Economic Policy October 1987 Printed in Great Britain

Germany under Kohl

Martin Hellwig and Manfred Neumann Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

Summary

Chancellor Kohl came to power when Germany was suffering its greatest post-war confidence crisis. Output was stagnant, the trade balance deteriorating, unemployment rising, and inflation uncom­ fortably high. Immediate priority was given to fiscal consolidation to bring the growing budget deficit under control. The authors argue that, in this instance, fiscal contraction sufficiently boosted private sector confidence that overall demand was actually stimulated. Together, fiscal rectitude by the Federal Government and monetary austerity by the Bundesbank made possible sustained output growth against a background of falling inflation. Lower deficits also crowd in private investment in the longer run. Thus the authors judge Kohl's macroeconomic policy a considerable success. However, unemployment has remained stubbornly high; the authors attribute this to supply-side failures. The German labour market remains subject to many distortions, which the Kohl govern­ ment has done little to remove. Nor has it seriously pursued deregula­ tion of product markets. German unemployment is likely to remain high, at least until favourable demographic changes take effect in the 1990s. Big business Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

The big feast

The word on the elephant's hat is 'Conglomerates'; the little man in the dustbin is marked 'Free market economy'.

Reprinted from Der Spiegel, Dec. 1, 1981 Economic policy in Germany: was

there a turnaround? Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Martin Hellwig and Manfred J.M. Neumann University of Bonn

1. Introduction In the election campaign of 1983, the new government of Chancellor Kohl asked the German public to 'vote for recovery'. Four years later, in the campaign of 1987, the government's policy for economic recovery was largely seen as a success. Professional and nonprofessional observers alike praised the general economic situation,1 and the outcome of the election was considered a foregone conclusion. This endorsement of the government is, in some respects, quite remarkable. If we look at the evolution of the main macroeconomic policy targets (Table 1), the picture is not without blemish. Real growth has now been positive for an uninterrupted period of four years, but by comparison with previous recoveries, it has been quite moderate. Throughout the period 1983-86 unemployment amounted to roughly 8% of the total labour force, more than twice the level it had reached in the depths of the recession in 1975-76. From 1.2 million in 1981 and 1.8 million in 1982, unemployment rose to over 2.2 million in 1983 and stayed there throughout the recovery. During the same period, inflation was reduced to a level that had last been reached in the sixties. It appears that, for the German voter, the government's policies have been responsible for the real growth and low inflation but not for the high unemployment of recent years.2 We attempt an evaluation of whether this judgement is justified. In Section 2, we first describe the

I I We would like to thank our two discussants, Roland Vaubel and Marcus Miller, the Editors and John Black for helpful comments on an earlier draft. 1 In an Infas survey before the election, 81% of the respondents considered the economic situation to be 'good' (Schultze, 1987). 2 In a survey of the Forschungsgruppe Wahlen, Mannheim, unemployment came first by a wide margin among the problems that the respondents considered 'very important'. At the same time, the government was seen as being more competent to deal with this problem than the opposition; see Schultze (1987). 106 Martin Hellwig and Manfred Neumann

Table 1. Selected economic indicators

1970-72 1974-76 1980-82 1983 1984 1985 1986

Real growth (%) 4.1 1.4 0.2 1.8 3.0 2.5 2.5 8.0 Unemployment (%) 0.7 3.4 4.9 8.1 8.2 8.3 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Inflation (%) 4.9 5.4 5.0 3.8 2.4 2.0 1.7 Current account as % of GNP 0.4 1.5 0.7 0.6 1.1 2.1 4.0 Real exchange rate 1.05 0.95 0.93 0.89 0.87 0.92 Relative price of oil 0.21 0.62 1.25 1.22 1.30 1.29 0.58 Ratio of real labour cost to productivity 0.54 0.57 0.57 0.55 0.54 0.54 0.53 Long interest rate nominal 8.2 9.1 9.4 8.0 7.8 6.9 6.0 real 3.6 3.8 4.7 4.2 5.1 4.9 4.3

Source: National Accounts (Statistiches Bundesamt); Reports of the Deutsche Bun­ desbank. Notes: (i) First three columns are annual averages, (ii) Unemployment as percent of labour force, (iii) Inflation is the change in the cost of living index adjusted for energy prices, (iv) Real exchange rate relative to 14 major trading partners, (v) Oil prices relative to GNP deflator, (1980= 1.0) (vi) Real interest rates are the average yield on all bonds minus a three-year moving average of inflation. serious problems faced by German policy-makers in the early eighties, and then discuss the alternative policy prescriptions that they were offered. Section 3 is devoted to the Achilles heel of the German economy-the labour market. We first review the evolution of wages and unemployment over the past 15 years, and then, in turn, discuss the effects of employment protection measures, input price shocks and structural rigidities in the labour market. Section 4 contains a discussion of the theoretical effects of fiscal policy, and our evaluation of the effects of the policy of fiscal consolidation pursued by the Kohl government. Finally, in Section 5, we offer our conclusions.

2. The economic situation of the early 1980s

2.1. Developments prior to 1983 At the beginning of the 1980s, the German economy was in dire straits. Real growth had come to a complete stop. Indeed, the level of real GNP in the first quarter of 1980 remained the highest quarterly value for the next four years. With a short lag, unemployment began to rise again sharply. The current account, which had been in surplus for almost three decades, moved into deficit by 1979 and deteriorated further in 1980. Finally, inflation continued its renewed upward trend. Germany under Kohl 107 It will be useful to trace some of the underlying developments in more detail. From 1978 to 1980 the current account moved from a surplus of DM 18 billion to a deficit of DM 28.5 billion. This change did not merely reflect a rise in oil imports, as net imports from overseas industrial countries (in particular the United States), travel abroad, and Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 transfers all rose. As for aggregate demand, up to the first quarter of 1980 the deterior­ ation of the trade balance was compensated by large increases in real investment. However, in the second quarter of 1980, private consump­ tion began to fall and so did real investment in plant and equipment. Indeed, the overall decrease in real gross investment expenditure in 1981 actually amounted to 12%; see Table 2. This dramatic set-back was largely unexpected, not only by the Federal Government and the unions, but also by official economy-watchers like the Council of Economic Experts and the five German research institutes. At the time, these developments were attributed to at least three factors, all of which were seen to be indicative of the structural weak­ nesses of the Germany economy. First, given Germany's dependence on imported oil and gas, the second oil price shock of 1979 implied a permanent deterioration of the country's terms of trade, bringing with it the same difficulties as the first oil price shock in 1974. Germany's energy bill rose by about 2% of GNP in 1979-80. However, the problems caused by the second oil price shock were exacerbated by a deterioration in the country's trade balance with non-OPEC countries.3 Second, this deterioration of the trade balance with non-OPEC coun­ tries was interpreted as reflecting a further structural weakness, decreased competitiveness of German products in the world market. In contrast, say, to the Japanese, German producers were said to be too slow to switch over from their traditional products and markets into either the new high-technology sectors or the newly expanding Far- Eastern markets. Third, as real investment fell, entrepreneurs were seen to be putting off the necessary supply-side adjustments to higher energy prices as well as to increased competition in world markets. The weakness of investment was mainly ascribed to structural rather than cyclical factors: high interest rates caused by excessive public sector borrowing in Ger­ many as well as the US; uncertainty about future interest rates caused by the public sector's apparent inability to control its budget; and regulatory constraints that made it difficult to do any construction work without going through a host of administrative and legal procedures.

