What Is Needed to Make Reforms Work

by Adam S. Posen, Peterson Institute for International Economics

Op-ed in Handelsblatt in the invited series "Germany from Abroad"
August 19, 2005

© Handelsblatt


It is easy nowadays to get a laundry list of what reforms need to happen for the German economy to recover and create jobs. The basic ideas—enhancing labor-market flexibility, reducing Lohnnebenkosten, bringing pension and health care costs onto a sustainable path, and restructuring the tax code—are thankfully now heard frequently in the German political debate. At least some elements of all of these can be found in all of the mainstream party platforms, most clearly at present in the Christian Democratic Union (CDU) manifesto. This kind of intellectual clarity is a necessary first step for progress, especially since it means that recognition of reality is replacing rhetoric that treated structural reform as a debate over values.

Unfortunately, while such clarity is necessary, it alone is not sufficient to bring about real economic progress in Germany. Even if the CDU/CSU (Christian Social Union) wins on September 18, and wields a majority in both houses of parliament, the party’s current agenda is unlikely to generate enough change to truly improve German economic prospects. The agenda as currently stated, however, is likely to generate significant backlash from domestic opponents, including party supporters and coalition partners. A successful reform effort needs the right political strategy and sequencing as much as it needs the right economic proposals.

In fact, from an external perspective, the absence of such a strategy is what doomed the Red-Green government’s Agenda 2010. Ironically for those who characterize Chancellor Schroeder as a political opportunist, his 2002–04 program got many of the economic priorities correct but blew the political requirements. Reducing the duration of unemployment benefits, making it easier for “Ich AG’s” to start, and improving the incentives for labor supply overall was indeed the place to start reforming the German economy. Cutting marginal income tax rates and adding copayments for health care were valuable next steps, and, even if limited in size, arguably among the most important ones for building up the sustainability of the German fiscal situation.

Yet, the implementation of and the private-sector response to these valuable reforms were sorely disappointing. The Red-Green coalition had overlooked some basic realities of economic policymaking. First, structural reforms do impose a transitional economic drag on the economy, and the more the change is resisted, the longer the drag persists. Second, the benefits of labor market reforms are usually not seen or felt until an economic recovery begins. Both of these factors meant that failure to ameliorate the contemporaneous recession also contributed to failure of structural reform (disproving the claims that only by constraining macroeconomic “activism” would structural reform be carried out).

Yet there are other general principles of reform in rich countries that go beyond the macroeconomic environment. Third, reforms to labor markets usually need to be accompanied by reforms to product and financial markets, since corporatist systems protect insider businesses and managements as well as unions (and they also make it politically difficult to sustain solely labor-focused reforms). Fourth, blaming the need for change on international factors can turn into scapegoating and backfire if it is overused. And finally, major reform efforts usually require a centralized push from a strong government.

So, it is possible to be hopeful or even confident that a pro-reform government will come to power with a working coalition following the election—especially since both the Free Democratic Party (FDP) and the Greens are articulating strong opposition to corporate subsidies and concern for long-term fiscal discipline—and still be uncertain whether that will result in the necessary changes. There are coalitions of interest groups who benefit from the current situation in Germany, and these are not limited to the labor union stalwarts. Mishandling them foiled many of the beneficial efforts of Schroeder’s Agenda 2010, and they will block the next chancellor’s reform agenda as well if s/he is not careful. In short, the primary barrier to change in Germany lies not so much in government or policy choices as in civil society.

Thus, the next chancellor’s program has to go beyond the economic principles that seem to make sense, and take into account as well the political economic strategies that will make reform work. These would include:

Use Macroeconomic Policy in Tandem with Reform. If cyclical recovery kicks in in Germany in 2006, the fruits of the Hartz IV reforms will lead to greater job creation than in recent upswings. This will begin to sap resistance to reform, because the benefits will become more evident along with the already apparent cutbacks in state generosity. So macroeconomic stimulus is more likely to pay off today, and is more needed than ever if it is to offset the growth drag from further reform efforts.

Despite interest rates at historic lows in Europe, there is still room for real rates to decline in Germany, especially in support of serious reform efforts. The European Central Bank (ECB) could and should justify such rate cuts as a response to the rise in economic growth potential—and resulting decline in inflationary pressures—that would occur in Germany if serious reform is carried out. It is not enough for the ECB to repeat that lack of reform impedes its ability to pursue accommodative policy; the positive opposite link must be made. Those who claim that the lack of investment response to current interest rate levels mean further cuts would be ineffective need to relearn their economics. As shown in Japan of late, and recent development of the theory of liquidity traps, when confidence is unusually low, it is the job of the central bank to drive down real interest rates to compensate.

