This Selected Issues paper and Statistical Appendix analyzes the link between Germany’s economic performance and institutions, taking a long-term perspective and focusing on the labor market. The thesis of the paper is that Germany’s institutional arrangements worked exceptionally well during the Wirtschaftswunder era of rapid catch-up growth, resulting in an economic performance that was envied by much of the world. The paper also examines fiscal consolidation and tax reform proposals, and describes the wage structure in Germany.

Abstract

This Selected Issues paper and Statistical Appendix analyzes the link between Germany’s economic performance and institutions, taking a long-term perspective and focusing on the labor market. The thesis of the paper is that Germany’s institutional arrangements worked exceptionally well during the Wirtschaftswunder era of rapid catch-up growth, resulting in an economic performance that was envied by much of the world. The paper also examines fiscal consolidation and tax reform proposals, and describes the wage structure in Germany.

I. Institutional Change and Economic Performance: A Fifty-Year Perspective1

A. Introduction and Summary

1. This chapter discusses the link between Germany’s economic performance and institutions, taking a long-term perspective and focusing on the labor market2 Germany’s postwar institutional arrangements feature a clear division of responsibilities among the key economic players (fiscal authorities, trade unions, employers’ associations, and (until end-1998) the Bundesbank). Moreover, Germany’s institutions seek to combine social solidarity and protection with strong market incentives, a combination that has come to be known as the “social market economy.” The thesis of the chapter is that Germany’s institutional arrangements worked exceptionally well during the Wirtschaftswunder era of rapid catchup growth, resulting in an economic performance that was envied by much of the world. However, as the impetus behind catchup growth and some of the special circumstances surrounding the Wirtschaftswunder era faded away, a large segment of Germany’s labor market, mainly comprising the lower-skilled/lower-paid, faced increasing difficulties in an environment of rapid economic and technological change. Furthermore, the labor market problems were echoed by financial policy reactions—including a strongly procyclical fiscal stance—that added strains to the economy’s demand side. To back up this diagnosis, the chapter necessarily uses a broad-brush approach, omitting many of the details of Germany’s postwar economic developments.3

2. With regard to the labor market, the chapter focuses on the main institutions that influence labor costs and work incentives—collective bargaining on wage and other work conditions between trade unions and employers’ associations or companies; the large-scale and publicly managed social insurance system; and the social safety net, which provides benefits to the long-term unemployed (unemployment assistance) and persons with low incomes (social assistance). Germany’s collective bargaining and social insurance systems are premised on the two principles of income solidarity and contribution-benefit parity. The income solidarity principle means that increases in labor compensation and improvements in nonwage benefits should apply at roughly similar rates across different types of workers. The contribution-benefit parity principle in social insurance says that contribution rates should be levied proportionally across the wage distribution and that social insurance benefits should be linked tightly to contributions4

3. During Germany’s Wirtschaftswunder era, the labor market institutions combined with an auspicious economic environment to underpin a smoothly working labor market both for lower- and better-skilled workers. However, the same institutional arrangements proved less well-adapted to the different economic environments of the 1980s and 1990s, which were inter alia characterized by skill-biased technological progress, globalization, immigration of less-skilled ethnic Germans from eastern Europe, and increased labor force participation of workers with less job attachment. In addition, the system was buffeted by a-series of large adverse shocks including the relative shrinking of employment opportunities in Germany’s large industrial sector and German unification.

4. The fallout from institutional inertia in a changing economic environment was concentrated at the lower end of the labor market, while much of the remainder of Germany’s labor market continued to function reasonably well. Skill-biased technological progress and globalization shifted labor demand in favor of higher-skilled/better-paid workers (the “highsiders”). Immigration, new patterns of labor force participation, and, in particular, German unification added to the pool of potential lower-skilled/lower-paid workers (the “lowsiders”). With collective bargaining wedded to the principle of income solidarity and with social contributions rising proportionally across the wage distribution, lowsiders found it more and more difficult to clear the labor productivity hurdles standing in their way, which, at least in the medium run, tended to be raised more in line with the highsiders’ productivity performance. In the short run, collective bargaining responded sensitively to the state of the labor market, as witnessed by a distinct pattern of alternating periods of across-the-board wage moderation (following labor shakeouts and rising unemployment) and across-the-board wage push (during cyclical upturns and following prolonged episodes of wage moderation).