3 Remarkably, even exports to OPEC countries went down in 1979. At the time, this decrease received much more attention than the subsequent resurgence. 108 Martin Hellwig and Manfred Neumann Table 2. Main components of real output demand (annual growth rates, %)

Consumption Investment Exports

Plant & Year GNP Total Public Total equipment Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

1980 1.5 1.6 2.6 -0.6 2.8 5.3 1981 0.0 0.1 1.8 -11.6 -4.8 8.2 1982 -1.0 -1.2 -0.8 -5.1 -5.3 3.2 1983 1.8 1.3 0.2 6.0 3.2 -0.6 1984 3.0 1.7 2.4 2.6 0.8 8.5 1985 2.5 1.9 2.2 0.2 -0.3 7.3 1986 2.5 3.7 2.5 4.2 3.1 -0.6

Source: National Accounts (Statistisches Bundesamt).

We are not persuaded that the late 1970s saw any major structural change in the ability of German firms to compete on international markets. If the notion of a structural decrease in competitiveness is to have any meaning at all, it must refer to market positions at constant exchange rates, i.e. there must be a shift of the entire schedule that relates exports, imports or market shares to exchange rates and other explanatory variables. However, we see no evidence that the deterior­ ation of the non-OPEC current account between 1978 and 1980 reflects such a shift of schedule rather than the substantial revaluation of the D-Mark in 1977 and 1978.4 Indeed we see little to distinguish between a 34% decrease (1978-80) in the non-OPEC trade surplus and a 32% increase in the deficit on foreign travel, which presumably was not caused by a structural shift in the Black Forest's ability to compete with the Grand Canyon. Needless to say, by 1984 the competitiveness of German industry in the world market was no longer seen as a serious problem. Nevertheless, the belief that there had been a decline in Germany's ability to compete in international markets played an important role in the developments of 1980-81. First, this belief enhanced the perceived losses of permanent income and wealth from the oil price shock. Second, it contributed to the abrupt change in the position of the D-Mark on international currency markets in 1980-81. Not only was the revaluation of 1977-78 undone, but in addition the D-Mark lost its position as a permanent candidate for revaluation and instead came to be seen as a candidate for devaluation. In the view of the German authorities, the

4 We accept Professor Vaubel's observation that fiscal expansion and the cyclical upturn may also have played an important part. However this observation reinforces the point that the develop­ ments of 1978 and 1980 reflect a movement along rather than a shift of schedules. Germany under Kohl 109 shift in the perception of the D-Mark and a growing net export of long-term capital to the US had important implications for German capital markets. It was feared that capital markets in Germany would becdme much more directly exposed to the vagaries of international interest rates and in particular to the remarkable increase in interest rates that was due to the grand experiment of defonomics (deficits, Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 deformation, default) in the US. For some authors, high American interest rates and the drain of capital into the US provided confirmation of the structural (relative) decline of the German economy. According to this view, the increase in American interest rates represented a shift in the American invest­ ment schedule that had no parallel in Eurosclerotic Germany; see e.g. Giersch (1985). Prior to 1984, we find no evidence for this view. Indeed in the recession of 1982, the decline of real investment in plant and equipment in the US exceeded that in Germany (—11% from the previous American high in 1979 compared with —9.8% from the previous Ger­ man high in 1980). The overall economic situation in 1980-82 may be summarized as follows. On the demand side of the economy, the second oil price shock of 1979, reinforced by the gloomy vision of decreased German ability to compete internationally, had significantly reduced the prevailing perceptions of permanent income and wealth and thereby caused the decrease in domestic demand that started the downturn in 1980. On the supply side of the economy, the oil price increase required firms to adjust to a drastically changed constellation of input and output prices. Due to the 1980-81 devaluation of the D-Mark, the absolute oil price increase was actually larger than in 1974. Moreover, as can be seen from Table 1, in the short run the increase in energy costs was not alleviated by changes in the cost of labour or capital. Reverting to the demand side, many different factors simultaneously contributed to the drop in real investment. The relative weight of structural factors in this context was a major bone of contention in the public debate on economic policy.

2.2. The economic policy debate Throughout the period under review, the political debate about the economy matched two conflicting views about the nature of the economy's problems and about the appropriate solutions. These con­ flicting visions correspond roughly to the demand-side and supply-side approaches to macroeconomics. The supply-side approach was most articulately formulated by the Council of Economic Experts, in particular in its 1981 and 1982 110 Martin Hellwig and Manfred Neumann Reports.5 According to the Council, the level of employment in the economy depends primarily on firms' production decisions. In the short run, employment and production are bounded above by the levels of capacity employment and capacity output that correspond to firms' fixed capital in place. However, employment and production may fall short of the levels corresponding to full capacity utilization. In fact they Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 will do so if capacity production is unprofitable either because of insufficient demand or because of high costs, in particular wage costs. Given this view of the employment decision, there are two reasons why employment in the economy may be less than full employment: actual employment may fall short of capacity employment, and capacity employment may be less than the available labour force. Thus, in the Fall of 1981, the Council of Economic Experts argued that half a million, or about a third of the prevailing unemployment could be attributed to 'cyclical' factors, i.e. insufficient utilization of available capacity, and the remaining million to 'structural' factors, i.e. insufficient capacity. Given this decomposition into cyclical and structural unemployment, the Council of Economic Experts suggested that enhanced real invest­ ment and growth were the key to the unemployment problem and that the low level of real investment was a major threat for the future. The weakness of investment was attributed to the low profitability of firms, high interest rates and enhanced uncertainty about the future. The low profitability of firms was, at least partly, attributed to high wages, especially since the mid-seventies. High interest rates were, in part, attributed to the government's demands on the capital markets. The great sense of uncertainty was attributed partly to the second oil price shock and the concurrent changes in international markets, and partly to a feeling that the government's budgetary policy was out of control. From this diagnosis the Council of Economic Experts deduced that, in the medium term, the unemployment problem could be solved if wage policy was sufficiently moderate, if the government managed to consolidate its budget, and if all regulatory constraints on investment were eased. In contrast, the Council explicitly asserted that a demand management policy (fiscal or monetary) would not solve the unemploy­ ment problem (1981 Report, p. 143). While such a policy might elimi­ nate underutilization of capacity in the short run, its medium-term consequences of raising inflation, wage demands by unions, budget deficits, and the general level of uncertainty in the economy would reduce the incentives for investment, capacity expansion and the creation of new jobs.

5 The Council of Economic Experts (Sachverstandigenrat) is a government-appointed but indepen­ dent body of five economists who regularly report on and evaluate the state of the economy. Germany under Kohl 111 In opposition to the Council of Economic Experts, the Trade Unions proposed a demand-side approach to the economy. According to their view, insufficiency of demand implies that firms are quantity- constrained. Hence, at least locally, marginal costs (wages) are not relevant for production decisions. Moreover, in view of insufficient demand there is little scope for capital-widening real investment. Most Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 investment is capital-deepening, endangering existing jobs. In this perspective insufficiency of demand was considered to be the key prob­ lem of the German economy. Accordingly, it was proposed that wages be increased in order to redistribute income to workers and thereby raise aggregate demand. Moreover, the proponents of the demand-side approach consistently asked for an expansionary fiscal and monetary policy.6 To the extent that the budget deficit was seen as a problem, this problem was to be solved by tax increases in the upper income ranges. In order to understand the change in government and the associated change in policy in 1982-83, it is useful to see this supply-side versus demand-side controversy in its political context. Throughout the period under discussion, the supply-side approach of the Council of Economic Experts was consistently shared by the Bundesbank and the Federal Government. The demand-side approach of the Trade Unions enjoyed strong support in the Social Democratic Party (SPD), the major govern­ ment party at that time. In the case of the Trade Unions and the Bundesbank, the positions they took corresponded closely to their strategic interests in the overall policy game. In a context of wage negotiations that are highly central­ ized, publicized and politicized, the Council's assertion that high wages lower employment put the Trade Unions on the defensive. It is no surprise then that they should embrace a position under which high wages enhance employment by raising demand, and responsibility for full employment rests squarely with the Federal Government and the Bundesbank. Similarly, the Bundesbank's rejection of a monetary policy geared towards short-term demand management must be seen in terms of its institutional self-interest. By law, the Bundesbank enjoys an institutional status of independence which is rare by international com­ parison: it does not take orders from the government or any other body, nor does it have to finance government expenditure. Moreover, by the Bundesbank Law, the Bank's ultimate obligation is to safeguard

