By Simon Tilford
Europe’s biggest economy could easily stop its own slide into long-term stagnation—but it would prefer not to.For much of the last 10 years, Germany has been lauded for its successful adjustment to globalization, its sound management of public finances, and its political stability. Some have even breathlessly talked of a new Wirtschaftswunder (economic miracle). Now fears are mounting that worsening global trade tensions and China’s slowdown spell serious trouble for the country’s export-dependent economy threatening to return the country to the “sick man of Europe” status it held in the early 2000s.
The situation is less dramatic. German’s economic performance has not been as good over the last 10 years as is often claimed, but the German government could now easily take steps to boost the economy should it choose to do so. There is little to indicate that it will do enough, however, thanks to a deep-seated belief in Germany—spanning the political spectrum—that deficit spending would be counterproductive economically and unpopular politically.
Seen over the last 10 years, the German economy has performed relatively well in comparison with similar European economies such as France and the United Kingdom, but it has done no better than the United States. Moreover, over the last 20 years, Germany has grown largely in line with other large European economies (bar Italy, which has done terribly) and on many measures less well than the United States. There has certainly been no Wirtschaftswunder.
Moreover, the German economy has become strikingly dependent on exports over this period. Germany has long tended to run a trade surplus, but never of the present magnitude. The country has averaged trade surpluses of close to 8 percent of GDP since 2005 and 6.5 percent since 2004. At close to $300 billion in 2018, the German trade surplus is easily the largest in the world. The heavily trade-orientated focus of the German economy helps explain why Germany bounced back more rapidly following the financial crisis than comparable European economies, but it also explains why Germany’s prospects have turned down particularly sharply over the last 12 months as the external environment has worsened rapidly.
There is a tendency in Germany and elsewhere to talk about trade balances in terms of competitiveness, with countries with surpluses being “competitive” and those with deficits being “uncompetitive.” Indeed, in response to U.S. President Donald Trump’s criticism in 2017 of the scale of Germany’s surplus, the country’s then-Economic Minister Sigmar Gabriel—a social democrat—joked that the United States simply needed to build better cars. German economists and representatives of the economy and finance ministries also tend to throw their arms in the air and argue that Germany’s trade surplus is simply the product of private-sector decisions over which the German government has no influence. Both claims are at best misleading.
A country’s trade balance is the difference between what it produces and what it consumes. Germany produces far more than it consumes, because the country saves far more than it invests. This is not primarily because of its aging population—the household savings rate has always been high and hasn’t risen significantly over the last 15 years—but because of ballooning corporate sector and government savings, as Germany has been running a fiscal surplus since 2013. The United States, by contrast, consumes more than it produces; that is, domestic savings are insufficient to fund domestic investment. This tells us little about the success of the two respective economies—at least if by success we mean productivity levels and hence living standards—as opposed to the price competitiveness of a country’s exports on global markets.
It is highly unusual for an economy as big as Germany’s to be so acutely sensitive to changes in foreign demand; typically an economy of its size is driven primarily by domestic demand. And there is nothing inevitable about Germany’s degree of export dependence—it reflects domestic policy choices in Germany over the last 15 or so years. Far from being at the mercy of global forces beyond its control, the German government could take steps to rebalance the country’s economy.
The principle reason why German savings have risen and investment has weakened is a big transfer of national income from households to firms, reflecting very weak wage growth for those on low to average incomes and tax policies that have favored the business sector over households. According to the IMF, German household consumption has fallen from around 63 percent of GDP in 2005 to 51 percent in 2018. While the transfer of income to the enterprise sector boosted its profits and the price competitiveness of German exports, it has done nothing to boost investment and hence productivity growth across the German economy as a whole. The reason is that the weakness of consumption has undermined firms’ incentives to invest at home—they are sitting on the cash instead.
Foreign demand for German goods is now shrinking, bringing the country’s economy to a standstill. But there is no reason for Germany to return to being the sick man of Europe. The biggest challenge facing the country comes from its own politics rather than the worsening international environment. Germany can easily take steps to boost domestic consumption and offset the weakening of external demand. The German government could reduce taxes on low to median incomes, raise public-sector wages, launch a major public investment program, and overturn the elements of the Hartz labor market reforms implemented in 2003 to 2005 that undermined the bargaining power of workers and helped to create a large low-wage economy.
Many German economists, and not just those on the left, are now calling on the government to reform the country’s constitutionally binding commitment to balance the federal government’s budget over the economic cycle. They rightly argue that it is preventing the country from upgrading its worsening infrastructure, and that with the government’s borrowing costs having turned negative—that is, investors are prepared to pay the German government to lend to it—borrowing to fund investment would more than pay for itself. Most conservative economists and business figures, however, continue to argue that what the country needs is tax cuts for business and more labor market flexibility.
There will be a compromise: an easing of the country’s fiscal rules and higher public investment but also the abolition of the so-called solidarity tax, a 5.5 percent surcharge on income and corporate tax introduced in the aftermath of reunification to fund the rebuilding of the eastern states. Higher public spending, particularly investment, will certainly provide a boost to the economy—especially given that the government can easily borrow for free. Higher public investment could certainly boost productivity, for example by alleviating the country’s transport bottlenecks and improving its poor telecommunications infrastructure, but it will not be a substitute for stronger private investment. And contrary to the claims of conservative economists, abolishing the solidarity charge will do little to boost investment, because it will disproportionately benefit the better off and firms, groups which that a high propensity to save. With the proportion of German business profits going toward taxes having already fallen sharply, firms are already sitting on unprecedented cash holdings. All that a further cut in the corporate tax burden is likely to do is further increase savings and with it the economy’s export dependence.
The German economy is not about to fall off a cliff, but neither is it likely to return to the decent growth rates of the last few years without significant reform. Germany requires not just a loosening of public purse strings and higher public investment, but also concerted steps to boost consumption, and therefore incentives for firms to invest in Germany. But there is little to suggest that the German government will take radical steps to reverse the decline in household spending power. Indeed, as the downturn takes hold, there is still a risk that the country will fall back on the policies that have depressed consumption and left it so vulnerable to the vagaries of foreign demand.