Germany: Biting the Bullet?

So it seems reality-check time is approaching. All the major commentators agree that this time Germany is going to have to bite the bullet. The only remaining question is which one? According to a widely held theory the reason the German economy is in such bad shapeis because is has failed to implement a series of universally recommended structural reforms. High on the list of these proposed reforms are changes in the system of unemployment and pension benefits, and changes in employment law to enable greater contractual flexibility. This is the mantra that seems to serve for each and every occassion:

A day after Chancellor Gerhard Schröder suffered a humiliating rebuke in state elections, politicians and economists here said today that the defeat might liberate his government, at long last, to undertake a wholesale reform of Germany's hidebound economy. With little left to lose politically, several analysts predicted, Mr. Schröder may revive the reformist agenda that guided his first two years in power but fell by the wayside as he fought for re-election last fall.

The first order of business is likely to be a rollback of the taxes that Mr. Schröder imposed last fall. He said they were necessary to close a hole in the budget. Mr. Schröder stays in power because a majority in the lower house of Parliament supports him, but now the conservatives hold an even larger majority in the upper house, thanks to Sunday's victories, and have threatened to block him. The chancellor now acknowledges that he must retool his proposals. Some of the taxes, he said, were not "closely enough assessed for the economic consequences." Any effort to reform the economy, experts say, must begin with Germany's labor laws and its welfare system. Ms. Dückert said the government would seek to lower the burden of social security on taxpayers. The labor market, she said, must be made more flexible.The government would achieve those goals by cutting the benefits that allow some Germans to be comfortably unemployed for years, and stripping away the job security of those who do work.
Source: New York Times
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Now important and inevitable as some of these changes are, it is worth first of all trying to understand why they may be important, and why it is that they are now seen as being so urgent. I would like to identify three factors which seem to be of some importance. Firstly the question of the current asset value of the accumulated experience of the German labour force. Secondly the problematic nature of the German welfare and pensions system at a time of rapid aging, and thirdly the problem of achieving optimum output and growth in the context of a currency union (ie the Euro).

Starting with the labour force: one of the factors which has received little comment, but which is clearly of great importance, is the role of accumulated experience during times of rapid change. During the late ninetees it became fashionable to wax lyrical about the enormous significance of the 'creative destruction' phenomenon (since the NASDAQ crash, strangely enough, we've heard relatively little about this, even though the gale seems to have been blowing through wall street more strongly than ever). One of the aspects of this Schumpeterian process which attracted relatively less attention was the effect of the creative destruction process on accumulated human capital. This takes on increasing importance in a services and knowledge-based-industry biased economy like that of the US, Germany, the UK etc. The shift to high value activity has meant that the proportion of the firm's value contained in its workforce has become more and more important, as has the devaluation of that workforce under the impact of technical change. Commenting on the continuing high levels of productivity increase achieved in the US during what he terms the 'jobless recovery', Brad Delong asks the following key question:

Rapid American productivity growth has continued through the recession. What conclusions should we draw from this? This question has two possible answers. The first answer is that changes in America's labor market have eliminated the old pattern by which firms tried to hold onto productive and experienced workers through the trough of the business cycle, because they knew they would be wanted soon and would be very expensive to replace. Such "labor hoarding" meant that measured productivity dropped in American recessions. Perhaps this institutional factor has now been erased from the American economy. However, if it has not been erased--if "labor hoarding" still exists--that means that the underlying productivity growth trend of the American economy has continued to accelerate, and that the future of American growth for the next ten years is very bright indeed.
Source: Semi-Daily Journal
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Now what if......? What if the value of those workers which were previously 'hoarded' has now, suddenly, diminished. It is clear that in times of slow change learned behaviour has, in Darwinian terms, a 'fitness' premium: hence the importance we attach to grandparents, older workers, or collective "wisdom". But in times of rapid and accelerating change - like the present - the premium for learned behaviour drops, and the advantage goes to rapid reactions on the fly. It is this delicate process of value transformation, now proceeding more quickly, now more slowly, that underlies the devaluation of the existing workforce. The impact of this is especially important in countries like Germany and Japan where economic success was based on the accumulated experience of an entire workforce. It is the dramatical devaluation of the worth of that experience which is one of the factors which helps to explain the recent years of slow growth in Germany.

Secondly the German population is rapidly getting older. In fact, if you discount immigration, and children born to parents of non-naturalised immigrants, Geramn mortality is now higher than fertility. Put in plain English more people die every year than are born: the population is shrinking. Of course, the effect of immigration is to mask this reality, as when you add-in the net annual migrant inflow the population appears to be more-or-less stable. This aging process has two important effects in the current context. Firstly if we were to attempt to derive a function to indicate the capacity of a society to change (its flexibility to use the contemporary argot), then surely age would be one of the key parameters to look at. Bluntly put: as we get older the more we have invested in what we have already learnt, and the less we have to get from new learning. Our capacity to learn, as I've unfortunately been discovering myself, also tends to decline with age (although Brad Delong and I are among those who seem determined to try and resist the ravages of time). And what is true for the individual is true for the firm, and is true for the country. In addition the unfortunate system of PAYGO pensions, which is a legacy of an earlier demographic profile, has left the majority of European states, Germany among them, lamentably short of acquired resources to fund future anticipated liabilites (this phenomenon could in fact be worse than even the most pessimistic actuarial provisions estimate since many demographers argue that the calculations are based on a serious underestimation of the way life expectancy is likely to increase over the next fifty years). This then is the fiscal trap that lies behind the growth and stability pact (a pact which was in fact written at the specific insistence of Germany), a trap which means that the German government is now attempting to raise taxes and reduce spending whilst glaring recession in the face (what is that expression: tough love in a time of cholera?).

The third and most obvious problem is that Germany is trying to confront this highly complex situation with BOTH hands tied behind it's back (the hands in question here being those that can reach for the levers of monetary and fiscal policy). Now this may be a situation which is just fine for a would be Harry Houdini, but for most of us normal folks it is more than likely pretty scary. As an after dinner piece these days I tend to compare our present situation here in the Euro countries with one of those Hollywood Airplane movies, where you go into the cockpit only to find the flight crew have all left (and instead of Harrison Ford we only get to have Romano Prodi and Wim Duisenberg). As I have already indicated the fiscal position is not too brilliant in any event, but on the monetary front, if Germany had control of its own economic policy, it could clearly do far more.

Summing-up then, I'm not convinced that the much demanded reform process will be either as well-received or as effective as many seem to believe. Change, as I said at the start, is both necessary and inevitable, but it would be better to set out on this process with a more developed appreciation of the magnitude of the impending tragedy, and of the reality that without a change in population policy, there is little hope of a successful outcome.