from Follow the Money

Germany 1, France 0? Plus some musings about the politics of globalization

October 2, 2005

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I agreed with a lot of what Fareed Zakaria wrote about Germany - certainly I would agree that Germany has done a lot more reform than France over the past few years.

Compare Germany with France. In Germany, both parties have serious reform proposals, and one has carried out some of these. There are numerous think tanks that explain why such reforms are necessary. A large part of the German press and business elite supports them vocally. None of this is true of France. There is more serious discussion about economic reform in one month in Germany than there is in one year in France.

And it is not just talk. German industry has begun a process of deep restructuring, forced by the pressures of global capitalism as much as by any government policies. Last week, despite the election results, Mercedes confirmed 8,500 job cuts and Volkswagen announced that it would keep a plant open because its union had agreed to large cost reductions. As a result of such measures, Germany's most competitive industries already are strengthening. Only two major economies have actually gained in their share of global exports of manufactured goods in the past five years: China and Germany. Last year Germany became the world's leading exporter of goods, larger even than the United States, despite the fact that the U.S. economy is five times as large. Germany's labor productivity is as high as that of America's, and its unit labor costs are now lower.

Unfortunately, if you look at the data, it is hard to argue that Germany is has been rewarded for reforms designed to make its economy more competitive.  

From 2001 on, when, as Zakaria notes, Germany has tried to reform its labor market institutions and France, broadly speaking, has not, German domestic consumption has increased by a measly 1.6% (that is the cumulative five year increase through the end of 2005, according to the IMF, not the annual increase).   What happened in France?  Consumption is up 11.1%. 

Average real growth rates tell a similar story.  From 2001 to 2005, real growth averaged 0.7% in Germany, 1.6% in France and 2.6% in the US.   Remember, the US population is growing by about 1% or so a year.  So in real per capita terms, France broadly kept pace with the US, while Germany did not. 

The simple correlation is more reform, less growth and far less domestic demand led growth.  I do not think this argues that Europe should sit still - some reforms are certainly needed.  European states have promised a bit more than I think they can realistically afford to deliver.

But I also think the argument that labor market reforms in Europe are the key to stimulating the demand growth needed for constructive global rebalancing is rather weak.   Yes, those reforms may increase the returns to capital and thereby increase investment - though that has yet to happen in Germany.  But if workers get nervous and start to save more, the resulting fall in consumption may overwhelm any rise in investment. 

Even the Economist (or at least Zanny Minton Beddoes in her magnus opus on global savings) recognizes as much:

The trouble is that reforms will take time to translate into economic growth.  In the meantime, they are making things worse.  People save more because they are worried about the future.  In Germany, in particular, there is evidence that the uncertainty created by economic reform has boosted the household savings rate.  ... The lack of consumer demand, in turn, reduces the incentive for firms to invest.

Zakaria's solution --  keep up the reforms, but find a sunny, optimistic German leader who gives Germany confidence - seems rather thin.    The empirical evidence, at least as I read it, suggests that rising housing prices, not reform, are the key to domestic demand led growth. 

If France follows the German path and starts to reform, I certainly would not have much confidence that French domestic demand growth will pick up substantially.  Some reforms imply a fall in real wages in the near term - both to compete with East Asia and to raise the return on capital in Europe to match that in the US - and falling or stagnant real wages is not the most obvious way to spur domestic demand.  Other reforms imply scaling back the government's future promises.  Again, not the most obvious way to get demand growth going.

To date, the countries that have done the best in face of the competitive challenge from China and (to a lesser degree) India are countries that broadly speaking, have opted to get out of their way rather than compete.    Get out of the way by reorienting their economy toward the production of houses and domestic services, and shifting workers out of sectors that compete with Chinese goods.   See the Economist' chart on the fall in manufacturing jobs as a share of total employment that Mark Thoma highlighted a couple of days ago.

Shifting out of sectors that compete with China is a bit different than shifting workers into sectors that try to sell goods and services to China.  By and large, that has not happened in places like the US.   US exports to China are small in relation to US imports from China and in relation to US GDP, and - leaving aircraft aside, hardly high-tech.  Think scrap iron.  

That story holds true if you look at the US economy more broadly as well.  Since 1997, imports have risen substantially as share of US GDP, while exports have actually fallen as a share of US GDP.

