Lessons from the German recovery (till date)

Even as the economies across Europe and the US appear to show no signs of any sustainable economic recovery from the Great Recession, there is growing evidence that Germany may be slowly breaking away.

The Germany economy is estimated to have grown at an astonishing quarter-on-quarter economic growth rate of 2.2%, the best performance since reunification 20 years ago and equivalent to a nearly 9% annual rate if growth were that robust all year. The country’s unemployment rate in July 2010 was 7.6%, almost at the pre-crisis level, down from 9.1% in January, and far cry from the over 13% rate five years back when the country was a symbol of labor-market inflexibility.

This performance is bound to lend credence to the German government's argument in favor of fiscal prudence and making short-term sacrifices (like informal wage freezes/restraints) necessary for long-term success.



It cannot be denied that the German economic rebound is a testimony to the role of targeted fiscal spending programs, mainly in the form of automatic fiscal stabilizers as against the conventional approaches of large-scale infrastructure government spending programs or tax cuts, during economic downturns. Its unique short work scheme, "Kurzarbeit", which allows companies to cut workers’ hours and the government would make up some of the lost wages, has been attributed to have played a significant role in preventing mass lay-offs.

In fact, during the first quarter of 2010, 22% of all firms and 39% of manufacturers were estimated to have used Kurzarbeit, whose financing comes from a fund filled in good times through payroll deductions and company contributions. At its peak in May 2009, roughly 1.5 million workers were enrolled in the program, and the OECD has estimated that by the third quarter of 2009, more than 200,000 jobs may have been saved due to it.

The main driver behind the German recovery has been exports, which rose in June by 28.5% compared with the year before, the highest level since the financial crisis began to pinch in October 2008. The weakening Euro has helped improve the competitiveness of German exports and the robust growth in China-led emerging economies have provided the demand for those exports. The decreasing yields on benchmark German bonds and widening spreads between German and other fellow Euro zone member benchmark bonds has meant lower cost of capital for German businesses.

In contrast to German fortunes, the French economy grew at just 0.6% in the second quarter, Italy and Spain by an anemic 0.4% and 0.2% respectively, while Greece’s shrank 1.5%. The German recovery will contribute growth in rest of Europe only if its economic growth rate translates into higher consumer spending and greater imports, especially from other Euro members.

There is the danger that the first signs of recovery would get the federal government to cut spending further in an effort to reduce the fiscal deficit and debt burden. This could, like the famous examples from history, nip out the nascent buds of growth and pull the economy back into slow growth phase. Another major concern is the possibility of slowdown in China, dragging down German exports and with slowing down growth.

Even the claim that Germany exercised fiscal austerity during the crisis and its recovery may be incorrect. In fact, Berlin actually spent more of its gross domestic product on fiscal stimulus than any other continental European state during the financial crisis. In fact, the IMF has estimated that apart from the US, Germany had the largest crisis-related discretionary fiscal stimulus among all the major economies in both 2009 and 2010. As already indicated, its fiscal spending was more targeted, especially at cushioning the labor market and those aimed at specific sectors like the successful cash for clunkers.

Further, there are important differences between the states of US and German economies (before and over the last three years) that makes the simple austerity-caused-recovery hypothesis look doubtful. Property markets in Germany did not experience the same degree of irrational exuberance as the US and the German banks and financial institutions did not indulge in the same level of recklessness. The macroeconomic account was more balanced in Germany.

Unlike the US, the social democratic polities of continental Europe have a much more effective social safety net that can mitigate the adverse effects of a recession. Traditionally, exports have been the locomotive of the German economy, whereas consumer spending has being the engine of growth in the US. However, while consumer spending declined significantly in the US, German exports held steady after a short blip in 2008.

Finally, the series of labor market reforms in Germany since 2005 have considerably enhanced labor market flexibility. As part of these reforms, retirement age was raised to 67 from 65, welfare payments were lowered and hiring and firing regulations were eased. These and other reforms may have contributed to increasing the resilience of the German economy and helping it recover faster than its neighbors.

Update 1
See this Krugman post which compares the real GDP and unemployment changes in the US and Germany over the past three years and finds how Germany managed to weather the worst of the job market, thanks to its automatic fiscal stabilizers and schemes like short-work.