6 This approach is laid out in the 'Memoranda' of a group of 'alternative economists'; brief sketches are contained in the dissenting opinions to the Annual Reports of the Council of Economic Experts. 112 Martin Hellwig and Manfred Neumann price level stability. The separation of monetary from fiscal policy is, of course, the result of historical experience: in this century Germany suffered two dramatic inflations; both of them had been financed by forcing the central bank to monetize government debt. Given this setup, the overriding self-interest of the Bundesbank is the preservation of its independence. Hence it is not surprising that Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 the Bundesbank should embrace the Council's view which places the responsibility for full employment squarely with the Trade Unions and the Federal Government's 'growth policy'. This attitude of the Bundes­ bank is even more understandable in the light of the fact that its deliberate overshooting of the official monetary target in 1978 had contributed to rekindling inflation and to lessening its credibility. Self- interest required restoration of the goal of price level stability as the predominant task of monetary policy, which provided the historical and legal basis for its position. At the same time, the Bank began to urge the Federal Government to postpone no longer the task of fiscal consolidation. This position, too, must be seen in a historical context in which rising government indebtedness meant a latent threat to the central bank's independence. In principle the Council's and the Bundesbank's position was also shared by the Schmidt government. Indeed the 1982 Economic Report of the Schmidt government explicitly accepted the Council's view that expansionary fiscal policy endangers employment in the medium term. Similarly, the Schmidt government accepted the need to reduce the 'structural' budget deficit in order to increase the scope for private investment. The government's acceptance of the supply-side approach should be contrasted with a distinctly Keynesian stance in the early seventies. The change in attitude, which was largely shared by the general public, was due to two adverse experiences. Both in 1974-75 and in 1978-79 a counter-cyclical expansionary fiscal policy had been implemented without much success. Unemployment was hardly affected, and after a while the increase in the public deficit and the public debt seemed to demand corrective action. Indeed, the experience of 1978-81 was seen as explicitly confirming the Council's view that expansionary fiscal and monetary policy may lower unemployment in the short run, but will raise it in the long run. Crowding out, which in the 1970s had been seen as a mere theoretical possibility, was now considered to be an indisputable economic fact. Beginning in 1980, the Schmidt government joined in the call for fiscal consolidation. Each year a target rate of growth of federal spending below the forecast growth rate of nominal GNP was announced. However, each year it turned out that the deficit rose rather than fell Germany under Kohl 113 because spending grew in excess of what had been planned while GNP growth fell short of its forecast. As a result, public confidence in the Federal Government began to deteriorate rapidly in mid-1981. With hindsight, the apparent failure of the Schmidt government's consolidation efforts is not too surprising: the dramatic fall in real GNP growth from 1979 to 1982 drastically aggravated the budgetary prob­ Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 lems. Moreover, the government consistently underestimated the depth and duration of the recession. To some extent these over-optimistic projections were shared, e.g. by the Council of Economic Experts; to some extent they simply provided a way to avoid taking tougher measures which would have brought to a head the demand-side versus supply-side dispute within the SPD. Thus nobody outside the govern­ ment believed the official forecast (in 1982) of 3% real GNP growth in 1983. Instead, public confidence was further eroded by the perception that the government was not facing up to the situation as it was because it wanted to avoid internal conflict. The perception that Schmidt and the SPD were unwilling to face up to the situation came to be shared by the Free Democratic Party (FDP), the SPD's smaller coalition partner. In September 1982, Graf Lambsdorff, the FDP minister of economics, confronted Schmidt with a 'Blueprint for a Policy to Remedy Insufficient Growth and Fight Unemployment'. This document condemned the policies of the Schmidt government as 'short-sighted', 'superficial', 'unsystematic' and 'incon­ sistent', and called for a clear turnaround, asking in particular for a more determined policy in such matters as fiscal consolidation, industrial deregulation, and the degeneration of the 'social net' of the welfare state into a 'social hammock'. In reaction to this document, Schmidt dissolved the coalition with the FDP, which then formed a new coalition with Kohl and the Christian Democratic Union. As we take stock of these developments, the following conclusions emerge. First, in contrast to experience elsewhere (e.g. the UK), economic policy in Germany must be seen less in terms of a unified government policy and more in terms of a strategic game in which there are at least three fairly independent players with conflicting interests. Two of these players, the Trade Unions and the Bundesbank, did not fundamentally change their positions in 1982. Second, in contrast to both UK and US experience, the change of government in 1982 did not represent a complete break with the past. The Schmidt government had already been pledged to a policy of fiscal consolidation, which was then more forcefully pursued by its successor. The main difference was that the Kohl government was less hamstrung by internal divisions, and from the very beginning its fiscal policies 114 Martin Hellwig and Manfred Neumann appeared to be more decisive than those that the Schmidt government pursued in 1982. In the remainder of this paper, we evaluate the supply-side pro­ gramme as well as the policies that were based on it. We shall mainly be concerned with the macroeconomic aspects of these policies. While we share the view of the Lambsdorff paper that microeconomic policies Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 are important, we must report that the Kohl government has simply done nothing in such matters as deregulation or government subsidiz­ ation of lame-duck and eternal 'infant' industries. In terms of macroeconmics, two issues seem to be central. First, what are the relative merits of the supply-side and demand-side approaches to the unemployment problem: more precisely, what are we to think of the Council's distinction between cyclical and structural unemploy­ ment and of the Council's view that in the medium term, only an increase in real investment will create more jobs? Second, how serious was the need for fiscal consolidation, how successful was it, and to what extent does experience bear out the Council's view that fiscal consolida­ tion was necessary and-ceteris paribus - sufficient for an increase in private real investment?

3. Economic policy and the labour market

3.1. The unemployment problem

In Table 3, we briefly review the evolution of the labour market since the early 1970s. At first sight, this evolution is dominated by the two oil price shocks. After the first oil price shock, unemployment rose from below 300,000 to over 1 million, and after the second oil price shock, from below 900,000 to over 2.2 million. The subsequent economic recoveries reduced unemployment only a little in 1977-79 and hardly at all in 1983-86. Twice there seems to have been a ratchet which prevented a return of unemployment to its previous lower levels. It is also interesting to note that in terms of sheer size, the increase in unemployment after the second oil price shock amounted to almost twice the increase after the first. A somewhat different picture emerges if we take account of changes in the labour force. After the first oil price shock, the labour force fell by some 600,000, so that in fact the total loss of jobs from 1973 to 1977 was almost 1.5 million. In contrast, in 1980-83, the labour force rose year by year so that in fact the loss of jobs in this period (1 million) was less than the increase in unemployment and less than the loss of jobs after the first oil price shock. The labour force also rose in both Germany under Kohl 115 Table 3. The German labour market 1970-86 (thousands of workers)

Total Labour force employment Unemployment

1970 26,815 26,665 150 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 1972 26,990 26,745 245 1974 27,145 26,565 580 1976 26,650 25,590 1,060 1978 26,690 25,700 990 1980 27,215 26,330 885 1981 27,415 26,145 1,270 1982 27,540 25,710 1,830 1983 27,590 25,330 2,260 1984 27,625 25,355 2,270 1985 27,840 25,535 2,305 1986 28,015 25,785 2,230

Source: Monthly Reports of the Bundesbank.