That strategy works so long as China and others are willing to keep on extending vendor financing to the US.   And so far, China's willingness to do so, at a considerable long-term cost to itself, has matched the United States' need for financing.

However, it also implies that the US has been able to postpone some of the difficult adjustments I suspect will be needed to respond to the competitive challenge posed by China.   I don't think the answer to how to compete with China is "build more suburban tract housing." 

That brings me to a column Stephen Roach wrote last week, one that I think should have received a bit more attention.  He implicitly argued, accurately in my view, that the political response to rising competitive pressures in the global economy in US has not been terribly impresive.    

After all, if China and India represent a de facto doubling of the global labor force that is driving down real wages globally, it hardly is obvious that the best response is tax cuts tilted towards those already likely to be on the winning side of globalization.  And it seems pretty clear that the fast-paced global economy is inconsistent with America's company based system for providing health care to its working population, and, as importantly, to their children. 

This is what Roach's said, slightly abridged:

The reforms of globalization shake the social contracts that bind nations together -- leading to recurring clashes between capital, labor, and deeply entrenched political power structures.  A globalized world must come up with a new model of the political economy.  Germany is struggling mightily with just such a challenge.  But it is hardly alone.

Two extremes frame the choices -- the United States with its minimal social contract and Old Europe with its deeply entrenched social welfare state.  A couple of numbers say it all: Public sector social expenditures are currently running around 15% of GDP in the US -- well below Europe's 24% share.  ...

A superficial assessment of the US model usually boils down to one word -- flexibility.  Americans are perceived to be risk-takers -- unafraid to re-invent themselves or their institutions in response to changing circumstances.  Possibly the best example of this trait is the painful restructuring of the 1980s -- a direct outgrowth of the economic quagmire of the 1970s.   ... At the other end of the spectrum, a superficial take on the European model can also be boiled down to one word -- in this case, rigidity.  Europe's deeply ingrained social contract has forced labor market adjustments to occur through the quantity axis rather than through wages.  ...

Beneath the surface, the contrasts between these two approaches are even starker.  In particular, the American model has taken consumerism to an extreme, with private consumption having averaged 71% of GDP since early 2002.  By contrast, the European consumption share is currently around 58%, whereas in Japan, it is only 55%; the Chinese consumption share trails the pack at 42%.  Ironically, the excesses of US consumerism have been accompanied by a shift in the shares of national income away from labor and back toward capital.  In the US, the worker compensation share fell to a 30-year low of 65% in 2005 whereas "economic corporate profits" currently stand at a near-record 11% share of GDP.  By contrast, worker compensation shares are higher elsewhere in the advanced world -- 67% in Japan and 68% in Europe.  Not only does America slice the pie differently, it has a very different appetite for eating it as well.

The American paradox of running a consumption-led growth model while tilting the rewards away from labor is a striking testament to the emergence of the Asset Economy.  Courtesy of unusually low real interest rates and the wealth effects they have spawned, the US model is also characterized by a profound shortfall of domestic saving and an equally large current-account deficit ...   That pretty much sums up the tactical objectives of the global body politic -- providing subsidized interest rates that underwrite the free-wheeling ways of the saving-short, overly-indebted American consumer.  "If you buy our goods," goes the logic, "we'll buy your Treasuries." 

While tactical gratification may work well for a time in today's world, beneath the surface, there are serious questions about sustainability.  That's especially the case with a world economy that remains on an extraordinarily unbalanced growth path.  ... Nor is it clear that the American model is the ideal that other nations or regions should aspire to emulate.  Wealth-dependent consumption excesses leave the US exposed to the dark-side pressures of a debt overhang and a current account adjustment.  And with post-Katrina aftershocks unmasking the long simmering problems of an impoverished underclass, the debate over America's social contract -- or lack thereof -- has now been re-opened.  America's shoestring economy may wake up to find itself ill equipped to provide the enhanced safety net needed for a reordering of social and political priorities.

Strip away the joys of the housing-centric economy, and I am not sure that the US is as far ahead adapting to the realities of the new global economy and much of the USA 1, Germany 0 commentary assumes.   Go back to those export numbers.   Germany has opted to try to trade its (high-end) goods for China's (increasingly high-end) goods, not trade Bunds (German Treasuries) for Chinese goods.  In the short-run, selling debt is far easier.  We will see about the long-run.

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