Economic Policy Proposals for Germany and Europe

Ronald Schettkat,Jochem Langkau

• Publisher: Routledge
• Year: 2008
• ISBN:
  9781134044412
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Despite exporting more good and services than any other country in the world, economic growth in Germany has been slow through the nineties and the early twenty first century with low wage growth, rising unemployment and increasing public deficits. German unemployment was traditionally diagnosed as structural, neglecting macroeconomic causes of eco

1 Introductory summary

Prosperity for Germany and Europe¹

Ronald Schettkat

Unnecessarily narrow economic policy debate in Germany

No country in the world exports more goods and services than Germany. Success in international markets is a concrete indicator of the competitiveness of the German economy, especially when prices of German products are comparatively high. At the same time, however, German GDP per capita growth was the lowest in the EU in the 1990s and at only 1.4 percent in the period 1991–2004 was close to that of the long stagnant Japanese economy (where the average annual GDP per capita growth was 1.1 percent in that period). In the years since 2000, the performance of the German economy has not been any better (see Table 1.1): its tremendous success in world markets has been accompanied by poor growth in domestic markets, stagnating wages, rising unemployment and increasing public deficits.

Why did the German economy stagnate for such a long time? Why did its enormous success in world markets not translate into strong domestic growth? The most popular hypothesis for Germany’s economic problems – strongly influenced by the Bundesbank and the ECB, business lobby groups like the “Initiative für Soziale Marktwirtschaft” and almost universally accepted among German politicians – states that the German labor market is overly rigid. “Labor market rigidities” or “structural rigidities” prevent the economy from growing and force the country into stagnation and high unemployment. According to this hypothesis, the economic problem of Germany is structural. The structure of the economy and its institutional framework are causing the slack. To bring Germany back on an upward growth path requires radical and painful changes: labor markets need to be made more flexible, taxes need to be reduced and transfer payments need to be lowered (for recent elaborations in this direction, see Siebert 2005; Sinn 2007). Given this influential diagnosis, the medicine prescribed by many German economists, the OECD’s jobs study, IMF and others consisted of supply-side treatments only. It is not that German governments ignored these recommendations, but until 2006 “reforms were visible everywhere but not in the economics statistics”.

Although almost universally accepted, the “structural rigidities” hypothesis is based more on theoretical assumptions and anecdotal evidence rather than on hard empirical facts, and it cannot explain the recent recovery of German growth rates. In the summer of 2006, the German economy showed signs of recovery: GDP growth reached about 2.5 percent on an annual basis, even full-time employment covered by social security increased and the situation of public budgets relaxed. Also, a 3 percentage point increase in the German VAT did not slow economic growth in 2007. For the first time in five years, the finance minister could inform Brussels that public deficit in 2006 was below the 3 percent threshold of the European Stability and Growth Pact (the so-called Maastricht criteria) and core inflation² is, at 0.6 percent, low and not showing any sign of acceleration. In 2007, the EU Commission formally released the deficit procedure against Germany, and predictions for annual growth of the German economy cluster around 3 percent.

Table 1.1 Average annual growth rates, different periods

How can this be if “structural rigidities” prevented the economy from growing? One answer is, of course, that past reforms – the marginal tax rate has been lowered substantially, unemployment benefits for those unemployed for a year or longer have been lowered, job-acceptance criteria have been sharpened and now any job is declared to be an acceptable job, unions have lost influence and are engaged in concession bargaining, public budgets have been reduced, etc. – have made the economy more flexible. Of course, the government has a preference for this view because it implies that their policy was on the right track. But timing is a problem with this answer. Why did growth and employment pick up now and not earlier? Why did economic growth recover first and only later employment? Alleged time lags between treatment and effect can solve the puzzle formally, but they are a weak argument because the right time lag allows any current outcome to be “explained” by past events. Unless one has a good explanation for time lags that have different lengths for different measures, only an already strong believer in these policies will be satisfied with this answer.

Another explanation of the upswing in 2006 is that the grand coalition changed the gear with respect to fiscal policy. Courageously, the new finance minister, Peer Steinbrück, an economist, openly gave up the “savings strategy” and argued that the federal budget of 2006 should be expansionary in order to stimulate the economy, which would consolidate public budgets and enable Germany to meet the 3 percent deficit criteria in the future. Although the conventional economic litany started immediately, ranging from the “straw-fire argument” to allegations that the 2006 federal budget is unconstitutional, Steinbrück was counting on an expansionary push that would be strong enough to overturn the contracting effects of the 3 percentage point rise of the value added tax in 2007. In the event, GDP growth for 2006 was 2.5 percent, tax revenues are rising, employment covered by social security is growing by about 600.000 in 2006/2007 and unemployment has dropped substantially below the 10 percent threshold (6.4 percent according to ILO definitions; see Bundesagentur für Arbeit 2007).

