Germany’s Chained Economy

Amity Shlaes. Foreign Affairs. Volume 73, Issue 5. September/October 1994.

The Social Contract Frays

The fanciful novel reads, “Guangzhou—January 4, 2022. The first world’s fair in the supermodern convention center of the south Chinese metropolis has just opened.” At the center of the exhibition, perpetual economic leaders such as Japan and the United States have set up their stands. Germany, however, is nothing more than a tiny, unimportant player relegated to a far corner. There, its diplomats to the world’s fair “wait around with embarrassment for a call from the Korean prime minister…[he] had important commitments, but he has agreed to appear out of old loyalty.”

This particularly German nightmare of geo-economic humiliation comes from Can the Germans Still Be Saved?, a 1994 book by Herbert Henzler, chairman of McKinsey Germany, and Lothar Spaeth, a former state governor and chief executive of the firm Jenoptik. Their scenario, of course, is exaggerated. After all, Germany is currently bursting out of its recession; 1994 in the newly enlarged Federal Republic, as in the United States, will go on record as a year of growth. The Deutsche mark dominates the European economy. Time and again since the birth of the Federal Republic, German leaders and economic analysts have wrongly predicted German decline. Just 12 years ago, warnings of Eurosclerosis possessed the land. National worries about competition from new, cheaper markets entering the European Community sent Germans into a funk. Gloom that Germany had hit a fateful unemployment level of two million (a bit more than half of the current level) helped topple one of the republic’s most successful chancellors, Helmut Schmidt. An ordinarily foresightful columnist from the Wall Street Journal, Vermont Royster, published an October 1982 column entitled “End of a Miracle.” A few years later, Germany was booming.

Yet today Germany—indeed, all Western Europe—faces something more serious than a case of Eurosclerosis. If in the old days worries about competition were caused by Spanish industry or Portuguese textiles, today they come from the countries that we call “emerging markets.” In the early 1980s, Asia’s little tigers were too small to grab attention in Munich or Hamburg; the single big threat from Asia was still Japan. Latin America lay in the thrall of the debt crisis; Mexico teetered on the brink of defaulting on its loans. Even absent a globalized economy, Germany and its western neighbors face a new economic environment. Post-communist nations with weak currencies and labor costs one-fifth to one-tenth of Germany’s are pulling in capital from sources around the globe—including Germany. And those new stars are Germany’s neighbors, as close as the Czech Republic and Poland, just a few hours to the east of Berlin by automobile.

For Germany, the grandmother of social welfare states, these changes pose a challenge to national identity unprecedented in the postwar period. The phrase “we are a socially oriented nation” is often the first one out of the mouths of Germans seeking to explain a century-long commitment made by the strong to the weak. Since World War II, the Federal Republic has continued that tradition, successfully serving its citizens with a mildly paradoxical system known as the “social market economy.” But Germany and indeed all the other West European nations to whom it exported social democratic ideas can no longer afford this notion. Even as the Federal Republic moved out of recession at the beginning of this year, unemployment was still moving upward. The cradle-to-grave social welfare system has yielded a peculiarly airless environment that stifles energy and innovation. “As soon as they leave school,” Volkswagen Chairman Ferdinand Piech says of German youth, “they ask what their pension will be.” The Federal Republic now faces the greatest test yet of its old social contract.

When Workers Unite

To understand Germany’s quandary, it is important to review the unexpected challenge that the absorption of some 17 million Eastern Germans and their polluted territory has imposed. In the heady days following the fall of the Berlin Wall, Western governments, including Bonn, joined East Berlin in assigning a high value to the East German economy. Their data backed their appraisal: as late as the 1980s, international organizations figured East German per capita GNP at about the same level as Belgium’s and higher than that of Italy, Saudi Arabia, or Britain. Although the Kohl government and its friends knew reunification would involve significant costs, they did not foresee the one trillion Deutsche mark increase in the national debt, a doubling over five years, that attended the process.

