The German Economy: Be Careful What You Ask For

By: Barry Eichengreen, University of California, Berkeley

Germans are having a hard time getting their minds around the fact that their economy is doing better.  I know this because of a seminar in which I participated in Munich this week to mark the publication of Hans-Werner Sinn’s Can Germany Survive? – and my own book, The European Economy Since 1945.

 

            Professor Sinn’s book has actually gone through eleven editions, which in and of itself tells us something about the economy’s survival capacity.  But the professor has not changed his hyper-pessimistic views.  Growth in Germany has lagged growth in the EU for more than a decade, and there are no reasons for thinking that this will change.  Denmark, Austria, Ireland, the Netherlands and Finland have all overtaken Germany in terms of per capita GDP.  Still more countries are queued up in the passing lane.  If Germany is doing better at the moment, this is a purely cyclical phenomenon.

 

The problem is that Germany is losing its manufacturing prowess.  It is becoming a “bazaar economy” in which its celebrated consumer and producer durables are cobbled together from imported components.  Professor Sinn’s favorite example is the Cayenne, Porsche’s luxury SUV.  While the car is nominally assembled in Leipzig, many of the parts are sourced abroad.  Even the basic assembly is done in Bratislava.  Only the engine is installed in Leipzig.  Domestic content is at most a third of final product. 

 

The explanation is simple: expensive German labor cannot compete with equally skilled but immensely less expensive workers to the east.   No wonder, then, that Porsche offshores the production of components and assembly operations.  No wonder that the share of share of manufacturing jobs in German employment has been falling steadily and with it Germany’s ranking in the GDP per capita leagues. 

 

The solution is equally simple.  Reform labor markets so that wages are more flexible.  Restructure an overly generous welfare state so that it no longer saps the incentive to work at rates that firms can afford.  Germany’s manufacturing champions will then be able to survive and prosper.

 

            There are only two problems with this story.  The first one is that Germany has in fact been doing rather well recently.  Growth appears to be accelerating from 2.8 per cent in 2006 to upwards of 3 per cent this year.  Exports are up by nearly 50 per cent since the beginning of the decade.  Even unemployment, a lagging indicator, is coming down.  Inconveniently for the undertaker, the patient evidently refuses to die.

 

To be sure, German exporters benefit from the fact that global growth is robust and emerging markets are voracious consumers of the machine tools that Germany exports.  But this is not the entire story.  The improvement in German export growth preceded the emerging market boom rather than simply following it.  In fact, the German economy’s improved performance is the fruit of five plus years of wage restraint

together with a long period of restructuring.  Even if German labor remains expensive, it is also exceptionally productive.  As Sebastian Dullien has pointed out, there have been some remarkable recent increases in productivity, in the metal-working sector for example.       

 

If one wants to worry about Germany’s economic prospects, then one must make a rather more subtle argument.  In fact, the country may have been too successful at retaining manufacturing jobs.  Germany has always specialized in manufacturing.  But this traditional specialization now places it squarely in the sights of China, India and other emerging markets.  These countries have immensely cheaper labor.  They are already learning to use and will soon learn how to produce sophisticated machine tools themselves, just as they have learned to produce auto parts.  Precisely the same thing that happened to Italy as China moved up the technology ladder into the production of more sophisticated consumer goods will happen to Germany as China moves into the production of more sophisticated producer goods.

 

The key to growth thus lies in getting out of the way of these behemoths and finding alternative forms of high-value-added employment.  That will mean moving out of fabrication in favor of product design.  It will mean moving out of industry in favor of services, many if not all of which require face-to-face contact, making them harder to offshore.  It will mean figuring out how to deploy information technology to raise productivity in retailing, finance and other service sectors where Germany remains leagues behind the United States.

 

Here other advanced countries have shown the way.  The UK has enjoyed such a successful economic run precisely because, for peculiar reasons by the name of Maggie Thatcher, it got out of manufacturing and into financial and other services at the right time.  My own state, California, has similarly been able to grow and prosper because the defense build-down of the early 1990s caused industries like aerospace assembly to wind down in favor of software and systems design for a host of products manufactured elsewhere.

 

The real problem in Germany is not the country’s an inability to retain more manufacturing employment but its failure to recognize that industry and prosperity are no longer synonymous.  The challenge going forward is to adapt the country’s university system, financial system and labor market to what will have to become a post-industrial economy. 

 

Here, unfortunately, there has not been much progress.  Many Germans have a visceral distaste for service sector jobs.  Providing a service to someone else makes one feel like the customer’s inferior, in contrast to a solid and respectable job in manufacturing.  Because of the country’s recent economic history, prosperity continues to be archaically associated with manufacturing.  Indeed, one worries that Germany’s recent success in boosting exports of manufactures may only cause further delay in recognizing that it will need a very different specialization – and therefore a very different set of supporting institutions – to survive in the 21^st century world.

 

 

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.

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