Why German wages need to rise

An interesting disagreement occurred this week between Martin Sandbu and the Economist, which prompted a subsequent letter from Philippe Legrain (see also Martin again here). The key issue is whether the German current account surplus, which has steadily risen from a small deficit in 2000 to a large surplus of over 8% of GDP, is a problem or more particularly a drag on global growth.

To assess whether the surplus is a problem, it is helpful to discuss a key reason why it arose. I have talked about this in detail many times before, and a similar story has been told by one of the five members of Germany’s Council of Economic Experts, Peter Bofinger. A short summary is that from the moment the Eurozone was born Germany allowed wages to increase at a level that was inconsistent with the EZ inflation target of ‘just below 2%’. We can see this clearly in the following chart.

Relative unit labour costs, source OECD Economic Outlook, 2000=100

The blue line shows German unit labour costs relative to its competitors compared to the same for the Euro area average. Obviously Germany is part of that average, so this line reduces the extent of any competitiveness divergence between Germany and other union partners. By keeping wage inflation low from 2000 to 2009, Germany steadily gained a competitive advantage over other Eurozone countries.

At the time most people focused on the excessive inflation in the periphery. But as the red line shows, this was only half the story, because wage inflation was too low in Germany compared to everyone else. This growing competitive advantage was bound to lead to growing current account surpluses.

However that in itself is not enough to say there is a problem, for two related reasons. First, perhaps Germany entered the Eurozone at an uncompetitive exchange rate, so the chart above just shows a correction to that. Second, perhaps Germany needs to be this competitive because the private sector wants to save more than it invests and therefore to buy foreign assets.

There are good reasons, mainly to do with an ageing population, why the second point might be true. (If it was also true in 2000, the first point could also be true.) It makes sense on demographic grounds for Germany to run a current account surplus. The key issue is how big a surplus. Over 8% of GDP is huge, and I have always thought that it was much too big to simply represent the underlying preferences of German savers.

I’m glad to see the IMF agrees. It suggests that a current account surplus of between 2.5% to 5.5% represents a medium term equilibrium. That would suggest that the competitiveness correction that started in 2009 has still got some way to go. Why is it taking so long? This confuses some into believing that the 8% surplus must represent some kind of medium term equilibrium, because surely disequilibrium caused by price and wage rigidities should have unwound by now. The answer to that can also be found in an argument that I and others put forward a few years ago.

For this competitiveness imbalance to unwind, we need either high wage growth in Germany, low wage growth in the rest of the Eurozone, or both. Given how low inflation is on average in the Eurozone, getting below average wage inflation outside Germany is very difficult. The reluctance of firms to impose wage cuts, or workers to accept them, is well known. As a result, the unwinding of competitiveness imbalances in the Eurozone was always going to be slow if the Eurozone was still recovering from its fiscal and monetary policy induced recession and therefore Eurozone average inflation was low. [1]

In that sense German current account surpluses on their current scale are a symptom of two underlying problems: a successful attempt by Germany to undercut other Eurozone members before the GFC, and current low inflation in the Eurozone. To the extent that Germany can make up for their past mistakes by encouraging higher German wages (either directly, or indirectly through an expansionary fiscal policy) they should. Not only would that speed adjustment, but it would also discourage a culture within Germany that says it is generally legitimate to undercut other Eurozone members through low wage increases. [2]

From this perspective, does that mean that the current excess surpluses in Germany are a drag on global growth? Only in a very indirect way. If higher German wages, or the means used to achieve them, boosted demand and output in Germany then this would help global growth. (Remember that ECB interest rates are stuck at their lower bound, so there will be little monetary offset to any demand boost.) The important point is that this demand boost is not so that Germany can help out the world or other union members, but because Germany should do what it can to correct a problem of its own making.

[1] Resistance to nominal wage cuts becomes a much more powerful argument for a higher inflation target in a monetary union where asymmetries mean equilibrium exchange rates are likely to change over time.

[2] The rule in a currency union is very simple. Once we have achieved a competitiveness equilibrium, nominal wages should rise by 2% (the inflation target) more than underlying national productivity. I frequently get comments along the lines that setting wages lower than this improves the competitiveness of the Eurozone as a whole. This is incorrect, because if all union members moderate their wages in a similar fashion EZ inflation would fall, prompting a monetary stimulus to bring inflation back to 2% and wage inflation back to 2% plus productivity growth.    

