How Germany’s Declining Innovativeness Contributes to Inequality

Economic growth in Germany is not as inclusive as it used to be. Recently, the country has even been labelled a ‘divided nation’  (Der Spiegel, 12.03.2016: Die geteilte Nation) and concerns have arisen that ‘rich Germany has a poverty problem’ (Somaskanda, 2015). Figure 1 shows the extent of the rise in income inequality and poverty since 1991, using various measures which also reflect the rise in the number of ‘working poor’.

//

//

//

//

Regional and societal disparities in Germany have undoubtedly increased, leading to far-reaching changes in the political landscape – including a notable rightward shift by voters in the 2017 Bundestag election.

Germany is however not the only Western nation to grapple with rising inequality, as the recent World Inequality Report 2018 shows. Ever since the global financial crisis in 2009, there has been a vigorous debate about inequality in the United States, as witnessed in the rise of such disparate figures as Elizabeth Warren, Bernie Sanders and even Donald Trump. As documented by Joseph Stiglitz in his book The Price of Inequality, the dream of the United States as “the land of opportunity” is fast fading.

1. The same, but different – Germany has some unique factors driving inequality

Expert consensus identifies three key factors behind the growth of income inequality in the United States:

1. The financialization of the economy
2. Globalization (which outsourced many middle-skill manufacturing jobs to emerging economies) and
3. Skill-biased technological change (e.g. automation) which caused wage polarization (see e.g. Autor et al., 2006; Baldwin and Venables, 2013; Lazonick, 2014).

Do these factors hold for Germany, too? The answer is: not really.

First, Germany has a different financial institutional set-up which largely avoided the financialization of its economy. Second, the country has also been a huge beneficiary of globalization: it runs the world’s largest trade surplus, and employment in its manufacturing sector still amounts to more than 20% of the labor force, about twice that of the United States. Third, empirical evidence suggests that skill-biased technological change only plays a small role in Germany. A recent study of the application of robots even found that “[…] robots have not raised the displacement risk for incumbent manufacturing workers. Quite in contrast, more robot exposed workers are even more likely to remain employed” (Dauth et al., 2017: 1). So why, then, has income inequality increased so markedly in Germany over the past two decades, and at an even faster rate than in the United States?

2. What is causing inequality in Germany?

This is the question we tackle in a recent report for the Bertelsmann Stiftung. We argue that the primary cause of Germany’s current social challenges can be traced back to a two decade drop in productivity growth and the governmental and institutional response to it.

Labor productivity growth’s long-term decline, decreasing to the point where by 2013 it was five times slower than in 1992, drove fear of a weakening of Germany’s international competitiveness. In response, government and businesses started to reduce real labor compensation as early as the mid-1990s. As a result of this “cost-based strategy”, various benefits of the social welfare state were reduced or abolished. Self-employment and forms of irregular and part-time employment with low(er) wages increased, while labor unionization rates dropped.

The corporate sector also lowered its relative labor cost by outsourcing and offshoring production, especially to lower-cost Central and Eastern European countries. At the same time, facing growing global competition vis-à-vis decelerating domestic demand, German corporate savings increased while net fixed capital investment declined. As technological innovations are frequently embedded in the capital stock, the decline in net fixed capital investment contributed to a further reduction in the labor productivity growth rate.

As a result, profits grew faster than wages, leading to a decline in the relative share of labor in the national income, and resulting, in turn, in top incomes rising at a much faster rate than the general population. Figure 2 shows the development of the top income share (the share of national income accruing to the top 10%) since 1980 – the increase of approximately 10 percentage points through 2011 stands out as a key inflection point.

3. The game changer towards inclusive growth: A fundamental change in the national innovation and entrepreneurial ecosystem

Germany needs to become more innovative again to counteract the current trend and reduce inequality. Innovative technology increases labor productivity growth and therefore real labor compensation. For this to occur, more technological innovation is needed with more robust entrepreneurship to commercialize and adopt technology in and across firms.

Though innovation is the key lever for inclusive growth, Germany’s best days as an innovation powerhouse seem to lie in the past. Innovativeness is in decline in the country that invented the modern university and the ‘triple helix’ system. This may seem a surprising statement. Isn’t Germany supposed to be a global leader in innovation? The country markets itself as a destination for foreign investment, lauding its prowess in innovation under the name ‘Land of Ideas’. The country indeed boasts world class scientific and research institutions such as the Max Planck Institutes and the Fraunhofer Society.

In terms of spending on innovation, Germany is doing extremely well. The business sector spent around EUR 140 bn on innovation in 2013, and more than 354,000 researchers are working in R&D. Expenditure on R&D increased by 66% and researchers by 37% since 2000. Total R&D as a percentage of GDP has been on an upward trajectory, approaching an enviable 3% of GDP by 2014. But – where is all this innovation activity going? Why aren’t these investment and research activities translating into ‘successful innovation’?

First, the ratio between successful (or granted) patents and applied patents has been on a long-term decline since the late 1980s (see Figure 3). But it is not just the share of successful patents that has been declining. There is further evidence that the quality of patents, as measured by patent citations, has also declined. In the 1980s German patent citations were on average 14% lower than that of the United States; in the 1990s 30% lower, and in the 2000s even 41% lower. Other countries such as China and South Korea improved their relative position in terms of patent citations vis-à-vis the United States over this time period. Data from the World Intellectual Property Organization (WIPO) shows that only four German firms are among the top 30 innovative companies in the areas of 3D-printing, nanotechnology and robotics, in terms of patent applications.