recoveries so that both in 1977-80 and in 1983-86 the gain in jobs was significantly larger than the reduction in unemployment. The evolution of the labour force reflects four distinct developments. First, in both recessions, significant numbers of foreign workers re­ turned to their own countries. Given the 1974 freeze on new hirings of foreign workers, this movement entailed a permanent reduction in the labour force. Second, throughout the period under consideration, there has been a steady increase in female labour force participation. Third, in addition to these structural changes, there were probably cyclical movements in and out of the labour f o"rce as the overall economic situation made it appear easier or more difficult to find a job. Finally, in recent years, the evolution has been dominated by demographic factors, which even outweighed cyclical factors in the downturn after 1980. By 1986, the labour force stood at 28 million, more than 1.1 million above its level at the previous cyclical peak in 1979. The overall change in unemployment can, in arithmetical terms, be attributed to the following factors. First, almost half of the secular increase in registered unemployment since 1973 is due to demographic factors rather than the oil price increases (800,000 out of 2 million). The demographic changes have been concentrated in the period since 1979; therefore they contribute to the impression that the unemploy­ ment effects of the second oil price shock were worse than those of the first. Second, the apparent constancy of unemployment in the upturns from 1977 to 1980 and from 1983 to 1986 is misleading. The increases 116 Martin Hellwig and Manfred Neumann in the number employed (+780,000 in 1977-80, +450,000 in 1983-86) suggest that the labour force rose substantially as the employment outlook improved. Third, in the recoveries of 1977-79 and 1983-86 the increase in the number employed fell far short of the loss of jobs in the preceding recessions. From 1973 to 1986, a total of 1.1 million jobs were eliminated, 600,000 in the recession-cum-recovery of 1973-80 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 and 500,000 in 1980-86. Given this assessment, we agree with the Council of Economic Experts that the unemployment problem in Germany must be seen in structural as well as cyclical terms. Moreover, we believe that structural problems are the more serious ones. Undoubtedly, cyclical movements of unem­ ployment of the order of half a million jobs and more are not to be taken lightly. Nevertheless, these cyclical ups and downs are less worry­ ing than the long-term, structural developments in the labour market. In order to assess these developments and the government's policy or lack of policy towards them, we must come to terms with the following issues. First, why did the labour market fail to respond to the demographic changes? Quantitatively, this issue is probably even more important than the labour force and unemployment statistics suggest. During the period 1979-86, the working-age population rose by roughly 2 million, almost twice the increase in the labour force. This observation suggests that there may be substantial hidden unemployment, for example students who remain 'parked' in the universities rather than entering the labour market. Second, what caused the net decrease in employment from the 1973 to the 1986 cyclical peak? In particular, what were the relative weights of demand-side and supply-side factors in this development?

3.2. Employment, wages and aggregate demand As we consider the determination of employment in Germany, we must take account of the fact that as a rule wages are not subject to individual bargaining. Instead they are determined in industry-wide collective bargaining between trade unions and employers' associations. For any member of an employers' association, a collective bargaining agreement provides a legally binding lower bound on what can be paid to any member of the union. In practice this bound is also applied to non-union members. Indeed, by the Collective Bargaining Law, those parts of a collective bargaining agreement that relate to the running or the consti­ tution of the firm apply to all employees regardless of whether they belong to the union. Similarly, by the equal-treatment clause of the Constitution of the Federal Republic, wage increases that are designed Germany under Kohl 117 to compensate workers for inflation must be granted to all employees alike. Moreover, in several industries (that now cover 20% of all workers) collective bargaining agreements have been declared legally binding for all employers and workers by government fiat; for details see Soltwedel (1987). Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Since the late 1960s, collective bargaining agreements have been concluded on a yearly basis. For the contract period of a year, the money wage may thus be regarded as fixed. There is some wage drift, but on the whole the relation between effective and contractual wages has been rather stable; see Table 4. In the very short run, then, Germany seems to conform to the standard Keynesian model of an economy with a fixed money wage. Expansionary monetary and fiscal policies should be effective - either because they improve the capacity utilization of fix-price sectors, or because they raise prices and lower real wages in flex-price sectors. However, because of the inherent lag structures, we must go beyond the contract period of a year and consider the determination of wages in collective bargaining agreements. In this context, the negotiating stance of the trade unions may be approximately characterized as follows. As political organizations, they are very much concerned with the 'fairness' of the distribution of income. In principle they want to raise or at least maintain the share of wages in GNP. Given this concern with the share of wage incomes, wage increases that are equal to the sum of (expected) inflation and productivity growth are regarded as 'neutral'. Any downward deviation from this 'neutral' level requires special justification; moreover such a downward deviation should be made up as soon as possible. The idea that wage increases equal to the sum of inflation and productivity growth are 'neutral' is widely shared among the German public. Indeed this idea corresponds quite closely to the concept of a 'cost-neutral' wage policy that the Council of Economic Experts has put forward to assess the impact of wages. If we look at the actual wage settlements (Table 4), we can distinguish three phases. In the early seventies, the unions actively pressed for a change in the distribution of income and imposed wage increases ahead of productivity growth and inflation. From 1975 to 1980, the unions followed a roughly 'neutral' course. Deviations from this course seem to be explained by cyclical considerations (especially in 1975-76) and by surprises, e.g. about the large productivity increase in 1976. Begin­ ning in 1981, the unions accepted wage increases somewhat below productivity growth and inflation. This seems to be a reaction to the recession. However, the 1986 settlement and the current negotiations 118 Martin Hellwig and Manfred Neumann

Table 4. Growth of wages, prices and productivity, 1970-86 (% per annum)

Prior forecast of Hourly wages Real GDP Cost of Real hourly Cost of Contractual Effective per hour living GDP living Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

1970 15.2 16.1 4.4 3.4 4.0 3.0 1971 14.4 13.0 4.1 5.3 4.0 3.5 1972 8.7 10.4 4.3 5.5 3.5 4.5 1973 10.2 12.8 5.6 6.9 5.0 6.3 1974 12.6 12.5 3.9 6.9 4.5 6.5 1975 9.1 8.5 1.5 5.9 4.0 5.8 1976 6.2 5.2 5.3 4.4 4.0 5.0 1977 7.5 8.5 2.8 3.6 4.5 4.0 1978 5.9 6.9 3.4 2.7 3.5 3.5 1979 4.9 6.9 3.9 4.2 3.5 2.5 1980 6.9 7.4 2.0 5.4 2.5 4.5 1981 5.7 5.7 2.3 6.3 2.5 4.0 1982 4.1 3.9 1.2 5.3 2.5 5.5 1983 3.3 3.7 2.6 3.3 2.5 4.0 1984 3.0 3.2 2.8 2.4 2.5 3.0 1985 4.2 4.2 3.2 2.2 3.0 2.0 1986 4.4 4.8 2.4 -0.2 2.5 1.5

Source: Bundesbank, Sachverstandigenrat. Note: Forecasts are those made in the previous year by the Council of Economic Experts.