5. As already noted, the problems at the lower end of the labor market were echoed by financial policy responses, which added demand side strains to an already difficult situation. In the 1980s and 1990s, fiscal policy at the federal government level, driven by a natural (and constitutionally mandated) urge to “restore order to the public finances,” adopted a pronounced procyclical fiscal stance.5 The federal government’s procyclical fiscal stance came on top of the traditionally procyclical fiscal orientation at lower government levels. And monetary policy, in turn guided by a clear legal mandate “to safeguard the currency,” responded determinedly with what some observers considered prolonged episodes of monetary tightening to blunt the inflationary potential of across-the-board wage push attempts inherent in the highsider-lowsider structure of the labor market and procyclical fiscal policies.

6. The chapter draws five main conclusions:

  • It is unlikely that there will be a return to the special circumstances of the Wirtschaftswunder era that would revalidate Germany’s postwar institutional arrangements. To the contrary, the advent of European Monetary Union (EMU) and the seemingly unrelenting pace of economic and technological change are likely to raise the social cost of inaction. This general diagnosis appears to be widely shared among policymakers and analysts.6

  • The more pointed diagnosis elaborated in this chapter suggests that in an environment that favors skilled labor, collective bargaining based on income solidarity and a large-scale social insurance system based on contribution-benefit parity will conflict with the objective of matching labor demand and supply at the lower end of the labor market. Almost experimental evidence in support of this diagnosis is provided, on the one hand, by the mushrooming number of small-time or DM 630 jobs (a relatively unregulated niche at the lower end of the labor market) and, on the other hand, by the massive labor market difficulties in eastern Germany (following the wholesale transfer of western Germany’s labor market institutions to the new Länder).

  • The two standard policy responses to Germany’s highsider-lowsider dilemma in the labor market—across-the-board wage restraint and determined fiscal consolidation efforts to “put the fiscal house back in order”—are generalized and natural policy responses, but they do not and cannot address the roots of Germany’s labor market problem.

  • The accumulated experiences of several other continental European economies—including Denmark, the Netherlands, and Switzerland—suggest that markedly different institutional labor market arrangements are available that can achieve most of the equity goals motivating the present German arrangements, but at a significantly lower efficiency cost to the economy.

  • Overcoming institutional inertia in the labor market area is also important for enhancing macroeconomic stability. In particular, under EMU and with monetary policy levers centralized at the European Central Bank (ECB), the need to safeguard the operation of automatic fiscal stabilizers in Germany has taken on an added urgency.

7. The remainder of the chapter is organized as follows. Section B briefly surveys stylized facts on growth and labor market performance. Section C provides some background on labor market institutions. Section D links the institutions and economic environment to account for the economic performance during the Wirtschaftswunder era of the 1950s and 1960s as well as the “fading miracle era” since the 1970s. Section E extends the discussion to the interaction between labor market institutions and financial stabilization policies. Section F briefly discusses possible remedies, a topic pursued in more detail in Chapters HI and IV.

B. Stylized Facts: Growth and Unemployment

8. Germany’s real economic performance in the 1950s and 1960s was characterized by rapid catchup growth in output (Figure I-1), while the initially high postwar unemployment rate fell precipitously (Figure I-2).7 Besides receiving a strong impetus from the large productivity gap vis-à-vis the “leader country” (the United States), the Wirtschaftswunder growth machinery was also powered by an auspicious external environment including a revival of liberalism in international trade, with Germany as one of a pacemakers; a buoyant world demand for capital goods, a traditional strength of German manufacturing; and a competitive exchange rate that boosted exports. In the labor markets, the 1960s constituted a period of acute worker shortages, only partly relieved by inflows of mostly unskilled migrant labor. Throughout the 1960s, Germany’s unemployment rate remained below 1 percent, apart from the years straddling the sharp but short-lived 1966-67 recession, and was well below the (weighted) average unemployment rate for industrial countries.

Figure I-1.
Figure I-1.

Germany: Output Performance, 1950-2000 1/

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Sources: World Economic Outlook database; Deutsche Bundesbank; Penn World Tables 5.6; and staff estimates and projections.1/ Data for 1999-2000 are staff projections.2/ Data for 1991-2000 refer to western Germany.3/ Hodrick-Prescott filter estimates.
Figure I-2.
Figure I-2.

Germany: Labor Market Performance, 1950-2000 1/

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Sources: OECD Economic Outlook database; Deutsche Bundesbank; and staff calculations.1/ Data for 1999-2000 are OECD projections.2/ Data for 1991-2000 refer to united Germany.3/ Weighted average.4/ Employment as a percent of working age population.

