Germany's Economic Ills

Martin Feldstein (1)

Horst Siebert is known internationally as the head of the prestigious Kiel Institute of World Economics and as a professor of economics at Kiel University. Professor Siebert is distinguished also by the breadth of his interest in the public policy issues in Europe in general and in Germany in particular. His comments on German policy are widely read and his position as a member of the German Council of Economic Advisers has given him an important voice in policy circles.

It is to reflect Horst Siebert's broad policy interests that I decided to write an essay that deals with many of the problems facing Germany rather than presenting a narrower and more technical paper for this volume. As an outsider I am of course reluctant to assume that I understand Germany's problems enough to prescribe specific policies. Instead, I will focus on describing what I see as Germany's primary economic problems and will raise questions about the causes and possible remedies of these problems.

Many of Germany's problems are shared with the other countries of Europe. Nevertheless, there are important enough differences that the German illnesses cannot be characterized as a pan-European disease. To different degrees, the problems are less or different in the Netherlands, in the Scandinavian countries, in the UK , Ireland and even in Spain, Italy and France.

Germany has an approach to economic policy that served it extremely well for several decades after World War II and that in some ways have continued to serve it well. It would be wrong to lose sight of the economic miracle of Germany's postwar economic recovery and the decades of strong growth, low inflation, and low unemployment. In the mid-1970s, German unemployment was less about 2.5 percent, less than half of that of the United States, and its inflation rate was close to zero. During those years, Germany also experienced a very satisfactory rate of real economic growth that substantially narrowed the gap between per capita real GDP in Germany and in the United States.

But the German policy approach that worked so well in those years has ceased to perform as well. Although the inflation rate has remained low, the unemployment rate has risen to nine percent and the rate of real economic growth over the past several years has declined to significantly less than that of the United States. In the very short run, Germany's GDP has actually been declining and its budget deficit is approaching the three percent limit imposed on European Union countries by the Masstricht treaty. Looking ahead to the very long run, Germany faces even higher taxes than those that it faces today as a result of the increasing cost of providing services and pension benefits to an ageing population. The difficulty, both political and economic, of raising taxes also limits Germany's ability to share in the proposed European and NATO defense activities.

I will start this essay by looking at the short-run problems of recession and of the loss of monetary policy independence as a result of the European Economic and Monetary Union. I will then consider two medium range issues: the high level of unemployment and the low rate of productivity growth. Finally, I will turn to the long term problems that are caused by the changing demographic structure of the German population.

1. The Business Cycle and Macroeconomic Policy

As I write this essay (in January 2002), the German economy is in an economic downturn. Gross domestic product fell during the most recent quarter for which data are available (2001:3) and the growth over the past year has been only 0.3 percent. This is substantially weaker than the performance of GDP in Germany's neighbors during the same intervals: France grew at 1.9 percent during the one-year growth rate, Italy at 1.9 percent and Spain at 2.8 percent.

Because Germany no longer has an independent monetary policy but is part of the European Economic and Monetary Union (EMU), the rate of interest and the growth of the money supply are determined by the European Central Bank (ECB) rather than the German Bundesbank. In setting monetary policy, the ECB must focus on the average condition of the twelve countries that are members of the EMU. It is of course difficult to know what the Bundesbank would have done in the current cyclical circumstances had the EMU not been created. Germany has a long history of cautious monetary policy devoted to achieving low inflation. But with an inflation rate of only 2.2 percent over the past year and declining in the most recent quarter, it is certainly possible that the Bundesbank would have been more aggressive in reducing interest rates and expanding money growth in order to stimulate the German economy.

The ECB has been relatively cautious during the year 2001, reducing short-term interest rates only from 4.7 percent to 3.4 percent. In contrast, the U.S. Federal Reserve caused a comparable short-term rate to fall from 5.4 percent to 1.7 percent even though US growth during the year was higher than that in Germany.

In writing this I certainly do not mean to be critical of the ECB. Its responsibility is to the EMU countries as a whole and on that basis the interest rate decline may have been appropriate. My point is rather that Germany would have benefitted from a more rapid reduction of rates.