Could it be that the German economic stagnation was not only caused by “structural rigidities” but that it was also caused by contracting macroeconomic policy? Was the savings strategy of Finance Minister Hans Eichel (minister for finance 1999–2005) the wrong approach? Could an expansionary fiscal and monetary policy have improved the economic situation? Such questions seem to be rare among German economists, where the common view seems to be based on the assumption that the control of inflation is not only necessary but also sufficient to achieve favorable macroeconomic outcomes. The analyses in this volume, however, show that past fiscal policy in Germany was clearly contracting and drove the German economy even deeper into stagnation. Robert Solow (“Broadening the discussion of macroeconomic policy”, this volume) argues that part of the explanation for misguided economic policy in Germany is the intellectual debate, which disregards macroeconomics and the demand side almost entirely. Being a Keynesian is a synonym for being a species soon extinguished in the world of German economists. Macroeconomic policy is discarded as wrong-footed; big spender, “big state” economics cannot deliver a useful contribution in the new world of global capitalism.

According to the common view among German economists, politicians and laymen, expansionary economic policies, either fiscal or monetary, are ineffective to stimulate economic growth and employment even in the short run. All expansionary economic policy can achieve is a straw-fire, expansionary impulses will soon end in accelerated inflation without substantial effects in the real economy. This view, however, is based on the assumption that the economy is always in Walrasian equilibrium, i.e. in a situation in which all individuals optimize their behavior and maximize individual utility, and markets clear. Then, the employed are best off when working and the unemployed are best off when unemployed. To get the unemployed into jobs requires different labor supply incentives. A theoretical position developed by Milton Friedman (1968) and Edmund Phelps (1968), which became known as the natural rate of unemployment and later as the NAIRU, posits a non-accelerating inflation rate of unemployment or structural unemployment rate to which the economy always returns in the long run. Accordingly, there is a strong belief that structural unemployment rates are very high in Germany (see OECD estimates displayed in Table 1.3 below) and that it hence requires structural reforms to improve the functioning of labor markets. The major if not the only impediment for higher employment lies in labor market institutions. Attempts to stimulate economic activity through fiscal or monetary policy would fail according to this view, because labor market rigidities will prevent quantities from reacting, i.e. unemployment is diagnosed as structural in the sense that everybody is optimizing within the existing institutional framework.

In other words, they hold that deviations of actual from potential output, even fairly large ones, are quickly and automatically self-correcting if only inflation is kept low and steady, and wages are flexible. Inflation is a purely monetary phenomenon and unemployment results only from excessively high real wages. So there is no stabilization function for fiscal policy to perform.

(Solow, this volume)

Was the German economic policy debate with its focus on structural reforms misguided; did it follow the wrong track? Was it a mistake to disregard macroeconomic policy options and to emphasize structural reforms only? The unanimous answer of the distinguished economists who contributed to this volume is a clear YES: a more expansionary economic policy could have improved the economic situation in Germany and Europe substantially. None of the analysts, however, take the position that supply-side measures improving the functioning of the economy are unnecessary; rather, by themselves they are unlikely to create economic growth – they may even produce adverse effects. Robert Solow, winner of the Nobel Prize for his contribution to growth theory, reminds us of the fundamental distinction between potential and actual economic output. Whereas potential output depends on supply-side variables, actual growth depends largely on demand. Markets are like scissors, they cut with two blades, supply and demand (Marshall 1920). If demand falls short of potential output, actual growth will be below potential growth, and thus some production capacity will be idle – Okun’s law – reflected in unused capital and unemployment. If there is idle capacity, the economy can expand without substantial upward pressure on prices. “Clear thinking requires a reminder: the reward from more efficient markets is higher potential output. There is no guarantee that an increase in potential output will be quickly translated into higher current output and employment” (Solow, this volume).