//

Second, if we measure innovation by total factor productivity (TFP) growth, a common indirect measure of innovation, ‘peak innovation’ in Germany occurred in the 1960s and 1970s, and has declined ever since. Similarly, labor productivity growth has significantly declined. The failure of innovation to raise labor productivity growth is of particular concern, as it implies a progressive reduction in real wages to maintain competitiveness.

Third, while total spending is high, it is concentrated in the larger companies. Most firms in Germany are actually investing nothing or very little in innovation. A measure of the ‘inequality’ or concentration in R&D investments by firms found this inequality to have risen sharply with a Gini-coefficient of around 0.94 by 2015 (see Figure 4).

//

4. What caused the decline in German innovativeness?

The Second World War presented a structural break in Germany’s innovativeness. The country experienced a significant brain-drain as well as substantial war destructions, and suffered in the decades to follow from the effects of the Cold War and the division of the country until 1990. Due to this particular combination “Germany could not pour large portions of its national resources into risky investments in research and development of new technologies” (Fohlin, 2016: 18), although the decades immediately following the war still experienced rapid economic growth, as a result of reparation works of its capital stock, the Marshall plan, and a large shift from agriculture to services.

The decline in innovation can also be traced to a lack of diversity and innovativeness in the German education system. It may be too specialized and intertwined with the current industrial structure, and too ‘un-entrepreneurial’ and bureaucratic. This makes the transferability of skills to another sector difficult in Germany, particularly since many skills are firm-specific. Iversen and Cusack (2000: 346) thus point out that “[…] a country like Germany with a training system that emphasizes specific skills will be politically more sensitive to occupational shifts than a country like the US where the educational system emphasizes general skills”.

A final reason is that entrepreneurship has been stagnating in Germany. This can be ascribed to conservative market-protecting strategies of the established corporate sector, a growing gap between innovation in a small group of leading and a large group of lagging firms, and, connected to the previous point, weaknesses in the education system. As a result, in almost all measures of entrepreneurship, including the number of unicorns, the number of billionaires and the volume of venture capital, Germany lags far behind the United States (Henrekson and Sanandaji, 2017: 29).

5. The way forward: Policies to promote innovation that drives productivity

To tap the potential of more inclusive growth, Germany needs an agenda for inclusive innovation-led growth that will drive stronger increases in productivity. In Naudé and Nagler (2017) we propose a battery of policies to support innovation-led inclusive growth. A key underlying premise of these recommendations is that technological innovations are not harmful, as suggested by some comments on the detrimental effects of future “jobless growth” – quite the opposite: we call for more, not less technological innovation, a greater diffusion of technology, and better managers and entrepreneurs with the skills to adopt new technologies. Specifically, what is needed are policies to support SME innovation, to diversify the education system, to provide for stronger competition, to develop venture capital markets, and to encourage firms to invest more in fixed capital.

Implementing and seeing the result of these policies, however, will take time as the problems are deep seated. In the meantime, strengthening the social welfare state is key. In particular, compensatory social welfare policies, including redistributive taxes and transfers and active labor market policies, remain the first line of defense against rising income and wealth inequality. With the challenges of changing demographics though, the sooner we begin to implement long term policy changes to address the innovation lag, the better.

References

Autor, D.H., Katz, L.F. and Kearney, M.S. (2006). The Polarization of the U.S. Labor Market. American Economic Review, 96(2): 189-194.

Baldwin, R. and Venables, A.J. (2013). Spiders and Snakes: Offshoring and Agglomeration in the Global Economy. Journal of International Economics, 90(2): 245-254.

Dauth, W., Findeisen, S., Südekum, J. and Wößner, N. (2017). German Robots – The Impact of Industrial Robots on Workers. CEPR Discussion Paper No. 12306.

Fohlin, C. (2016). The Venture Capital Divide: Germany and the United States in the Post-War Era. Department of Economics, Emory University.

Grabka, M. and Goebel, J. (2017). Real Income Rose Significantly between 1991 and 2014 on Average – First Indication of Return to Increased Income Inequality. DIW Economic Bulletin, DIW Berlin, German Institute for Economic Research, 7(5): 47-57.

Henrekson, M. and Sanandaji, T. (2017). Schumpeterian Entrepreneurship in Europe Compared to Other Industrial Regions. IFN Working Paper No. 1170.

Iversen, T. and Cusack, T.R. (2000). The Causes of Welfare State Expansion: Deindustrialization or Globalization? World Politics, 52(3): 313-349.

Lazonick, W. (2014). Labor in the Twenty-First Century: The Top 0.1% and the Disappearing Middle-Class. AIR Working Paper No. 14-08/01.

Naudé, W. and Nagler, P. (2017). Technological Innovation and Inclusive Growth in Germany. Bertelsmann Stiftung. Inclusive Growth for Germany: Edition 18. Bertelsmann Stiftung.

Somaskanda, S. (2015). Rich Germany Has a Poverty Problem. Foreign Policy, 5 May.

//