Before the introduction of the euro, the combination of lower interest rates in Germany and the weakness of the German economy would probably have caused the German mark to decline, raising the competitiveness of German products and helping to dampen the economic decline and to eliminate Germany's current account deficit. This too can no longer happen because the mark has been replaced by the euro. The euro did decline during the past year by about five percent relative to the dollar but only by about two percent on a trade-weighted basis.

Without deliberate or automatic monetary or exchange rate adjustments, the only countercyclical macroeconomic policy can be a relative fiscal expansion. Germany's budget deficit did expand in 2001 to an estimated 2.5 percent of GDP (according to the most recent OECD estimate), twice the percentage deficit for the Euro area as a whole. Since the Growth and Stability pact requires the members of the European Union to avoid deficits that exceed three percent of GDP, the European Commission has recently put Germany on notice that it should not allow its budget deficit to continue rising.

Americans are of course aware of the inability of individual states within the United States to respond to a decline in demand by an explicit countercyclical policy. The US states not only lack independent monetary and exchange rate options but are bound by state constitutions to seek a balanced budget. While individual state reserve funds permit temporary deficits, these are limited by the capital market pressures on the interest rates on state government bonds.

Within the United States, however, individuals respond to state or regional declines in demand by moving to other regions and by reducing wages relative to those of other regions, thereby increasing the attractiveness of producing in the region and reducing the prices of the products of the region relative to prices elsewhere in the country. While such migration and wage responses are in principle available in Germany, the reality is that migration to other countries is severely limited by differences in language and wages are much less responsive than they are in the United States.

The current downturn in Germany will no doubt end but the problem caused by the absence of monetary and exchange rate responses will remain. One way to improve the future situation within the framework of the EMU would be for the European Union (EU) to develop a less restrictive policy about deficits in national governments, perhaps linked to previously accumulated surpluses held in national reserve accounts. Under such an arrangement, a government that wants to increase its fiscal flexibility might be allowed to accumulate surpluses in a reserve account and to have deficits that exceed the permissible Growth and Stability Pact levels as long as they have sufficient funds in their reserve account to balance the new excess deficits.

Even with such a more active fiscal policy, the effect of the EMU is likely to mean greater cyclical fluctuations in unemployment and higher average levels of unemployment than would have been possible with national monetary policy and a national currency.

An optimistic view is that this will lead to more flexible wage setting procedures so that real wages and relative wages might be able to decline more when aggregate demand falls.

2. Medium Term Problems: Structural Unemployment and Low Productivity Growth

Structural Unemployment

Germany's low unemployment rate was once the envy of the industrial world. In the 1970s, when I first began to study problems of unemployment, Germany's unemployment rate was about 2.5 percent, less than half of that in the United States. In the year 2000, that ratio was reversed. The United States had an unemployment rate of 4.0 percent while Germany's unemployment rate exceeded 8 percent.

Although some of this reflected the strong cyclical position of the U.S. economy at that time, the sustainable unemployment rate in the United States has no doubt been reduced by reforms of unemployment insurance (taxing benefits, limiting durations, strengthening experience rating) that decrease the average duration of unemployment spells and the frequency of layoffs. Even during the current U.S. recession, the median duration of unemployment of those who are out of work is less than eight weeks. The majority of those who become unemployed are no longer unemployed after 8 weeks.

Why is unemployment so much higher in Germany (and in most but not all other countries of western Europe) than in the United States? Although the unemployment rate is substantially higher in most European countries than in the United States, the proportion of employees who become unemployed is actually lower. It is the much longer durations of unemployment in Europe that keeps the overall unemployment rates higher.

The longer duration of unemployment in Europe reflects the different incentives facing both unemployed individuals and firms. Individuals in Germany who are unemployed often have little incentive to find a new job or to accept the wage reduction that would be necessary to be able to obtain work. The key impediment is the high levels of benefits paid to the unemployed and the long duration for which they are available. In contrast, in the United States someone with average earnings will receive unemployment benefits equal to half of their previous wage. Higher wage workers will receive a substantially smaller replacement rate. Benefits are limited to six months and are paid only to those with substantial labor market experience in the months before unemployment begins, thus excluding new entrants to the labor market and those who are looking for work after a long spell of being at home.

