Don't envy Germany

When the euro was launched in 1999, Germany was dismissed as the “sick man of Europe.” Over-taxed and over-regulated, its economy was stagnant, and four million Germans were unemployed. In the early years of the new century, the German economy plodded, outshone by fizzier growth in Britain and southern Europe. But after the financial crash in 2008, things looked rather different. With most of the west laid low by flashy but ultimately fragile financial engineering, a country renowned for its stable and solid industrial engineering now appeared enviably secure. While others had built houses of cards based on debt, Germany had saved prudently. Whereas most of Europe seemed ill-equipped for a new era of competition with China, German exports to the Middle Kingdom were booming. While unemployment has soared to record levels across much of Europe, Germany’s jobless rate today is lower than before the crisis. In a time of fiscal incontinence, the German government has even balanced its budget. When panic swept through the eurozone in 2010, Germany seemed like the safest of havens: investors were even willing to pay its government to take their money. As Europe’s largest and most populous economy, its largest exporter and its biggest creditor, Berlin seems to hold all the cards. Many fear it, some loathe it, but few question its supremacy.

Politicians and pundits of all stripes, from Bill Clinton to Nicolas Sarkozy, have queued up to praise Germany. In Britain, where admiration for the Rhineland model was once limited to thinkers on the centre-left—such as Will Hutton, former Editor of the Observer—whose influence on the last Labour government was slight, even market-oriented Conservatives now look to it for inspiration. David Cameron, Prime Minister, believes that Britain needs a “Germanic approach to skills.” George Osborne, Chancellor of the Exchequer, heaped praise on Germany in a recent piece for the Financial Times co-written with his German counterpart, Wolfgang Schäuble. Labour leader Ed Miliband’s economic strategy seems to consist mostly of trying to emulate Germany. As Philip Collins, a columnist at the Times, put it: “Ed’s plan for Britain: be more like Germany.”

Apparently intoxicated by all this flattery, one senior German politician quipped that “now all of a sudden Europe is speaking German.” After her re-election last year, Chancellor Angela Merkel declared: “What we have done, everyone else can do.” Berlin-boosters boast of 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, predict that by 2030 Germany will become the world’s richest large country by income per head.

Yet the belief that Germany is a world-beater is misconceived. Its economy is not particularly successful, still less a model for others. Its banks are sickly, its productivity growth poor and its investment inadequate. Allowing for inflation, the average German earned less last year than in 1999—that’s 14 years and counting of stagnation. It is a bit more prosperous—measured by gross domestic product (GDP) per person adjusted for purchasing power—than Britain and France, but poorer than 12 other advanced economies, including Australia, Austria, Canada, the Netherlands, Sweden, Switzerland and the United States.

Since the crisis, its performance has been less awful than many—in early 2014 France’s economy was slightly bigger than in early 2008 and Britain’s slightly smaller, while southern Europe had fallen off a cliff—but hardly earth-shattering. While Germany’s economy is only 3.6 per cent larger than six years ago—and shrank between March and June—Switzerland and Sweden are both up more than 7 per cent. Even the US, the epicentre of the financial crisis, is up by a similar amount.

If one takes a longer view, the perspective changes. Since the turn of the century, Germany has been a laggard, not a leader. Between 2000 and 2013, its economy grew by only 15 per cent—a mere 1.1 per cent a year—level-pegging with France. That is slower than those freewheeling Anglo-Americans, Britain (up 21 per cent) and the US (up 25 per cent), not to mention the supposedly lazy Latins (Spain is up 19 per cent) and reckless Celts (Ireland is up 30 per cent). Among the 18 countries in the eurozone, Germany ranks 13th.

Sustained economic growth comes from a combination of productive investment and productivity gains, and on both counts Germany is weak. Investment fell from 22.3 per cent of GDP in 2000 to 17 per cent in 2013. While the investment rate in Britain is even lower, Germany lags behind countries such as France, Spain and even Italy. Public investment is particularly feeble—a mere 1.6 per cent of GDP in 2013—less than in Italy and Britain (2 per cent) and far behind countries such as France and Sweden (3.3 per cent). After years of neglect, infrastructure is crumbling. Sebastian Dullien of the European Council on Foreign Relations, a think tank, says: “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.” In March 2013, the Kiel Canal, a vital trade artery, had to be closed temporarily because two of its locks were in such a state of disrepair. Yet in her latest budget plans, Merkel has again cut public investment.

More seriously still, Germany has fallen behind in educating its workforce. It spends only 5.7 per cent of GDP on education and training, less than in France and many other countries, including Britain, where the figure is 7.6 per cent. While many foreigners admire its apprenticeships, young Germans are less keen on them: the number of new apprentices has fallen to its lowest since reunification in 1990 and many places now go unfilled. Moreover, under a quarter of Germany’s workforce has a university degree, fewer than in several other European countries, including France, Spain and Britain (34.7 per cent). Fewer young Germans are graduates (29 per cent) than young Greeks (34 per cent), let alone young Britons (45 per cent). “Germany has failed to invest in its public university system,” observes Adam Posen, president of the Peterson Institute for International Economics, an American think tank. Globally, the highest-ranked German university is the Technical University of Munich, in 50th place.

