Stephen King: What happened to the German economy?

Unless competitiveness leads to better living standards, Germany is simply prostituting itself for rest of world

Do you remember the days when Germany was regarded as Europe's economic powerhouse? In the 1980s, the German economy could do no wrong. It enjoyed reasonable growth, remarkably stable prices, a strong currency and a central bank that topped the monetary policy credibility league.

Do you remember the days when Germany was regarded as Europe's economic powerhouse? In the 1980s, the German economy could do no wrong. It enjoyed reasonable growth, remarkably stable prices, a strong currency and a central bank that topped the monetary policy credibility league.

In 2005, the general view is that Germany has lost its way. Over the past decade or so, Germany has vied with Japan for the worst growth performance among the major industrialised nations. While the US has enjoyed an intoxicating mix of productivity and credit growth, Germany's economy seems to have been nursing a rather unpleasant hangover. And the central bank that once ruled Europe and sent shivers down the spine of many a politician now has no more influence on European monetary policy than the Bank of Greece.

To someone travelling into the future using a late 1980s-vintage time machine, all of this might be rather unexpected. In the 1980s, Germany's economic success was attributed to characteristics that, in some ways, have not changed very much over the past 20 years. Germany is still seen to be a stakeholder economy, an economy that takes the interests of all economic groups to heart. It's an economy that's still broadly built on a form of consensus capitalism: cross-shareholdings, for example, supposedly link the interests of banks with the interests of the companies to which they lend.

So why is it that the model that was so successful in the 1980s is now more associated with economic failure than success? And will Germany's apparent economic demise continue?

One obvious reason for Germany's decline is the impact of reunification. A comparison of French and German growth over the past 15 years demonstrates quite clearly that construction activity has been Germany's Achilles' heel. Having been through an initial construction boom immediately after reunification, German builders spent many years in the wilderness.

Reunification created other problems. The conversion rate from "ostmarks" into Deutsche marks removed at a stroke the competitive advantage that might have stemmed from an influx of educated east Germans who, initially, had to work with very poor capital equipment. Paying them too much when their overall productivity levels were still rather low meant that German companies simply leap-frogged over east Germany and invested in Poland and the Czech Republic instead. The German taxpayer was left to pick up the pieces.

Central and Eastern Europe's economic success has also played an important role. The gradual integration of these economies into the European Union has provided significant advantages to German companies and their shareholders. The increasing flexibility of global capital has meant German companies have been able to immunise themselves from some of the more difficult aspects of the domestic economy.

For example, Germany has famously high non-wage labour costs, acting as a tax on jobs. Companies, though, can avoid these costs simply by locating their factories outside Germany. This is hardly good news for the German government, nor for German taxpayers or for those on social benefits. Nevertheless, this process of capital mobility helps to resolve an apparent enigma about the German economy: the economic data may be poor but the corporate sector appears to be in remarkably good health. In the final quarter of 2004, the German economy unexpectedly contracted but there were few complaints from companies. For them, what matters is their ability to improve competitiveness. And, to date, they've made a pretty good fist of it.

The original source of improvement was outsourcing: companies improved their competitive position by becoming less "German". German companies were perhaps delivering less in the way of German stakeholder value, but they were certainly beginning to deliver a lot more in the form of shareholder value. Increasingly, though, it looks as though the initial outsourcing effects are beginning to change the dynamics of the German domestic economy as well.

The table shows changes in the shares of world trade experienced by some of the major industrialised countries over the past 10 years. Since the beginning of this century, Germany is unique among G7 nations, having achieved an increase in its share of world trade. In this comparison, Germany's recent performance is more like China's than America's or the UK's. And, given China's extraordinary competitive advantages, it's remarkable that Germany has achieved so much when its competitors have achieved so little.

Germany's success in this area is a mixed blessing. German companies have been keen to sell abroad in part because domestic demand has been so pitifully weak. Perhaps German exports would have fared a little less well had the domestic market offered better prospects.

Nevertheless, Germany's export success rests on more than just domestic failure. One of the more obvious factors has been Germany's ability to get to grips with its labour costs. At the beginning of the 1990s, German labour costs spiralled upwards, hit by the impact of reunification and its implications for German domestic demand. More recently, though, German labour costs have been brought under control.

The story again relates to outsourcing. Last year, when oil prices headed upwards, many people thought Germany would, once again, be damaged by seemingly inflexible labour relations. Higher oil prices would mean lower spending power which would lead workers to demand higher wages which, in turn, would lead to higher prices. And so Germany would, once again, suffer from a wage-price spiral.

But it never happened. German companies, faced with lower profits as a result of high oil prices, simply told their workers to accept pay cuts or to look forward to redundancy as their jobs were outsourced to Central and Eastern Europe and beyond. Not the most pleasant of messages, perhaps, but the results have certainly helped German competitiveness: real wages have been falling in recent months, suggesting both that German workers are pricing themselves back into jobs (see chart) and that German companies are pricing themselves back into global product markets.

Of course, this isn't just a case of Germany keeping up with the Chinese. Otherwise, German labour costs would have to plunge to Chinese levels, which would hardly be a source of economic comfort or, indeed, success. But Germany still has some obvious advantages: BMWs still sell like hot cakes in most parts of the world. So long as it retains its comparative advantage in aspects of design and engineering, there's still some hope.

The true test for Germany will come when it puts in a further spurt in domestic demand. It hasn't managed it yet and with the tax regime not particularly friendly for companies, the chances of seeing a major investment-led multiplier coming through are still rather slim. It's all very well being able to demonstrate that German competitiveness has improved but unless the improvement leads to better domestic living standards, Germany is simply prostituting itself for the satisfaction of consumers in other parts of the world.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com