suggest that we may currently be seeing the reversal of this develop­ ment. Throughout the entire period, there does not seem to have been any money illusion. Deviations from a 'neutral' path of wage increases were the result either of genuine surprises or of conscious decisions by the trade unions. Given the absence of money illusion, the scope for expansionary demand policies is rather limited. Beyond the duration of the current wage agreements, there is no room for the possibility that an expansionary demand policy makes production more profitable by raising prices and lowering real wages. Any argument for an expansionary monetary or fiscal policy would have to rely on the existence of a significant fix-price sector whose production decisions depend on quantity constraints rather than profitability.7 While it is clear that some industries do indeed work under quantity constraints n :i ' Similarly, the unions' argument that wage increases raise employment assumes that firms are quantity-constrained so that considerations of marginal costs and marginal revenues of produc­ tion are irrelevant. Germany under Kohl 119 (e.g. steel quotas set by the EC), we see no evidence that this is the rule rather than the exception. Most prices seem to be flexible enough to ensure that, at least in the medium run, production choices depend on considerations of profitability rather than quantity constraints. We are not claiming that employment is totally independent of aggre­ gate demand. To the extent that changes in aggregate demand affect Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 the profitability of production and employment, they should certainly play a role. We believe, however, that in the German context changes in aggregate demand have this effect only if they have not been antici­ pated or if there has been a conscious decision to disregard them. When the Bundesbank reduced its money growth rate from 12% p.a. to zero in 1974, this policy change, which had not been anticipated, had severe adverse consequences. Similarly, we suspect that the extent of the monetary deceleration in 1979 and 1980 was partly unanticipated. This may explain why the 1980 wage increases took no account of the second oil price shock and contributed to the severe decline in profitability. Wouldn't it be possible to exploit«the non-neutrality of unanticipated demand policies? In considering this question, we return to the observa­ tion that economic policy in Germany corresponds to a strategic non- cooperative game with at least three 'large' players. Each of these players attempts to understand, to exploit and, if possible, to influence the other players' strategies. If the government players (Federal Govern­ ment and Bundesbank) were to adopt a systematic strategy of using 'unanticipated' demand shocks in order to maintain a high level of employment, then this strategy would be anticipated, and wage settle­ ments would be adjusted accordingly. Indeed, the experience of the early seventies must be seen in this perspective. From the 1967 enactment of the 'Law for Economic Stability and Growth' until about 197; 4-75, the unions-as well as everybody else' - seem to have felt that the Federal Government and the Bundes­ bank were responsible for full employment so that they were free to pursue their expansionary wage policies without risks. When the Bun­ desbank in 1974 decided that price stability came first, the ensuing shock seems to have had a significant effect on the unions' understanding of the game in which they are involved. Their greater caution after 1975 seems to have been related to the fact that the Federal Government and the Bundesbank were no longer unconditionally committed to full employment and that a significant portion of the general public attributed the severity of the recession at least as much to the 1974 wage settlements as to monetary policy. Since 1975 the trade unions have consistently tried to convince the public that fiscal and monetary policy rather than wages are responsible for full employment, and they have tried to pressure the government 120 Martin Hellwig and Manfred Neumann into accepting this responsibility.8 Their very insistence upon this theme suggests that they are fully aware of the strategic situation. We conclude that there is no room for a systematic use of unanticipated demand shocks to maintain a high level of employment. Given the unions' current perceptions of fiscal and monetary policies, a one-time unantici­ pated shock would probably be quite effective, the 1974 experience in Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 reverse; however, it would probably also reverse the 1974 switch in the unions' vision of the game in which they are involved. Given that the different players are quite aware of the strategic situation, a more promising approach might be to change the current non-cooperative game into a cooperative one. Thus we might think of an agreement under which the fiscal and monetary authorities and the unions jointly pledge themselves to an expansionary demand policy and a moderate wage policy. An agreement of this type actually seems to have underlain the developments of 1978 and 1979. This episode was abruptly ended by the inflation surprise of 1979. Thereafter, in 1980, the unions' main goal was to recapture the ground that they had lost.

3.3. The time horizon of the employment decision We now turn to the firm's employment decision. In contrast to the textbook model, the employment decision in Germany must be seen as a long-term rather than a short-term decision. Labour rather than capital must be regarded as the fixed factor of production in Germany. Specifically, firms face the following restrictions on dismissals. First, under the Law for Protection against Dismissals, any dismissal of a worker who has been with a firm for more than six months is void if it is 'socially unjustified', (i.e. if it cannot be justified by reasons related to the person in question or the urgent needs of the firm; if the worker in question has not been chosen in accordance with the appropriate 'social criteria'; or if it would be possible to employ the worker in another job or another plant of the firm). The burden of proof lies with the employer. During the 1970s, the number of dismissal cases in the courts significantly increased. Moreover the labour courts have become increasingly restrictive in their interpretation of a 'socially justified' dismissal.

In this context, their attitude towards the relation between wages and employment seems to be somewhat ambivalent. In principle they have always maintained that wage increases raise employ­ ment by raising aggregate demand. In practice, in the recessions of 1975 or 1982-83, they have been willing to accept significant downward deviations from the presumed 'neutral' level of wage increases. Germany under Kohl 121 Second, in many industries, collective bargaining agreements since the early 1970s have outlawed dismissals of workers above 55 years of age who have been with a firm for more than a specified length of time (between 3 and 25 years). Third, if a firm wants to dismiss a significant number9 of workers within 30 days, it must notify the Labour Office. Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 The Labour Office may then stop the dismissals for up to two months. Finally, under the 1972 Betriebsverfassungsgesetz (Law Concerning the Constitution of the Firm), any substantial changes in the firm's practices must be discussed with the Workers' Council. To the extent that such changes entail significant economic disadvantages for the employees, (e.g. in cases of large scale production cutbacks) the Workers' Council can ask for compensation through a 'social plan'. If the firm's management and the Workers' Council fail to agree on a social plan, it can be imposed from outside by a mediation committee in which the deciding vote is cast by a 'neutral', usually court-appointed chairman. The upshot of all these regulations is that since the early 1970s firms have found it difficult and quite costly to dismiss workers. Although it is hard to quantify these effects, a recent survey of the Institut der deutschen Wirtschaft suggests that the cost of social plans are non- negligible. For more than one-fifth of the responding firms these costs exceeded both their investment spending and their annual earnings. Moreover, on average, negotiations about a social plan took more than two months. The restrictions on dismissals have several important consequences for firms' employment decisions. First, adverse developments affect employment with a lag as firms try to avoid dismissal costs, e.g. a social plan, by delaying layoffs until either the situation has improved, the problem has been solved by attrition, or the firm has been overtaken by bankruptcy. Second, the firm will not hire people unless it expects an increase in demand to have some permanence. The lag of employ­ ment behind production in a cyclical upturn has therefore increased. Finally, in hiring people, the firm will recognize that the situation might worsen, in which case it will have to bear the cost of dismissing them with severance pay, social plans, etc. The expected costs of employing a worker are thereby increased. The preceding considerations reinforce our reluctance to consider 'unanticipated', short-term aggregate demand management as a system­ atic employment policy. Given that restrictions on dismissals lead firms to increase employment only if the increase in demand is expected to

9 More than 5 dismissals in a firm of 20 to 60 workers; more than 10% of workers or 25 workers in a firm of 60 to 500 workers; more than 30 workers in a firm of more than 500 workers. 122 Martin Hellwig and Manfred Neumann have some permanence, we do not see how temporary demand shocks can do much for employment.