Start-ups are stunted. It is harder to start a business in Germany than in Russia or Senegal, according to the World Bank’s “Doing Business” rankings. Ireland, in 12th place globally, towers over Germany (111th). All of Germany’s leading companies are old and entrenched; there is no German Google. No wonder 50,000 German entrepreneurs have emigrated to Silicon Valley.

Low investment, decrepit infrastructure, a decaying education system, a lack of enterprise—these are all worrying indicators. But the decisive proof of Germany’s underperformance is its poor productivity growth: a mere 0.9 per cent a year over the past decade, less than in Portugal. To be a sustainable success, Germany needs much faster productivity growth. What little growth Germany has had has been driven primarily by manufacturing exports, at which it excels. It ranks second globally behind China. It accounts for nearly half of EU exports to China. And its foreign sales have doubled since 2000, outperforming every other advanced European economy. Moreover, whereas manufacturing has shrunk in most advanced economies over the past 15 years, it has expanded in Germany.

But the country’s export boom is less impressive than it seems, and its reliance on manufacturing may turn out to be a weakness in years to come. Its export performance has been flattered by its firms’ outsourcing of production to central and eastern Europe. Cars “made” in Germany now contain many parts produced in Slovakia, Hungary and elsewhere; when a car is exported, its total value is ascribed to Germany, although only part of it will have been made there. Germany has also been lucky. Its traditional exports—capital goods, engineering products and chemicals—are precisely those that China has needed during its breakneck industrial expansion.

The euro has also been a huge boost. It has been much weaker than the Deutschmark doubtless would have been, inflating foreign sales. It has prevented competitors in places such as Italy from devaluing to undercut German firms. Until the crisis struck, it also provided Germany with booming export markets in southern Europe. But since then, the recession in southern Europe has deprived Germany of an outlet for its exports. Now that China’s economy is also slowing and shifting away from investment-led growth, Germany’s export machine is stalling. Since the crisis, its share of world exports has slumped from 9.07 per cent in 2007 to 8.01 per cent in 2013—as low as it was at the turn of the century.

Worse, Germany’s earlier export boom was achieved on the backs of German workers. Downward pressure on wages—which began with a tripartite agreement in 1999 between government, companies and unions rather than with former Chancellor Gerhard Schröder’s labour-market reforms in 2003–5—and the absence of a legal minimum wage have resulted in some workers earning as little as €4 (£3.17) an hour. According to Germany’s Institute for Employment Research, around a quarter of the German workforce are paid less than two-thirds of the median wage, a higher proportion than in all but one of the 17 European countries for which comparable data are available.

The problem is not just that some Germans are extremely low paid; it’s that the average German is not rewarded for his or her productivity gains. The typical worker produces 17.8 per cent an hour more than in 1999, but earns fractionally less. While some politicians, notably the Greens and the left-wing party Die Linke, bemoan this wage stagnation, most German policymakers celebrate it. After all, keeping wage costs down boosts the competitiveness of German exports. But while curbing pay may make sense for an individual business owner, for the economy as a whole wages are not costs to be minimised, but rather a benefit to be maximised—provided they are justified by productivity. So while low wages are necessary if productivity is low, holding wages down below productivity is perverse. If wages are kept artificially low, there is less incentive for workers to upgrade their skills and for companies to invest domestically and go upmarket. And if Germany fails to move up the value chain, new higher-skill, higher-wage and higher-value-added production will increasingly take place elsewhere. “Wage compression will not be a successful growth strategy for Germany or Europe’s future,” Posen says.

Some change is in the offing, however. After Merkel’s former coalition partners, the liberal Free Democrats, lost all their seats in the federal elections to the Bundestag, her Christian Democrats (and allies) teamed up with the Social Democrats (SPD) instead. The SPD demanded the introduction of a minimum wage of €8.50 (£6.75) an hour (this will be phased in by 2017). Nearly one in four workers in the former East Germany and one in seven in the west earned less than that in 2011. Nationwide, half of the workers in hotels and restaurants and a quarter of those in retail did. But while a minimum wage will provide a welcome boost to low-paid workers, there is no sign that others will be paid their due—especially not in manufacturing.

Viewed from Britain, where manufacturing accounts for just 10 per cent of national economic output, Germany’s outsized manufacturing sector may look like a strength. But it’s not all it’s cracked up to be. For a start, there is nothing special about making things. Is making cars more valuable than making people healthy? Is manufacturing washing machines more important than programming computers? Manufacturing takes an even bigger share of the economy in the Czech Republic, Ireland and Hungary. Does that make them more successful economies than Germany?