9. When the pull of rapid catchup growth faded away in the 1970s, Germany’s average output growth rate leveled off at about 2 percent per annum. At the same time, labor market performance—in terms of both unemployment and employment rates—began to deteriorate markedly. Starting from the very low level in the early-1970s, unemployment ratcheted upward in several spurts, first in the mid-1970s and then again at the beginning of the 1980s. Following German unification, a more drawn-out but once again a marked increase in unemployment ensued. While there is little doubt that some of Germany’s current unemployment is cyclical, most of the rise since the 1970s has been noncyclical. Put differently, the structural rate of unemployment has drifted upward over time. This is suggested inter alia by the relentless upward shifts in the relationship between the unemployment rate and capacity utilization (Okun curve) since 1960 (Figure I-3).

Figure I-3.
Figure I-3.

Germany: Unemployment and Capacity Utilization, 1960-98 1/

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Source: German Council of Economic Advisors.1/ Data refer to western Germany.2/ Capacity utilization as estimated by German Council of Economic Advisors.

10. A sole focus on aggregate labor market trends since the early 1970s masks a striking disparity in disaggregated unemployment and employment developments by skills: the labor market problem has been overwhelmingly concentrated in the lower portion of the skill distribution, where “skills” are defined on the basis of schooling characteristics (Figure I-4). For example, the unemployment rate for lower-skilled workers in western Germany has risen to a multiple of its level in the mid-1970s, with a particularly sharp increase after unification; in 1997, it stood at 26.9 percent, compared with an aggregate unemployment rate of 9.8 percent. Employment of lower-skilled workers fell almost by half during the same period.8

Figure I-4.
Figure I-4.

Germany: Labor Market Trends by Skills, 1976-97

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Sources: Reinberg and Rauch (1998); and staff estimates.1/ Data refer to western Germany only.

11. While the data in Figure I-4 depict only the situation in western Germany, the adverse labor market trends for the lower-skilled workers in eastern Germany were even more pronounced. For example, the unemployment rate of workers with lower skills rose to 55 percent in 1997, relative to an aggregate unemployment rate of 18.2 percent in the same year.

C. Labor Market Institutions9

12. This section briefly describes the main “rules of the game” (institutional arrangements) in the labor market: the collective bargaining framework between trade unions and employers’ associations; the large-scale and publicly managed social insurance system; and the social safety net for the long-term unemployed (unemployment assistance) and persons with low incomes (social assistance).

13. The autonomy of collective bargaining is enshrined in the German Constitution and in the wage contract law of 1949, with the partners to the negotiations consisting of the trade unions (organized along sectoral lines) on the one hand and the employers’ associations or individual companies on the other hand.10 Postwar data on wages and labor productivity suggest that collective bargaining has been aimed at preserving a stable relative wage structure, while being mindful of the need to assure overall profitability in the economy. In this connection, three observations can be made: (i) increases in tariff wages preserved relative wage ratios between high- and low-skilled workers, as illustrated by the almost constant wage ratios between the highest and lowest tariff wage groups in selected sectors during the period 1959-89 (first panel, Figure I-5); (ii) although some wage drift, i.e. a markup of effective wages over tariff wages can be observed during the labor shortage period of the 1960s, wage drift has been small since the beginning of the 1970s (second panel, Figure I-5);11 and (iii) aggregate real wages followed closely aggregate real labor productivity, although persistent periods of wage moderation were punctuated by short periods when average wage increases markedly outpaced productivity increases (third panel, Figure I-5). Observations (i) and (ii) suggest a high degree of “income solidarity” across different types of workers, in particular since the early 1980s, while observation (iii) suggests that there is not much evidence supporting the view that aggregate wage increases have been excessive relative to aggregate productivity increases.12

Figure I-5.
Figure I-5.

Germany: Wage Setting

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Sources: WSI-Tarifarchiv; Statistisches Bundesamt; and staff calculations.1/ Ratio between highest and lowest tariff wages in selected sectors (data for 1959, 1969, 1979,1989, and 1999).2/ Blue collar workers.3/ White collar workers.4/ Ratio between effective and tariff wages in industry (western Germany).5/ Gross income from dependent employment per employee (divided by GDP deflator); 1991-98 united Germany.6/ GDP per employed person (in 1991 prices); 1991-98 united Germany.7/ Adjusted for relative shifts in dependent and self-employed work force.