3.4. The determination of employment We now consider the factors underlying the firm's employment decision. Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 If the employment decision can be changed at will from period to period, then in the short run the firm's desired employment level depends on the available plant and equipment, its expectations of sales and prices in its output markets, and the level of wages and other input prices, in particular energy prices. But, as we noted above, the existence of significant dismissal costs may cause the firm to deviate from this desired short-run employment level. In the medium run, the firm can also change its available plant and equipment. The installation of more equipment, or of more labour- intensive equipment, is likely to raise the desired employment level. Capital widening-the installation of more capital-is of course the effect on which the Council of Economic Experts (and the Kohl govern­ ment) put most weight. However, we must also consider the role of capital-labour substitution or capital-energy substitution in the invest­ ment process. Presumably such substitution processes depend on cur­ rent and expected future input prices. Given this conceptual framework, we can return to the two funda­ mental questions: why was the increase in the labour force not accommo­ dated by the market, and why did employment drop by more than a million (peak to peak) from 1973 to 1986? In our view (see also Bombach, 1985; Bruno and Sachs, 1985), any answer to these questions must begin with the unfavourable movements of input prices in the early seventies: the relative real cost of labour increased because of the unions' attempt to change the distribution of income and because of increased government regulation; and the rela­ tive real cost of energy increased quite dramatically because of the first oil price shock. Given these input-price movements, we should expect to see an immediate reduction in production, energy use and desired employ­ ment. In some firms and industries, we might see a decline in actual as well as desired employment; in other firms and industries, restrictions on dismissals might maintain actual employment above its desired level. In the medium run, changes in relative input prices should affect firms' investment behaviour. At a constant cost of capital, we should expect to see both a relative decrease in real investment and a switch towards less labour-intensive and less energy-intensive techniques of production. Germany under Kohl 123 The Council of Economic Experts emphasized the relative decrease in real investment due to the reduction in profitability. Thus, in its 1975/76 Report, the Council stressed the fact that since 1969 investment had declined relative to GNP, and since 1973 investment had even declined in absolute terms (see also the OECD 1985/86 Economic Survey for Germany). Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 We are not convinced by this interpretation of the data. A closer look suggests that the decline of real investment relative to GNP was almost entirely due to the relative and absolute decline of real government and private residential construction (Table 5). In contrast, the share of private investment in equipment and buildings (non-residential) in GNP has remained roughly constant. In our view the decline of government construction as well as private residential construction must be attributed to secular factors such as the decline in the need to replace buildings destroyed in the war, the fact that the road system had been largely completed, and changing demographic trends which led to a stable long-term need for housing. We conclude that we should be concerned not so much with the declining share of gross investment in GNP as with the long-term decline in the common growth rates of GNP and business investment. Here at least part of the explanation must come from the role of substitution in the investment process. In response to the increases in labour and energy costs, firms shifted from capital widening to capital deepening. Given this substitution process at constant (business) invest- ment/GNP ratios, we should expect to see a decline in both investment and GNP growth simply because the other inputs into production do not grow at the same rate. This expectation is in line both with the Council's observation of a long-term decrease in capacity growth and with the OECD's observation of a decreased 'output-efficiency' of real investment. The hypothesis of increased capital deepening is also in line with the behaviour of net investment in Table 5. Since 1970, the share of net business investment in net national product has declined from roughly 15% to roughly 6%. By 1986, more than two-thirds of current invest­ ment was replacement investment, in 1970 less than a half. With constant shares of gross business investment in GNP, this behaviour of net investment is precisely what we should expect to see if production becomes more capital-intensive. Given the increased role of capital deepening in the investment process, we must take another look at the unions' wage policies since 1975. As we noted above, these wage policies entailed roughly the sum of productivity growth and inflation. Along a steady-state growth path, such a policy may indeed be said to be 'neutral' towards employment. 124 Martin Hellwig and Manfred Neumann

Table 5. Real investment in construction and equipment (% of GNP)

Gross investment

Of which Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Public construction Private equipment and private and Net investment Total residential non-residential by enterprise

1970 25.7 12.0 13.5 13.5 1972 26.1 12.8 13.1 12.4 1974 22.4 11.2 10.9 8.0 1976 21.2 10.1 10.8 8.0 1978 21.6 9.9 11.5 7.6 1980 22.6 10.0 12.3 8.9 1981 21.5 9.5 11.8 6.1 1982 20.5 9.0 11.4 5.1 1983 20.9 8.9 11.8 6.1 1984 20.4 8.6 11.5 6.3 1985 19.9 7.7 11.8 5.9

Source: Annual Reports of the Sachverstandigenrat.

Away from the steady-state path, however, one must distinguish between productivity growth from a change in technical knowledge and productivity growth from capital-labour substitution. Thus it is likely that the large productivity shock in 1976 was due to labour shedding rather than any increase in technical proficiency. Given the role of capital deepening, wage policy since 1975 cannot be said to have been 'neutral' towards employment (even though it would have been 'neutral' in the steady state). To the extent that this wage policy incorporated the productivity gains from capital-labour substitution into real wages, it continuously reinforced the initial wage shock and the perceived need for further capital deepening.10 Thus the presumed 'neutral' wage policy after 1975 continuously reinforced the initial shock to desired employment. Given this interpretation, we must ask ourselves why the more moder­ ate wage increases after 1981 had so little effect. Here there are two issues. How significant was this effect relative to the previous increases in relative real wages? To what extent was the policy change after 1981 regarded as permanent rather than cyclical?

' The interaction of the unions' 'moderate' wage policy with the process of capital deepening seems to involve an inherent instability because deviations from the steady state mutually reinforce each other. In simple growth models, this process may lead to employment that converges to zero as the percentage excess of the wage over the marginal product of employed labour remains bounded away from zero. Germany under Kohl 125 Given the lack of reliable data on the extent of capital-labour substitu­ tion since 1975, we find it hard to say much about the first question. However if we accept the OECD's estimate that roughly one percentage point per year of productivity growth in Germany was due to capital- labour substitution, then we must conclude that the wage restraint of recent years has been insufficient to restore real wages to their 1969 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 level (productivity-adjusted). This conclusion accords with the observa­ tion that the share of wages in GNP has returned to its pre-1969 level, which at a reduced level of employment means that cumulatively since 1969 real wages are still significantly ahead of productivity. If we look at the share of wages in national income, i.e. net national product, the cumulative effects are even stronger. On the second question, however, it is clear that the trade unions themselves regarded their greater moderation as being temporary rather than permanent. Indeed last year's settlements and this year's rhetoric suggest a clear desire to make up lost positions. In this context, it must be remembered that the 1984 wage negotiations were dominated by the metal workers' and printers' demands for a reduction of the work week from 40 to 35 hours together with an increase in the weekly wage by some 3 to 5%.n After a six-week strike, the actual settlement largely followed the 'neutral' rule (inflation plus productivity growth). However, by that time the damage was done; the 1984 slowdown in the growth of domestic demand, in particular real investment in plant and equipment, seems to date from this episode. In summary, we believe that the changes in relative input costs in the early 1970s and since then explain a large part of the decrease in employment from 1973 to 1986. This assessment is in line with the Council of Economic Experts' judgement that in 1986 the economy was close to full capacity utilization, i.e. that unemployment in 1986 was largely due to a lack of jobs rather than a lack of demand. We are aware of the fact that according to the Bundesbank's and the IFO-Institute's measures, there was still a significant amount of unused capacity in 1986. Moreover, these alternative measures evaluate the amount of slack at least partly on the basis of registered unemployment. This procedure is inappropriate if unemployment is at least partly caused by supply-side rigidities due to fixed real wages or ex-post com­ plementarity of capital and labour. Indeed a measure of capacity utiliz­ ation which involves positive slack as long as there is unemployment

1' The unions' argument that reductions in the work week must raise employment of course depended on their proclaimed view that the inherent 15% wage increase had no significant adverse effects. 126 Martin Hellwig and Manfred Neumann will tautologically lead to the conclusion that all unemployment is due to insufficient demand. The decrease in employment by a million from 1973 to 1986 would have raised unemployment even if the labour force had been constant. The actual increase in unemployment was much larger because the labour force grew. To accommodate the increasing labour force, the Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 economy would have needed a decrease in the real wage, i.e. a further departure from the 'neutral' rule of wage increases equal to the sum of productivity growth and inflation. As far as we are aware, such a 'permanent' decrease in the real wage has not been seriously considered by the trade unions. What then is the scope for economic policy towards the unemploy­ ment problem? As we have argued above, we are sceptical about the scope for demand-side policies, especially because of their systematic repercussions on the strategic interactions of the different players. At this point, we are also sceptical about the Council of Economic Experts' insistence on capital widening. To be sure, capital widening would enhance employment. But there is no guarantee that increased real investment will lead to capital widening rather than capital deepening. As long as the underlying factor prices are distorted and wages follow the 'neutral' path, we fear that wage policy and capital-labour substitu­ tion mutually reinforce each other. In our view, economic policy should perhaps concentrate more directly on the structural problems of the labour market. To some extent, this may be a matter of industrial relations outside the scope of government activity. To some extent though the government's activities directly affect relative input prices. As we have seen above, government restrictions on dismissals raise expected costs of employment; other regulations have similar effects. In this area, the Kohl government has been remarkably inactive, at least in relation to the hopes that it raised when it came in. In the area of restrictions on dismissals, it has introduced two measures. The 1985 Employment Promotion Act permits firms to hire new, formerly unem­ ployed workers on term contracts of up to eighteen months (up to two years for new, small firms), thus reducing the coverage of the restrictions against dismissals. The 1986 reform of the Betriebsverfassungsgesetz exempts new firms for four years from the regulations concerning social plans. It is difficult to evaluate the quantitative impact of these measures.12 Moreover, even as they were introduced, the trend towards more

