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Since the housing and mortgage expansion reached its unsustainable zenith nearly five years ago, economic headwinds and financial contraction have been at the forefront of financial market discussions. Two years ago, the sovereign debt problems of the developed world further added demand-side challenges (See Lacy Hunt Interview: Roadblocks to Recovery).  Over that time economic policy has concentrated on resurrecting demand via government debt-financed spending or monetary expansion.  It is safe to say that we have now learned that the Keynesian tools that served well in a less debt-challenged environment no longer solves the macroeconomic problem.  If it did, we would not be facing the question of yet another QE.

Moreover, we do not have an answer to the larger question of the sustainability of the Western social model of a government-funded retirement with medical care.

In the following guest blog, Dr. Wilfried Prewo points out that a decade ago, Germany was faced with a similar problem of sustaining the economy and delivering on the government’s social commitments.  As a result, she devised supply-side policies that have been very effective in meeting both goals. Today, Germany has the lowest unit labor cost despite also having the highest wages in Europe. As a result, she runs a trade surplus, has relatively low unemployment and a near balanced fiscal budget.  The U.S. has a lot to learn from these innovative supply-side policies.

Germany: Export Powerhouse Despite High Wages
by Dr. Wildfried Prewo

Just ten years ago, Germany was labelled the “sick man of Europe”. Following its remarkable post-WW II recovery, Germany became complacent in the three decades from 1970 to 2000. Its labor cost rose to the highest in the world, benefits became more and more generous, and the work-week was shortened to as low as 35 hours. Productivity growth slowed down, wage increases did not. Germany’s competitiveness as measured by unit labour cost (labour cost adjusted by productivity) slumped and threatened Germany’s export success despite otherwise superior engineering and product quality.

Over these three decades, Germany’s social model became less and less sustainable. With every recession during that period, unemployment ratcheted up and, in the following upswing, did not recede to the pre-recession level. With higher unemployment, payroll taxes had to be raised, thus exacerbating the labor cost situation and spinning a vicious cycle of higher unemployment and yet higher payroll taxes. In 2003, when Germany shrank by 0.2 percent, unemployment was 10.5 percent. But in 2005, with positive growth of 0.8, unemployment still stood at 11.7 percent. Then things changed.

By the time of the Lehman Brothers collapse, in September 2008, German unemployment had been brought down to 7.3 percent. Even more remarkable is the fact that, a year later, in 2009, when Germany’s GDP shrank by 4.7 percent in recession following the financial crisis, unemployment had hardly increased (7.9 percent in September 2009). Another September later, in 2010, when German GDP grew by 3.6 percent, unemployment was at 7.2 percent. Now, in February 2012, unemployment is at a seasonal 7.4 percent. If we were not overwhelmed by the debt crisis in Europe’s olive belt, prospects would be bright.

The improvement – or better, structural change – in Germany’s labor market was not achieved by axing wages and benefits. In 1997, German hourly compensation costs (wages plus benefits) in manufacturing were 29 percent higher than in the U.S., making Germany the world’s labor cost leader at that time. In 2009, Germany’s wages still were among the highest in the world, with only four small countries (Norway, Denmark, Belgium, Austria) having higher wages. But from 1997 to 2010, German labor cost had an annual average increase of 1.9 percent only, as compared with 3.2 percent in the U.S. Over the last decade, wages in Germany did not fully compensate for inflation. On top of that, German labor productivity did increase and restrained German unit labor cost to an increase of just 6% from 2000 to 2011. Contrast that with percentage increases of 19.9 in the U.S., 24.1 in the 27 EU countries overall, 32.5 in Italy, a major German competitor in machines and autos, or even 31.2 in Greece. (As an aside: This shows that the profligacy of countries like Greece and Italy was the cause of their debt crisis, and it shows what has to be corrected.)

The German labor cost mitigation was primarily not the work of government, but a joint and self-organized effort of companies and their employees. It was a sea change in labor relations as it replaced rigid work conditions and one-size-fits-all union wages by a myriad of flexible plans.

The change in labor relations began around 2003 and in small and medium sized companies with a lower degree of union influence. At that time, many of these companies, still reeling from the previous 2001/02 recession with its onerous cost of severance packages, were not profitable and strapped for money to invest in new equipment and material in a feeble recovery. The employees realized the dire situation and, in trying to preserve their own jobs, made significant concessions: Work rules were made more flexible, weekly hours were increased to 40 and beyond without extra pay; annual, in some cases even life-time work time budgets replaced rigid weekly hours; this allowed companies the flexibility to adjust weekly work hours to demand, say, anywhere from 25 to 45 hours as long as they stayed within the longer-term, annual time budget. Overtime compensation was scrapped. Even the regular wage for extra hours was not paid out in cash, but deposited in individual deferred compensation accounts which were to serve as rainy day funds.