14. The principle of income solidarity also shaped collective bargaining on nonwage work conditions, including workhours per week, number of vacation days, and nonwage benefits (e.g., vacation bonuses and sick pay).13 In 1998, average nonwage costs (excluding social insurance contributions of some 42 percent) in western Germany’s industrial sector amounted to about 52 percent of gross wages (excluding nonwage benefits). In eastern Germany, average nonwage costs excluding social insurance, while lower than in western Germany, still represented a markup of some 38 percent on gross wages (excluding nonwage benefits).14

15. A large-scale and publicly managed social insurance system covers risks related to old age, health, long-term care, and unemployment. This social insurance system is run on a pay-as-you-go basis (PAYG) and largely financed by social contributions, with budget transfers (mainly from the Federal budget) covering the balance. Social contribution rates have increased sharply over time, rising from some 24 percent in 1957 to more than 41 percent in 1999 (first panel, Figure I-6). As from April 1, 1999, the full insurance contribution rate of about 41 percent (split equally between employee and employer) applies to gross wage earnings across the board, except for a reduced lump-sum rate of 22 percent that applies to small-time jobs (providing earnings of less than DM 630 per month) and subject to upper monthly earnings ceilings of DM 6,375 (health, long-term care) and of DM 8,500 (pensions, unemployment) (second panel, Figure I-6). As the full contribution rate of about 41 percent applies to earnings exceeding the small-time job limit of DM 630, additional earnings of DM 1 above the DM 630 ceiling increase labor costs by about DM 130 (hence equivalent to a marginal contribution rate of some 13,000 percent).

Figure I-6.
Figure I-6.

Germany: Social Contribution Rates

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Source: Ministry of Labor.

16. As regards the link between contributions and benefits, the design of Germany’s social insurance system aims to observe the principle of contribution-benefit parity. In particular, public pension benefits are closely linked to previous pension contributions. Nonetheless, a significant portion of pension spending (estimated at some 30 percent of total spending) goes to benefits that are unrelated to previous contributions related to imputed contribution periods (World War II service periods; early retirement; time spent unemployed or sick; time spent in education; and time spent raising children). Budget transfers to the social insurance funds are supposed to cover spending unrelated to previous contributions.

17. Finally, a comprehensive social safety net provides means-tested benefits with basically unlimited duration: the long-term unemployed are eligible for unemployment assistance; and persons with low incomes are eligible for social assistance. The level of social assistance is often held to define a lower floor below which net wage earnings cannot be reduced. Social assistance benefits for recipients with dependents expressed as a percent of average wages have increased substantially since the 1960s (Figure I-7).

Figure I-7.
Figure I-7.

Germany: Social Assistance

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Sources: Boss (1999), Kiel Working Paper No. 912.

D. Accounting for Postwar Labor Market Developments

18. This section uses a dual (skilled-unskilled; highsider-lowsider) labor market framework to account for the broad features of the markedly different labor market outcomes of Germany’s Wirtschaftswunder era and the period since the 1970s. The elements of this labor market framework are labor demand schedules for skilled and unskilled labor and labor supply (wage setting) schedules for the two types of labor.15 Labor market outcomes depend on the shifts as well as slopes of these four schedules, which in turn are determined by institutional arrangements and changes in the environment.

19. The Wirtschaftswunder era provided an auspicious environment for the operation of both the skilled and unskilled labor markets: a period of rapid catchup growth; technological change that increased labor productivity of workers across the skill distribution at broadly similar rates; strong demand for unskilled labor in some labor-intensive sectors, in particular construction; ongoing improvements in the skill composition of the labor force, shrinking the supply of unskilled labor; and an auspicious external environment favoring skill-intensive manufacturing. Moreover, jobs were usually full-time and job attachment of workers was relatively steady.

20. In this auspicious environment, Germany’s labor market institutions worked well in-both the skilled and the unskilled segments. Overall labor market conditions were tight, as reflected in record levels of vacancies and large influxes of (mostly lower-skilled) foreign workers, the latter suggesting that conditions at the lower end were characterized by labor shortages. The one-size-fits-all approach to collective bargaining on wages and work conditions may even have helped to dampen excessive demand pressures; the generous social safety with benefits of essentially unlimited duration and relatively weak work requirements remained untested; and the large and comprehensive social insurance system, with the level of social contributions at about 25 percent, was in tune with the aspirations of full-time (mostly male) breadwinners. Thus, the experience of the Wirtschaftswunder era appeared to validate resoundingly Germany’s institutional arrangements in the labor market,

21. Since the 1970s, changes in the economic environment included the end of catchup growth, deindustrialization, skill-biased technological progress, a further pickup in the pace of globalization, and growing labor force participation of workers with less job attachment. Moreover, increased immigration of ethnic Germans from eastern Europe and the Former Soviet Union during the second half of the 1980s and the early 1990s and, above all, German unification at the beginning of the 1990s added in relative terms to the unskilled labor supply. Deindustrialization, skill-biased technological progress, and increased globalization are all likely to have shifted labor demand in favor of skilled labor, while greater immigration and German unification are likely to have at least slowed the ongoing improvements in the skill composition of the labor force.

