Paradigm Lost: The Euro in Crisis

Greece, Ireland, Italy, Portugal, and Spain (GIIPS) have become increasingly uncompetitive since adopting the euro. But competitiveness is relative, raising an important question: how did Germany, Europe’s largest and most competitive economy, fare under the euro? The answer begins with Germany’s unification ten years prior, which was followed by massive investments designed to modernize the East’s economy and integrate it with Germany’s industrial heartland. Though this process remains incomplete even today, it has prompted far-reaching structural reforms and contributed to exceptional wage moderation following the immediate post-unification surge. Additionally, the introduction of the euro consolidated Germany’s unit labor cost advantage vis-à-vis its Euro area partners. Exports surged and domestic demand growth fell behind that of the GIIPS, widening bilateral trade surpluses. Germany, now poised to derive the greatest gains from the euro’s crisis-triggered decline, should boost its domestic demand to compensate for the deflationary measures taken by the GIIPS.

Post-Reunification Reforms

Immediately after reunification in late 1990, Germany experienced a significant loss of competitiveness. Unit labor costs (ULC), which measure increases in wages relative to productivity, rose significantly. Wages in the East rapidly began to converge to those in the West even as productivity in the former remained substantially lower. As a result, unit labor costs grew by 17.6 percent from 1990 to 1995, compared with an average of 11.5 percent in the rest of what would become the Euro area.

IMGXYZ5051IMGZYXReunification also brought a demand boom that emphasized services over export sectors. As the West made transfers to the East in order to boost living standards, domestic demand expanded by nearly 7 percent of GDP from 1990 to 1992. This fueled services, which grew 7 percent on average each year from 1990 to 1995, compared to only 3 percent on average from 1996 to 2008. On the other hand, exports fell as a share of GDP from 1991 to 1993.

The economy’s historic restructuring and the high unit labor costs in the East hindered the country’s competitiveness, and drove unemployment up from 4.2 percent in 1991 to 8.2 percent by 1994. Export-oriented industries were particularly hard hit in terms of employment. 

Germany responded to these challenges with structural reforms, including wage moderation and industry restructuring. Government spending on employee compensation fell by 1 percent of GDP from 1993 to 2000 and the private sector soon followed the public sector’s lead. Rising unemployment, as well as the ability of corporations to turn to cheaper sources of labor in other countries, encouraged domestic labor to soften demands in collective bargaining. As a result, unit labor costs actually fell 3.4 percent in industry from 1995 to 2000 and stayed almost stagnant in services, rising only 1.8 percent over the same period.

As a result of these changes, Germany saw its export performance improve and rise in significance. From 1993 to 2000, the share of exports in its GDP rose by more than 10 percentage points, from 22 percent to 33 percent. Despite its exports losing 3.5 percent of world share from 1990 to 2000, Germany outperformed advanced economies as a whole, whose share fell by 6.3 percent, over that period.

Euro Adoption and the Export Boom

Germany’s exports benefited further from the adoption of the euro, which eventually became cheaper than the deutschmark might have been, given that it reflects Europe’s—and not only Germany’s—competitiveness trends. For example, the European Commission estimated that the euro was about 10–12 percent undervalued for Germany in the first quarter of 2009. The euro also increased external demand, including from the GIIPS.

Since adopting the euro, Germany has seen its exports regain world share, rising 0.5 percentage points from 2000 to 2009—a remarkable performance compared with the 11.6 percent contraction in the share of advanced countries over that period. Over the same period, exports have gained an additional 14 percent of GDP share in Germany, bringing the total gain from 1993 to 2008 to a remarkable 25 percentage points. In a nutshell, while the GIIPS became more inward-focused and driven by domestic activities, Germany became the world’s largest exporter.

The percent of total German exports going to the Euro area as a whole has actually declined since the euro was introduced because the Euro area has grown more slowly than other regions. Germany’s bilateral trade balance in goods with each of the GIIPS, however, has improved. For example, Greece’s bilateral trade deficit with Germany widened from -1.5 percent of Greece’s GDP in 1999 to -2.5 percent in 2008. Other core European countries, like the Netherlands, saw similar developments with the GIIPS, suggesting that all of the surplus countries benefited from increased demand in the weaker Euro area members.

 

Low Wage Growth and Sluggish Domestic Demand

Despite the benefits the euro brought Germany, its wage growth has remained moderate, keeping unit labor costs highly competitive relative to the rest of Europe. From 2000 to 2009, unit labor costs rose 7 percent in Germany, compared to an average increase of 31 percent in the GIIPS over the same period. Again, Germany’s ULC performance has been due more to limited wage increases than to relative productivity growth: compensation grew by 11 percent from 2000 to 2009 in Germany—15 percentage points below the Euro area average and 36 below the GIIPS average—while productivity grew 13 percent—only 2 percent above the Euro area average and substantially below the 25 percent growth exhibited in both Greece and Ireland.

However, while Germany’s unit labor costs in euros have declined relative to the GIIPS and even other core European countries like Austria and the Netherlands, they did rise vis-à-vis major countries outside of the Euro area, including the United States, Japan, and China.

Slow GDP growth and even slower growth of domestic demand contributed to Germany’s wage moderation following the adoption of the euro. From 2000 to 2008, Germany’s average annual GDP growth, 1.4 percent, was half that of the GIIPS, which grew 3 percent on average each year. Over the same period, domestic demand’s share of GDP contracted by 5.8 percentage points in Germany, while it gained an average of 0.6 percent in the GIIPS. A variety of factors account for this demand slump, from the Euro area’s monetary policy—too tight for Germany, but too loose for several of the GIIPS—to high unemployment and low wage growth to high savings among an aging population.

Thus, while Germany’s improved competitiveness did come on the back of tough domestic reforms—an experience the GIIPS can learn from—it also depended on demand from other countries, including those same GIIPS.

With the euro having depreciated by more than 20 percent against the dollar since late November and emerging markets booming, Germany is in a good position to both grow exports and expand its domestic demand. Increasing domestic demand would not only ease the painful adjustments of Germany’s weak Euro area partners, whose exports are oriented predominantly inside Europe, but it would also shield Germany’s own economy from excessive reliance on international markets. Unfortunately, German policy makers are unlikely to pursue this, given that it runs counter to the stated intention of bringing the deficit back in line with the Maastricht criteria by 2013.

Uri Dadush is a senior associate in and the director of Carnegie’s International Economics Program. Vera Eidelman is the managing editor of the International Economic Bulletin.