The Role Of The German Economy In Europe And The World

This essay was written on November 16, 1998, at the end of the Kohl era in Germany and what proved to be some eight years of socialist party government, years in which the eurozone economy has staggered along at around 1% growth rates. In retrospect, then, many of the predictions made in the essay materialized in the event.

The Role of the German Economy in europe and the World

The likely impact of the new Schroeder government’s economic policy on the German and European competitive position

The end of the Kohl era and the ushering in of a new governing coalition in Germany on the eve of the start of the single currency in Europe provides a vantage point from which to reflect on the evolution of the German and European competitive position over recent decades and the outlook for the next few.

Many will agree that throughout most of the 1980s and 1990s Helmut Kohl displayed statesmanlike qualities in successfully managing for Germany primarily, and for Europe in the framework of the Atlantic Alliance, several major coincident and mutually influencing currents in economics and politics. The major currents included: the Western economic expansion in the 1980s; technological innovation, especially in the information technology and telecommunications sectors, leading to significant developments in national and international financial systems and global trade and investment; the end of the Cold War; German unification; European integration through the Maastricht process; the maintenance of the Welfare State in Europe.

Since last century and especially since the 1930s, Western countries have combined the industrial market economy and the Welfare State. Germany emerged from the post-WWII settlement as Europe’s industrial powerhouse and it challenged the United States for pre-eminence in several sectors and many markets as productivity improved at a greater pace and the D-mark appreciated in real terms. Meanwhile welfare spending, government budget deficits, and inflation began rising in the mid-to-late 1960s, though the Germans appeared to be more adept at managing their finances and economy than most of their European partners and the US. In any case, these were some of the major factors which led to the breakdown of the fixed exchange rate system under the Bretton Woods agreements. Then, in retrospect, the post-WWII boom period can be said to have come to a definitive end in the wake of the two oil shocks in the 1970s, a decade marked by stagflation, decolonization, and the Soviets’ gaining the upper hand in the Cold War. A new economic and political formula on a global scale was needed as Western countries faced the prospect of getting their stagnating economies moving again, financing welfare-induced deficits and debts spread over aging populations, and regaining the geo-strategic momentum. The answer, led by the United States and Great Britain, was supply-side economics, privatization, financial deregulation, free trade, the wide-spread application of new information systems and telecommunications technologies to finance, industry and commerce on a global scale, preparation for new markets in East Asia, Latin America and, later, central Europe, and, finally, the arms build-up. All these factors played a major role in exposing the inefficiencies of the Soviet system, leading to its unexpectedly premature collapse.

Germany thrived economically, along with its Western partners and Japan, though its success was less due to the application of neo-classical policies than to its universal banking system, the harmonious relationship between business and labor, on the one hand, and the education system and the job market, on the other, a more long-term approach emphasizing asset accumulation and market share, and careful monetary management. The high quality of German products overcame the high cost of labor and the inefficiencies of the country’s welfare and financial systems, certainly, at least, to a greater extent than was the case with Germany’s main European partners/competitors such as France and Italy. Indeed, the quest for greater financial, labor, and goods market efficiency to stimulate the European economies and better finance their Welfare States was one of the major driving factors on the path towards European integration in addition to the need for a more compact security arrangement. And indeed, again, in the geo-political sphere, Germany’s support was crucial to the peaceful and favorable outcome of the Cold War, and Chancellor Kohl’s efforts bore fruit as the two Germanys were united and the Maastricht Treaty was signed.

However, by 1992, the post-Cold War world of emerging markets, global capitalism, and the high costs of German unification exposed some of the weaknesses of the European competitive position. The Bundesbank maintained a tight monetary policy despite slow growth and/or recession, in order to stave off inflation and help pay for the costs of integrating the eastern Länder. The most vulnerable countries were those featuring high welfare-induced budget deficits and unsustainable debt, bloated bureaucracies, overly burdensome tax systems stifling innovative investment, rigid labor markets dominated by powerful unions with a significant influence on fiscal policy, and inefficient financial systems. The first victim was Italy which, along with Great Britain, was forced to leave the EMS in September 1992. In the summer of 1993, the EMS nearly collapsed under the pressure of high German interest rates. And in 1994 and early 1995, the Mexican crisis, the persistent budget problems in Canada, and the trade deficit in the US cast doubt over the stability of the North American financial system. In late winter/early spring 1995, the US dollar, Italian lira and Swedish crown, among others, reached all-time lows against the D-mark. The Bundesbank’s severe monetary policy management inspired investors’ confidence when they compared the alternatives and short-term capital seeking a safe haven, as well as reserves, poured into the D-mark (and into the Swiss franc and the Japanese yen). However, between March and August 1995, a series of coordinated policy measures and, from September, somewhat more responsible fiscal policies on the part of the several nation-States, helped to stabilize the international currency markets, halt, and later reverse, the rise of the D-mark, and get the European countries back on the integration track as envisioned by the Maastricht Treaty.

However, during this period, the D-mark’s brilliant performance on European and international currency markets obscured certain ongoing developments acting against the competitive position of Germany in particular and Europe as a whole. First, notwithstanding the Mexican crisis and the trade deficit, a new political balance in Washington set the United States down the path to serious welfare and budget reform. This was accompanied by a long period of economic expansion featuring a high level of investment in innovative technologies yielding good returns, high levels and high proportions of foreign direct investment into the United States and US FDI abroad, low unemployment and inflation rates, and now even a small budget surplus. Meanwhile, the newly industrialized countries and emerging markets of East Asia were experiencing almost double-digit annual growth rates. And though the current crisis has revealed that much of the investment there, funneled through shoddy banking systems, was overly speculative, real gains have been made and the basis for another round of dynamic growth, though probably at a lesser pace than in the boom years of the 1990s, is still intact. Analogous observations could be made concerning South America, though to a somewhat lesser extent.