22. This relatively unfavorable environment for unskilled labor was met by institutional arrangements that largely precluded relative wage adjustments via collective bargaining. With collective bargaining wedded to the principle of income solidarity, the labor market lowsiders found it more and more difficult to clear the labor productivity hurdles standing in their way, which, at least in the medium run, tended to be raised in line according to the highsiders’ superior productivity performance. At the same time, the social safety net’s benefits tended to rise in line with, or even faster than, average wages (Figure I-7), raising reservation wages and undermining labor supply incentives, at least at the very low end of the labor market.

23. The design of the social insurance system and the PAYG requirement to finance rising levels of social insurance spending by higher social contributions added two vicious circle elements to the lowsiders’ already difficult situation. First, the de facto indexation of most social benefits to average wage growth meant that average growth of social benefits was also boosted by the fact that labor shakeouts fell overproportionally on low-wage earners.16 This indexation effect raised the required PAYG social contribution rate, raising labor cost across-the-board, and, because of labor market adjustments falling mainly on lowsiders, further spurred (average measured) wage growth. And second, labor shakeouts led to across-the-board increases in social contribution rates, thereby boosting labor costs of lowsiders, and the ensuing labor shakeout added to social spending requirements, putting further pressure on social contribution rates.

24. It is noteworthy that in the short run, collective bargaining responded quite sensitively to the state of the labor market, as witnessed by a distinct pattern of alternating periods of across-the-board wage moderation (following labor shakeouts and rising unemployment) and across-the-board wage push (during cyclical upturns and following prolonged wage moderation) (Figure I-8):

  • At the beginning of the 1970s, with the economy heating up, average wage growth surged ahead of average productivity growth, indicating wage push behavior; this was followed by Germany’s first massive labor shakeout episode during the recession of the mid-1970s.

  • A period of relative wage moderation after the mid-1970s shakeout was followed by another period of more aggressive wage setting; a second labor shakeout took place at the time of the cyclical recession at the beginning of the 1980s.

  • The 1980s saw a long stretch of wage moderation behavior, which, however, came to an abrupt end with German unification (wage setting in eastern Germany being an extreme example of “income solidarity” behavior); as the economy went into recession at the beginning of the 1990s, the third major labor shake out ensued.

  • A new phase of wage moderation behavior began in 1993; however, this time wage moderation was partly offset by the political decision to finance unification through the social insurance system, reflected in the significant hike in social contributions; the 1994-98 period was marked by a drawn-out phase of weak labor market performance.

Figure I-8.
Figure I-8.

Germany: Aggregate Wage Share and Unemployment, 1960-98

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Sources: Deutsche Bundesbank; and staff estimates.1/ For 1960-90 data refer to western Germany; for 1991-98 data refer to united Germany.

25. The apparent “rocking chair pattern” of wage setting that emerges from this stylized description points to a highsider-lowsider dilemma inherent in the present institutional arrangements: on the one hand, across-the-board wage setting consistent with average or above-average labor productivity increases in the economy appears to have undermined the employment opportunities at the lower end of the labor market in the economic environments of the 1980s and 1990s; on the other hand, across-the-board wage moderation, while perhaps consistent with productivity developments at the lower end of the labor market, would imply diverging wage and productivity developments in the upper part of the wage distribution, leading to pressures to end wage moderation. The fact that labor shakeouts tend to take place during recessions should not divert attention from the fact that the buildup of disequilibria between labor cost and productivity at the lower end of the labor market is likely to begin some time before the recession and the actual labor shakeout occur.17

26. Two particular labor market niches—i.e. segments of the labor market that are in part exempted from the current rules of the game—provide an (almost) experimental setup to explore the employment effects of alternative labor market institutions:

  • Until April 1, 1999, workers holding small-time or minor jobs (working less than 15 hours work time per week and earning less than DM 620 per month) were exempted from paying social contributions; although accurate statistics on the number of small-time jobs are not available, there is evidence that the number of small-time jobs may have risen sharply, to some 5.6 million by 1997 (or well above 10 percent of the official labor force).18

  • Younger workers in Germany are typically employed in apprenticeship schemes that are also not subject to the full gamut of labor market rules. Although more recently there have been difficulties in providing sufficient numbers of apprenticeship posts for young workers, Germany’s youth unemployment rate still remains among the lowest rates in the OECD.19

27. The labor market experience of eastern Germany since unification, on the other hand, provides a regional example illustrating the adverse employment impact of Germany’s labor market institutions-in a particularly difficult environment.20 The stylized facts on eastern Germany’s labor market experience including the marked rise in lower-skilled unemployment were reviewed in Section B. Following the wholesale transfer of western Germany’s institutions to eastern Germany coupled with an agreement to quickly raise tariff wages in the east to west German levels, some optimistic observers hoped initially for a repeat of the Wirtschaftswunder performance. But despite large-scale active labor market policy initiatives and massive investment incentives, the task to raise labor productivity of east German workers quickly close to west German levels proved to be more difficult and time-consuming than most observers had expected. Adding a drag from the labor supply side, social benefits in eastern Germany in the meantime rose to levels close to western levels, substantially boosting reservation wages relative to workers’ take-home pay.