At the same time, Germany should live up to the reinterpreted Stability and Growth Pact in spirit rather than as an excuse. In other words, it should trade violations of the 3 percent budget ceiling today not for temporary budget measures or promises of future cuts in good times, but for ambitious restructuring of the social welfare system that affects the long-term sustainability of Germany’s fiscal balances. While the idea of revenue neutral (or positive) tax switching has merit, particularly from those taxes on employment to less distortionary tax bases, imposing a rise in the VAT is not the right switch to make; as Hans-Werner Sinn has argued, it will make little difference to incentives for expanding service employment. It will also cause a significant hit to consumption and growth, thus undercutting the reform effort. Instead, the cuts in the tax wedge on wages should be financed by expenditure cuts on subsidies and by changes in the formulae for future health and pension benefits.

Reform the Corporate Sector as well as Labor Markets. The CDU, CSU, and Social Democratic Party (SDP) are all lacking in their economic programs. Their manifestos largely ignore growth enhancing deregulation possibilities that will do no harm to (and possibly help) the Federal budget, that tend to enhance growth rather than drag it down even in the short run, and that are key to raising the returns on capital in Germany. They make no proposals for constructive corporate sector reform (and some that would make things worse, like reimposing the capital gains tax on corporate sales of long-held cross-shareholdings). These programs also do themselves a political disservice by seeming unfair in putting the entire burden of adjustment on workers while leaving untouched the vast network of subsidies and protections that impede corporate competition.

The debates back and forth on tax rates on high-income individuals, on shop hours, and even on rules about hiring and firing, that preoccupy German politicians all merit far less attention than they are being given. A cynic would suggest these distractions are no accident, because they divert eyes from what is really at stake: the corrupt insider linkages between management, union leadership, local politicians, and government protected financial institutions that keep German industry from achieving efficient consolidation and growth in sector after sector. The recent revelations at Volkswagen and elsewhere should present an opportunity for some politicians to take initiatives to address these problems.

In particular, it is healthy to talk about breaking down the nationwide wage bargaining system to increase flexibility of wage-setting by company. Doing so does the economy more good, and the individual worker less harm, than almost all other labor reforms currently proposed. Yet, why free only small business from this restraint, as the CDU/CSU propose, except to give the managements and owners of these companies an unfair advantage? So doing further reinforces the incentive for German firms to remain below efficient scale, as the current Mitbestimmung rules do, and to thus be financed through nontransparent bank lending rather than securities. This in turn increases the number of middlemen—such as bankers, company managers, and local shop foremen—privy to and making a living from every corporate decision, while decreasing the returns to shareholders and hiding revenues from the tax collector.

If a chancellor is going to take on the trade unions anyway by proposing changes to the nationwide Tarifrunde, s/he might as well go for a full-scale reform rather than stopping short. There should be in the end only one labor market in Germany in which wages are set. Dividing up the labor market by creating preferential rules leads to the kind of exclusionary employment outcome seen in the Neuen Bundeslaender, driven by the same kind of incumbent protections. Similar examples of insider privileges for German companies, backed by banks and some labor officials, can be found in the guilds protecting various professions, the links of Mitbestimmung to politically directed lending by public banks and Sparkassen, and the barriers to foreign takeovers of German corporations. All are similarly of benefit to a select few while harming the well-being of most Germans, and all could well be reformed as part of a balanced effort that looked beyond labor markets.

Modernize German Federalism. In any organization, having a proliferation of agenda setters and potential veto points for decisions is a sure fire recipe for blockage of change. The current German political system is a clear illustration of the problems with having too little centralization of power in the government. Obviously, historical legacies have a lot to do with this situation (not least the postwar occupying Americans’ desire to put in place US-style strong states as a check on German government control). Many of those same legacies understandably make Germans reluctant to make political changes. Still, the creation of the Joint Commission for the Modernization of the Federal System underscores the emerging recognition of the inappropriateness of the current system. Even if the two houses share a majority party, this structural split in government power will interfere with structural reform.

In this regard, it is useful to look at the example of the United States. A few distinguished German and European leaders have made positive reference to the US experience with federalism, suggesting that experimentation by individual states and even competition between them has been a key part of the US economic success story. Actually, federalism in the United States has been far more hindrance than help in the economic sphere. The US economy’s Achilles heel is our abysmal primary and secondary public education systems, which are under local and state government control and thus impervious to federal reform efforts. Competition between states has led to self-defeating bidding wars between governments to land corporate investment, which often yields less benefit than the subsidies offered were worth. Federalism has blocked unification of the tax code in various areas, of financial regulation in other realms such as insurance, and of cuts in agricultural and military spending programs.