These developments stand in contrast to the manner in which the integration process in Europe has been completed. For example, it is true that the 3% government budget deficit target has, by and large, been met, but this has been achieved with the benefit of accounting tricks in almost all the countries participating in the euro, though flagrant cases stand out, such as Italy. Meanwhile real welfare and labor market reforms, where at all, have been timid. For Germany, and other European countries, this has translated into high unemployment rates and slow export-led growth; the bulk of productive investment is directed to high-technology and export-oriented industries, reducing the need for unskilled industrial labor. And in those industries where a relatively high proportion of unskilled labor is still required, there have been sizable outflows of foreign direct investment from the West, led by Germany, to central Europe, and to East Asia and South American as well. The greatest benefit, then, of monetary integration to Germany and to Europe is a more efficient, continent-wide financial system, a financial system now integrated into the global economy; large-company exports and investment in emerging markets abroad will generate the bulk of the earnings growth necessary to finance the continuation of the Welfare State as European populations age.

Against this backdrop, the Asian crisis has had an ambiguous effect on the German and European economy. On the one hand, the cessation of high growth rates in East Asia and the exploitation of the soft spots of its financial systems mean that Europe must face a weakened, though still potentially formidable, competitor on the global market. The immediate benefits were seen in the run-up to the single currency as capital flowing into all European currencies totally eliminated any latent risks of last minute speculation against its realization. In the short/medium-term, it also means less pressure to reform Europe’s welfare systems and labor markets. On the other hand, the Asian crisis has meant a noticeable slowdown in Europe’s export-led growth. In addition, the Russian crisis has been a significant blow to Germany whose banking and industrial systems are more exposed than those of any other country. The overall effect has been the emergence of a risk of world-wide recession in 1999.

In this situation, the main priority in the economic program of the new Schroeder government is to provide a boost to consumer purchasing power as part of a Keynesian-style demand stimulus policy. Other countries such as Italy have attempted, or are attempting, a similar approach. In Germany, the impact of the proposals on the redistribution of income in favor of low/medium-income groups, with a high propensity to consume, is rather significant, as personal income taxes will be reduced and welfare payments to families will be increased. Business tax rates will also be reduced, but the tax base will be widened as the scope of allowable deductions and exemptions will be diminished. Nonetheless, according to the Schroeder government’s projections, both businesses and workers are expected to benefit from the tax rate reductions; the burden of welfare taxes in Germany is equally distributed between companies and employees. Meanwhile, the government proposes to finance the reduction in welfare taxes through a rise in taxation on energy products. Some studies simulating the effects of a 3% reduction in welfare taxes in Germany financed by an increase in indirect taxes suggest a 1% rise in consumer spending, boosting employment by 0.8% and GDP growth by 0.6%.

In addition, the new government will eliminate the modest labor market and pension system reforms introduced in the latter years of the Kohl government (reduction in sick pay, pension cuts, greater employment flexibility for small businesses, etc.). This intention confirms that supply-side policies do not seem to play a fundamental role in the new government’s framework. Such a step, in addition to the new tax measures, has strongly upset business which now appears rather skeptical about the main pillar of the new government’s jobs promotion policy, namely the Alliance for Jobs. The prospects for the tripartite negotiations between government, business, and labor for the moment seem obscure and the evident perception by the business community of a new government hostile to its demands is not a good starting point.

In conclusion, Europe is still one of the wealthiest and highest income-producing-potential regions in the world, and Germany is the leading economy in Europe. The real issue is what level of average growth Europe will be able to achieve over the coming years and decades, how it will be achieved, how it will be distributed, and how it will continue to finance the maintenance of the Welfare State. One answer has been export-led growth and income generated from foreign direct investment, especially, in the case of Germany, in low-labor-cost central European countries and Russia, in the context of the global economic system. Other European countries with somewhat different trade and investment patterns, such as Spain, Portugal, Great Britain and Sweden, may provide for some diversification (though the latter two are not, as of yet, participating in the single currency).

But there are risks to this strategy. The global economy and financial system are still prone to crises and income flows are far from being smoothed out. Furthermore, Germany, the largest European economy, has the greatest exposure to central Europe and Russia. The former may prove to be a slow-growth area, caught in the middle, as it is, between already slow-growth Europe and Russia itself where efforts to transform the country into a functioning and prosperous free market democracy may fail.

Internally, reform of Europe’s indebted welfare systems and rigid labor markets has been very gradual where any real progress has been made at all. Current governments, led by Schroeder’s Germany, are implementing policies designed to stimulate consumer demand through income redistribution in an effort to stave off a potential recession (in addition to other domestic political considerations). This strategy may work as a short-term expedient, but the risk is that Europe will remain a slow-growth region of the world, its rate of investment and productivity growth will lag behind that of the United States and possibly a revived Japan and East Asia in a few years, the population will continue to age, small and medium-sized business enterprises will be crowded out, and the investments in central Europe and Russia will not provide an adequate return. Such a scenario would mean a stagnant Europe, economically, politically, socially and culturally, and a people dependent on the fortunes and whims of big government and big business in the face of a fiercely competitive global environment.