One reason for these costs was the absolute bankruptcy of the East German regime and its command economy. Yet Bonn actually had an unparalleled opportunity in East Germany. By its own admission, the Kohl administration found West Germany overtaxed and overbureaucratized. Reunification offered an opportunity to debureaucratize through national reform, or at least to allow the new states of East Germany an experimental period under a low-tax, low-regulation regime. Such ideas were voiced by, among others, Otto, Count Lambsdorff of the Free Democratic Party. But in the fray of reunification, they were ignored.

Instead the Kohl government pursued a massive program of social redistribution. Germans, in retrospect, point out two errors. The first was the Federal Republic’s high appraisal of the value of East Germany’s physical assets, such as factories and heavy machinery, and its focus on that estimated value, rather than assuming that it would have to start from scratch. The most valuable properties in East Germany turned out to be favorably located “green fields” rather than outdated factories. The second was Bonn’s decision to extend all of West German law and regulation to East Germany and then compensate for the strains of that regime with special reunification subsidies and tax loopholes. Rather than laying the foundations for fresh growth, it attempted to ordain growth by setting a currency exchange rate of one Deutsche mark-to-two East German narks, thus importing West Germany’s prohibitive wage levels (and economic expectations) to East Germany. The hope was that a Keynesian spending spree of DM 150 billion per year would sufficiently prop up demand to launch eastern Germany.

Many Germans argue that the Kohl government had little choice. Locked in by two sets of elections in 1990, the incumbent Kohl made his historic promise to former East Germans that “no one will have a worse situation than before.” Yet this policy provoked the disappointment, even the anger, of central bankers. Karl-Otto Poehl resigned from the Bundesbank presidency following the currency union. The current bank president, Hans Tietmeyer, voiced oblique criticism at a New York meeting of the American Council on Germany this spring when he argued that “new social questions must be tackled not by a policy of redistributing income but primarily by a policy which fosters, rather than impedes, performance.”

The result of the Kohl government’s policy in any case was to create a work force that expected to earn something close to Western wages while offering about half the productivity. (Reports this year from Goldman, Sachs show that the eastern German unit labor cost, a measure that reflects productivity, is 44 percent above western German levels.) Workers at the Volkswagen plant in Wolfsburg, in the former West Germany, cost too much, but so do underskilled German workers a few miles across the old border to the east. They cannot compete with Czechs or Poles, whose economic betters they were only a few years ago. Over a billion dollars in German investment has already moved to Poland, Hungary, and the Czech Republic. For Germany, this is not a terribly significant sum, but it has helped lower unemployment in the smaller countries: the figure for the Czech Republic has recently been a decidedly un-European 3.5 percent.

Paying More for Less

Beyond political discontent, neo-Nazi flashes, and unemployment rates in the mid-teens or higher, the clearest sign of this failure is the absence of successful new East German businesses. The few new companies are frequently either objects of massive investment from the federal government or “bear” companies that have wagered their future on economic decline elsewhere.

Eastern Germany, of course, is a special case, and its treatment, in any case, is a fait accompli. The fundamental problems, and those that will cause most trouble in the future, lie throughout Germany in a social commitment that continues to drive labor costs upward despite new circumstances. One of the best examples of this is Wolfsburg, the international headquarters of Volkswagen. Although Volkswagen today is one of the world’s largest companies, the “people’s car” was originally part of a Rooseveltian public works program that was one of the more successful National Socialist campaigns. For many years, social commitments like Volkswagen “worked”; that is, the VW Bug was exported and sold across the world and Germany suffered far fewer of the long strikes that plagued, for example, he United Kingdom. Even in 1994 the scale of the vast grounds of the VW plant at the headquarters in Lower Saxony reminds visitors of the postwar glory days when the entire economy sometimes appeared to be based on seamless interaction and planned cooperation between organized labor and heavy industry.

Today, the Volkswagen plant epitomizes the jam caused by Germany’s social commitment. The average German citizen is entitled to 25 to 32 days of paid vacation, plus 10 to 13 days off on state and religious holidays (citizens of Germany’s Catholic states enjoy the largest number of such days). Volkswagen workers have done even better, with up to 60 days off. The average German enjoys health care as an entitlement and a generous pension, as does the VW worker. The German government keeps a handle on youth unemployment by joining with businesses to run an extensive apprenticeship program; Volkswagen does its share by training more than 4,000 apprentices at an annual cost of $15,000 Or more per participant. Volkswagen, like much of the German auto industry, has excess capacity in its domestic plants. But, a VW employee says, “VW tries never to lay off.”

