Germany: The case for reform

Economics Department

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Germany, still the world’s third largest economy after the US and Japan, has seen its performance slipping over the past testing decade.

If the economy is to be returned to its previously robust state and put on a footing that will enable it to deal with pressing challenges, such as paying for pensions, health and education, Germany must embrace comprehensive reforms.

When the Berlin Wall came down in 1989, so too, it seemed, did the barriers to a new phase of Germany’s already formidable economic success. In the 1980s, growth of real GDP per capita in Germany and the other EU countries was roughly the same as in the United States, at around 2% per year. Sure enough, between 1990 and 1991, German growth steeply accelerated when incomes in the newly liberated East rapidly expanded, while growth elsewhere in the EU had sagged, having already peaked in 1988.

But as this initial euphoria subsided, growth in Germany slowed sharply and more markedly than in several other European countries (see graph). So when countries like the US, the UK and, to some extent, France enjoyed a strong period of growth in the latter half of the 1990s, Germany found itself trailing behind.

To a considerable extent this detachment in the pace of economic growth since 1993 reflects the economic shock associated with unification. This is most visible in construction investment in eastern Germany, which has been contracting for several years in a row now, after the initial boost at the beginning of the last decade. External factors were also at work: convergence of real interest rates to lower German levels in the run-up to European Monetary Union implied some stimulus for several European countries, such as Italy and France, but because its interest rates were already relatively low, Germany did not benefit from this effect.

The persistence of the negative spread in economic growth, not just between Germany and the US but also with its main EU competitors, points to both the size of the structural adjustment challenge Germany is facing, and to difficulties in adapting to the changed environment after unification. Today, serious impediments, particularly in the labour market, are preventing the economic rebound that is needed to bolster Germany’s high standards of living.

The weakness of Germany’s economic performance is mainly reflected in weak employment generation. Indeed, the total hours worked per inhabitant have actually declined, causing real GDP growth per capita to weaken by some three-quarters of a percentage point per year over the past decade. By contrast, employment growth contributed positively to economic expansion in other European countries and the US.

So why the decline in German employment? For a start, because of ageing; the size of Germany’s working-age population has shrunk somewhat faster than in other European countries. But this has not had the impact on growth that lower employment rates and reduced working hours per employee have had. Overall, for France, Italy and Spain taken together, higher employment in terms of total hours worked per inhabitant has contributed more than a percentage point to per capita GDP growth since 1995. For Germany, the contribution was negative. So, while much of Europe enjoyed a burst of employment-intensive growth in the second half of the 1990s, this was not the case in Germany.

To some extent the drop in average hours worked per employee reflects a substantial increase in the share of part-time employees, who work only a few hours a week. Such jobs, which provide an extra degree of flexibility in employment adjustment, have benefited from a more favourable tax treatment than regular employment. A close look also shows that not all of Germany’s sectors have lost workers: there were

falls in employment in manufacturing, construction and government sectors, whereas employment in services has expanded.

There is little doubt that ongoing restructuring in the eastern Länder has had a strong influence on these employment trends, including downsizing in the construction and government sectors. Nevertheless, the fact that this downsizing has not yet been offset by stronger employment growth elsewhere, either within the new states or in the larger, more advanced, western Germany, suggests the need for greater flexibility in the German economy as a whole.

High effective taxation of labour is one important factor hampering employment. In fact, Germany stands near the top of the OECD area with respect to the so-called tax wedge, which is the difference between wage costs paid by employers and wages taken home by employees. An average production worker in Germany takes home about half what it costs to employ him or her, compared with about 70% in the US.

Moreover, Germany’s tax wedge widened rapidly in the first half of the 1990s with social transfers to the east, which were financed via social charges on earnings. This discouraged labour demand, as well as damping disposable income growth, despite buoyant increases in overall wage rates. So, while from 1991 to 1995, real compensation per employee increased by 2%, after-tax real wages per worker rose by just 0.3% annually.

In the first half of the 1990s, these high labour costs contributed to the decline in Germany’s international competitiveness and put downward pressure on wages. But wage moderation in the second half of the 1990s did not translate into stronger employment growth. Consequently, private consumption has been squeezed, growing by just 1.5% per year between 1991-2001, well below that of its major competitors.

Other factors have contributed to reducing the economy’s capacity to generate new jobs. Wage distribution does not spread out enough to support employment generation for the low-qualified. Also the restrictive features of Germany’s dismissal protection impede hiring of certain groups such as older people.

But if lower employment contributed to Germany’s weaker growth, surely labour productivity will have compensated? True enough, labour productivity rose faster in Germany than in other European countries, but the increase was not fast enough to offset the adverse effect on GDP growth of falling employment. Why?

The reasons concern both the quality and level of investment and partly relate to unification. In particular, the capital investment that was diverted by support policies has caused distortions in the manufacturing production structure in eastern Germany that appear to have held back productivity growth. And the boost in construction investment in the first half of the 1990s, which was largely driven by state aid, also implied a significant diversion of investment away from investments with higher productivity potential.

Productivity may also have been handicapped by a relatively slow penetration of information and communications technologies in German firms (see article in this edition by Dirk Pilat). More generally, the volume of equipment investment which had boomed in Germany in the early 1990s, tapered off thereafter. Indeed, since the mid-1990s, subdued investment in machinery and equipment has accounted for roughly a quarter of the GDP growth differential between Germany and the rest of the EU.

For some years now, German GDP growth has been buoyed largely by a positive contribution from net exports. But with domestic demand being weak, the country has become less resilient to adverse external shocks, like oil price rises and exchange-rate shifts. Whether strong exports can be sustained depends far too much on external circumstances for Germany’s own good. In fact, export conditions have already deteriorated, with sluggish global demand since 2001 and the depreciation of the US dollar since the last quarter of 2002.

Nevertheless, there are clear positive signs. Germany’s external competitiveness improved in the second half of the 1990s as wage growth moderated and with exporters pricing closely to the market. Eastern German exporters are gaining market share, with some branches growing rapidly, despite low growth in the new states overall. Working-time flexibility has improved substantially in recent years. And regulatory reform in certain network industries appears to be more advanced than in some other countries.

Such positive developments need to be supported, by improving the framework conditions for higher growth and employment. Indeed, if the economy is to return to its previously robust self and put on a footing that enables it to deal with the pressing challenges that lie ahead, such as paying for pensions, health and education, Germany must embrace comprehensive structural and administrative reforms.

The German government seems ready to grasp the nettle. The chancellor, Gerhard Schröder, announced a momentous economic reform programme in March which contains serious steps in the right direction, such as easing overly restrictive features of protection against dismissal, making unemployment-related benefits more incentive-compatible and making it easier to set up small handicraft businesses.

Several of the measures envisaged closely resemble recommendations the OECD has made in previous economic surveys of Germany. Yet, as Mr Schröder knows, having these reforms accepted by Germany’s powerful social partners represents a major political challenge. But try he must, for implementation is what finally counts, and time is not on Germany’s side.


OECD (2003), Economic Survey of Germany, OECD, Paris. Order from the OECD bookshop (see link below).

Wurzel, E., (2001), “The economic integration of Germany’s new Länder”, OECD Economics Department Working Paper No. 307; available online (see link below).

Adema, W. (2002), “Taxing benefits”, in OECD Observer No 230, January 2002; available online (see link below).

Heady, C. (2002), “Taxing work”, in OECD Observer No 230, January 2002; available online (see link below).

©OECD Observer No 237, May 2003

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