Photographer: Krisztian Bocsi/Bloomberg

The Changing Face of the German Economic Miracle?

For decades the image of the archetypal German household has been one of thrifty stoicism in the popular imagination - a stereotype that has been actively encouraged by Angela Merkel, who has often paid homage to the proverbial schwäbische Hausfrau.

That might be changing. The German postwar economic miracle - the Wirtschaftswunder - driven in no small part by the failure of worker pay to keep up with productivity gains is now undergoing a dramatic shift. With unemployment in the country at record lows and wages finally rising, analysts expect the driver of Europe's largest economy to move from exports to consumer spending.

As Hans-Werner Sinn, president of Germany's Ifo institute, said on Wednesday: "Private consumption remains the pillar of the upswing [in 2016] because the income outlook of private households continues to be good on the back of a further improved labor market situation."

Yet not everyone is convinced that this represents a structural shift away from the mercantilist policies of the recent past.

Regulation and reunification

Although Germany has been seen as a powerhouse economy over recent years, churning out solid GDP growth even as the euro-zone as a whole struggled to recover from the financial crisis, in the late 1990s and the early 2000s the country was often called "the sick man of Europe." Growth averaged 1.2 percent between 1998 and 2005, while unemployment climbed into double figures.

In the background, significant changes were afoot. In West Germany in the 1980s a combination of strong labor unions and stringent labor market regulation helped keep negotiated wage settlements high even as the unemployment rate hovered around 8 percent. That meant, in effect, West German industry was becoming less competitive as labor costs outstripped productivity growth and regulations kept potential workers out of the labor supply.

That all started to change in 1990s with the collapse of the Soviet Union and the reunification with East Germany.

While this led to a period of painful adjustment - from 1993-2003 West Germany spent around 900 billion euros ($983 million in net transfers) - it also saw the beginnings of a recovery in competitiveness that would only build momentum over the next two decades.

Despite the gains in competitiveness, unemployment remained stubbornly high in Germany throughout the 1990s. To  combat that, unions and employers negotiated a policy of wage restraint. As Peter Bofinger, a member of the German Council of Economic Experts, reports:

"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."

Coupled with reforms passed in 2002 and 2004 to reintegrate the unemployed into the workforce, the deal allowed German industry to improve its competitiveness against international rivals and to add jobs at the cost of workers' share of income. As the IMF noted, the "decline in labor compensation as a share of GDP happened in the U.S. and U.K. as well, but in Germany it took place despite a strong increase in corporate value-added relative to GDP."

Consumer businesses also cut costs through a policy of domestic outsourcing, where employers used contractors, temp agencies and franchises rather than hiring employees directly. So wages in those industries fell 10 percent to 15 percent, compared with similar jobs that weren't outsourced.

A changing model?

As with most structural reforms, the impact of the new German model took some time to show. Only in the aftermath of the credit crunch and the euro-zone crisis that followed that did the improvements in German competitiveness that had been building for over a decade allow the country to pull away from its peers, driven by exports.

While euro-zone unemployment remains above 10 percent over eight years since the start of the crisis, German joblessness has plunged to 4.5 percent, government data show. With the supply of unemployed workers falling and labor demand still picking up, the deal between unions and employers to moderate wage growth has started to fray with higher wage demands becoming much more common.

As a result real wages are increasing at their fastest pace in over 20 years, and Germany's central bank is reporting "lively" consumer spending, kindling hopes that Europe's largest economy could become a major source of demand for weaker euro-zone members.

However, nominal wage growth remains surprisingly weak given the apparent tightness of the labor market. This, combined with a run of weak industrial output figures that has flattered the significance of the domestic demand pick-up, has raised questions over whether the recent pick-up in consumer spending represents a sustainable economic rebalancing.

"The recent improvement in real wages has largely come from the decline in inflation, driven by the collapse in oil prices," said Simon Tilford, deputy director of the Centre for European Reform. "The question is whether it will be sustained once inflation picks back up."

While acknowledging that there are ground for "cautious optimism," Tilford said he has lingering doubts over whether German policymakers, who have demonstrated strong anti-inflationary bias in the past, would be willing to allow rising consumer spending to push the pace of price rises materially higher. Indeed instead of using fiscal policy to bolster growth, the German government has elected to run substantial current account surpluses throughout the post-crisis period climbing over 8 percent of GDP in September.

Whether the German consumer can remain a key driver of regional growth depends on the increase in consumer demand prompting businesses to boost investment. This is no small challenge. In the post-crisis years German corporates have continued to increase their net savings despite higher wage costs and rising dividend payouts eating in profits - by cutting back investment even further.

If this risk-averse behavior continues, and the German state continues its policy of living ever further within its means then the nascent consumer boom and the dream of sustainable rebalancing in the euro-zone may not survive the winter.

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