Germany’s labor costs are the world’s highest. Volkswagen’s added benefits mean that its workers in Germany are paid more than auto workers anywhere else. The industry average for the indirect social costs of labor amounts to about DM 84 over the DM 100 spent on gross wages. Volkswagen’s outlay is 20 percent higher. Although business troubles outside Germany were the biggest problem, domestic labor costs did contribute to a record $1 billion plus loss for Volkswagen internationally last year. This year VW expects to break even, but labor costs are still high enough that its vehicles are too pricey for the currently modest level of German demand.

Volkswagen, one suspects, would dearly like to make dramatic layoffs in Lower Saxony, where it has an excess capacity of 30,000 workers. But the firm has already eliminated numerous jobs through attrition; a significant number more, warns a VW manager, would increase the area’s 10.4 percent unemployment rate to 16 percent. Volkswagen and the businesses that serve it provide 85,000 jobs in Lower Saxony. So accustomed are the firm and the state’s citizens to job security that the notion of further, large-scale layoffs frightens both groups. Significant layoffs, the Lower Saxony manager warns, would mean “social revolution.”

Whether or not he is correct in his assessment, there are additional barriers to any such move by Volkswagen management. Labor’s strength in Germany means that laying off unionized workers is very expensive: “The only way a German company can lay people off is to go bankrupt,” one bitter businessman says. Large, publicly traded German firms are typically governed through the special German system of “codetermination,” under which trade union representatives join management at the boardroom table. The arrangement is typically a 50-50 one, but in VW’s case the scales are tipped in favor of labor. The state of Lower Saxony is a minority shareholder in Volkswagen, and the state prime minister represents the state on the board. The state’s current prime minister, Gerhard Schroeder, is from the Social Democratic Party, historically the union’s party. Along with labor’s representatives, Schroeder’s board presence has precluded any solutions that would be viewed as asozial, or antisocial.

To spare its 30,000 excess employees, VW embarked on a massive adventure in rearranging production. Workers at its German factories went on a four-day workweek at reduced pay. The savings there have gone toward retraining the 30,000 surplus workers; apprentices have been phased in and early retirees phased out. Volkswagen has guaranteed jobs for two years to the 30,000 who are being retrained The company reckons it has saved DM 1 billion through this alternative to the settlement costs of layoffs.

Much of German government shares VW’s focus on preserving existing jobs as an economic solution. Lower Saxony’s Governor Schroeder warmly welcomed VW’s job-saving reorganization; he backed VW’s sideline training program and has said that the state will probably sponsor a widening of VW’s effort to include excess workers from other firms. He favors and practices government intervention in the local economy where possible and argues that “the old separation between government and business just doesn’t exist.”

The close coalition of business and government represented a large concession from the trade unions, who formerly frowned on any but the most standard hour and wag-e arrangements. Across much of Western Europe, redividing existing jobs to avoid social cutbacks is now trendy. In a policy paper released at the end of July, the European Commission stressed that “if these flexible forms of work are to be generally accepted, it is important to ensure that such workers are given broadly equivalent working conditions to standard workers.” Yet even on this socially oriented continent, conventional wisdom now holds that such ingenious efforts can not alleviate the basic problem: “Legislated, across-the-board work sharing addresses the unemployment problem not by increasing the number of jobs through more economic activity, but through rationing gainful work. Enforced work-sharing has never succeeded in cutting unemployment significantly,” wrote OECD authors in 1994.

In the meantime, high costs have driven Volkswagen to seek more attractive profit margins outside Germany; the voices of VW executives are enthusiastic only when they are speaking of areas where they expect to see strong growth, such as at VW’s Skoda factory in the Czech Republic, or in China, or even in Mexico and the United States. BMW’s investment in Spartanburg, South Carolina, is one example of new German investment in the United States; Daimler-Benz also has recently established a Mercedes factory in the United States. Reports from Dow Jones show that last year, a bad one for auto sales in Europe, the Skoda factory saw a 10 percent increase in production to 220,000 cars. In 1993, VW cars sold domestically in Germany dropped 15.5 percent to 215,242 cars.

