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Structural factors may explain a significant part of the growth gap …
A significant part of the growth gap between Germany and its partners is, therefore, left
unexplained. A decomposition of the growth path of potential output shows that labour
market behaviour is an important factor behind a lower than average growth rate in Germany
after the mid-1990s. According to DG ECFIN estimates, German potential growth during the
second half of the 1990s could have been around 0.5 percentage points higher per year if
Germany had developed like the Euro-area average. Most of this difference can be explained
by developments in the labour market. Two factors, in particular, stand out, each explaining
about one half of the overall difference in potential growth. First, the labour market
participation rate has seen a more subdued development in Germany than in other countries.
On the other hand, the estimated equilibrium unemployment rate as measured by the NAIRU
has remained rather stable in Germany, while it has trended down in most other EMU/EU
countries.
… with rigidities in the labour market standing out as a key factor, …
It is a difficult task to pinpoint the exact underlying factors, which account for the different
labour market experience of Germany in comparison with other European countries.
Nevertheless, it seems likely that a lack in labour market reform in Germany lies at the root of
these differences. Several impediments in the German labour market could be identified
which might have a dampening effect on labour market participation and the equilibrium
unemployment rate: (i) wages out of line with productivity due to the nature of the wage
bargaining process in Germany, especially for the unskilled segment of the labour market,
with the East-West wage differentiation remaining a particular problem; (ii) high marginal tax
rates which, in combination with a long benefit duration and high benefit rates for certain
groups, lead to significant unemployment traps; and (iii) a general lack of flexibility and
mobility.
… which interacted with factors related to re-unification.
In general, however, labour market regulations in Germany are not much higher than in most
other continental European countries. Differences in outcomes are, therefore, most likely due
to differences in the evolution of structural labour market impediments during recent years
rather than their level. In particular, while many European countries made efforts to render
their labour markets more flexible, similar effort have been largely missing in Germany. On
the contrary, in addition to reversing some of the timid measures adopted by the previous
government with a view to increasing labour market flexibility, the present government
implemented regulations which were widely seen as adding further constraints. Although the
direct effects of these measures on employment creation were probably small, in view of a
broad consensus that Germany needs to lower labour market rigidities, the political
orientation of these actions might have generated harmful signalling effects in the longer
term. It needs to be emphasised, in this context, that in many respects re-unification has made
the country more heterogeneous than it had been before. The appropriate response to such an
increase in heterogeneity would have been a decisive move to make labour markets more
flexible. In this sense, existing rigidities were made worse through their interaction with re-
unification-related factors. For instance, a significant share of the East German labour force
was priced out of the market because wage rises much above productivity increases concurred
with Germany’s general compression of wages at the lower end of the wage scale.
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While continuous reforms of product and capital markets will be important…
Although, in general, the growth potential of an economy may be seriously constrained by
product and capital market rigidities, in comparative terms they seem to be of lesser
importance in explaining the specific growth performance of Germany. Indeed, Germany has
made substantial progress during the 1990s in liberalising its network industries. While state
aid, which is mostly geared towards large industrial companies and based on subsidising
capital inputs, continues to act in a distortionary way in various markets its scale does not
seem to differ significantly from that observed in other European countries. On the other
hand, outdated regulations tend to limit the creation of jobs in new types of activities, thereby
reducing potential employment. Overall, however, imperfections in product and capital
markets do not seem to go beyond those of Germany’s EMU/EU partner countries. These
considerations are also corroborated by the above-mentioned simulation exercise which
shows that neither equipment investment nor total factor productivity can account for the gap
in potential growth between Germany and its European partners. Indeed, this gap is
exclusively explained by the labour contribution to potential growth.
… labour market reform will be key to bring Germany back onto a robust growth path.
Looking ahead, according to DG ECFIN estimates, Germany is likely to have a medium-term
growth path of some 2% which compares with a potential growth rate of close to 2½ % for
Germany’s EMU/EU partners. This reflects first of all a demographic differential between
Germany and other European countries, but also insufficient labour market flexibility to cope
with change in comparison with other European countries. Notwithstanding some recent
measures in this field, Germany would need to undertake labour market reforms to lower the
NAIRU and increase the participation rate if it wants to catch up with the other Euro-area
countries and face enlargement and the consequences of its ageing population. Without a new
round of labour market reforms the German medium term growth outlook is likely to remain
bleak.
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