National Council of Applied Economic Research
Opinion: Barry Eichengreen.
There is a profound mismatch between Germany’s current economy and its institutional inheritance from the postwar period. If the current crisis prompts a wholesale rethink of that inheritance, the logjam blocking necessary reforms could finally be broken.
Germany is the poster child for everything that is wrong with the European economy. GDP is on track to fall for a second straight year. Energy-intensive industries like chemicals and metalwork are in the tank. National champions such as Volkswagen and ThyssenKrupp have announced unprecedented job cuts and factory closures.
I have long argued that the best way to understand these problems is as a negative consequence of Germany’s own prior economic success and of the institutional underpinnings of those earlier achievements. The German economy’s current malaise is further evidence of this.
In the aftermath of World War II – a period of upheaval and crisis but also of renovation and opportunity – what was then West Germany developed a set of economic and political institutions ideally suited to the conditions of the time. To capitalize on its existing prowess in quality manufacturing, policymakers put in place successful vocational training and apprenticeship programs that expanded the supply of skilled mechanics and technicians. To exploit rapidly growing world trade and penetrate global export markets, German industry doubled down on the production of motor vehicles and capital goods, fields where it had developed a pronounced comparative advantage.
At the same time, West Germany built a bank-based financial system to channel funds to dominant firms in these sectors. To ensure harmony in its large companies and limit workplace disruptions, it developed a system of management codetermination that gave workers’ representatives input into C-suite decisions.
Finally, to limit disruptive politics, and specifically to check the kind of political extremism and parliamentary fragmentation that had haunted Germany in the past, a proportional electoral system was put in place so that all mainstream parties had a voice, subject to a 5% minimum threshold for parliamentary representation (to limit the influence of fringe parties).
The happy result of this alignment of institutions and opportunities was the Wirtschaftswunder, the growth miracle of the third quarter of the twentieth century, when West Germany outperformed its major advanced-economy rivals (with the sole exception of Japan).
Unfortunately, these same institutions and arrangements proved exceedingly difficult to modify when circumstances changed. Focusing on quality manufacturing became problematic with the rise of new competitors, including China, yet German firms remained heavily invested in the strategy.
Attempts to alter workplace organization, much less close down uneconomical plants, were stymied by codetermination. Funding startups in new sectors was not the natural inclination of fusty banks accustomed to dealing with long-established customers engaged in familiar lines of business. And a proportional electoral system with a 5% threshold yielded unsatisfactory results and unstable coalitions when voters moved to the extremes, positioning the Alternative for Germany on the right and the Sahra Wagenknecht Alliance on the left to earn parliamentary representation, while leaving the more moderate Free Democrats at risk of being shut out.
The solutions, it would seem, are obvious: Invest more in higher education and less in old-fashioned apprenticeships and vocational training so that Germany can become a leader in automation and artificial intelligence. Develop a venture capital industry to take risks that banks are unwilling to shoulder. Use macroeconomic policies to stimulate spending instead of relying on tariff-ridden export markets. Rethink codetermination and a mixed-member proportional electoral system that has outlived its usefulness.
Not least, release the “debt brake,” another inheritance from the past, which limits public spending. Doing so will permit the government to invest more in research and development and in infrastructure, two critical determinants of economic success in the twenty-first century.
Imagining such changes may be easy, but implementing them is not. Change is always hard, of course. But it is especially hard when one seeks to modify a set of institutions and arrangements whose successful operation, in each case, depends on the operation of the others. Attempting to do so is akin to replacing a Volkswagen’s transmission while the engine is running.
To take one example, German banks, which rely on their existing customer relationships, are most comfortable when lending to long-established firms doing business in long-established ways. In turn, those firms perform best when they have long-standing relationships with banks on which they can rely for finance.
Replace those established firms with startups, and the banks, lacking the expertise of venture funds, will be at sea. If they lend nonetheless, they are at risk of going under. Replace banks with venture capital funds, which have little interest in stodgy metal-bending firms, and those firms will lose access to the external finance on which they depend. Such is the nature of Germany’s institutional gridlock.
The bad news, then, is that there is a serious mismatch between Germany’s current economic situation and its institutional inheritance, and that there are major obstacles to altering the latter to realign it with the former. The good news is that a crisis that prompts a wholesale rethink of that institutional inheritance could conceivably break the logjam. Maybe this is just the crisis that Germany needs.
Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley, is a former senior policy adviser at the International Monetary Fund. He is the author of many books, including In Defense of Public Debt (Oxford University Press, 2021).