German revival exposes deep fissure within Europe’s economies

In the 1990s and early 2000s, Germany was seen by many as the new ‘Sick Man of Europe’. Between 1991 and 2005, GDP growth averaged only 1.2 per cent a year, compared to 3.3 per cent in the UK. Since then, the German economy has revived dramatically. The recovery in the German cluster of economies from the financial crisis has been as strong as in the United States, with the previous peak level of output being regained in 2011. Germany itself experienced virtually no increase in unemployment in 2008 and 2009, its exports are at record levels, and even the crisis in the Euro area has not prevented expansion in both output and employment.

There are two reasons which are frequently given for this. The first relates to the favourable exchange rate at which the German mark entered the Euro, giving an initial competitive edge to the economy. The second is the so-called ‘Hartz reforms’, a series of legislative labour market reforms which began in the mid-2000s. Both have validity.

There is a deeper reason for the recent turn-round in the performance of the German economy, which is rooted in institutional structures. In an article in the most recent Journal of Economic Perspectives – one of the world’s top academic journals – Christian Dustmann and colleagues agree with the general view that the evolution of unit labour costs has played a key role in the favourable performance of German tradable goods. But the main reason for this is in fact ‘the specific governance structure of German labor market institutions which allowed them to react flexibly in a time of extraordinary economic circumstances’.

German labour market flexibility is not based on legislation, but is laid out in contracts and mutual agreements between the three main actors in Germany: employer associations, trade unions, works councils. The formal institutional structure has remained unchanged, but there have been major changes in recent years in the way in which it works in practice. In particular, there has been a massive decentralisation of the wage-setting process from the industry level to the firm level, with a sharp fall in the proportion of workers covered by union agreements.

The fall of the Berlin Wall created opportunities for German industry to both source from, and relocate to, countries such as Poland and the Czech Republic which had stable political structures and skilled labour forces. Gradually, the German labour force appreciated that these developments required it to operate in a considerably more flexible way than it had previously. This has led to a rise in wage inequality within Germany, but the benefits have been a strong employment and output performance.

This decentralisation is in sharp contrast to economies such as Italy and France, where union wages and work hour agreements apply to all firms within an industry, or are subject to legal limits. These countries lack the flexibility and resilience which are required in a globalised economy. The structural problems of the EU run much deeper than the public debt issues revealed by the financial crisis.

As published in City AM on Wednesday 19th February 2013

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