentage points above internationally standardized values. Wage growth at that time in West Germany accelerated somewhat, but not dramatically. On the other hand, the Kohl government which was determined to finance the reunification without new taxes increased contributions to the social security systems and financed parts of the costs of German unification this way. As in Germany, contributions to the social security systems have to be paid by both employers and employees, this increased nominal labour costs.
The increase in labour costs would not have been overly dramatic had there not been the crisis in the European Monetary System (EMS) of 1992: With inflation accelerating in Germany to more than 4 percent in 1991, the Bundesbank became really nervous and hiked nominal short-term interest rates to almost 10 percent. As foreign exchange markets became increasingly sceptical whether the partners in EMS could follow the high-interest-rate course, speculative attacks mounted against other European currencies. In September 1992, a number of European currencies were forced to devalue, including the British pound, the Italian lira, the Spanish peseta and the Portuguese Escudo. The Italian lira lost at its peak roughly 30 percent against the German Mark. However, the currency attack was triggered less by the impression that current account positions of the European partners had become unbearable, but rather by the impression that the Bundesbank interest rates had become unbearably high for the other European countries. Hence, the EMS crisis, combined with the increase in wage and non-wage-labour costs propelled Germany to a situation of overvaluation in the mid-1990s. Relative to the rest of Europe, Germany appreciated by more than 10 percent in real terms against the rest of EMU from 1991 to 1995 – a sizable shock for a country closely integrated into the continent’s trade and trading mainly with other countries of the same degree of development.
The reason why it took so long to correct this overvaluation was then that the overvalued exchange rate was fixed later by the transition to European monetary union in 1999. While the Italian lira again appreciated somewhat before the adoption of the euro, the exchange rate with which it entered EMU was still significantly below that exchange rate of 1992. The same holds for Spain, Portugal and Ireland.
From this point on, any correction of the German real exchange rate relative to its neighbors was only possible by nominal wage restraint, which in turn depressed domestic demand in Germany, as employment did not react quickly and hence disposable income of the average household stagnated or even contracted.
In fact, while overall competitiveness of the German economy weakened again after 2002 when the euro started its strong appreciation against the US dollar (by which up to today it has gained about 70 percent in value), it approved further as you can see in the development of nominal unit labour costs relative to the trading partners in EMU.
Figure 2: Unit labor costs relative to EMU
However, competitiveness is not the whole stroy why German growth was depressed for most of the past decade. In addition, there was a necessity for correction in the construction sector, also stemming from economic mismanagement of the German reunification. During the reunification time, Germany experienced a tax-induced building boom which ended in an oversupply of housing which made a correction in the second half of the 1990s necessary after the government slushed tax subsidies. As construction workers can only be slowly redeployed in other parts of the economy, this correction depressed aggregate demand and growth and pushed up unemployment.
Together, these two facts explain why domestic demand has been extremely weak over most of the time since 1995.
Figure 3 shows the growth contributions or Lundberg components as calculated by the German Bundesbank (source).
Figure 3: Growth contributions
The turnaround in 2006 came when both of the adjustment processes (real exchange rate and construction sector) had reached a point from which on they contributed to growth again: First, by undercutting wage increases in the rest of EMU since the late 1990s even though productivity was in fact growing faster, Germany had gained competitiveness again to an extent which was comparable to that of just immediately before the German unification. Together with a booming world economy, this provided Germany over several years with export growth well in excess of that of other industrialised countries. For much of the time from 2003 to 2005, export was almost the only source of growth for the German economy.
Second, the construction sector again had reached a magnitude which might be sensible for an economy as the German. In addition, the turnaround in the construction sector was amplified by the phasing out of tax-subsidized for owner-occupied newly built homes: Only those who started building in 2006 could still claim sizeable tax deduction. For the first time since the turn of the century, construction thus again contributed to growth in 2006.
The role of residential investment in explaining growth differentials has been stressed already in 2006 by the Kiel institute. The lasting slump in the construction sector explains a large share of growth differentials. The slump went hand in hand with falling house prices for 10 years in a row. The role of house prices has been stressed in another post by Daniel Gros — we “borrow” figures 4 and 5 from his post (source). Figure 4 shows the fraction of building investment in GDP and Figure 5 shows the price/rent ratios for selected European countries. Germany has a falling share for a number of years in a row and a falling price/rent ratio. As we know from the US, housing can be a very powerful amplifier for economic trends – for the better as for the worse.
Figure 4: Share of housing investment in GDP
Figure 5: Price/rent ratios for selecetd European countries
So, where does the wage restraint come from which helped the German economy to regain competitiveness to an impressive extent since 1995 if not from the Agenda 2010? We would argue that the German wage setting process is inherently geared towards wage restraint. German wage restraint helped the country to protect competitiveness in the 1950s and 1960s, but the undervaluation was regularly corrected by the nominal appreciations under the Bretton Woods system. In the time of floating exchange rates after Bretton Woods, the exchange rate often overshot, making German labour expensive in international comparison. However, the bias towards nominal wage restraint has held up recently well until today (after all, even after the German unification, when GDP growth in Western Germany hit 5 percent, wage growth remained relatively modest).
In addition, there has been a continuous decline of union coverage and union bargaining power in Germany since the late 1990s which has led to an even amplified wage restraint after 2000. After unemployment rose in the mid-1990s, unions have adopted wage restraint as their second nature and union representatives regularly talk about the perceived need of keeping wage growth below productivity increases and the target inflation rate of the ECB (in fact, no major wage contract since the turn of the century has even come close to this number). There is little evidence, however, that this wage restraint is directly or indirectly related to the Agenda 2010 which only was passed in 2003 and did not come into effect before 2005. The wage restraint has been here before and it might be set to stay even when the Agenda would be completely rolled back.
This post was co-posted at Eurozone Watch.