Say it Ain't So, Angela

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From 2011 to 2014 philippe legrain was an economic adviser to the president of the European Commission, José Manuel Barroso. His book, European Spring: Why Our Economies and Politics Are in a Mess — and How to Put Them Right, was named one of the Financial Times' best books in economics of 2014.

Illustrations by Peter Horvath

Published April 27, 2015

 

When Germany won soccer's World Cup last summer, the country rejoiced to the national anthem, Deutschland Über Alles. Most Germans are convinced that their economy is also a world beater – and it's hard to find much disagreement among the talking heads of economics and finance elsewhere. Finance Minister Wolfgang Schäuble regularly boasts that Germany is Europe's most successful economy, and German policymakers regularly school their European Union counterparts on the need to become more Germanic. As Chancellor Angela Merkel declared on her re-election 18 months ago, "What we have done, everyone else can do."

Not just can do, must do: Germany is using its clout in the European Union to try to reshape the eurozone in its own image. But far from being an archetype of success that merits imitation, a close look reveals that Germany's economy is dysfunctional in surprising ways – and that imposing its model on the rest of the eurozone is dangerous for the continent, not to mention the rest of the world.

The Economy Behind the Curtain

If you drive a Volkswagen or a BMW and own a house full of Bosch or Miele appliances, it is easy to leap to the conclusion that the German economy is a hot ticket. Yet appearances are deceptive. Germany does make terrific cars and dishwashers, but it nonetheless suffers from low productivity growth, broken banks, inadequate investment and tepid GDP growth – as well as a rapidly aging population that will become an increasing drag on growth. Merkel's mercantilist economic strategy, which turns on suppressing wages to subsidize exports, is beggaring Germans as well as their neighbors.

Worship of all economic things German has a patchier history than many people remember. Back at the euro's creation in 1999, the German economy, overtaxed, overregulated and still suffering indigestion from unification with East Germany, was widely viewed as the "sick man of Europe." GDP growth was sluggish and unemployment high. In the years before the global financial bubble burst, it plodded on, outshone by fizzier growth in the United States, Britain and southern Europe.

But after the crash, plodding was seen in a new light. With the West laid low by flashy, but ultimately fragile, financial engineering, a country renowned for its conservative financial management and solid industrial engineering looked like a winner.

While others had built houses of cards based on debt, Germany had prudently saved. While much of the West seemed ill-equipped for a new world of competition with China, German exports to the Middle Kingdom were booming. While unemployment soared elsewhere, Germany's jobless rate, below 9 percent in 2009, marched steadily downward. And in an age of fiscal incontinence, the government in Berlin has even balanced its budget. Indeed, as Europe's largest and most populous economy, its top exporter and its biggest creditor, Germany seems to hold all the cards.

Politicians and pundits of all stripes, from Bill Clinton to Nicolas Sarkozy, have queued up to praise this latest variant on the German Miracle. Moreover, Berlin boosters predict even brighter days ahead. In their 2012 bestseller, Fat Years: Why Germany Has a Brilliant Future, Bert Rürup, a former chairman of the German government's council of economic experts, and Dirk Heilmann, a journalist at Handelsblatt, the business newspaper, predicted that by 2030 Germany would become the world's richest large country. That would be no small achievement; today, Germany's GDP per person (measured in purchasing power terms) is a fifth less than that of the United States.

The almost-unchallenged German myth is that, thanks to regulation-shedding reforms of the labor market enacted a decade ago by Merkel's predecessor, Gerhard Schröder, the sick man morphed into an Olympic athlete. But while it is true that unemployment has plunged as millions of Germans found jobs (albeit, part-time "mini-jobs" in many cases) the rest of its economic record is unimpressive.

Germany, which has a lower GDP per person (adjusted for purchasing power) than more than a dozen other advanced economies ranging from Canada to Sweden to Australia, is hardly booming. Since the crisis struck in early 2008, it has grown by less than four percent, which is less awful than the rest of the eurozone, but half as much as the growth enjoyed by Sweden, Switzerland and the United States. Worse, since the euro's introduction in 1999, GDP growth has averaged only 1.2 percent a year, which places Germany 15th out of the 19 countries in the eurozone and well behind Britain (1.7 percent).

 
Germany's reliance on manufacturing is really a vulnerability, not a strength.
 

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The Bill Comes Due

The explanation for Germany's lackluster economic performance is that Berlin hasn't taken many of the painful steps needed to become more dynamic since the sick-man era; rather, it has simply cut real wages and other costs. Businesses have failed to plow resources into productivity growth, as has the government. Investment plunged from 22 percent of GDP in 2000 to 17 percent in 2013. That is three percentage points less than in the United States, and lower even than in Italy.

Public investment, for its part, is a mere 1.6 percent of GDP. After years of neglect, infrastructure is crumbling. "Highway bridges are in such poor condition that lorries carrying heavy loads often have to make detours, while some transport infrastructure in waterways dates back to a century ago," points out Sebastian Dullien of the European Council on Foreign Relations. Outside the big cities, broadband Internet speeds are notoriously slow.