The important thing is not what people do, but whether it adds value—and even in Germany, well over three-fifths of value-added comes from services. Unfortunately, productivity in those sectors—everything from transport and telecoms to retail and restaurants—is often dismal, not least because they tend to be tied up in red tape. Regulation of professional services is stricter in Germany than in all but five of 27 countries ranked by the Organisation for Economic Co-operation and Development (OECD). In the liberal professions, which account for a tenth of the German economy, rules dictate who may offer what sort of service, the charges professionals are allowed to levy and how they may advertise. For example, only qualified pharmacists can own a pharmacy, and they are limited to four. Other shops may not compete, even for non-prescription drugs. In many professions, investment by outsiders is restricted.

The weakness of German services is particularly worrying because its industry is unlikely to be able to defy gravity for much longer. Like agriculture before it, manufacturing tends to weigh less heavily in the economy over time—this is true even in China, the workshop of the world. As technology improves, we can make better quality goods more cheaply and, as people get richer, they devote more of their income to services—holidays, healthcare, home help—rather than spending it all on accumulating more stuff. So Germany’s over-reliance on manufacturing makes it vulnerable. Unless its economy can adapt, it would be hit hard by a fall in demand for its manufactured goods, not least as China moves up the value chain and its firms start to compete directly with higher-end German products. In those areas in which German businesses have already had to face the full force of Chinese competition, notably the manufacture of solar panels, they have failed to improve performance and have resorted instead to protectionist appeals to the EU. 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.

Rising energy prices pose an immediate threat to energy-intensive sectors such as chemicals. The price of electricity has already more than doubled since 2000. Because of the shale gas revolution in the US, German companies pay almost three times as much as their American competitors for electricity, according to a study by Siemens, the engineering and electronics giant. Moreover, the government plans to phase out nuclear power and replace it with expensive renewable energy while spurning cheaper shale gas.

If it is to prosper in the future, Germany’s economy will need to adapt. Unfortunately, it is often arthritic. Product markets are highly regulated, limiting competition and favouring established companies over potential challengers and the interests of producers over those of consumers. While Schröder’s labour-market reforms helped to create low-end jobs and nudge the long-term jobless back into work, they did not make Germany’s labour market more flexible. In fact, it is harder to lay off a permanent worker in Germany than in any other OECD country. Nor are things improving: the OECD says that since 2007 Germany has brought in fewer pro-growth reforms than any other advanced country. As a result, its economy is far too rigid and sluggish. It is good at cutting costs, but not at changing course.

Germany also faces particularly severe demographic challenges, which will be a drag on future growth. Its population is the oldest in the EU, with an average age of 46, compared with 40 in Britain and 36 in Ireland. On current trends it is projected to fall below Britain’s and France’s in the 2040s. In the absence of a productivity miracle or increased immigration, that implies a correspondingly smaller economy too.

An economy with an ageing population in which wages (and therefore spending) are weak, investment feeble and the government doesn’t borrow will always generate a huge surplus of savings—that is, a current account surplus. This is often seen as a symbol of Germany’s superior “competitiveness.” But if Germany is so successful, why do businesses not want to invest there?

As a result of its 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. In a debt crisis, Germany’s position as a net creditor gives it clout. But its loans to foreigners have often been badly invested. In the bubble years, both its giant private banks, such as Deutsche Bank and Commerzbank, and the state-owned Landesbanken poured money into bets on dodgy American subprime mortgages, financed property bubbles in Spain and Ireland, funded a consumption boom in Portugal and lent recklessly to the now-insolvent Greek government. Contrary to the myth that German taxpayers have since bailed out southern Europe, their loans to southern European governments have primarily bailed out the German banks and investors that invested their savings so poorly in the pre-crisis years.

A study by the DIW economic research institute in Berlin suggests that Germany lost €600bn, the equivalent of 22 per cent of GDP, on the valuation of its foreign portfolio investments between 2006 and 2012. Now that Germany is fearful of making losses on its loans to foreigners, it is particularly perverse to keep piling up surpluses that necessarily have to be invested abroad. Once it turns out that debtors cannot or will not pay—which Germany’s refusal to contribute to European growth makes more likely—its huge foreign exposure will lead to hefty losses.

Germany’s much-vaunted current-account surpluses are a symptom of a sick economy, not a strong one, therefore. Stagnant salaries swell corporate surpluses, while subdued spending, a stifled service sector and stunted start-ups suppress investment, with the result that savings are squandered overseas.

“Das Modell Deutschland” is in urgent need of an overhaul. German workers ought to enjoy the fruits of their labour in higher wages. To boost living standards in the long term, policymakers ought to focus on raising productivity growth. They should invest more in future growth, not least by upgrading the country’s dilapidated infrastructure and decaying education system. They should also open up new opportunities for businesses to invest, by injecting competition into ossified markets and making it easier to start a business. And they should be more welcoming to immigrants, who will be essential if Germany is to ward off demographic decline, as well as being a source of new ideas and businesses. While Germany excels at incremental innovation and cost cutting, it needs to become much more dynamic and adaptable to adjust to a world of disruptive technological change.

Without such reforms, Germany’s future does not look especially bright. It turns out that the German eagle never soared as high as we were led to believe. And eventually it will also have to land.