Against the Grain: What Italy and France should really learn about German economic resilience

Paul Ormerod
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IT’S EASY to forget that Germany was once seen as the Sick Man of Europe. Between 1991 and 2005, its GDP growth averaged only 1.2 per cent a year, compared to 3.3 per cent in the UK. Since then, of course, the German economy has revived dramatically. The recovery in the German cluster of economies from the financial crisis has been as strong as in the US, with the previous peak level of output regained in 2011. Germany itself experienced virtually no increase in unemployment in 2008 and 2009, its exports are at record levels, and even the Eurozone crisis has not prevented expansion in both output and employment.

Two reasons are frequently given for this. The first relates to the favourable exchange rate at which the German mark entered the euro, giving an initial competitive edge to the economy. The second is the so-called Hartz reforms, a series of legislative labour market reforms that began in the mid-2000s. Both have validity.

But there is a deeper reason for the recent turnaround, rooted in institutional structures. In an article in the most recent Journal of Economic Perspectives – one of the world’s top academic journals – Christian Dustmann and colleagues agree with the general view that the evolution of unit labour costs has played a key role in the favourable performance of German tradable goods. But the main reason for this is “the specific governance structure of German labour market institutions, which allowed them to react flexibly in a time of extraordinary economic circumstances”. In other words, politicians can’t take all the credit for Germany’s economic revival.

German labour market flexibility is not based on legislation, but is laid out in contracts and mutual agreements between the three main actors in Germany: employer associations, trade unions, and works councils. The formal institutional structure has remained unaltered, but there have been major changes in recent years in the way that it works in practice. In particular, there has been a massive decentralisation of the wage-setting process from the industry level to the firm level, with a sharp fall in the proportion of workers covered by union agreements.

The fall of the Berlin Wall created opportunities for German industry to source from – and relocate to – countries like Poland and the Czech Republic, with their stable political structures and skilled labour forces. Gradually, the German labour force appreciated that these developments required it to operate in a considerably more flexible way than before. This has led to a rise in wage inequality within Germany, but the benefits have been a strong employment and output performance.

This decentralisation is in sharp contrast to economies like Italy and France, where union wages and work hour agreements apply to all firms within an industry, or are subject to legal limits. These countries lack the flexibility and resilience required in a globalised economy. The structural problems of the EU run much deeper than the public debt issues revealed by the financial crisis.

Paul Ormerod is an economist at Volterra Partners, a visiting professor at the UCL Centre for Decision Making Uncertainty, and author of Positive Linking: How Networks Can Revolutionise the World.