By the beginning of the 2008 recession, these accounts were bloated and could then be depleted as companies sharply reduced their work hours during the recession. This preserved income levels, and German private consumption remained a robust pillar throughout the downturn. (As an automatic stabilizer, the German law compensating for “Kurzarbeit” had the same effect; under this government program, the wage reduction due to a recession-induced shorter work week is compensated by unemployment insurance at the unemployment benefit level, allowing a worker an effective take-home pay of around 90 percent of his previous wage, even if he is idled for a third of the week.)

In return, German companies guaranteed not to reduce their labor force except under exceptional circumstances, and they kept that promise. Companies also promised investment in German production facilities in order to allay labor fears that offshoring and outsourcing, a must-do in any globalized industry, would come at the cost of German employment.

German labor unions at first fought this bottom-up development as it reduced their influence and, of course, poked holes into their rigid and top-down, one-size-fits-all union contracts. But eventually, reason prevailed and the unions condoned these agreements by their rank and file members in the companies. Flexible union contracts that offer cafeteria-style provisions for individual companies’ circumstances are now standard.

With nominal unit labor cost remaining nearly flat over the last decade, German companies benefited from the strong decline in real unit labor cost. As a result, the profits of German companies, as a share of GDP, jumped from 14.8 percent in 2000 to 20.9 percent in 2008. German companies could invest and deleverage at the same time. When the 2008 recession hit them, they were in a financially robust state. By September 2011, they had more than erased the damage their balance sheets suffered during the recession.

On the cost side, these changes in labor relations were the major reason for Germany’s V-shaped recovery from the recession. On the demand side, the recovery was fuelled, as early as in the spring of 2009, by strong export orders from China and other Asian countries that were not inflicted by the financial crisis. The German export mix of cars, machinery, chemicals, and other investment goods with a high engineering content and requiring a skilled labor force is exactly what is demanded by strongly growing emerging markets. While in 2000 only 1.6 percent of German exports went to China, that share had risen to 5.6 percent by 2010. For the major emerging markets, the BRIC countries together (Brazil, Russia, India, China), the increase was from a share of 3.9 to 10.4 percent. Germany is now exporting more to the BRICs than to the U.S., whose share of German exports declined from 10.3 to 6.8 percent in the decade. (In absolute numbers, German exports to the U.S. are not lower now than in 2000.) Another symbol for the rising importance of emerging markets is that, since 2010, Mercedes has been selling considerably more of its top-of-the-line cars, the S class, in China than in the United States.

Manufactured goods with cutting-edge technologies require good engineers and a highly skilled labor force. Many Western countries, including the U.S., have the first, a pool of good engineers, but what the U.S., France, the U.K., or Italy as major German competitors lack is a broad highly skilled labor force. Too often, the manufacturing workforces in American or British companies consist of workers who have been trained for brief periods and only for the specific skills at their work stations. In Germany, the typical worker has undergone a three-year vocational training program after leaving school. As a consequence, Germany has few unskilled workers, and the systematic training at the beginning of the career is a base for further training later on as will inevitably be required by technical change. Germany is not the only country offering such a system; Austria, Switzerland, or Denmark have similar systems. All of these are countries which are successful in exporting and which also pay high wages. Comparing wages among industrial countries is a comparison between apples and oranges if skill differences are not taken into account.

In foreign production facilities where nationwide training systems do not exist, German companies often engage in considerable in-house training efforts in order to be able to achieve the same product quality as in Germany. Although these isolated, single-company training efforts are less efficient than a nationwide system, they are a second-best solution and work. One example: Who would guess the name of the largest exporter of American made cars to outside the NAFTA region? It is a German company – BMW. I am convinced that American machinery or chemicals manufacturers could emulate the German export success if there were a similar training system.

Society also benefits from systematic youth training: In January 2012, unemployment among young people (age 15-24) stood at 16.0 percent in the U.S., 22.4 in the EU as a whole, 23.3 in France, 31.1 in Italy, and a staggering 49.9 in Spain. In Germany, the rate is only 7.8, and the situation is comparable for Austria or Switzerland. In the other countries, youth unemployment is roughly double the overall unemployment rate and a cause for social problems.

When contemplating economic policies for the United States, it might be worthwhile to consider systematic youth training. It will take more time than an election cycle to show its effect and it is not a quick fix, but quick fixes rarely lead to a sustainable resolution.

March 22, 2012

Wilfried Prewo is chief executive of the Hannover Chamber of Industry and Commerce in Hannover, Germany. He holds a Ph.D. in economics from Johns Hopkins University and has taught economics, early in his career, at the University of Texas at Austin.

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