If Japan can do it, why not Germany? That's been one of the most hotly-debated questions in global macro circles in recent years. After three days and six cities in Germany last week my most extensive visit yet I left with the distinct impression that the biggest engine of Europe is finally shifting gears. Not only would that be good news for a long-hobbled European economy, but it could also be a very important development for a still unbalanced global economy.
German productivity on the up
I have always thought that a German turnaround would hinge on the productivity story. From this perspective, there are grounds for encouragement on three fronts the labor market, IT spending, and corporate restructuring. Yes, Germany still has one of the world's highest-cost labor forces, with hourly compensation in manufacturing of $32.53 in 2004 nearly double the $18 average for the industrial world, according to the US Bureau of Labor Statistics. And, of course, the fixed costs associated with the hiring and firing of German workers remain prohibitive.
The good news is that Corporate Germany has responded to this cost disadvantage by moving to an increasingly flexible work force. Germany's so-called "flexi-workers" part-time and contract temps now make up over 40% of the country's total labor force; that's up over 10 percentage points from the flexi share of a decade earlier. Meanwhile, once powerful German labor unions have lost their swagger, and the shortened workweek has increasingly fallen by the wayside. Yes, Germany still has a very rigid, high-cost labor market but less rigid and less costly than was the case just a few years ago.
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Increased use of IT-enabled productivity strategies
Within the developed world, Germany has been a laggard in embracing IT-enabled productivity strategies. There are signs that is now changing. According to OECD calculations, the IT share of total German capex (equipment and plant, combined) moved up from 13.3% in 1995 to 16.2% in 2000 well short of the US (29.9%) but above the shares in France (14.4%), the United Kingdom (15.0%), and even Japan (16.0%).
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Additionally, there are indications of further increases in the IT-intensity of the German economy in more recent years; according to OECD metrics, through 2003 there have been meaningful increases both in the IT contribution to German GDP growth as well as in the IT share of business sector value added (see "OECD Key ICT Indicators," April 2006, available at www.oecd.org). Consequently, just as IT-enabled capital-labor substitution strategies were key to America's productivity revolution in the late 1990s, there is increasing hope for an analogous outcome in Germany a decade later.
At the same time, corporate restructuring efforts, as gauged through merger and acquisition activity, are back on the rise in Germany. The volume of German M&A transactions could top US$160 billion, on average, in 2005-06 essentially double the $84 billion average over the 2002-04 period. And our stretched investment bankers tell me that the pipeline is brimming with German assignments.
The German economy: what the statistics tell us
All this paints a far more compelling story for German productivity growth than has been the case in years. Interestingly enough, the numbers are now starting to hint at just such a payback. According to estimates made by Elga Bartsch, our German economist, productivity in Germany has been running at about a 1.7% y-o-y clip over the five quarters ending in 2Q06. While that pales in comparison to a much more vigorous US productivity revival, it does represent a marked acceleration from the anemic 0.7% annualized German productivity trend evident over the 1998 to 2004 period. And this may be just a start. After all, an important lesson from the US experience is that it takes time for the IT payback to bear fruit: The five-year US trend productivity comparison first accelerated to 2.5% by 2000 before rising further to 3.4% by 2004. Meanwhile, German productivity growth has now essentially doubled off a low base, to be sure, but an impressive achievement nevertheless for any developed economy.
Like all productivity stories, the outcome in any given year reflects the interplay between cyclical and structural forces. In light of the recent upturn in the German economy, I suspect both such forces have been at work over the past five quarters in Germany. That also leads me to warn of a likely cyclical downshift in German productivity growth in 2007. That's a distinct possibility in light of our forecast of decelerating GDP growth next year +0.7% in 2007 versus +2.1% in 2006 on the back of the imminent VAT tax hike, as well as an outgrowth of the lagged impacts of ECB monetary tightening and a stronger euro. Notwithstanding that possibility, I think the interplay between all three forces - improved labor market flexibility, IT-enabled capex, and an accelerated pace of corporate restructuring suggests that the structural German productivity outlook could be better than it has been in a long time. Moreover, I suspect that any cyclical shortfall of economic activity in 2007 could well evoke a new round of intensified restructuring by Corporate Germany - adding even greater impetus to structural productivity improvements.
The political constraint always gets a good deal of attention in Germany especially the long-simmering debate over reforms. Unfortunately, Chancellor Angela Merkel repeatedly stymied on matters of pensions, healthcare, tax reform, and social security has yet to make any meaningful progress on the reform front. However, like the apparent demise of the EU constitution, this setback should not be blown out of proportion. In studying restructuring over the years whether it is the US, Japan, or even China I have come to the conclusion that government matters far less than the private sector in driving fundamental change. As long as the government stays out of the way, while at the same time allowing market forces to unlock efficiencies, restructuring and productivity enhancements will follow.
The key risk of the political constraint, in my view, is when governments take actions, such as protectionist trade policies, that inhibit the functioning of markets and thereby perpetuate embedded inefficiencies. Despite continuing political disappointments on the road to reform, that does not seem to be the case in Germany these days although recent talk of government efforts to introduce minimum wage legislation is hardly good news for German labor market reform.
The German economy: reasons to be optimistic
The numbers are really only part of the upbeat story in Germany. In traveling around the country last week, I picked up a gathering sense of optimism from business leaders and investors that stood in sharp contrast to their far more morose temperament I have observed over the past five years or so. I mention this because this is precisely the same type of mood swing I first picked up in Japan about three years ago when the Japanese economy was still widely perceived to be languishing in a protracted structural malaise.
Just as the attitudinal shift in Japan turned out to be an accurate leading indicator of the eventual improvement in the state of the real economy, there may well be good reason to believe that a similar development could be in the offing in Germany. That would be welcome news, indeed, for Europe's biggest economy and for the world's third-largest economy. First Japan, now Germany's Wirtschaftswunder (economic miracle) these are two unambiguously positive developments on the long and arduous road to global rebalancing.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum
If you're interested in the German economy, then see our recent articles on whether the World Cup effect can last and investing in German property.