American workers are also much more likely to move from one region of the country to another in the pursuit of work. Such migration is much more important when there are structural declines in employment in a region than in response to cyclical variations. The decline of textiles, shoes and later of military production caused workers to leave my own region (New England) and move to the south and southwest where new jobs were available. Part of the greater mobility reflects cultural differences between the U.S. with its long tradition of internal migration and part of it is the incentive effect of unemployment benefits.

Wages are also much more flexible in the United States than in Germany. A significant reason for this is the stronger incentive in the U.S. to reduce one's reservation wage when unemployment insurance benefits are relatively low (as they are for high wage workers) or when they are about to be exhausted. But the wage flexibility in the U.S. also no doubt reflects the much less significant role of unions in the United States than in Germany. Only about 15 percent of the U.S. labor force is unionized and the greater part of the union membership are employees of governments and nonprofit institutions because competition among firms limits the potential gains that unions could bring to their members.

Firms contribute to the high European unemployment rate by their greater reluctance to hire unemployed workers. The high cost of hiring workers that results from payroll taxes that often add 40 percent to the money wages is a substantial incentive to use more capital intensive means of production. But firms are also reluctant to hire workers because of the difficulty and cost associated with laying them off when demand declines. Back in the 1960s and 1970s, when demand continued to increase year after year, firms could ignore the potential costs of layoffs. But once it became clear that there would be occasional period of declining demand, firms began to take these high severance costs into account when deciding whether to make a new hire. In effect, the cost to the firm of hiring a new employee is not only the wage and fringe benefits and payroll taxes but also the potential costs associated with future severance.

Low Productivity Growth

The second major medium term structural problem now facing Germany and most other western European economies is the failure of productivity to accelerate in the second half of the 1990s in the way that it did in the United States. The comparison is perhaps clearest if we look just at manufacturing since the measurement of output and productivity in services is more difficult and international comparisons more questionable.

Between 1995 and 2000, output per employee hour in manufacturing rose at an annual rate of 4.9 percent in the United States, up sharply from the 3.2 percent rate of the previous 15 years. In contrast, productivity growth in German manufacturing between 1995 and 2000 was only 2.8 percent, only slightly more than half the US rate. While it is difficult to make longer term comparisons because of the expansion of Germany to include the former East Germany, it is noteworthy that manufacturing productivity in the former West Germany rose at 2.5 percent, not very different from the post-1995 rate in the united Germany.

In France, there was also little acceleration of productivity. French productivity growth in manufacturing rose from an annual rate of 3.7 percent from 1980 to 1995 to 4.1 percent from 1995 to 2000.

It is of course possible to dismiss the sharp acceleration in the growth of productivity in US manufacturing as simply a temporary event of no significance. I think such a view would be wrong for several reasons. First, the gain was not confined to manufacturing. For nonfarm business as a whole, productivity accelerated from the 1.5 percent a year from 1980 to 1995 to 2.6 percent from 1995 to 2000. Even in 1991, a year of recession, nonfarm business productivity rose at 1.8 percent, ending the year with a 3.5 percent productivity gain in the fourth quarter.

An important difference between the productivity performance in the US and in Europe is that the U.S. productivity gain was achieved while also increasing total employment and hours. Nonfarm employment rose at an annual rate of 1.7 percent per year between 1980 and 1995 and at 2.4 percent between 1995 and 2000. Total employee hours in the nonfarm business sector behaved in a similar way, rising at 1.6 percent from 1980- to 1995 and then at 2.1 percent a year from 1995 to 2000.

European employment and hours did not rise in this way. Much of the gain in productivity was achieved by substituting capital for labor. That's why the common statement that productivity increases in Europe is evidence of the strength of the European economies is wrong. Higher productivity will inevitably follow increases in total labor costs that are forced upon firms by union negotiations and increased payroll taxes. If firms do not increase their productivity in line with these rising labor costs, they will lose money and eventually go bankrupt. The rise in productivity is achieved by restricting increases in employment so that the accumulation of capital is concentrated on a smaller labor force.

