In memory of Dr. Andreas Höfert

Debunking some German labor market myths

| Tags: Andreas Höfert

Within the last 10 years Germany has evolved from being the “sick man of Europe” to an economic role model that the rest of the world should – and peripheral Europe is being forced to – emulate. Many reasons are usually given to explain this success story. The problem is that some of them are not completely right… and unfortunately some of the right ones cannot be easily replicated in other European countries.

Germany’s current success is usually attributed to the former German Chancellor Gerhard Schröder (1998–2005), who implemented the so-called Hartz reforms. Among other things, they dramatically limited and reduced unemployment benefits, leading to a much more flexible labor market. Wages remained low while productivity rose. Unit labor costs declined in absolute terms, but they fell even more strongly in relative terms against other Eurozone countries, especially in the manufacturing and tradable sectors. Between 2000 and 2007 Germany managed to gain market share both inside and outside the Eurozone at the expense of its Eurozone partners. While there is some truth to this narrative, it fails to grasp the whole story. This is what a new study by four German economists recently laid bare (See Christian Dustmann, Bernd Fitzenberger, Uta Schönberg, and Alexandra Spitz-Oener (2014): “From Sick Man of Europe to Economic Superstar: Germany’s Resurgent Economy,” Journal of Economic Perspectives, 28/1, pp. 167–188).

Looking into the details of German labor market data, the authors discover as a first counterintuitive result that the decline and stagnation in German wages was much more pronounced in non-tradable sectors and in tradable services than in tradable manufacturing, where wages actually rose at a good pace. As a second counterintuitive result, they find out that the value-added part of the tradable manufacturing sector was not the main driver of the gain in its unit labor costs. The decline in unit labor costs of the non-tradable goods and services that went into the tradable manufacturing sector as inputs played a much larger role.

This second discovery gives support to the narrative which states that Germany has been profiting from cheap inputs manufactured by its neighbors to the east (Poland, the Czech Republic and Hungary). However, the study also relativizes this by showing a third counterintuitive fact: that between 1995 and 2007, the share of domestic inputs to the total value of tradable goods barely moved in Germany.

The conclusion out of this is therefore that tradable “manufacturing drew on inputs from domestically provided non-tradable and especially tradable services, where real wages fell between 1995 and 2007… [and] that productivity increases in the manufacturing sector have outpaced wage increases in that sector.”

So far, so good: the Hartz reforms had a different impact than one would have thought, but they were still responsible for Germany’s success. Weren’t they? In fact – and here comes another core finding of this study – they were not as important as one would think.

What really mattered was that, in Germany, wages and labor conditions are not set in a centralized way by the government or by trade unions, but in a decentralized firm-by-firm way. Indeed, in Germany firms have the option not to recognize nationwide union agreements provided their employees accept this. Coverage by union contracts fell from 75% in 1995 to 60% by 2010 in the country, while it remained at between 85% and 90% for France and Italy during this period.

To put it in less technical language: the greater flexibility of the German labor market compared with the French or Italian ones comes from the comparative prevalence of decentralized labor agreements. Hence the very counterintuitive result: if a government tries to use centralized directives to render the labor market of its country more flexible, it might in fact achieve quite the opposite. Therefore, if a country really wants to copy the German model, it needs to get the narrative right in the first place.