GERMAN ECONOMIC DISEASE

Hans Werner Sinn recently wrote a piece in WSJ discussing anemic growth prospects of the German economy (link). The German economy is expected to decline by about 6 percent annually, following a major decline in export sector. Foreign orders decreased by 43 percent in January and February. Many commentators emphasized the risk of Germany's exposure to foreign trade and its vulnerability to global economic shocks.

In spite of absorbing a rather strong shock from a decline in exports, the major backlash of the German economy is the rigid labor market and the lack of wage flexibility. In recent years, German policymakers launched the increase in minimum wages as an attempt to ward-off international low-wage competition from emerging market economies. What happened? In turn, workers in low-wage industries were protected againist labor-intensive producers from India, China and so forth.

In addition, as minimum wages grew, the labor cost of low-wage workers increased to such an extent that employers couldn't afford to hire them. Consequently, the creation of high-wage jobs was discouraged as "skills" were less abundant than low-wage jobs. High tax burden and extensive labor cost discouraged job formation and thus many young German minds voted with their feet and moved abroad to places such as neighboring Switzerland, Canada, United States and Australia.

It is simply not true that the expected output contraction will accelerate only because of the near collapse of export and manufacturing sector. Economists and policymakers often discuss the backbones to economic growth. The empirical studies showed that the rigidity of labor market comes at the cost of less job creation and productivity decline. This is exactly what happened in Germany.

When I was writing one of the forthcoming papers, I estimated the potential daily working time in OECD. While Korea hits the top with a stunning average of more than 9 hours of daily labor supply, Germany hits the bottom with no more than the average of 6 hours of daily labor supply. In microeconomics, this is a pure substitution effect - higher tax wedge discourage labor supply and induces individuals to consume more leisure. To stimulate labor supply, the policymakers should liberalize labor market and remove the disincentives to work. Second, the liberalization of the labor market goes hand in hand with the reform of the old-fashioned German welfare state. Keeping minimum wages above the wage rate in the private sector will not diminish the unemployment rate and stimulate job creation.

Also, providing the unemployed with generous entitlements and welfare benefits, will not cure the disease of low productivity. Third, in 2008, government spending reached equaled 45.7 percent of the GDP should be reduced. German economic performance lagged behind the EU. Between 1995 and 2009, the economies of EU15 grew by 27.1 percent on average. German economy expanded by 14.3 percent, only surpassing Italy, whose economy expanded by 11.9 percent during that period. A wise combination of deregulation of labor market, reform of the welfare state and reduction in government spending is the right path for German economic recovery.