Although the acceleration of productivity in the United States in the second half of the 1990s may be due in part to the stage of the US business cycle during those years and to the increased rate of capital investment, I share the view of many experts that the primary force for faster productivity growth was the change in technology made possible by the more user-friendly personal computers, by the internet, and by the corporate intranets. These have in many changed how business is done in U.S. companies. Layers of middle management have been eliminated since intranets allow managers to deal directly with a larger number of staff members. Companies have also eliminated sales and purchasing staff since many of those activities can be done over the internet, often in a fully automated way.

There is in principle no reason why German firms could not have enjoyed the same productivity gains. The technology and software of the internet and the intranet are as available to firms in Germany as in the United States. But what is missing in Germany and in other European countries is the ability to change work rules and to lay off workers who are made redundant by the new technology. The increase in productivity growth from 1.5 percent a year to 2.6 percent is equivalent to getting the same work done with one fewer employee per one hundred former employees. Of course, these are not random or proportional reductions but fall more on some occupations than others. Work rules, worker management councils, and other impediments to change make it difficult if not impossible for German firms to turn many of the potential efficiency gains into actual efficiency gains. And if managements cannot achieve the financial savings from layoffs or worker reassignments, why bother to introduce the new technology at all?

If Germany and other European economies are to take advantage of the new communication and control technology, labor markets must change. If employment does not become more flexible, the adoption of the new technology will be impeded. If that happens, real incomes will grow more slowly or the growth of employment will be depressed.

There are of course other reasons for the slower growth of productivity in Germany. German management has not experienced the increase in incentives achieved in the United States by the interaction of lower marginal tax rates and increased emphasis on management "pay for performance" through greater reliance on bonuses, stock options, and other forms of incentive compensation.

Education in Germany has fallen from its earlier status as a model for other nations to a very poor level. Recent OECD studies put both the secondary and university education systems of Germany in the bottom half of OECD countries. Substantially fewer students in each age cohort go on to complete a university degree in Germany than elsewhere. The quality of the education is generally regarded as inferior to that available elsewhere in Europe and in the United States. Although I am not well enough informed about education in Germany to be confident about my views about the reasons for this poor performance, I am struck by two features: the universal free education and the "democratization" of the university governance.

Free education in Germany for all who attend universities, rather than scholarships for those in need and fees from those who can afford to pay, restricts the total funds available to the universities. One effect may be the lower enrollments per person of university age in Germany than in the United States, Britain, the Netherlands and elsewhere. Another effect may be to substitute zero tuitions for higher quality education.

The governance of universities in the United States puts all educational decisions in the hands of the faculty and the professional administration. In Germany, university administration shares with businesses the system of codetermination that makes it hard to achieve changes and that therefore causes many potentially useful changes not to be considered at all.

Improving human capital through increased higher education in the sciences, engineering, and business administration can contribute to the future growth of the German economy. But with the government budget already stretched by the various social welfare spending and by a commitment to free higher education, it is not clear that such improvements and increases in university education can take place in Germany. The prerequisite to educational progress may be changes in university finance and governance and possibly even a more general shift in the priorities of the government budget.

3. Long-term Problems of Demographic Change

Horst Siebert has devoted a substantial amount of his attention and of the activities of the Kiel Institute to the problems of the ageing population in Germany and in the world. This attention is well deserved. The average age of the German population will rise sharply during the coming years, causing a sharp increase in the ratio of retirees to the working population. Unless there are fundamental reforms, the ageing of the population will bring with it a very substantial rise in the government outlays for Social Security pensions and for the health care.

The projected rise in the costs of pensions and health care will push up the already high tax rates, imposing large deadweight losses on individuals and an overall drag on the economy. The high tax rates mean less entrepreneurship, less individual effort and risk taking, less investment in human capital. The consequence would be a small future level of GDP and therefore a lower standard of living.