Germany has also fallen behind in investment in its workforce. It spends only 5.7 percent of GDP on education and training, much less than many other countries, including the United States (7.4 percent). While foreigners are inclined to admire Germany's traditional apprenticeship system, young Germans seem less keen: The number of new apprentices has plunged to its lowest level since reunification in 1990 and many positions go unfilled. Moreover, only 26 percent of Germans aged over 25 have university degrees, a far lower proportion than in France, Britain or the United States. A lower percentage of young Germans are graduates (29 percent) than young Greeks (34 percent). And the higher education that Germans are offered is not up to the standards of the global elite. By one rating, no German university ranked above 29th best in the world, and by another, no better than 49th.

Handicapped by underinvestment, Germany's sclerotic economy struggles to adapt. Despite Schröder's reforms, it remains harder to lay off a permanent employee than in any other rich member of the OECD. Starting a business is a nightmare: By this measure, Germany ranks 114th globally, behind Tajikistan and Lesotho, according to the World Bank's Doing Business rankings. Its big firms are all old and entrenched. There is no German Google or Facebook; the nearest equivalent in the digital sector, the software giant SAP, was founded in 1972. Indeed, Germany's industrial structure has scarcely changed in decades.

The services sector is particularly hidebound. Productivity in services ranging from transport to telecoms is often dismal, not least because these sectors tend to be tied up in red tape. Regulation of professional services is stricter than in all but five of 27 countries ranked by the OECD. In fact, in the professions, which account for a tenth of the economy, rules typically dictate who may offer what sort of service, how much they may charge and how they may advertise. For example, only qualified pharmacists can own a pharmacy and individual pharmacists can own no more than four of them. Other shops may not compete, even for nonprescription drugs.

Not surprisingly in light of the general environment of self-congratulation, the government has been slow to acknowledge that something's amiss. It has introduced fewer pro-growth reforms over the past seven years than any other advanced economy, according to the OECD. The upshot is that labor productivity growth has averaged only 0.9 percent a year over the past decade, far behind the 1.4 percent in the United States and less even than in Portugal.

German workers have paid the price for this poor performance. Starting with a corporatist agreement involving government, companies and unions in 1999, wages have been suppressed. Thus, while German workers' productivity has grown by 17.8 percent over the past 15 years, their pay (after inflation) has actually fallen.

Schäuble and others celebrate this wage stagnation as a key plank of Germany's superior competitiveness. But countries are not companies; while a business owner may wish to minimize wage costs, for society as a whole, wages are not costs to be minimized but benefits to be maximized – provided they are justified by productivity. Suppressing wages also harms the economy's longer-term prospects because it erodes incentives for workers to upgrade their skills and for businesses to invest in productivity-enhancing technologies.

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Thanks in part to the shale-gas revolution in the United States, German companies pay almost three times as much for electricity as their American competitors.
 

Spreading the Joy

Consider, too, that stagnant wages sap domestic demand, leaving Germany reliant on exports to sustain employment and growth. Exports have not disappointed, doubling since 2000 in large part because they are indirectly subsidized by Germans' artificially low wages. The euro has also provided a big boost. It has been much weaker than the mark was, helping German sales outside the eurozone. The lock created by a common currency has prevented France and Italy from devaluing. And until the crisis, the capital flows that the euro facilitated fueled booming export markets in southern Europe. Germany has also been lucky; its traditional exports – capital goods, engineering products and chemicals – are precisely what China needed to power its breakneck industrial development since the turn of the century.

But with southern Europe now in a slump and China's growth slowing, the German export machine is sputtering. Its share of global exports is down from 9.1 percent in 2007 to 8 percent in 2013, as low as in the sick-man era. Moreover, since cars and other exports "made in Germany" now contain many components produced in central and Eastern Europe, Germany's export share is at a record low in value-added terms.

Most German exports are manufactured goods. Indeed, whereas manufacturing has shrunk as a share of GDP in most advanced economies over the past 15 years, it has expanded in Germany. That makes many people in countries with shriveled manufacturing sectors envious, but it shouldn't. There is nothing special about making things. Is making cars more valuable than developing medical technology? Is manufacturing washing machines more important than programming computers?

Note, too, that manufacturing represents an even bigger share of the economies of the Czech Republic, Ireland and Hungary. Does that make them more successful than Germany? In the end, the important issue is not what is made, but how much value it adds – and whether it is likely to continue adding as the global economy evolves.

In any case, German industry is unlikely to be able to defy gravity for much longer. Like agriculture before it, manufacturing tends to weigh less heavily in every economy over time – and that even goes for China, the workshop of the world. As technology improves, we can make better-quality goods more cheaply – think of flat-screen TVs. As people get richer, they devote more of their income to services (holidays, health care, household help) rather than spending it all on accumulating more stuff. So Germany's reliance on manufacturing is really a vulnerability, not a strength.