In its reduction of labor costs and relocation of production outside of Germany, VW is typical: 19 of the 20 largest firms in Germany reported that they laid off employees in the recession of 1992-93. In the last recession German industry lost roughly one million jobs, which it does not appear capable of entirely replacing. This summer, Western German unemployment dropped a bit to 8.3 percent. However, across Germany unemployment remains above nine percent; in Lower Saxony the result is a stubborn unemployment rate of ten percent plus. Even more troubling is that when Germans—and indeed all Europeans—become unemployed, they are likely to remain so for a long time. OECD numbers show that of all German unemployed, 33 percent have been out of work a year or longer; in the United States that rate is 11.2 percent.

To help the unemployed—and to make good the social contract—Germany’s government spends generously. Germans, like many other Europeans. unemployment assistance indefinitely. Specifically, employees receive 67 percent of their net wages for up to 15 months and 57 percent in welfare cash thereafter. A reemployment and retraining program of the sort the Clinton administration is considering has long been a fixture in Germany, which spends over $15 billion annually to educate adult workers further. In addition to unusually generous unemployment benefits, the government offers a range of programs to the jobless; $8 billion alone went to creating 290,000 spots in a social welfare program known as the Arbeitsbeschaffungsmassnahmen, or ABM, which reimburses private and public organizations for taking on unemployed citizens. As a share of GDP, government outlays are around 50 percent, below France but many points above the United States. So generous is Germany that its unemployed often enjoy greater benefits—free health care, for example—than the working poor in the United States.

Supply Side Regulation

The same system that helps preserve old jobs often prevents the creation of new ones. Says Volkswagen’s Piech, “If you want to start a new business, Europe is not yet a good place.” For the casual visitor to Germany, the most obvious reason is heavy regulation of supply. One of the clearest examples is the sales law, or Rabattgesetz, which prohibits stores from marking down merchandise except simultaneously and in prescribed “sale periods.” Neighboring Austria reformed its Rabattgesetz several years ago, but Germany’s is still on the books.

Another example—particularly maddening for the tourist—is Germany’s store-closing hours. The German government and trade associations, in the name of economic management, have long colluded to control demand. Labor unions have also argued against more flexible hours. A trade union recently declared that “the right of 2.7 million retained employees to go home at the weeknight closing time of 6:30 p.m. clearly outweighs the desire of a few individuals to shop in the evening.”

German stores close at lunchtime three Saturdays each month and remain firmly shuttered on Sunday. Businesses who can prove they somehow provide services to those with special needs (for example, sandwich shops in train stations) are the only exception. The German entrepreneurs’ frustration with this antiquated system is visible everywhere. On a recent Sunday in Berlin, colleagues and I went looking for a place to photocopy a document. Posted to the (locked) door of the firm Copyhaus in the genteel Schoeneberg neighborhood was the following sign: “CAPITAL’S SCANDAL: After seven years of being opened, CLOSED on Sundays. The State Office for Protection of work denies us the chance to occupy employees on Sundays and holidays. Justification?: lack of public interest (!!?). We think that more than 200,000 customers during Sunday hours speak out in incomprehension!”

Steeply progressive taxes present an added obstacle to businesses such as Copyhaus. According to the calculation of the Hanover Chamber of Industry and Commerce, some 53 percent of the revenues of the Copyhaus and businesses like it go to government; the rate is 56 percent in Lower Saxony. While the federal government has moved recently to loosen the Rabattgesetz and store hours, it has moved in the other direction on taxation. Since reunification, the Kohl government has passed ten tax increases: a special “solidarity extra” for the costs of reunification, an energy tax, an insurance tax, an automobile tax, a tobacco tax, a one-point increase in the value-added tax to 15 percent, a tax on interest, another insurance tax, another energy tax, and another tax on personal vehicles. The taxes, moreover, are largely progressive. “Hunt for the Better Earners,” read a recent headline in the magazine Focus, which reported that the top five percent of German earners—those who earn over DM 125,800 annually—provide the government with some 40 percent of all income tax revenues. Bundesbank reports show that tax and social costs are equivalent to 43.7 percent of GDP, compared to 30.7 percent for the United States and 33.4 percent for Britain.