The increase in the deadweight loss implies a decrease of real income in a way that may not be visible in the national income accounts. The higher marginal tax rate causes individuals to change the form of compensation to fringe benefits and other expenditures that are worth less than cash to individuals but more than the net-of-tax cash that is the alterative to the fringe benefit. In addition, the deadweight loss may also take the form of reductions in pretax incomes caused by reductions in hours, effort, human capital etc..

A rise in the marginal tax rate implies an increase in deadweight loss of the existing tax system that is proportional to the rise in the square of the marginal tax rate. The combination of income, payroll and VAT taxes now produces typical marginal tax rates that exceed 50 percent. Increasing the marginal tax rate from 50 percent to 60 percent would increase the deadweight loss of the tax system by more than 40 percent.

At the current tax rate levels in Germany, an increase in the tax rate may also have a limited ability to actually raise tax revenue because of the adverse effect of a higher tax rate on taxable income. My own research based on the 1986 changes in the US income tax suggest that increasing a proportional tax rate from 50 percent to 60 percent would reduce the tax base by about 13 percent, implying that the revenue would not rise by 20 percent (the proportional difference between the 50 percent and 60 percent tax rates) but only by about 4 percent.

Even if the response of taxable income to a reduction in the net-of-tax-share were only half of what the previous experience suggests, a 20 percent increase in a proportional tax rate from 50 percent to 60 percent would only raise revenue by about 12 percent. With a graduated tax rate structure, the net revenue increase could be even less.

It might therefore be literally impossible to raise the tax revenue needed to fund the increased costs of the ageing population with the current structure of benefits and taxes. The future benefits would have to be reduced to fit the available revenue. The German government has already announced that there is not the political will to continue to provide the benefits written in current law. The law has therefore been revised to provide for the gradual introduction of very small reductions in future benefits .

Because of the extremely high ratio of today's benefits to preretirement wages, further cuts might well be made. Indeed, such larger cuts were originally proposed by the current Social Democratic government. For comparison, the ratio of Social Security retirement benefits to peak preretirement wages in the United States is about 40 percent for someone with average lifetime earnings and less for those with higher earnings. Although additional benefits are payable for spouses who have not had sufficient earnings during their working lives, the role of these dependent benefits will become decreasingly important in the future as women assume a more equal place in the U.S. workforce. These Social Security benefits are subject to the regular income tax to the extent that the household's income exceeds a nominal threshold; as prices and nominal incomes rise, an increasing proportion of benefits will be taxed in the future.

Germany is of course not the only country facing the problems caused by an ageing population. Such ageing is happening throughout the industrial world and many other governments have taken steps to reduce the future tax burdens while maintaining future benefits. The key to this change is a shift from the pure pay-as-you-go system to one that incorporates an investment-based component. Among the OECD countries, Australia, Britain, Mexico, Sweden, and the Netherlands have moved in this direction. Germany has taken a small step in that direction in its recent reforms by providing an incentive for individuals to accumulate funds in individual retirement accounts. Although the magnitude of this incentive is small, the combination of explicit reductions in future benefits and the provision of fiscal incentives to raise private accumulation represents a start of a process that can reduce the future tax rates that would otherwise be needed.

4. Conclusion

As Europe's largest economy, Germany has a special role to play in the future of Europe and of the global economy. In the quarter century after World War II, Germany showed how a combination of good economic policies could lead to low inflation, strong growth, and low unemployment. Since then, the growth of government spending and the accompanying rise in taxes, the increase in economic regulation, the weakening of the educational system, and the hardening of labor market rigidities have conspired to weaken Germany's economic performance. The traditional strength of Germany as a manufacturing superpower has not continued and has not been transferred to the new economy in which services and knowledge based products have become increasingly important.

Horst Siebert has been an eloquent voice calling attention to these problems and proposing policies to correct them. If his words are heeded, Germany will be a better place in the decades ahead.

Cambridge, Mass.
January 2002

1. Martin Feldstein is the George F. Baker Professor of Economics at Harvard Univesity and President of the National Bureau of Economic Research. This essay was prepared for a volume honoring Professor Horst Siebert on the occasion of his 60th birthday.