I I 12 Surveys indicate that a large fraction of the employment increases since 1985 involve the new short-term contracts. However, this does not prove that the introduction of these contracts actually caused the employment increase. Germany under Kohl 127 restrictive judicial and administrative rulings continued. Despite its initial rhetoric, the Kohl government has not really changed the rules of the game in the labour market.

3.5. Structural rigidities in the labour market Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Until now we have considered the employment problem only in terms of aggregates. However, the adjustment and substitution processes of the past decade involved substantial changes in the interregional and intersectoral structure of the German economy. Traditional industries such as steel and textiles declined while new industries grew up. As the industrial structure changed, so did the comparative and absolute advantages of different regions. The question is whether wage policies have adequately responded to these developments. Some of the intersectoral and interregional changes can be inferred from the development of unemployment in the different Lander. For each Land, and for the Federal Republic as a whole, Table 6 lists unemployment in percent of the dependent labour force in the success­ ive peak and trough years. We observe a growing disparity between the Lander on the North Sea coast and the traditional coal and steel regions of Nordrhein- Westfalen and Saarland on the one hand and the south German Lander (except the Saar) on the other. This shift reflects both the decline of shipbuilding (on the coast of the North Sea and the Baltic), textiles (Nordrhein-Westfalen) and coal and steel (Nordrhein-Westfalen and Saarland); and the rise of new industries, especially service industries in the Rhein-Main area, Bavaria and Wurttemberg. This shift is equally noticeable in the upswings of 1977-80 and 1983-85 as in the preceding downturns. On the whole it is to be expected that changes in industrial structure are closely linked to changes in regional structure. In many cases a change in industrial structure affects a region's specific resources. Thus the Saarland and Nordrhein-Westfalen were bound to suffer when coal and steel went into decline. However, the question is how the economic system reacts to such changes. From foreign trade theory we know that in the absence of factor mobility there is no reason why absolute wages in different regions should be the same. Instead absolute wages in different regions should depend on both the absolute and comparative advantages of those regions. They should change and certainly their relation to each other should change with exogeneous circumstances. However, a brief look at Table 7 shows that in fact the inter­ regional wage structure in Germany did not adapt to the changes in industrial structure that have taken place. The above-average wages in 128 Martin Hellwig and Manfred Neumann Table 6. The interregional distribution of unemployment rates (%)

Region 1973 1977 1980 1983 1985

Schleswig-Holstein 1.6 5.2 4.2 10.5 11.1 Hamburg 0.8 4.2 3.4 10.2 12.3 Niedersachsen 1.8 5.5 4.7 11.3 12.3 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Bremen 1.6 5.4 5.3 13.1 15.2 Nordrhein-Westfalen 1.3 5.0 4.6 10.6 11.0 Saarland 2.0 7.2 6.5 11.8 13.4 Hessen 1.0 4.0 2.8 7.6 7.2 Rheinland-Pfalz 1.1 4.6 3.8 8.5 8.6 Baden-Wurttemberg 0.5 2.9 2.3 5.9 5.4 Bayern 1.3 4.6 3.5 8.1 7.7 Berlin 1.1 4.5 4.3 10.4 10.0 Federal Republic 1.2 4.5 3.7 9.3 9.4

Source: Statistical Yearbook (Statistisches Bundesamt).

Nordrhein-Westfalen and Saarland have been maintained unchanged. In the city of Bremen the wage differential to the rest of the Federal Republic has actually increased even though the unemployment rate in Bremen rose to over 15%. The same picture emerges if we look at the intersectoral distribution of wages. Here again the relative wage structure seems to be absolutely rigid, unresponsive to changes in the economic environment. In recent years, wages in the lame-duck industries (shipbuilding, iron and steel) have increased their lead over the federal average. At the disaggregated level, Tables 7 and 8 exhibit the same rigidity of relative wages that previously we discussed in terms of aggregates. Just as the trade unions as a whole are not willing to adapt their wage policies to the change in the labour force, so the individual unions in different districts are not willing to adapt their wage policies to changes in their industries' and regions' absolute and comparative advantage. The reasons for this rigidity are not clear. One possible explanation would focus on intra-union competition among different district leaders, which might force them all to press for the same percentage growth in wages. In addition though, some uniformity seems to be imposed at the federal level of union organizations. In any case, it seems clear that the rigidity of the wage structure (and perhaps some other rigidities as well) will widen the disparities among regions. As relative wages fail to adjust, new capital moves into new rather than old regions; to some extent the capital-labour substitution that we discussed above then also became a substitution of new industrial regions for old. Germany under Kohl 129 Table 7. The interregional distribution of wages (% deviation of gross hourly earnings from Federal average)

1973 1977 1980 1983 1985

Schleswig-Holstein +5.0 + 1.4 + 1.6 +0.8 -0.8 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Hamburg + 14.0 + 12.6 +14.9 + 14.0 +11.3 Niedersachsen + 1.9 + 1.0 +2.2 + 1.9 + 1.8 Bremen +4.0 +3.1 +3.7 +5.0 +7.3 Nordrhein-Westfalen +3.5 +2.5 +2.2 +2.1 +2.4 Saarland -0.2 + 1.6 + 1.7 +2.4 +2.9 Hessen + 1.0 +0.9 +0.7 +0.7 + 1.2 Rheinland-Pfalz -3.3 -2.3 -2.5 -2.0 -2.0 Baden-Wurttemberg -1.7 0.0 +0.1 +0.2 +0.7 Bayern -8.0 -7.4 -6.6 -6.4 -7.1 Berlin + 1.1 0.0 -0.9 +0.8 -0.7

Source: Statistical Yearbook (Statistisches Bundesamt).

In this context, we must remark that the Federal Government - under Kohl as well as under Schmidt - has greatly encouraged the prevailing inertia and rigidities. Subsidies to industry may be small by international standards. However, they are almost entirely directed towards the lame-duck industries: coal, steel and shipbuilding. Moreover, in spite of many promises there has been no significant reduction in the level of subsidies; see Section 4.4 below. Indeed the current debate about coal and steel suggests that the government is fully committed to the conservation of these industries. Unfortunately at least some of the entries in Table 8 suggest that the unions are aware of this 'conservative' government policy.