E. Financial Policy Reactions

28. Institutional inertia in a rapidly changing environment may also have encumbered the cyclical settings of fiscal and monetary policies, adding strains to the demand side of the economy.21 As regards fiscal policy, the long-run interplay between poor labor market performance and rising social spending and contributions was already highlighted in previous sections. The present section focuses only on the stabilization function of fiscal policy.

29. Comparing the movements of actual and structural general government balances provides a visual impression of the behavior of fiscal policy over time (Figure I-9).22 In the absence of procyclical fiscal policies, the structural fiscal balance would be represented by a smoothed version of the actual budget balance. However, over the last 20 years or so, the structural balance of the general government has been strikingly more variable than the actual balance, reflecting pronounced procyclical swings of the structural balance. Moreover, regression estimates indicate that these procyclical swings in the structural balance offset roughly the automatic fiscal stabilizers. In view of the decentralized nature of Germany’s fiscal system, it is of some interest to trace procyclical fiscal behavior to the different levels of government, in Figure I-9 represented by the central government (federal government and social insurance sector) and the lower government levels (states and municipalities). Empirical estimates of their respective core budget balances indicate that the fiscal behavior of the central government turned procyclical at the beginning of the 1980s, while the lower government levels behaved procyclically throughout the period 1960-98 23

Figure I-9.
Figure I-9.

Germany: Fiscal Policy Behavior, 1960-98

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Source: IMF, World Economic Outlook; and staff estimates.1/ In percent of GDP.2/ In percent of potential GDP.

30. Procyclical behavior of fiscal policy is more likely to occur under a fiscal system with any of the following three characteristics: (i) the fiscal system includes a large PAYG social insurance system, where the PAYG principle enforces approximate budget balance in the large social insurance spending portion of the budget; (ii) the containment of high deficits and debt in the nonsocial insurance part of the budget is enforced by binding (constitutional) rules, or debt and deficits are so high that free operation of the automatic stabilizers is considered too costly; and, (iii) the fiscal system has a significant decentralized component and at least some of the units at the lower government levels follow balanced budget rules that offset the operation of their automatic fiscal stabilizers.

31. In the particular case of Germany, all three characteristics appear to be relevant. But the problems in the labor market since the early 1970s are likely to have aggravated existing procyclical fiscal tendencies through two channels: (i) the upward ratcheting in the unemployment rate puts pressure on the finances of the PAYG insurance system and social spending more generally; and (ii) persistent wage moderation that typically follows labor market shakeouts tends to undermine revenue during recessionary periods.

32. The analysis of the factors behind the observed procyclical stance suggests that restoring more scope to the operation of automatic fiscal stabilizers would need to be underpinned by institutional reforms in the labor market. Moreover, in the new EMU environment, a revitalization of automatic fiscal stabilizers could at least partly compensate for the loss of monetary policy autonomy, and, in view of Germany’s relative size, also improve EMU’s overall capacity to absorb macroeconomic shocks.

33. The setting of monetary policy by the Bundesbank (until end-1998) was guided by a clear legal mandate to preserve medium-term price stability. While the Bundesbank often followed a pragmatic course influenced by historical circumstances, it always remained focused on maintaining Germany’s “stability culture.”24 From the point of view of monetary policy, the wage push phase inherent in the highsider-lowsider structure of the labor market contained the seeds of an inflationary boom, as wage increases would outpace productivity increases, and particularly so at the lower end of the labor market. In addition, these inflationary pressures were likely to be reinforced by a procyclical stance of fiscal policy.

34. The Bundesbank’s main instrument to stem the perceived inflationary pressures—raising interest rates—had its limitations as the employment prospects of skilled workers (the chief proponents of wage push episodes) were relatively immune to tighter monetary conditions. As a consequence, monetary policy tended to meet perceived inflationary pressures promptly and decisively by tightening the monetary stance (Figure I-10). By contrast, and perhaps also reflecting an attempt to encourage prolonged across-the-board wage moderation, periods of economic slack were characterized by more gradual, and what some observers considered a somewhat asymmetric, relaxation of the monetary policy stance.

Figure I-10.
Figure I-10.

