Why Germany's economy will outshine Japan

For the past 15 years, many a pessimist has had a field day with the so-called race to the bottom between the world's second and third largest economiesJapan and Germany. As a post-bubble Japanese economy became trapped in deflation and a series of rolling recessions, an increasingly sluggish and inherently rigid Germany economy was widely feared to be next. The verdict is now inthose fears were vastly overblown. Not only did Germany never fall into a Japanese-like quagmire, but the engine of Europe is now very much on the mendwith a newfound sense of vitality that is still missing in Japan.

Japan vs. Germany: export performance

Both economies have traveled very different roads in roads in recent years. Japan's singular event was an epic asset bubble that all but obliterated its inherently shaky banking system and its keiretsu trappings of cross-holdings of company shares. Germany was weighed down by two external developmentsthe reunification of the former East Germany and the steep costs associated with the launch of the European Monetary Union. Notwithstanding these differences, both economies share some striking similaritiesespecially, rigid labor markets, high wages, and a seemingly chronic deficiency of private consumption.

At the same time, the modern-day German and Japanese economies have both drawn disproportionate support from their export sectors. It is in that key area where Germany is now outshining Japan. German exports have surged even in the face of a strong currency, while Japan has had to rely on a sharp weakening of the yen to achieve a comparablealbeit less spectacularoutcome. In my view, this is emblematic of an important gap that is opening up between an increasingly solid German economy and a still fragile Japanese economy.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Germany's export miracle

Germany's export prowess is nothing short of stunning. In a recent research note, Elga Bartsch details the record of Germany's export accomplishmentsnoting, in particular, the country's leadership position in global merchandise exports for the fourth year in a row (see her 16 February dispatch, "Germany: Excelling at Exports"). As Elga points out, Germany has been alone in the industrial world in holding market share in the face of the extraordinary export growth coming from China and elsewhere in the developing world. The Germany-Japan export comparison has been especially striking over the past dozen years. Back in early 1994, both economies had roughly 10% market shares in overall global merchandise exports. In 2006, Germany's global share remained about the samearound 10% - whereas that for Japan had tumbled to just 6%.

The outperformance of German exports vis--vis Japan is all the more apparent in looking at two of the world's most advanced product linesinformation technology and telecommunications equipment. Based on data compiled by Catherine Mann of the Institute for International Economics, Japan held the #1 position in worldwide IT exports in 1990 with a 20.4% market share; by 2004, Japan had slipped to #5 with just a 7.9% position (see Mann's Accelerating the Globalization of America, Institute for International Economics, 2006). By contrast, Germany's global market share in the IT export business held relatively steady at around 7% over the same period. In the communications area, Japan went from a dominant #1 position with a 26.7% market share in 1990 to only a 6.9% share in 2004, whereas Germany's share in this key category actually rose from 7.4% in 1990 to 8.9% in 2004. Germany's performance in these two product lines is all the more stunning in the face of China's rapid emergence as a global export powerhouse. As recently as 2000, China still ranked #13 in global market share in IT and #5 in communications equipment. A scant four years later, China was #1 in world export shares of both of these key product lines. Both Japan and the United States wilted dramatically under the onslaught of the Chinese export juggernaut. Within the industrial world, Germany stood alone in holding its own.

The hows and whys of Germany's competitive prowess have long been debated. It's always possible that Germany could simply be luckya capital goods exporter that happens to be in the right place at the right time. As I travel through China, I certainly see highly visible signs of a voracious appetite for German-made productsnew factories equipped with the latest in German machinery as well as stunning examples of German infrastructure, such as the high-speed maglev train in Shanghai Pudong. Chinese imports of German-made products hit US$30.7 billion in 2005; that made China Germany's 11th-largest export marketbehind the US and Germany's largest European neighbors but ahead of Japan, Korea, Russia, and every other country in the developing world. But it is not just China. Germany is also playing a key role in supplying its neighbors in Eastern and Central Europe with the capital equipment that drives an increasingly vibrant outsourcing function.