Obviously, there is no quick fix for this situation. Attempts to put through major constitutional change at the same time as economic reform would probably overload the system, and would certainly engender opposition from within the Bundesrat. In the short term, the best the incoming chancellor can do is to be cognizant of this issue, and do his/her best to retain central control of the reform agenda. At a minimum, s/he can abjure any proposals to devolve programs to the Länder, to jointly programs them with the Länder or the municipalities (a disadvantageous trade of control for cash), or to separate the proposals of the reform program allowing more deliberation or amendment. At the same time, through careful choice of cabinet and Bundestag party leadership after the election, the chancellor can maximize loyalty while minimizing alternative power centres.

Address Globalization Rather than Scapegoating It. The tendency under the Schroeder government has been to treat globalization as a threat and blame it for forcing reforms the Red-Green coalition would otherwise have been reluctant to make. This has occasionally paid off as a tactic, as when the Landesbanken were partially privatized by invoking EU pressure. Its overuse and passive, resentful tone, however, has ultimately backfired—Gerhard Schroeder in recent years has joined with Jacques Chirac to weaken Brussels and its liberalization agenda, to promote intergovernmental logrolling of protections and subsidies, and to limit the competitive impact (and thus the benefits) of EU expansion and global trade deepening. As a result, Germany has abandoned its traditional leadership role in the European Union and the G-7 as an advocate for international economic integration and discipline, to both its own and the world’s detriment.

One could be thankful that the major party programs for the election do not directly seek to roll globalization back (as some of the rhetoric in the May Nordrhein-Westfalen election did). This arguably reflects recognition by the politicians of the underlying commitment of the German electorate to European and Western integrationist ideals and of the dependence of Germany on an open world economy. Given that baseline of support, however, it would be better to return German policy to one that seizes the opportunities from globalization. Rather than reluctantly enforcing changes imposed from outside, the next chancellor should take international economic initiatives that rest on their own merits, but have the additional benefit of abetting the reform agenda at home.

First would be addressing constructively the ongoing migration of low-wage workers from the east into Germany. This trend will not stop, no matter what policy the government undertakes, any more than the United States can stem the flow of illegal migrants from Mexico and Central America: The mutual economic gains from their employment are too great. Rather than defensively relegating Turkey to a “privileged partnership” only rhetorically and obstructing the EU services directive with de facto minimum wage laws, the next chancellor can directly engage with the governments of Poland and Turkey to put in place formal and managed guest worker programs. While deepening security and political relationships with these key countries, such programs would also supply Germany with the price-competitive service employees needed (and remove the opportunity for protected German businesses to cloak their self-interest in the garb of national security).

A second initiative would be cooperating with the United States to manage China’s integration into the global economic system. At present, the German government has largely treated China’s rise as a reason for narrow competition with the United States over large government contracts and market access—a classic fear-driven shortsighted view. Yet, the absence of German (and thus EU) cooperation with the United States increases the prospect of China-US economic conflict because the People’s Republic thinks they face a less than unified West, and the United States will have to back down. As a result, Germany risks disruption of the trading system, let alone the Doha Round, and a sharp rise in the euro against the dollar (in the absence of further Chinese currency adjustment), both of which would be greatly harmful to German economic prospects. Germany could lead the European Union in making positive approaches to China in coordination with the United States, in particular by trading consolidation of EU representation in international organizations for greater Chinese voice, and thereby play a useful good cop to the US bad cop of trade threats. This will ultimately abet German economic reform by maintaining macroeconomic stability and by maintaining international competition, but can again be justified in direct foreign policy terms.

There is a reason successful economic reform is rare in rich countries, even when problems are obvious, as seen in the decades of postwar decline in the United Kingdom or the still uninterrupted stagnation in most of Italy. Even when the economic prescriptions are largely recognized, their prioritization and implementation must be guided with an eye to the political constraints a wealthy stable democracy imposes on reform. The next German chancellor must go beyond the economic policy platforms to see reform through. S/he must use macroeconomic policy in tandem with reform, take on corporate as well as labor market reforms, centralize the agenda-setting and implementation, and grapple positively with globalization. Then the benefits of enhanced structural flexibility and fiscal sustainability will be achieved in the German economy.

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