Unless its arthritic economy can adapt, Germany would be hit hard by a fall in demand for what it manufactures. Already, China is starting to compete directly with higher-end German products. And how, for example, would Germany fare if Google's self-driving vehicles disrupted the global car industry?

In the few areas in which German businesses have already faced the full brunt of Chinese competition, notably in solar panels, they have failed to up their game, resorting instead to appeals for EU protection. For similar reasons, German politicians are now keen to see Google broken up. Germany's position is particularly precarious because it is reliant on four sectors – vehicles, machines, electronic devices and chemicals – for more than half of its exports.

Germany is already losing its edge in energy-intensive sectors like chemicals. Thanks in part to the shale-gas revolution in the United States, German companies pay almost three times as much for electricity as their American competitors. And the gap isn't likely to narrow: Berlin is committed to phasing out nuclear power and replacing it with pricey renewables rather than cheaper gas-powered generation.

Germany's export obsession resulted in a whopping current-account surplus of $283 billion in the first 11 months of 2014, exceeding 7 percent of GDP. Schäuble and others view this as emblematic of Germany's superior competitiveness. But if Germany is so competitive, why don't businesses want to invest there?

This huge surplus is, in fact, a symptom of Germany's economic malaise. Suppressed wages swell corporate surpluses, while low consumer spending, a stifled service sector and stunted start-ups suppress domestic investment, with the resulting surplus savings often squandered overseas.

As a result of these surpluses, Germany has become Europe's biggest net creditor. Back in 2000, its overseas assets barely exceeded its foreign liabilities. By the end of 2013, its net international investment position had risen to a whopping €1.3 trillion – almost as large as China's. But that is hardly unalloyed good news since the slosh of assets ending up abroad made the fortunes of German financial institutions highly vulnerable to the global debt meltdown. A study by the DIW economic research institute in Berlin suggests that Germany lost €600 billion, the equivalent of 22 percent of annual GDP, on the value of its foreign portfolio investments between 2006 and 2012.

While compressing wages to subsidize exports is bad for Germany, it is worse for the rest of the eurozone. Far from being an "anchor of stability," as Schäuble claims, Germany spreads instability. Germany escaped the real estate frenzy. But German banks' reckless lending of Germans' excess savings financed property bubbles in Spain and Ireland, funded an unsustainable consumption boom in Portugal and lent the profligate precrisis government in Greece the rope with which to hang itself. And now that the bubbles have burst, it is exporting deflation to those debtor countries.

Nor is Germany a "growth locomotive" for the eurozone. On the contrary, its weak domestic demand is a drag on growth elsewhere in Europe.

Foisting the German adjustment model on the rest of the eurozone makes matters worse. The German-inspired conventional wisdom that wages in southern Europe are too high is at best simplistic, and at worst just plain wrong. Wages fell as a share of GDP everywhere in the pre-crisis years. Slashing them now depresses domestic spending and makes debts harder to bear.

For struggling southern European economies whose traditional exports have been undercut by Chinese and Turkish competition, the solution is not to try to produce the same old stuff at lower wages, but to invest in moving up the value chain. In any event, the eurozone is collectively too big and global demand too weak for it to rely solely on exports to grow out of its debts – hence stagnation will be its lot as long as Germany is emulated.

Trying to turn the eurozone into a greater Germany is also harmful to the rest of the world, not least the United States. Stagnant European demand crimps American exports, while suppressed wage growth gives eurozone exports an unfair edge – and ultimately risks a protectionist response.

The European Central Bank's turn to quantitative easing has sent the euro plunging against the dollar. In early March, a euro bought only $1.08 – down from $1.39 as recently as May 2014. That may be desirable for the eurozone as a whole, given Germany's failure to contribute to regional growth. But it is perverse for the rest of the world, considering that the eurozone is collectively running a $300 billion-plus current-account surplus. In the meanwhile, German savings that once sloshed into southern Europe are now being sprayed around more widely, with the country's notoriously badly managed banks still in charge of choosing where it goes.

Digging Out

German policymakers have spent the post-crisis years lecturing the world in general and southern Europe in particular on the virtues of the German Way. Yet the German model urgently needs an overhaul.

Germany should focus on improving productivity, not "competitiveness." Unleashing competition and enterprise would be a good place to start. While the German economy excels at incremental innovation and cost cutting, it needs to become much more adaptable in a world increasingly prone to disruptive technological change.

Workers should be rewarded for their productivity gains. And with a balanced budget, a triple-A credit rating and an economy in which stimulus couldn't possibly generate inflation, the government should take advantage of near-zero interest rates to invest in the country's infrastructure and to encourage businesses – especially start-ups – to invest, too. Germany would also do well to welcome dynamic young immigrants to stem its demographic decline; with an average age of 45, its population is the oldest in the EU and is shrinking fast.

Is all this too much to ask? It is difficult to disrupt the status quo in any economic culture that does not see itself as in crisis. And it would probably be even more difficult for Germany, which has solid historical reasons to shrink from rapid change. It would be a tragedy, though, if Germany abdicated its responsibilities to Europe – and to its own citizens – until that crisis was all too evident at home.