What is Germany Doing Right?

In the last few decades, thanks to a relentless assault on Keynesian economics, we witnessed the emergence of a peculiar new orthodoxy. On the surface of it, this not-so-new paradigm promoted the deification of the markets and called for very limited interventions into their functioning: money supply and interest rates being the two most obvious ones.

However, this seemingly benign hands-off-the-perfect-markets paradigm had significant political components, such as an almost total deregulation of all economic activities, the removal of environmental or social protection mechanisms, a fierce push back against trade unions in an effort to lower wages and globally enforced free trade arrangements.

This way businesses could cut their cost of doing business by lowering wages, destroying the environment and the social safety networks or they could simply get up and go to cheaper labor countries protected by the rules of global free trade. As a bonus, most of the time, this move enabled them to reduce the amount of taxes they paid in one place.

When the 2009 recession hit Western economies, the universal answer was to implement austerity measures, lay off workers and go after social safety funds. Welfare state, which was already a dirty word became a swear word. Trade unions, already in steady decline lost most of their bargaining powers.

Except in Germany.

High taxes, heavy regulation, powerful unions and a big welfare state are turnoffs for pretty much any true blue (and especially red) American, but they are also the four cornerstones that have led Germany to its strongest quarter in 20 years.

Today, the world's fourth largest economy in the world confirmed a 2.2 percent GDP growth in the second quarter, a tremendous feat for a developed nation during a global downturn. To compare, America grew 0.6 percent during the same quarter (and similarly, France grew 0.6 percent and Spain by 0.2 percent).

German unemployment has decreased to the near pre-recession level of 7.6 percent, from 9.1 percent in January.

In May 2011 German exports rose to their highest level since data started to be collected in 1950:

German exports surged in March to their highest level since records began, as the growing global economy lifted demand for its products and services.

The country's exports for the month totalled 98.3bn euros ($142bn; £87bn), 7.3% higher than February.

How did they achieve this miraculous feat? 

Unlike America, for example, Germany still manufactures most of its own goods, so that any export revenue is driven back to the country. A recent New York Times article also highlighted a government-subsidized labor program used to avoid layoffs:

[Government officials] extended the "Kurzarbeit" or "short work" program to encourage companies to furlough workers or give them fewer hours instead of firing them, making up lost wages out of a fund filled in good times through payroll deductions and company contributions.

To me, the key to German success was their deep understanding of how capitalism works. From Marx to Schumpeter, German political economists knew that business cycles have a specific dynamic. In a competitive setting, businesses try cutting costs by going after labor first. But since labor cost cannot be reduced beyond a certain limit, the next step involves technological innovations to increase productivity. An increase in productivity means that for the same amount of labor more goods are produced, which in turn makes some labor redundant and lowers the price of the goods produced. The problem stems from the fact that less labor in the production sphere directly translates into fewer buyers of those goods, however cheap they may be.

In the past, a wide range of solutions were applied to this problem. They tried selling goods to other countries bypassing the domestic market. Direct administration colonialism of the 19th century was a result of this (as well as WWI which was essentially a sharing dispute among colonialists, new ones like Germany not being happy with the status quo). After the WWI, they tried the elimination of competition through corporatism (remember also Dr. Schacht and his public works program) which called for a mediated relationship between capital and labor.

After WWII, Keynesian policies continued the same labor-capital alliance along with an extensive social safety network known as the Welfare State. Unfortunately, eliminating or regulating competition slowed down technological innovation and productivity increases. So when the1973-4 oil price hikes came, the aging production facilities of the Western world were unable to cope with it (unlike Japan which was largely unaffected).

This brought Keynesian policies to an unglamorous end. Rolling back the Welfare state (along with breaking unions) became the battle cry of Reaganomics and its British variant with Margaret Thatcher. They also implemented measures to deregulate markets, reduce corporate taxes and allowed corporations to set up shop elsewhere and sell their goods with no penalties or obstacles.

This new orthodoxy (which became a quasi-religion in the US and with Reagan turning into a cult-like figure for initiating it) led to a steady decline of real wages. It also provided the mechanisms for a series of bubbles (like the Internet and real estate bubbles), which replaced what used to be called business cycle crises. And it created a consumer economy which relied heavily on cheap credit to maintain its level of consumption.

Except for Germany.

They painstakingly continued the old Keynesian policies (known in Germany as Soziale Marktwirtschaft or Social Market Economy) of heavy trade union involved in economics decision making, maintaining high wages and extensive regulation of economic activities. The difference between the old Keynesian policies and the one was that, they continued to invest in R&D not just to increase productivity but also to improve upon the existing goods with complex and innovative elements. They also invested in R&D and the creation of new goods. So, German goods had significant engineering value added and they were also the leaders in new technologies such as solar panels and wind turbines.

Most of the country’s products are in engineering, especially in automobiles, machinery, metals, and chemical goods. Germany is the leading producer of wind turbines and solar power technology in the world. Exports account for more than one-third of national output. Germany is such an export-driven economy that German companies own 35 percent of the container ships in operation worldwide.

Whereas everyone else was investing in skilled machinery and moving elsewhere to use cheap, de-skilled labor, German companies kept the production of most of their goods in Germany. They relied more on their highly skilled workforce and were investing in better engineered goods and emerging technologies. The dual advantage of this strategy is that German labor did not become a disposable production input unit as was the case elsewhere. They remained highly trained and highly skilled people whose work and loyalty was important for their companies. They were also paid well and consequently they did not need to rely on credit to maintain their consumption. So, in economic downturns, they were able to continue to consume the domestically produced goods.

Also, the highly engineered nature of German goods means that they are not easily copied or duplicated by cheap labor countries (such as China). That is because, the cumulative R&D investment is too important and the process is not easily condensed. And of course, the labor skill requirements are very different.

Remember also that while most of these policies were initiated by the Social Democrats, the conservative government of Angela Merkel did not oppose them (like Cameron in the UK) on ideological grounds. They made sense so she kept them. More importantly, she skillfully managed and enhanced this existing system.

Much has been made of here refusal to initiate stimulus spending but this is a misreading of the situation. First, because the basic economic framework was so sound that it kept unemployment down and maintained (and increased) its export levels. The need for a blunt Keynesian intervention was minimal. Secondly her recent announcement is actually a huge stimulus package, something other countries should have done at the outset of the crisis.

Her announcement that Germany will phase out its nuclear power plants by 2022 is very important. I predict that this will further improve short to medium term economic prospects of Germany and it will help maintain Germany as a global economic powerhouse for the foreseeable future.

As Germany relies on nuclear energy for a quarter of its energy requirements, this phasing out means that they will have to save more energy on the one hand and produce more energy using alternative methods.

These are crucial investment areas and if they can pull it off by developing more conservation technology such as energy efficient machinery and by building high output solar and wind power plants, they will have a tremendous lead over the rest of the world.

Not to mention a stimulus of the first order.

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UPDATE: Compare the German resolve with this sequence of American presidents, all promising the development of new technologies to move beyond oil. Eight of them in succession. Narrated by the incomparable Jon Stewart.