German macroeconomics revisited

At the end of April George Bratsiotis and David Cobham organised a conference with the provocative title “German macro: how it's different and why that matters” which I unfortunately was not able to attend. Six of the papers presented, plus some additional papers on related themes, are published here. The papers by Peter Bofinger and Michael Burda are related to earlier work by both authors that I have discussed in earlier posts here and here.

Many of the themes in these papers have been briefly discussed in past posts. Peter Bofinger notes that the macro taught in German universities is little different from that taught elsewhere, but stresses the prevailing influence of Ordoliberalism and the ideas of Walter Eucken. Michael Burda emphasises the role of German self-interest in influencing the policy positions of German macroeconomists. As I note here, it is often difficult to distinguish between the relative importance of ideas and self interest.

This is particularly true when ideas and self interest reinforce each other. According to Bofinger, Ordoliberalism reacted to the demand problem identified by Keynes by stressing the importance of wage flexibility and sound money. Germany’s distinctive wage bargaining structure allows an unusual degree of flexibility. In the context of a fixed rate system or monetary union where other countries cannot respond in kind, this does indeed allow a way out of demand deficiency as we saw in the early years of the Euro. As a result, virtually the only country to survive to Eurozone recession largely unscathed was Germany.

I hope it does not need spelling out that this route out of demand deficiency only works by taking demand from other countries. [1] If Germany had its own currency and a floating exchange rate, any fall in domestic prices would be offset by an exchange rate appreciation. Luckily for Germany its neighbours, perhaps attracted by its ability to keep inflation low, have been eager join fixed rate systems or monetary unions where the wage cutting trick will work (see the book by Yanis Varoufakis reviewed here for example).

The only points I would add is that this unusual economic outlook is not confined to macroeconomics, and that it depends to some extent on a degree of insularity from international mainstream discussions of economic policy. It is hard to imagine a reputable UK or US research institute talking about the minimum wage and saying “minimum wages have time and again been shown to help some workers earn more at the cost of the low-skilled losing their jobs”, as if the work of Card and Krueger had never happened. I have sometimes wondered whether in Germany business has an influence on the economic debate that in the UK and US has been replaced by the influence of finance, but that at the moment is purely a speculative idea.

[1] An important point to note here is that if you have a target for the level (or path) of the money stock, then wage and price flexibility might get a closed economy out of recession if it was successful in raising inflation expectations. However the ECB has an inflation target and not anything like a price level target.

Was German undercutting deliberate?

In what I described over a year ago as the untold story of the Eurozone crisis, Germany held nominal wage increases below the level of other core Eurozone countries, gradually gaining a large competitive advantage over them. This had a number of consequences, but perhaps the most important is that when the Great Recession hit, Germany was much better placed than all the other Eurozone countries. (It is essentially a zero sum game, because the Euro exchange rate moves to influence overall Eurozone competitiveness, which is why I describe it as Germany undercutting its Eurozone neighbours.)

Up until now I have always been careful to avoid describing this as a deliberate beggar my neighbour policy. But one of the five members of Germany’s Council of Economic Experts, Peter Bofinger, writes:

“In 1999, when the Eurozone started, Germany was confronted with an unemployment rate that was too high by German standards, although it was still below the EZ average. The solution to the unemployment problem was typical of Germany’s corporatist system. Already in 1995 Klaus Zwickel, boss of the powerful labour union IG Metall, made the proposal of a Bündnis für Arbeit(pact for work). He explicitly declared his willingness to accept a stagnation of real wages, i.e. nominal wage increases that compensate for inflation only, if the employers were willing to create new jobs (Wolf 2000). This led to the Bündnis für Arbeit, Ausbildung und Wettbewerbsfähigkeit (pact for work, education and competitiveness), which was established by Gerhard Schröder in 1998. On 20 January 2000, trade unions and employers associations explicitly declared that productivity increases should not be used for increases in real wages but for agreements that increase employment. In essence, ‘wage moderation’ is an explicit attempt to devalue the real exchange rate internally.”

You still hear people say that the DM was overvalued when it converted to the Euro, but my research at the time suggested otherwise, and it is difficult to argue against the view that with today’s current balance surplus of over 7% of GDP Germany is grossly undervalued.

It is hard to overstate the importance of all this. German employers and employees connived in a policy that would take jobs away from their Eurozone partners. Whether this was done knowingly, or because of a belief is some kind of wage-fund doctrine, or something else I do not know. But it makes Germany, a country with perhaps a unique ability to cooperate on an internal devaluation of this kind, a dangerous country to form a currency union with. The thing I find extraordinary about all this is that Germany’s neighbours seemed to have let it happen without a whisper of recognition or complaint.

What is it about German economics?

