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What Challenges is Germany Facing?

What Challenges is Germany Facing?
 Eric Chaney
Senior Fellow - Economy

Eric Chaney is the economic advisor at Institut Montaigne

On the other side of the Rhine: another political planet

Political debates can hardly be more remote than those having opposed Angela Merkel and Martin Schultz on September 3rd on the one hand and Marine Le Pen and Emmanuel Macron five months earlier on the other hand. True, German political debates are courteous and consensual, if not boring – at least until now - but the relative economic health of each country also had an impact on the tone of exchanges. While France is deeply anxious about globalization - wondering whether it should move away from it or only seek protections –, about the governance of the Eurozone or whether it must reform its welfare state, these topics do not make the headlines in the German electoral campaign. Germany is indeed feeling comfortable on these issues and would rather debate about the management of a prosperous economy, the opportunity to cut taxes, or the number of immigrants the country needs, with employers complaining about labour shortages.

However, in both countries, the debate is much lighter on long term challenges, such as the sustainability of the French government debt and pension scheme or, in Germany, issues linked to its ageing population, the preservation of its competitive advantage, which is often linked to a social model that will eventually have to adapt to the uberisation era, as well as the over reliance on its export markets’ growth.

Since 1998, unemployment decreased six times faster in Germany than in France

A comparative review of current economic conditions will help understand how two neighboring countries, with closely intertwined economies and with a nearly stable exchange rate since 1983 can display such diverging political situations. In 1998, on the eve of the creation of the euro, the GDP per capita of Germany, still impacted by the unification travail, was 3.9% lower than France’s. In 2016, it was 4.3% higher. Since 1998, wealth increased by 26.1% in Germany, vs. 17.1% in France, which is a relative loss of approximately 8% (1). Even more striking, from December 1998 to July 2016, the unemployment rate fell by 5.3 percentage points in Germany, to 3.7% whereas it receded by only 0.9 point, to 9.8% (2), that is, a six times slower decline.

It is therefore not surprising that the debate in France revolves around "how to change things" while in Germany, changes are sought only at the margin. In the latter, a hotly debated question is the reduction of income inequalities, which widened between individuals and regions. Indeed, despite important subsidy transfers from Western to Eastern Länder that persist up until today through the solidarity tax, the west/east economic gap is far from being closed.

The German success, as a consequence of the crisis caused by unification…

How can we explain Germany’s impressive achievements ? The country that used to be referred to as "the sick man of Europe" twenty years ago, is today an example for most European states. To such an extent that in several countries, voices are calling to "make Germany pay", whether through talks of war reparation in Greece and Poland, or more subtly, demands for a form of mutualisation of sovereign debts. The question is all the more relevant as, when exchange rates for future euro members were set in 1998, the German mark was overvalued compared to its partners’ average, due to high wage inflation following unification, as well as lira and peseta devaluations in September 1992.

Gerhard Schröder’s reforms were not limited to the Hartz IV law

Understanding the reasons behind Germany’s evolution thus requires going back to the 1992 crisis, the recession and the stagnation period that followed. When it crossed the five million threshold, unemployment triggered a major political shock, convincing labor unions of the benefits of wage moderation – if not wage reduction – to secure employment, and compelling political parties to rethink the national economic model. The "Agenda 2010" presented by Gerhard Schröder in 2003, then gradually implemented until 2005, was the outcome. Today, only the labor market and unemployment benefit reforms are remembered (Hartz IV reform). It admittedly played an important role in making employment more flexible, opening the market to the least productive workers ("mini-jobs"), and increasing incentives to go back to work by reducing the duration of unemployment benefits. Other facets of Schröder’s program are however neglected, such as the unwinding of cross-shareholdings that were impeding German capitalism, thanks to profit and capital gain tax cuts, or the reduction of regulations on retail and services, including with regards to job search. Even though economists are still debating the magnitude of the "Agenda 2010"’s impact, a large consensus concedes that it has greatly contributed to restoring German competitiveness and that it has helped a transition from mass unemployment to full employment.

Germany has clung on to China’s growth

Reforms alone are not sufficient to explain a growth difference of more than 7 points between France and Germany since 2005, even if the lack of structural reforms in the former is part of the story. Globalization, characterized by China’s entry into global trade, represented the other main lever of German growth. Its specialization in equipment goods and the premium segment of the car industry, largely benefitted from China’s fast industrial modernization. Indeed, China’s openness towards foreign companies’ direct investments, as well as the quickly rising wealth of an important part of its population, eager to gain access to high end goods produced in the West, account for a large part of the German model’s success.

This aspect is crucial: it widely explains why German industrials are currently so "euphoric" – to quote the economic research institute Ifo (3)’s comments on its July and August business surveys –, in spite of the euro’s appreciation since the beginning of the year. As firms such as Apple, LVMH or BMW well know, demand for luxury goods relies on customers’ wealth and is little price-sensitive. It is also crucial in order to understand the challenges that Germany will have to overcome in the near future.

