July 2013 newsletter – Letter from Germany

From ‘Sick Man of Europe’ to ‘Reluctant Hegemon’: Germany 1993-2013

In what is sadly his last Letter from Germany Ray Rees1 reports on the dramatic transformation of its economy following unification. For many years Ray has provided the Newsletter with many fascinating insights into living and working in Germany, as well as other entertaining articles, and readers will want to use this occasion to say a heartfelt ‘thank you’ and to wish Ray a long and enjoyable retirement.

In 1993, when I first moved to Munich, Germany was moving into a period of a decade or so characterised by critics both inside and outside the country as one of economic stagnation and malaise. The hackneyed term ‘sick man of Europe’ was often applied. Now, just as I am moving back from Germany to Wales, I read an article in the Economist2 criticising Germany’s leaders for refusing to accept its responsibilities as the dominant European economic power, to become its ‘hegemon’, the shaper of Europe’s future and the guardian of its stability. That is quite a long way to travel in two decades. How did Germany do it?

Part of the answer is that the state of the German economy then was not so dire, and its state now not so unproblematic, as the contrast suggests. When we deflate for the inevitable exaggerations of the critics, the distance between the two end-points is not so great. A constant factor throughout has been the strength of Germany’s core manufacturing sector, with its leading-edge technology, well-trained labour force and ability to generate huge export surpluses. Then, as now, Germany had the lowest youth unemployment rate in Europe, thanks to its excellent apprenticeship system. The rest of the answer is that one of the two problems that dominated this decade of malaise up to the mid-2000’s, secular growth of long-term unemployment and relatively slow growth of per capita output, appears to have been solved. The other, the depressed state of East Germany that was the outcome of the botched unification of the East and West German economies, remains unsolved but seems not to matter so much anymore. But other problems remain that will fully engage German policy makers for some time to come and make it very unlikely that they will want to adopt the role of Masters of Europe. If indeed any one country alone can play that role, which I very much doubt.

Throughout the 1980’s and ‘90’s, up until 2004, Germany had an amazingly generous unemployment benefit system. On becoming unemployed, workers received 67 per cent of previous net earnings if they had children and 60 per cent if not, for a period of 32 months. They were free to turn down job offers that they felt were not commensurate with their qualifications and experience. After that period, if still unemployed, they received respectively 57 per cent or 53 per cent of previous net earnings until they reached retirement age. In addition to this high earnings replacement rate, there was a standard poverty trap, with liability to pay health and social security contributions being incurred and welfare benefits lost on taking a job. Finally, it was often advantageous to take early retirement and so the de facto average retirement age was 59. It is then hardly surprising that throughout the 1980’s and ‘90’s, each successive unemployment cycle had a higher peak and a higher trough than the one before. Over the same period, German labour costs were rising rapidly relative to those of its competitors. Extrapolation of these trends naturally presented a picture of economic disaster, even if the current picture was one of relative stagnation at a high level of prosperity.

In 1993, the euphoria surrounding the fall of the Berlin Wall and the beginning of the reunification process had given way to the sobering realisation that the economics of this process had been dreadfully mismanaged. The economic naivety of leading politicians and administrators and the cynical pursuit of self interest by West German employer associations and trades unions in ‘negotiating’ uncompetitively high wage rates for East German workers had wiped out large swathes of the East German economy. High and growing unemployment was the result. Because of the application of West German standards of unemployment benefit and social welfare payments, many people in East Germany enjoyed higher living standards than they had had as workers in the socialist DDR. But the consequence was a sharp increase in the German budget deficit and a continuing redistributive burden that severely impacted the budget deficits and growth rate of the newly united Germany.

At the root of much of the intensity of the critical comment in the decade from the mid-90’s was the sense that Germany’s rulers, whether the conservative government of Helmut Kohl in the period up to 1998 or the social democrat/Greens government of Gerhard Schroeder that succeeded it, were unable or unwilling to understand the problems and to do anything about them. Kohl, apparently undaunted by the failure of his vision of a flourishing East German economy within 3-5 years after 1989 to materialise, was heavily involved in the negotiations setting up the Euro currency area. An interesting insight into Kohl’s attitude to this has just emerged.3 He admits that he had had to act ‘like a dictator’ in forcing Germany’s entry into the Euro area on the German electorate, who, he was sure, would have overwhelmingly rejected the proposal if a referendum had been held. He felt that politicians had to be above the ‘ebbs and flows of opinion’ as manifested in elections, and saw himself as safeguarding the future Europe from the wars that had devastated its past. Be that as it may, he was voted out in the following election.