I recently had the privilege to speak in Berlin at the 10th anniversary celebration of the Macroeconomic Policy Institute (IMK). (The talk I gave, on the Knowledge Transmission Mechanism, is here if anyone really wants to watch it.) I had known about the IMK for some time through reading incisive posts by Andrew Watt on the Social Europe website, but more recently I had been citing important papers by other IMK economists looking at the costs of austerity. You could describe the IMK group within Germany in various ways (see below), but one would be an island of Keynesian thinking in a sea that was rather hostile to Keynesian ideas.

As my talk, and this subsequent post, focused on how Keynesian ideas are pretty mainstream elsewhere, this raises an obvious puzzle: why does macroeconomics in Germany seem to be an outlier? Given the damage done by austerity in the Eurozone, and the central role that the views of German policy makers have played in that, this is a question I have asked for many years. The textbooks used to teach macroeconomics in Germany seem to be as Keynesian as elsewhere, yet Peter Bofinger is the only Keynesian on their Council of Economic Experts, and he confirmed to me how much this minority status is typical. [1]

There are two explanations that are popular outside Germany that I now think on their own are inadequate. The first is that Germany is preoccupied by inflation as a result of the hyperinflation of the Weimar republic, and that this spills over into their attitude to government debt. (The recession of the 1930s helped create a more serious disaster, and here is a provocative account of why the memory of hyperinflation dominates.) A second idea is that Germans are culturally debt averse, and people normally note that the German for debt is also their word for guilt. The trouble with both stories is that they imply that German government debt should be much lower than in other countries, but it is not. (In 2000, the German government’s net financial liabilities as a percentage of GDP were at the same level as France, and slightly above the UK and US.)

A mistake here may be to focus too much on macroeconomics. Germany has recently introduced a minimum wage: much later than in the UK or US. I think it would be fair to say that German economists generally advised against this. In the UK and US the opinion of economists on the minimum wage issue is much more balanced, largely because there is a great deal of academic evidence that at a moderate level the minimum wage does not reduce employment significantly. So here German economics also appears to be an outlier.

Many people have heard of ordoliberalism. It would be easy to equate ordoliberalism with neoliberalism, and argue that German attitudes simply reflect the ideological dominance of neo/ordoliberal ideas. However, as I once tried to argue, because ordoliberalism recognises actual departures from an ideal of perfect markets and the need for state action in dealing with those departures (e.g. monopoly), it is potentially much more amenable to New Keynesian ideas than neoliberalism. Yet in practice ordoliberalism does not appear to allow such flexibility. It is as if in some respects economic thinking in Germany has not moved on since the 1970s: Keynesian ideas are still viewed as anti-market rather than correcting market failure, and views on the minimum wage have not taken on board market distortions like monopsony. But that observation simply prompts the question of why in these respects German economics has remained isolated from mainstream academic ideas. [2]

One of the distinctive characteristics of the German economy appears to be very far from neoliberalism, and that is co-determination: the importance of workers organisations in management, and more generally the recognition that unions play an important role in the economy. Yet I wonder whether this may have had an unintended consequence: the polarisation and politicisation of economic policy advice. The IMK is part of the Hans-Böckler-Foundation, which is linked to the German Confederation of Trade Unions. The IMK was set up in part to provide a counterweight to existing think tanks with strong links to companies and employers. If conflict over wages is institutionalised at the national level, perhaps the influence of ideology on economic policy - in so far as it influences that conflict (see footnote [1]) - is bound to be greater. 

As you can see, I remain some way from answering the question posed in the title of this post, but I think I’m a bit further forward than I was.  

[1] The ‘Hamburger Appell’ of 2005, signed by over 250 German economists, is clearly anti-Keynesian. The intellectual rationale given there is unclear, but one theme is that a more effective way of increasing employment is to increase international competitiveness by holding down domestic costs. Now if you are part of a fixed exchange rate regime or a monetary union, and you have - for institutional reasons - an ability to influence domestic wage costs that other countries that belong to the regime do not have, then it may make perfect Keynesian sense to use that instrument. This is exactly what happened (deliberately or not) from 2000 to 2007, which of course is a major reason why Germany is currently not suffering the recession being experienced by the Eurozone as a whole. (Of course, unlike a fiscal stimulus, it is a beggar my neighbour policy, because demand increases at the expense of other countries in the regime: for the regime as a whole a flexible exchange rate will offset the impact of lower costs on competitiveness.)

[2] On this isolation see Tony Yates here. At the end of this post Tony also references an interesting discussion regarding ordoliberalism and other issues in comments on a post of my own: see here.