A Patent Failure

Job creation is blocked by another German problem—a failure to innovate. Germany from the late nineteenth century forward was a machine of innovation. A sampling of Nobel Prize winners at the turn of the century shows Germans took the prizes for physics and medicine in 1901, chemistry in 1902, and physics, chemistry, and medicine in 1905. Whereas Germany took five Nobel prizes in chemistry in the first decade of the twentieth century, it took only one during the 1980s.

For industry and business, the problem is enormous. The numbers for science are damning. The Wall Street Journal recently quoted a report from the German chancellor: “In microelectronics the number of German patents between 1987 and 1992 shrank from 289 to 181, while the Japanese registrations have risen from 17,408 to 23,082. The U.S.A., with a doubling of its patents from 848 to 1,671 [over the same period] is substantially better off than German enterprises.” The chancellor saw similar lags in large computers, communications electronics, office technology, and lasers.

The area of biotechnology is also troubling. Open field tests—those conducted outdoors instead of inside labs or areas contained by glass—are crucial to the development of bioengineering plants. By 1992, Germany had only two such experiments in progress, in contrast to more than 300 in the United States or Canada. For 1994, the German figure has risen to ten—one percent of the number of such tests in the United States.

The proximate cause of the Innovationskrise (innovation crisis), as some Germans have dubbed it, is a legal system that is overly restrictive. Although Germany’s Green Party remains small compared to the dominant Christian Democratic Union and Social Democratic Party, green thinking preoccupies Germans of all political backgrounds and generated a chain of new environmental legislation beginning in the early 1980s. Motivated by genuine and compelling problems of overcrowding, quality of life, and pollution, Germany has adopted some of the strictest laws in the world. In the case of biotechnology the problem is Germany’s Gentechnikgesetz, or law on genet-ic engineering, which has been liberalized somewhat but remains extremely restrictive by world standards. To obtain permission for an open-field experiment, businesses must undergo a lengthy process. American businesses, by contrast, must only obtain approval for the product.

Other areas of heavy industry report being similarly constrained by government regulations. The chemical company Henkel, for example, reports that due to new laws and the Bundesimmisionsgesetz (federal emissions law) the average number of months it takes to get permission to build a new chemical plant has grown to 17.5 in 1992 from 5.8 in 1985. A recent survey indicated that establishing a new factory takes an average of 22 months in Germany, compared with six in France. In the words of Wilfred Prewo of the Hanover Chamber of Commerce: “The Americans invent, the Japanese produce, while the Germans still debate ethics.”

The Innovationskrise has another, subtler source—the failure of German education. Germans study, to a large degree, tuition free, at cost to the state. There are very few private business schools and universities; The result has been to some degree a “dumbing down of institutions that were once world leaders in research; now students have an unrelenting menu of overcrowded state institutions. Public generosity and antiquated requirements also mean that the education of young people lasts too long. Germans spend, on average, double the number of semesters in institutions of higher learning that Americans do. Those trained in German programs start work at companies in their late 20s and early 30s, an age by which they are often, in the words of a Deutsche Bank vice president, “simply too old” to be flexible.

German educational institutions also lag behind American ones in innovation and energy. Whereas Germany was a world center for training in medicine, chemistry, and physics before World War II, it is now to Cal Tech, Harvard, or Stanford that Germans, indeed all Europeans, flock.

Old Folks at Home

The hardest test of all for the German social welfare state is its clash with demography. Germany, like other West European nations, is an aging country. As the Frankfurter Allgemeine Zeitung recently noted, in 1980 every fifth German was over 60 years old; in the year 2000 every fourth German will belong to this age group; by 2030 the figure will be 37 percent. By 2030, Germans over the age of 65 will outnumber their younger countrymen by a 10-to-6 ratio. Because Germany, like the United States, has a “pay as you go” system for publicly funding retirement, it will feel the budget shocks of this social change directly; there is no cushion for the debt the working population will accrue when German baby boomers retire.

