Germany: From “Sick Man of Europe” to “Economic Superstar”

Germany’s economic upturn since 2000

A glance at Germany’s economic development over the last 15 years shows almost astounding progress. During the early years of the new millennium, Germany was considered to be the “sick man of Europe”. Gross domestic product (GDP) was either stagnant or actually decreasing. Falling competitiveness had led to a trade deficit and rising unemployment. Social market economy was being derided as being past its expiry date.

And yet the German economic and social systems have now become an example many other countries aspire to. The current account surplus has been growing since 2001 and is presently 8 percent of GDP (see fig. 1).

Fig. 1: Annual current account balance in percent of GDP, estimates start after 2014, source: International Monetary Fund, World Economic Outlook Database, October 2015 (data downloaded on December 9, 2015).

The number of people at work residing in Germany has increased steadily over recent years. According to Germany’s Federal Statistical Office, in the third quarter of 2015 around 43.2 million people were economically active, meaning employment is at its highest level since the reunification of East and West Germany. At the same time, unemployment has fallen: it dropped from 5.3 million in the spring of 2005 to 2.6 million in November 2015. The sick man of Europe has recovered in just a couple of years to become an “economic superstar”.

How can this economic upturn be explained?

The economic upturn of recent years occurred thanks particularly to Germany’s increasing competitiveness in international terms, since to date the country’s economic growth has been driven primarily by exports. In my view, there are essentially two reasons for the German economy’s export surplus: extremely favorable development of labor unit costs in international terms and membership in the European currency Union.

An economy’s unit labor costs can be calculated by dividing total labor costs by the total of the goods and services produced (i.e., GDP). By this definition of unit labor costs, these costs remained almost unchanged in Germany from 1995 to 2008/09. By contrast, in most other industrialized countries, unit labor costs increased by 30 to 40 per cent over the same period. The reason why unit labor costs in Germany increased so little is a combination of technological advances, which have increased productivity, and restrained wage negotiation policies on the part of the unions.

The second important reason for Germany’s competitiveness is its membership in the European currency union. Normally, an export surplus leads to strong demand for the exporting country currency, because importing countries need that currency to pay for those imports. High demand for a particular currency causes that currency to appreciate. This makes the exporting country’s products more expensive for the rest of the world, so leading to a reduction in its exports. The launch of the euro has meant the end of this compensatory mechanism, so that Germany’s strength in terms of exports is no longer reduced by an appreciation of the country’s currency.

The price of economic strength

However, Germany’s economic success does have its downside. In terms of the domestic economy, stable unit labor costs mean wage restraints. Real employee incomes (i.e., adjusted for inflation) between 2000 and 2011 have remained virtually unchanged, while income from business and assets has risen by 30 percent. This means that the price of high competitiveness on the international level consists of more income inequality, leading to dissatisfaction with the social market economy. What is more, this income inequality is increasingly acting as a brake on growth.

In terms of foreign trade, it is important to bear in mind that Germany’s export surplus means that there must be corresponding trade deficits elsewhere in the world. These will have various kinds of impact on the economic development of the countries running those deficits.

• In Germany, high exports mean high production and high employment levels. This has a positive effect on public finances.
• In countries with trade deficits, the opposite effect is making itself felt: production levels are lower, since there is a demand for goods and services produced abroad, rather than those produced at home. Unemployment is higher and public debt increasing, due to falling tax receipts and increasing costs for tackling unemployment.

In a nutshell, thanks to its export surplus, Germany is also exporting unemployment to other countries.

Wage restraint and increasing exports – a way forward for Europe?

At the core of Germany’s economic upturn lie long-term restraints on wages. The concomitant drop in purchasing power and domestic demand has been compensated for by an increase in exports. Is this approach an option for the crisis-ridden countries in Southern Europe to boost GDP and employment?

Wage restraints do improve a country’s international competitiveness, by leading to increased export opportunities and a positive stimulus for growth. At the same time, it is necessary to take into account that there will be a drop in consumer demand. Also, an increase in exports from one country will have a negative impact on export opportunities for the rest of the world. Furthermore, the extent to which wage restraints in the domestic economy will have an impact depends on how other countries react when setting their own wage policy.

The question of what impact wage restraints will have on economic growth in a single country can only be answered if such knock-on effects and feedback loops are taken into account. In order to do this, a macro-economic multi-country simulation model is required that can interconnect the countries using their cross-border trade activities. To this end we are currently working with our project partner, Prognos AG, on a study which takes into account these inter-relationships. We will be publishing the results from this simulation at the beginning of January 2016.

Reference: We recently analyzed the reasons behind Germany’s export strength in our blog post “Germany’s export surplus – a blessing or a curse?“.