Germany: Monetary Policy Behavior, 1960-98

Citation: IMF Staff Country Reports 1999, 130; 10.5089/9781451810417.002.A001

Sources: World Economic Outlook database; and staff estimates.1/ In percent of potential GDP.2/ Defined as a difference between 3-month deposit rate and annual CPI inflation rate.

F. Remedies

35. Two standard policy responses to the recurrent labor shakeouts, across-the-board wage restraint and putting the “fiscal house” back in order, are natural and to a large extent unavoidable in the present institutional setting. Given the constraints of the solidarity principle, however, collective bargaining outcomes are likely to alternate between generalized wage moderation and generalized wage push, where generalized wage moderation builds up the momentum for the next wage push. On the fiscal side, the wage base for the social security system is permanently weakened by labor shakeouts and the upward ratcheting in the unemployment rate, and fiscal consolidation efforts typically result in a new and higher plateau of social contributions. These generalized policy responses are built into the current system but are essentially passive and unlikely to prevent the recurrence of labor shakeouts in the medium term.

36. The standard list of broad-brush institutional remedies is, by now, well known and needs only a brief summary here (Chapters III and IV expand further on remedies): collective bargaining institutions that are more cognizant of the need to match labor cost and productivity of the lower skilled; a multipillar social insurance system that would avoid charging very high social contributions at the lower end of the labor market; and stronger work incentives for the lower paid. In view of society’s equity objectives, income safeguards in the form of in-work benefits for lower-paid workers through the tax-transfer system would likely be needed, for example, through graduated withdrawal of benefits or earned income tax credits.

37. In the absence of meaningful institutional reforms, workers and firms are likely to continue to search for opportunities to avoid the strictures of the present collective bargaining and social insurance frameworks. Examples of “endogenous adjustments” include the proliferation of DM 630 jobs and self-employment schemes that avoid paying social contributions; the declining shares of companies and employment that are parties to area-wide collective bargaining agreements; the increased use of opt-out clauses from collective bargaining agreements, in particular in eastern Germany; and there appear to be an increasing number of cases where firms that are members of employers’ associations pay below-tariff wages with the tacit agreement of their workforce.

38. The experiences with labor market policies in several continental European countries may offer useful benchmarks for Germany’s reform agenda. Three cases—the Netherlands, Denmark, and Switzerland—are of particular interest, as a common thread of these cases is that policies are mutually complementary, rooted in social consensus, and consistent with equity aims that are broadly similar to Germany’s own. When the Netherlands faced crisis conditions in the early 1980s, the authorities and social partners agreed on wide-ranging labor market measures that relied on a two-pronged approach; (i) strong complementarity of the reform measures, i.e., benefit reform contributed to spending restraint, facilitating fiscal consolidation and cuts in the tax wedge; tax cuts and benefit reforms favored wage moderation that helped strengthen labor demand; buoyant employment boosted the tax base, setting in motion a virtuous circle in the labor market and public finances; and (ii) social consensus fostered by the authorities’ consultative style and the new “rules of the game” implied by the tax and labor market reforms. The new rules then delivered growth, jobs, and core social protection, cementing popular support.25

39. Denmark’s labor market policies have focused on improving employability of workers and on strengthening incentives and making job search and matching more efficient.26 With radical reductions in benefit rates and minimum wages not considered feasible politically, policy measures have focused on tightening of eligibility and activation requirements and reducing the duration of benefits. There are clear indications that the measures to strengthen work incentives affected behavior and improved the functioning of the labor market.

40. The case of Switzerland’s labor market institutions is of particular interest. Apart from the obvious disparity in size, the Swiss and German economies share a number of common features: large, export-oriented, high-wage manufacturing sectors; high saving rates and similar education and training systems; similar exposure to demand and technology shocks; and highly decentralized political systems that require broad consensus on the need to implement reforms. However, the key institutional differences that appear to support Switzerland’s relatively favorable labor market performance are: (i) a decentralized wage bargaining system that sets wages in accordance to conditions at the firm level; (ii) a multi-pillar social insurance system that permits significantly lower contribution rates, with the public pillar providing mandatory basic insurance and private pillars offering supplementary coverage; (iii) limits on duration of unemployment benefits coupled with a requirement to participate in active labor market programs; and (iv) lower employment protection and less generous nonwage benefits. At the same time, and reflecting a strongly held social consensus, social benefit replacement rates are, as in Germany, relatively high.

41. As in these other continental European countries, institutional reforms in Germany would likely require the assent of all the main players and necessitate abandoning entrenched positions all around. The Alliance for Jobs, Education, and Competitiveness —a forum initiated by the new coalition government and comprising the government, employers, and the trade unions—represents a potential framework for taking stock and finding home-grown solutions to Germany’s labor market malaise.