The statistics for eastern Germany yield a troubling portrait. American demographer Nicholas Eberstadt recently looked at fertility numbers for eastern Germany since the initial reunification shock of 1989-90. Before 1989, births ranged between 215,000 and 246,000 annually; afterwards patterns changed, and the rate fell by more than 45 percent. In the first five months of 1993, the total number of births was down by 60 percent from 1989. Marriage rates fell by 62 percent between 1989 and 1992. “Whereas eastern Germany’s marriage rate had been consistently higher than western Germany’s during the 1980s,” writes Eberstadt, “by 1992 it was less than half as high.” One would suppose that, in a better financial climate, eastern Germans would be just as willing to marry and have children, writes Eberstadt, but they “are not behaving like a population whose living standards have been significantly increased.” The generations of eastern Germans older than 30, in particular, often referred to as “the lost generations,” are a troubled group—they will continue to face adjustment long after the numbers start to show successful economic integration. Without younger breadwinners to pay their pensions, they face an even harder future.

Those Were the Days

What is different about Germany’s problems today that makes them worse than other problems of the postwar period? Under the same system, with the same social commitment, Germany outperformed the vast majority of OECD countries from the 1950s to the 1970s. The simplest answer is the strength of the German currency—a devaluation of the currency toward something closer to DM 2 to the dollar would do much to help German competitiveness. A more fundamental challenge is globalization—East European and Asian competition drives Germany as never before.

Another difference, though, is complacency. To battle the devastation left by World War II, Germans in the 1940s and 1950s relied on individual resources. “We can’t do magic, but we can work,” read a conservative party poster from 1949, and a high regard for that work ethic was shared by citizens of all political backgrounds. Today, the willingness to sacrifice is absent among all citizens of the Federal Republic, old and new. Following the war, the Federal Republic’s national fathers, Konrad Adenauer and Ludwig Erhard, started Germany off with a free-market program. Erhard and the Allies who backed him lifted price controls; Erhard also cut back regulation and sought to lower taxes. The freedom provided West Germans with the energy to work their economic miracle.

Only after the miracle was launched did German political leaders, conservative and liberal, write many aspects of the current social welfare regime into law. This German tradition of “work, then redistribute” is one many Germans now recall wistfully. Following the collapse of the Berlin Wall, eastern Germans could be seen on the streets of Berlin carrying reprints of Erhard’s famous book on economic policy, Prosperity for All. It is a contemporary irony that the Erhard model has taken hold more successfully in some parts of Eastern Europe than in Germany.

The easiest, and most obvious, cure for Germany would be a change in political direction. The recent success of The End of Individualism, a plea by two German think tank authors for a return to a society with more American-style self-reliance, is indicative. Along these lines, the Kohl government this year is already campaigning hard on a platform of reducing social benefits. In now-famous remarks, the chancellor told fellow citizens that Germany cannot continue on the current path toward becoming a “national amusement park.”

Throughout Western Europe there are similar signs of such recognition at the end of May the European Union finance ministers pushed the European Community to shift its emphasis from job preservation and creation to deregulation that could free up supply.

Labor market deregulation won endorsement from the International Monetary Fund in April.

For Germany, though, the answer is not likely to be a simple “Erhardization” of Helmut Kohl, or even his “Thatcherization.” Such a program might do nothing more than convert Germany, a country whose poor are unemployed, into an America, a country in which many of the employed are still poor. The German change is likely to be a generational change, in which younger Germans, along with other younger Europeans, reassess Europe’s ossifying position on the global map. Italy’s radical political purges foreshadow other such near-revolutionary shifts in all the gerontocracies of Western Europe, including Germany.

The degree to which Germany remains a true economic Grossmacht, a big power, will depend on the degree to which it turns onto a new path. The idyll of the tame Federal Republic seems to be gradually ending in any case, something even Germans inclined more to the lyrical than the economic have predicted. “Anything in the world can be endured,” wrote Goethe in 1815, “except a succession of prosperous days.”