The coalition of Social Democrats and Greens that replaced him brought with it some sense of the possibility of change, but not in the area that most concerned critical economists, the failing labour market and social security system. The new Kanzler (Prime Minister) Schroeder was reluctant to confront the left wing of his party and its supporters in the trades unions, who fiercely opposed what they called the ‘neo-liberal’ proposals for reform. Perhaps it was the near loss of the election in 2002 to the Bavarian conservative Edmund Stoiber, together with the ever-worsening economic prospects, that finally convinced Schroeder to take up the cause of reform. In March 2004 he announced his Agenda 2010, which, as the name suggests, was a list of reforms that were intended to restore the competitiveness of the German economy by the end of the decade. It included raising the official retirement age from 65 to 67 while also reducing pension benefits, cutting health insurance premiums, which are levied as a payroll tax, while also making some reductions in coverage, and exempting certain types of low paid jobs from social security contributions. The centrepiece however, and the main source of contention, was a drastic re-structuring of the unemployment benefit system. Following redundancy, unemployment benefit was to be paid for 12 months, not 32, and after that would be replaced by payments under the social welfare system, which were on a much lower scale. The Federal Labour Office was to become much less of an agency administering unemployment compensation and far more one with the function of getting people back to work. Schroeder spent the rest of his term of office fighting to get these reforms implemented.

Compared to the struggles Margaret Thatcher had with the British trades unions in the 1980’s, Schroeder’s battles were relatively tame. Nevertheless they cost him first the party leadership, then his position as Kanzler, when he lost the 2005 election to Angela Merkel, and finally his political career. Yet, as it has turned out, these reforms, much helped by a decade of restraint in wage settlements, have been a success. Germany’s unemployment rate fell steadily from over 11 per cent in 2005 to under 6 per cent in 2012, and its unit labour costs are now well below those of its competitors. The economy’s rapid rebound in 2009 from the recession following the 2007/8 financial crisis, which went further and faster than those of other countries, though helped by the wise policy of subsidising short-term working to avoid layoffs, must owe a lot to the increased flexibility of the labour market. As economists we probably underestimate the importance of circuses relative to bread. In 2006 the Football World Cup was held in Germany and, even though the German team did not reach the final, the success Germany had in staging the event and its improved sense of how it was perceived in the rest of the world led to a major lifting of the national mood. This has interacted with the improved economy to create a sense of confidence about the future reflected in, among other things, Angela Merkel’s high ratings in the public opinion polls.

Problems of course remain, and are well discussed in the Economist article I referred to earlier. Energy policy has to solve the problem of exploding electricity prices following the ambitious attempt to change the energy mix relatively rapidly from coal and nuclear generation to wind and solar power. An ageing population and declining labour force presents challenges to policies dealing with immigration, education, family support and female labour supply as the means of counteracting them. As far as the most pressing immediate problem is concerned, that of devising a mechanism to deal with the risk of sovereign default in Eurozone countries, I think the brief sketch of recent economic history I have given here makes the German attitude very easy to understand. Though insistence on economic competitiveness and sound public finances as a place to start may appear to lack vision, the alternative is far worse. Helmut Kohl had great visions of blossoming East German meadows and a single currency forever banishing conflict among the countries of Europe. I much prefer a leader who thinks like a boring economist. Think Angela Merkel.

To close on a personal note, now that I have exchanged the charms of one of Europe's great cities for the magic of the mountains of Snowdonia, I did not think I could reasonably go on writing these letters, much as I have enjoyed doing so. I am pleased to say that Michael Burda of the Humboldt University, Berlin, has agreed to take over from me, and I very much look forward to reading his letters in the future.


1. Ray Rees is Professor Emeritus at the University of Munich and an Associate Fellow in the Economics Department, University of Warwick.

2. ‘Europe’s reluctant hegemon’, Economist, June 15-21, 2013.

3. Report in the Telegraph, June 24 2013, concerning a previously unpublished interview he had given in 2002.

From issue no. 162, July 2013, pp.3-4.

Related resources