To me, the most impressive aspect of Germany's export miracle is that it has occurred in the face of a strong currency and a high-wage work force. The euro is up more than 55% versus the dollar since mid-2001, and hourly compensation in German manufacturing stood at US$33.00 in 2005 -- fully 40% above that in the US and 52% higher than pay rates in Japan. With these disadvantages, it is nothing short of a miracle that Germany has done so remarkably well in the global export sweepstakes. Such an outcome is, in fact, quite consistent with the conclusions I reached last fall after an extensive tour of Germany (see my 22 September 2006 dispatch, "The New Wirtschaftswunder?"). At work, in my view, was an increasingly impressive improvement on the German productivity frontdriven by the confluence of IT-enabled investment, M&A-led restructuring activity, and a new "flexi" workforce dominated by rapid growth of part-time and temporary workers. Germany's successes on the export front may well be a very important manifestation of this productivity dividend.

Japanese reform

It is not as if Japan has been standing still as Germany has gotten its act together. There has been plenty of restructuringboth in the financial and nonfinancial segments of Corporate Japan. Moreover, Japan has moved aggressively to dismantle the worst of its labor market rigiditieslifetime employment. And Japan has done an important about-face on its economic relationship with Chinaembracing the Chinese outsourcing option as an efficiency solution rather than as a threat that might lead to the hollowing out of its domestic production base. But have these actions been enough? That remains a very legitimate question in light of Japan's stunning loss of share in world export markets over the past 15 years. And it is an even more telling question in the face of Germany's equally stunning successes during the same period.

The hows and whys of Japan's competitive prowess are very different from those of Germany. In the early decades of the post-World War II era, Japan competed mainly on the basis of cost and pricing. Then in the 1960s and 1970s, it began to compete on the basis of product quality. And in the 1990s, Japan's competitive successes were in the area of processespecially production, inventory control, and so-called quality circles. Throughout this entire period, however, a quasi-socialist system provided a warm blanket of support to banks, companies, and workers. The Great Bubble of the late 1980s marked this state-directed system to market and forced Japan and its reformers to find a new way. Prime Minister Junichiro Koizumi was the embodiment of that new direction, and during his tenure in office from 2001-05 pushed ahead vigorously on the reform front.

Japan's healing has been very different from that of Germany. Even nowfully five years into economic recoveryJapan has yet to distance itself from the risks of a deflationary relapse. The nationwide CPI is in positive territory only by the slimmest of margins (+0.1% y-o-y in January 2007), and is actually threatening to slip back into negative territory within the next month or so. The difficulty Japan is having in extricating itself from a post-bubble deflation may well be emblematic of deeper problems that continue to afflict the world's second-largest economy. This same difficulty may also be having an important bearing on Japan's competitive prowess. The damage from the bubble may well have been so wrenching and so fundamental to the system that it simply may be asking too much of Corporate Japan to rise quickly from the ashes and hold its own against the rapid emergence of China, the intense determination of Germany, and the solid gains evident by exporters elsewhere in the developing world.

Unlike Japan, Germany did not have to reinvent its systemit "simply" had to figure out a better way to cope with an uncompetitive cost structure and the external burdens of pan-regional unification and intra-German reunification. In many respects, those costs have now been absorbed and Germany is moving on to face to new challenges, with much to show for the efforts in terms of productivity growth and global export shares. Japan is still struggling. Yes, it finally has a sustainable recovery in the real side of its economy. But that is not enoughespecially if it turns out to be more of a cyclical rebound than a structural healing. Japan is still somewhere in between its old system and a yet-to-be-defined new system. And in one important respect, it continues to face a steep uphill climbit remains encumbered by a one-party political system that still has a stranglehold on the pace and breadth of a nascent transition.

Why Germany will outshine Japan

Japan's progress looks monumentalmainly because of where it has come from. Yet relative to the rest of the world, there is still plenty of heavy lifting ahead. To the extent that Japan's progress continues to be heavily subsidized by the weakest currency and the lowest nominal interest rates in the world, it is hard not to underscore the still fragile state of its turnaround. By contrast, Germany has been stress-tested by a strong currency and an independent central bank. It has met the challenges of a new global competition head-on. It was never the "next Japan." Only time will tell if the next Japan is truly a new Japan.

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum