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Germany is no beacon

France is in dire straits economically. Still, its long term prospects are decidedly better than those of its neighbor on the other side of the Rhine River.

Ask five economists, or so the saying is going, and you are going to receive six answers. But things turn out different when it comes to the economies of France and Germany, respectively.

With respect to France, you would find it difficult to come up with economists who wouldn’t concur with the consensus reflected in the international media: the French economy is sick, almost impossible to reform, and its prospects are dire.

Germany, by contrast, is seen as a beacon for Europe: dubbed as “the sick man of the Euro” by the British “Economist” magazine just 15 years ago, it is believed to have regained its former strength by labor market and welfare state reforms, more flexibility on the firm level (made possible by workers’ representatives behaving reasonably), and fiscal consolidation.

However, while this view is not flatly wrong, it is much too simplistic. While France could very well surprise the world – and itself – on the upside over the next ten or so years, Germany is in for a rude awakening. Not this year or next. But the time will come when Germans will view the first half of this decade as the good old days.

It is important to understand that Germany has changed its business model. During the much-touted “Wirtschaftswunder” of the 1950’s and 1960’s, Western Germans benefited from a combination of factors: While the labor force was growing, high investment rates contributed to rapid productivity gains which in turn made fast growth in real wages and material living standards possible.

Now the labor force is ageing – and is set to decline beginning by the end of this decade at the latest. Ageing has contributed to low investment levels which in turn have dampened productivity and wage growth. In other words: Germany used to compensate high wages with high investment rates and productivity growth. Growing older, it now compensates low investment and productivity with stagnant wages. And the introduction of the Euro has only helped Germany pursuing this new business model for the time being.

To any victim of “teutophile” propaganda, this must sound awkward. But consider these seven points:

• First, since the fertility rate has been at around or below 1.5 children per woman for a long time, Germany’s baby boomers — those born between 1950 and 1969 — are followed by age groups that are much smaller. There are now more than twice as many 50-years olds than one-year olds living in Germany. We have already seen a dramatic ageing of the workforce and electorate. In 2013, the median age was 45.3 years, making Germany the only country in Europe in which more than half of the population had already celebrated its 45th birthday. (The median age in France was 40.5 years, well below the Euro area’s average of 42.7 years.)
• Second, the Federal Republic’s public investment spending in relation to GDP has for decades been on a downward trend that even the reunification of Germany interrupted for only a hand full of years. In the European Union, Germany is one of the two countries (Austria being the other) in which the level of public investment is persistently lower than in any other member state.
  While there is no clear-cut reason for this, ageing is a prime suspect. When it comes to public investment, large parts of the cost (and the nuisance that come with large construction sites) have to be borne by today’s tax-payers (and voters) while the benefit is widely spread; with regard to hand-outs of the welfare-state, it tends to be the other way round. It is therefore not far-fetched to expect a rapidly ageing country to shift expenditures from investment to consumption. However, ageing doesn’t necessarily imply that the demand for public investment declines. In Germany experts expect air, road and rail traffic to increase significantly in the foreseeable future, meaning that the need for infrastructure investment won’t decline even when it serves fewer people.
• Third, ageing in Germany has not meant yet that the number or the share of seniors has exploded. To the contrary, the number of those who are 65 and over even declined slightly in recent years. Actually, demographically Germany is currently enjoying a ridge of high pressure in a sense. That is because the number of young people has started to decline already while the number of seniors has not increased yet. In this respect, Germany’s welfare state is more affordable now than it was 10 or 20 years ago. Put differently, Germany’s public budgets currently look healthier than they fundamentally are. After all, the current ridge of high pressure will soon be followed by a long-lasting storm.
• Fourth, the public sector, burdened with a pay-as-you-go pension system, does little to prepare for this durable demographic storm. The corporate sector, however, does. To any manufacturer who thinks about building a new plant, locating it in Germany must sound like a silly idea. He or she might be able to staff the plant right now — but that the same will still be true in 10, 20 or 30 years from now seems doubtful anywhere in the country. This is likely to be a major force behind the weakness of private investment in Germany ever since the millennium. In the private sector annual net fixed capital formation (excluding R&D) has declined from seven per cent of GDP to around two per cent.
• Fifth, a wealthy country such as Germany should strife to remain at the top of the value chain by investing heavily in technology, education, and R&D. Germany, however, does not (relatively high R&D spending is more than offset by sub-par investment in education). High investment expenditures certainly aren’t necessarily spent efficiently or effectively — just think of the recent real-estate bubbles in the U.S. and elsewhere.
  But low investment levels are making high productivity growth in a rich country virtually impossible. And this is what you see in Germany. Productivity per hour worked grew by four percent in the 1970’s; this growth fell to two percent in the 80’s. It remained at this level in the 90’s when some convergence in Eastern Germany was offset by weak productivity dynamics in the West. And since the alleged “Wirtschaftswunder 2.0” began in 2005, labor productivity per hour worked grew by a mere .9 % annually. This poor number will have to be revised further down, once the data for 2014 comes in.
• Sixth, it is productivity growth that in the medium- and long-term determines the room for real wage increases. Thus, you’d only expect wage gains in Germany over the last two decades to be lower than in the decades before. But the average worker didn’t receive a single cent as a reward for the — modest — productivity gains in the last 20 years. Adjusted for inflation, the average monthly salary of full-time employees has never reached its 1995 peak again. This prolonged period of wage moderation has depressed domestic demand. And it is a major factor behind the dramatic expansion of German exports. It was exactly at the same time that the period of wage moderation began — around 1995 —, that exports as a share of GDP began to break away from the level seen in France or Italy.
• Seventh, artificially holding back wages is nothing less then a form of devaluation. Internal devaluation would have been a strategy of limited effectiveness in the D-Mark era since important trading partners on the European continent could have compensated losses of competitiveness by letting the value of the Lira, the Peseta, or the Franc slide.

With the introduction of the Euro, however, external devaluation ceased to be an option for national policy-makers. Nevertheless, in all countries that later took center stage in the Euro crisis, wages rose much faster than productivity. Between 1995 and 2008, unit labor costs relative to the respective trading partners rose by more than 25 percent in Greece, Ireland, Italy, and Spain, while in Germany it fell by 25 percent. (In France, it slightly rose, which helps to explain why its economy lost some ground but unlike the main crisis candidates didn’t accumulate huge current account deficits.)

To put it differently: The effectiveness of German wage moderation was turbo-charged by the fact that other countries let wage costs spiral out of control. But for the time being, it seems unlikely that countries such as Spain or Ireland will make the same mistake twice. For Germany’s exporters this implies that wage moderation won’t do the wonders anymore that it did for so long.

To sum up, Germany in truth is much weaker and much less resilient that you are usually told. Its key business model doesn’t look sustainable. And what is more important, there is not much to do about this. As for the flexibilisation of the labor market, Germany has already picked all the low-hanging fruit.

Even more important are demographics. Had German policy-makers 30 years ago found means to significantly increase fertility again, this could have had a major impact on investment levels, productivity growth and the long-term soundness of public finances. Even 15 years ago, a higher fertility rate would have had a considerable impact; after all, back then more than half of all female baby boomers were still under the age of 40. However, even then, policy-makers didn’t seriously try to bribe couples into having more babies. Then Chancellor Gerhard Schröder famously denounced all such efforts in 1998 as “Gedöns” (hullabaloo).

Now it’s too late. Large age groups can produce large age groups; small age groups cannot. With the youngest female baby boomers turning 46 this year, Germany’s demographic fate is largely sealed. Even a dramatic increase of the fertility rate won’t prevent the population to shrink big-scale. And it’s an illusion to believe that immigration could compensate for this. Just to keep the size of the German population stable, net migration would need to be around 400,000 people a year, twice the level German has had over the last half century. Even if this were feasible politically (which seems unlikely), it simply won’t happen. After all, 70 percent of new migrants in recent years have come from Southern and Eastern Europe – regions that are about to face declining populations themselves.

France, by contrast, is in a very different position. It does face demographic challenges that seem tiny in comparison to Germany’s. Indeed, according to the United Nation’s base scenario, France’s population will continue to rise throughout the 21st century. And it will have surpassed the German one by the year 2050.

What is more, the low-hanging fruit that has been picked in Germany already is still available on France’s trees. The question whether Germany will manage to become an economically dynamic country again has more or less been answered already. In France, it simply comes down to political will-power.

So what should French policy-makers do?

Start with stopping to admire Germany no matter what. Trying to be as German as possible would be self-defeating.

Also, do acknowledge what many players in Germany recognized in the late 90’s: that it’s not a lack of demand that stifles the economy but structural rigidities on the supply side.

Accordingly, do stop blaming others — the Germans, the Americans, the speculator, the banks, the ECB etc. — for France’s largely homegrown weaknesses.

More specifically, don’t wait for some large-scale German public investment program. Yes, it would be wise for Germany to increase public investment — and a better time to do so will never come. However, an additional 20 billion Euros a year would suffice to lift Germany’s public investment in relation to GDP above the Eurozone average. Don’t expect the 10,000-billion Eurozone economy or even the French economy to be kick-started by this kind of sums. Plus, 25 billion Euros are way more than anything that seems remotely realistic in Germany right now.

Finally, do keep reminding the Germans of their responsibility for the survival of the Eurozone. Greece, Ireland, Portugal and Spain have managed to push down relative unit labor costs in recent years and will have to push them down further. Italy and, to a lesser extent, France will need to start going down this road, too. All austerity and all liquidity injections will be for nothing if the countries that have faced troubles don’t regain their cost competitiveness in the end. And since Germany is among the most important trading partners for all those countries, any gain in competitiveness will automatically mean a loss of competitiveness for Germany.

The Germans will be tempted to drive down their unit labor costs again once this loss is being felt seriously. But that would undermine the painful process of regaining ground elsewhere. It is easy to imagine how a vicious circle of internal devaluations would prove to be the last, fatal blow to the European Currency Union as we know it.

German elites, in their religious belief in wage moderation, are not likely to recognize this by themselves. They’ll need their good French friends to convince them.

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