Table 1.2 Components of growth (annual averages, excluding stockbuilding, %)

If the hypothesis of high structural unemployment is valid, German industry should regard it as a disaster if foreign demand for German products were to increase substantially. If foreign demand is happily satisfied, why not domestic demand, is a bold question Robert Solow asks. It seems implausible that the German economy would not respond with higher output to higher demand, given that actual output is currently below potential. The “labor market rigidities as the root of European unemployment hypothesis” fits the cross-country data well, but it fails to explain why unemployment rose substantially in Germany. “The claim that institutional change would resolve European unemployment problems did not take account of the longitudinal data. It rested entirely on cross-section comparisons of institutions and outcomes” (Richard Freeman, “Wanted: a new German Wirtschaftswunder”, this volume).

This book: a fresh view from international economists

This book presents fresh, innovative analyses of the German economic policy debate from different angles. All papers are written by distinguished international economists with the highest reputation. None has German nationality. Three authors are US citizens – Robert Solow (MIT and Russell Sage Foundation), Richard Freeman (Harvard University and NBER) and Adam Posen (Institute for International Economics, Washington); one author, Wendy Carlin, is Australian and teaches at the University College in London; and the other authors are from neighboring countries: Charles Wyplosz, France (Graduate Institute of International Studies, Geneva and CEPR); David Soskice, Britain (London School of Economics and Duke University); Paul de Grauwe, Belgium (University of Leuven); and Cláudia Costa Storti, Portugal (Banco de Portugal). We invited these prominent international economists to comment on the German economic policy debate because external observers are not partisan and have an unbiased view on the German debate. Many arguments have been repeated so many times in the German debate that they are not questioned any more. Often these arguments are regarded as facts even though there is sometimes a complete lack of evidence. Often it seems that careful empirical research is ignored if it does not pass the filter of prejudices which strong theories seem to produce. Just like anybody else, economists seem to be more attracted by “facts” which fit their views than by contradicting results. But in the German case, the debate has become overly narrow, focusing on simple cost-reducing supply-side measures only and excluding a whole set of policy options which can fruitfully be used to improve economic prosperity.

Many participants in the German economic policy debate have forwarded specific arguments so rigorously that it is hard to discard them. Furthermore, being in the middle of the mist, it is often more difficult to see the major lines than with a clear view from above. Foreign economists not too deeply involved in the German debates, working at first-class universities, and being very knowledgeable about the German economy, offer fresh, non-partisan views. Nobel Laureate Robert Solow (this volume) sees a lack of a serious macroeconomic policy debate in Germany. Although reforms to improve the functioning of labor markets (and also product markets) are desirable, Solow argues that the debate is far too narrow if it stops there. Ignoring macroeconomic factors is symptomatic of a misunderstanding of both the German situation and economic theory. Slow and inadequate economic growth and unemployment are specific macroeconomic problems.

When even economics professors (e.g. Eekhoff in Berliner Gespräch Phoenix March 2005) declare that public budgets in Germany were expansionary in the past because they were in deficit (actually they were highly pro-cyclical, see Wyplosz, this volume) and that public budgets are like budgets of a family where the father cannot reduce a deficit by increased spending, it shows a deep misunderstanding of macroeconomics (see also Baumol 2005). The ignorance of macroeconomic insights is somewhat unique to the German economic policy debate, and it makes many foreign economists wonder why Germans are so dogmatic. It seems that “Deutsche Gründlichkeit” leads many to ignore fundamental insights of economics, producing unnecessary and counterproductive restrictions of thinking and potential policy instruments, as all authors in this volume seem to agree. “I think there are purely intellectual sources of the narrowness that seems to have characterized it” (Solow, this volume). However, theories which discard a whole set of policy options are very costly, reducing the wealth of Germans unnecessarily if they are wrong.

The international community of economists does not fit in the tight theoretical straightjacket of the German economic policy debate and uses much broader theoretical perspectives. Calling someone a Keynesian is not showing any disrespect among US economists. Keynesian economics is also not a matter of left and right political views as the former chief economic advisor to US President Bush, Gregory Mankiw (2006), argues. Keynesian economists, among the most respected and honored American economists, have been advisors to democratic as well as republican administrations. And this has a long tradition from Robert Solow advising John F. Kennedy, Joseph Stiglitz advising Bill Clinton, to Gregory Mankiw. In American politics, in the admini...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Notes on contributors
• 1 Introductory summary: prosperity for Germany and Europe
• 2 Broadening the discussion of macroeconomic policy
• 3 Monetary policy and the real economy
• 4 Germany in the monetary union
• 5 Reforms, macroeconomic policy and economic performance in Germany
• 6 Exportweltmeister – so what? Better goals for German foreign economic policy
• 7 Wanted: a new German Wirtschaftswunder