References

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1

Prepared by Albert Jaeger.

2

The term “institution” denotes here the “rules of the game” (formal and informal) in a society. A more detailed definition is provided in footnote 9.

3

As sources on Germany’s postwar developments this chapter draws inter alia on Giersch, Paqué, and Schmieding (1992), Deutsche Bundesbank (1999), and the consecutive annual reports (starting in 1964/65) of the German Council of Economic Experts.

4

As discussed further in paragraphs 15 and 16, there are important exceptions to these “rules of the game” related primarily to small-time jobs (“DM 630 jobs”) and some social insurance benefits that are not tied to previous contributions.

5

Two exceptional historical events, German unification and the run-up to Stage 3 of EMU, have also contributed to the procyclicality of fiscal policy during this period.

6

For example, the proposal by Prime Minister Blair and Chancellor Schröder (1999, p. 6) (at http://www.labour.org.uk/views/index.htm) called for “…a re-evaluation of old ideas and the development of new concepts” as “…national economies and global economic relationships have undergone profound change.”

7

There was an even more exceptional growth episode in 1948-50 following the currency reform of June 1948; real GDP growth during this episode averaged more than 15 percent per annum.

8

The skill-specific unemployment data are taken from Reinberg and Rauch (1998). A crosscountry comparison of available skill-specific unemployment data in Manacorda and Petrongolo (1999) suggests that unemployment rates of the unskilled in industrial countries are generally above those of the skilled (with Italy being a notable exception in Manacorda’s and Petrongolo’s data set). Moreover, the relative trends in aggregate and unskilled unemployment rates since the 1970s differ significantly across countries, with Germany experiencing one of the most marked relative increases in unskilled unemployment.

9

The term “institution” is used here in the sense of North (1990): institutions are defined as the formal and informal constraints or “rules of the game” in a society; institutions may change, usually gradually, in response to fundamental changes in relative prices (brought about inter alia by changes in the relative scarcity of factors of production, in the cost of information, or in technology) or changes in society’s preferences.

10

Van der Willigen (1995) provides a concise description of the collective bargaining system.

11

The cumulative wage drift during the period 1981-98 in industry (western Germany) amounted to 3 percent.

12

For additional and more detailed evidence on relative wage developments, see Chapter III.

13

For example, in 1949 the metal industry tariff agreements stipulated 48 hours work per week, 12-18 week days of vacation (depending on seniority), and no supplementary wage payments. By 1999, weekly work hours had been reduced to 35 hours, days of vacation had increased to 30 work days (independent of seniority), and a wage supplement (vacation bonus) amounting to 75-105 percent of monthly pay (depending on seniority) had been introduced.

15

This framework is developed in Nickell and Bell (1995). Chapter IV uses a formal version of this model to study tax-transfer solutions to the low-skilled labor problem.

16

This effect was reinforced by underestimation of the rapid growth of small-time jobs (DM 630 jobs) in the official employment statistics.

17

The highsider-lowsider perspective contrasts with the traditional insider-outsider view of the German labor market. The basic insider-outsider view assumes that the average wage is set to achieve the highest wage increase consistent with continued employment of insiders, ignoring the employment interests of the outsiders. The highsider-lowsider perspective suggests that across-the-board wage increases are benchmarked on the productivity performance of the highsiders, ignoring the (possibly) lagging productivity performance of the lowsiders.

18

Based on Ochs (1999); see also Chapter IV, Box IV-3.

19

For example, for persons aged 15-24, unemployment rates in Germany and France in 1997 amounted to 10 percent and 28.1 percent, respectively. The average rate for OECD Europe in 1997 was 19.0 percent.

20

This paragraph draws on Chapter IE, IMF Staff Country Report No. 97/101 for Germany.

21

The Federal government’s Annual Report 1999, signed by the previous Minister of Finance Lafontaine, argued forcefully that lack of coordination between wage, monetary, and fiscal policies was a key element in explaining Germany’s labor market malaise. The report, however, stopped short of broaching the need for institutional reforms in the labor market.

22

This discussion draws on Chapter I of the IMF Staff Country Report No. 98/111 for Germany.

23

German unification and the runup to Stage 3 of EMU, both exceptional historical events, also contributed to observed procycltcality of fiscal policy during this period.

24

See the various chapters in Bundesbank (1999) for in-depth treatments of Germany’s postwar domestic and external monetary policies. This discussion also draws on Carlin and Soskice (1997).

25

The Dutch experience is discussed in more detail in Watson and others (1999).

26

For more details, see the IMF Staff Country Report No. 99/88 for Denmark.

Germany: Selected Issues and Statistical Appendix
Author: International Monetary Fund