Challenge n°1: accommodating China’s growth change

While its productivity catch-up slows down and its labor force decline accelerates, China’s growth can only decelerate in the years to come. Even if the attractiveness of Western premium brands is sustainable – reputation and image are long term assets – Chinese firms’ competition in their own market can only intensify, as is shown by the success of Huawei smartphones to pick an example. It is the German model’s first challenge, inherited from its high specialization in the car and associated equipment goods industry. To preserve a premium image – especially in the car industry –, German companies will have to deeply transform their product lines, at a time when China is focusing on environmental issues, after the awful excesses of fast industrialization, and when the traffic boom in mega-cities provides a perfect opportunity for autonomous and electric vehicles, and thereby for local technological competition. In the 2017 edition of its "50 smartest companies" list, the Massachusetts Institute of Technology (MIT) included young Chinese companies such as iFlytek, Face++ or DJI, from the "intelligent machines industry" sector, alongside more established brands such as Tencent, Ali Baba or Baidu. For Germany, only Adidas and Daimler made it to the ranking, not due to their size but because the former launched a robot intensive micro-factory able to produce locally and on demand, and the latter for its introduction of its Urban eTruck, the first all-electric heavy-duty truck.

Challenge n°2: the German social model facing the technological wave

German economy’s second challenge is to adapt its social model, built on negotiations, internalization of economic constraints by labor unions and their participation to board meetings, to the technological wave, often roughly called uberisation. Artificial intelligence’s rapid progress, the open access to new technologies, most often available online, new funding channels such as crowdfunding or cryptocurrencies, favor the emergence of individual entrepreneurs or small businesses aiming at a global market, and having the potential to become global giants. These changes are seemingly at odds with the power of labor unions or the structure of large Konzerns (vertically and horizontally integrated business entities inherited from German history). Although this challenge is similar in all developed countries, it is more important for Germany because of it strong industrial specialization and the central role of co-management between capital and labour.

Challenge n°3: tackling the demographic decline

The third challenge is the country’s demographic trend. Germany is ageing quickly: its natural demographic balance (i.e. the number of births minus the number of deaths) is heavily negative, around -190 000 per year. In 2016, the population rose by 0.7%, reaching 82.8 million thanks to robust immigration flows (750 000 people, after 1.1 million in 2015). In a high version of the Federal Institute of Statistics’ projections (4), which assumes a cumulated immigration of 8 million by 2050, the population would still decrease by 7 million and the proportion of people over 60 would increase by 10 points, to 39%. Despite the uncertainty inherent to any projection, Germany clearly needs sustained immigration flows, or it will be hit by a significant fall of its living standards due to the declining labor force together with the rising financial burden of pensions. Solutions are well-known and unchallenged by traditional parties (CDU, SPD, FDP and Greens) :

  • systematically raising the retirement age;
  • promoting and managing immigration;
  • investments aiming at stimulating innovation and thereby productivity;
  • accumulating capital to fund future pensions.

This last point is actually the main reason behind Germany’s external surplus (5).

Investment, or tax reduction?

However, the debate regarding the practical implementation of such measures is not as clear. Indeed, welcoming millions of migrants requires a large investment program in infrastructure as well as training and education, which political parties fail to assess, as they are scared of not being able to allocate the budget surplus (6) to tax reductions. Similarly, if Germany is generally successful in terms of scientific research, namely thanks to the Max-Planck Society (7), federal funding for basic research, which grants top American universities a decisive competitive advantage, remains limited.

Finally, even though the accumulation of external surplus is justified by the necessity to fund future pensions, the way these savings are invested by pension funds and life insurance companies, mainly in sovereign bonds with very low returns, goes against the desired goal. It even triggers a vicious circle, as it encourages saving even more, at the expense of investment or consumption. Besides, the Bundesbank is highly concerned by the impact of ultra-low interest rates on life insurance solvency. This is an issue that the next Chancellor will have to tackle in priority. More fundamentally, the funding model of the German economy, mostly relying on loans from a fragmented banking industry – not very profitable and dependent on local political hazards – and to a very small extent by equity markets, will need to be restructured before the unavoidable reversal of the economic cycle.

The loose consensus that has characterized the electoral campaign somewhat ignored the challenges awaiting Germany, despite or maybe due to the last fifteen years’ significant successes. These challenges will nevertheless necessarily be confronted. This is decisive for Germany, but also for its partners since its economy has become the backbone of Western Europe.

(1) IMF, World Economic Outlook database, July 2017, GDP per capita in euros with constant prices (inflation-adjusted). An alternative IMF measure, using purchasing power parities at current prices, shows that GDP per capita in France was 5.6% lower than Germany’s in 1998, and 12% lower in 2016, that is a relative loss of 7%, comparable to the one measured in constant euros.
(2) Eurostat. The unemployment rates are the national unemployment rates calculated according to the International Labor Organization’s common norm.
(3) Leibniz-Institut für Wirtschaftsforschung. IFO stands for Information und Forschung
(4) Destatis, 13th coordinated population projection based on the population on 31/12/2013. Variant 2 (G1-L1-W2)
(5) Germany’s balance of current payments’ surplus reached 8.3% of GDP in March 2017.
(6) The German general government (federal and local entities) budget balance documented a 1% of GDP surplus in Q1 2017, following a 0.8% surplus in 2016.
(7) For example, the Leipzig-based Max Planck Institute for Evolutionary Anthropology, where the Swedish researcher Svante Pääbo developed methods of analysis of ancient DNA, attracted talented scientists from around the world, including the French anthropologist Jean-Jacques Hublin.

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