4. Fiscal consolidation

4.1. The problem of 'crowding out' The most important macroeconomic consequence of fiscal expansion, financed by debt, is neither strong inflation nor short-run crowding out of private expenditure but the danger of a pricing out of capacity. Since Tobin (1969) we know that in a general three-asset model, with money, bonds, and capital, a relative increase in the stock of government debt raises the real rate on bonds and, depending on the relative degrees of asset substitutability, drags along the required real rate of return on capital. Whether bonds are closer substitutes for capital or for money is an empirical issue about which we do not know much. But the Keynesian assumption that government bonds and capital are perfect 130 Martin Hellwig and Manfred Neumann Table 8. The intersectoral distribution of wages (% deviation of gross hourly earnings from Federal average)

1973 1977 1980 1983 1985

Coal mining +5.6 +7.9 + 13.8 + 14.0 + 13.7 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Iron and steel +7.2 +5.7 +4.4 +3.0 +6.8 Chemical Ind. +4.6 +8.3 +5.4 +7.5 +7.3 Tools & machines +5.5 +5.0 +4.2 +2.9 +4.9 Shipbuilding +7.9 +7.7 +8.4 +7.7 +9.3 Office equipment -8.9 -6.5 -6.3 -4.8 -4.9 Consumer goods -11.8 -11.4 -11.7 -12.7 -12.9 Motor vehicles + 11.9 + 15.0 + 13.9 + 13.4 + 13.1 Textiles -17.0 -17.5 -18.6 -19.1 -19.0

Source: Statistical Yearbook (Statistisches Bundesamt). substitutes in the short run is certainly unnecessarily restrictive, as it precludes portfolio crowding in (Friedman, 1978). It may be useful to sketch a stylized story of the demand and supply effects of debt-financed fiscal expansion. This requires a reference model which allows for some price and wage flexibility, and hence goes beyond the narrow Keynesian setting of Blinder and Solow (1973). A suitable framework was provided e.g. by Brunner (1976) and Brunner and Meltzer (1976). Their model permits a full interaction of the asset markets with the output market, and it contains a price-wage adjustment which governs short-run output supply. Using this framework leads to the following conclusions. An increase in government spending, financed by debt, on impact raises output and employment by reducing the real wage rate. The net effect of debt issues on total expenditure is expansionary as an induced rise in the price of existing capital dominates the contractionary effect of the concurrent rise in the bond rate.13 The initial short-run crowding in, if it occurs at all, cannot last, however, because the induced increase in the price of output will feed back to nominal wages. The German unions are accustomed to allowing for anticipated inflation. In the absence of money illusion, price-wage adjustment will raise the real wage rate and reduce output and employment. If the process is stable the economy will converge to a medium-run position with complete crowding out and a zero deficit. Under the assumption of an unchanged capital stock, output will be back at its original capacity level while the price level will

13 Clearly, this is a (debatable) empirical assumption which neglects, for example, that induced uncertainty about the future incidence of tax liabilities may immediately reduce private con­ sumption (Barro, 1981; Feldstein, 1982; Chan, 1983). The assumption serves to guarantee stability of debt finance in the theoretical model. Germany under Kohl 131 be permanently higher. It goes without saying that the speed of the process depends upon the way expectations are formed. Under extreme rational expectations assumptions the complete crowding out of private demand in the medium run will occur immediately after the first surprise. So far, the capital stock, hence capacity output, has been held constant. Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 But it has to adjust downward in the long run if the required real rate on capital equals the perceived real rate on bonds. The higher level of the common required rate of return prices part of the capital stock out of the market. This direct portfolio effect of rising public debt will be reinforced if rising deficits induce agents to expect time-inconsistency in policy behaviour (Baltensperger, 1984; Brunner, 1986). Rising per­ ceived risk of default (through monetization or open debt repudiation) puts additional upward pressure on the real rate of interest. Again it has to be noted that these 'long-run' effects may show up rather soon in real time if agents perceive debt-financed fiscal expansion to be permanent rather than temporary. To summarize, expansionary spending by government may have positive effects on output and employment on impact, but will lead eventually to complete crowding out. This is the unavoidable con­ sequence of the empirical fact that agents do not suffer from money illusion. Policy makers who understand this may wish to argue that it is worthwhile to collect positive impact effects over time by stepping up government spending, period after period. But that would be a serious error because the long run cannot be avoided by creating a series of short runs. Once agents understand the game and anticipate a per­ manently rising expansion of government debt, they will immediately bid up the required real rates of return on bonds and capital by more than is required by current stocks and flows. As a result, real private capital formation will decline sharply and more than 100% crowding out will occur. This pricing out of existing as well as potential capacity will appear statistically as falling capacity utilization and declining growth in the private sector's capital stock. The numbers shown in Table 9 are sugges­ tive in this respect. Between the early seventies and 1983 the ratio of public debt to private capital has doubled, from 0.07 to 0.14. Since then the growth of the ratio has slowed, and by 1986 had presumably been halted. Of course, Germany is an open economy of moderate size. This implies that domestically produced portfolio crowding out is exported to some degree, by raising the world real rate of interest (Buiter, 1985). This in itself mitigates the negative effect on domestic capacity growth though it does not eliminate it. However, there is a second channel, 132 Martin Hellwig and Manfred Neumann Table 9. Debt/capital ratios (%)

Public debt outstan ding as a percentage of

Private sector capital Public sector capital (1) (2) (3) (4) Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

1970-1972 7.4 7.0 88.7 84.3 1980-1982 12.3 11.6 137.7 129.2 1982 13.1 12.9 145.8 143.6 1983 14.0 14.3 154.7 158.6 1984 14.4 14.7 160.3 164.7

Source: National Accounts (Statistisches Bundesamt); Monthly Report of the Deutsche Bundesbank. Note: Capital stocks exclude civil engineering and are valued at replacement prices. Columns (1) and (3) are based on nominal debt, columns (2) and (4) on estimated market values.

the real exchange rate. A permanent, anticipated expansion of debt finance will induce a real depreciation of the domestic currency. The reason is that the anticipated underlying equilibrium value of the real exchange rate will fall in response to the anticipated permanent rise in future external debt service. The resulting real depreciation stimulates short-run output demand but raises the anticipated relative price of imported raw materials. Consequently, firms will shift from capital widening to capital deepening, and capacity output will be depressed.

4.2. The programme of the new government Kohl was elected Chancellor by a new coalition in October 1982. His government was confirmed by federal elections in March 1983. The basic promise of the new government was to set the stage for a turn­ around of the economy in 1983 and for a lasting improvement of real growth in the years thereafter. In line with the reasoning of Lambsdorff (1982), it was explained to the electorate that this required the promo­ tion of capital formation at the expense of consumption. Keynesian-type programmes of demand stimulation, in contrast, were explicitly ruled out. The new policy which was announced included the following main elements. First, consolidation of public sector finance over several years. In order to reduce and finally eliminate crowding out and to stop the steep rise in the government's interest expenditure, top priority was given to cutting the deficit. As a starting point for a medium-run phasing out, it was decided significantly to cut public consumption expenditure and transfers and to postpone rises in personnel expenditure and Germany under Kohl 133 pensions. For the years to follow it was promised that the rate of growth of government expenditure would be held several percentage points below the growth of nominal GNP. The second element was tax reform. A three-stage strategy was sketched. There would be immediate tax relief for private investment Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 and a reduction of business taxes to be financed by an increase in value-added tax. Next, there would be tax relief for small and medium- sized businesses, starting in 1984. Later on, wage and income taxes would be reduced provided fiscal consolidation had made headway. Third, housing policy would be stimulated. A programme of promot­ ing publicly-assisted housing construction was started in 1983, financed by an investment assistance levy on higher incomes to be refunded in the late 1980s; enterprises raising investment by five times the levy would be exempt. In addition, legal restrictions on the raising of rents and on agreements on graduated rent increases over time were relaxed. Further promises of the new government included a marked reduction of subsidies to enterprises, privatization of government-owned enter­ prises, and the initiation of a process of deregulation, in order to 'revitalize' the market economy.

4.3. Fiscal consolidation measures 1983-86 In this section we will report on the fiscal policy measures pursued by the Kohl government since 1983. The interpretation of what has been going on will be mainly based upon an examination of a series of indicators and less on the tracing of specific policy measures. In order to assess whether the Federal Government has made head­ way with respect to the task of consolidation it is sufficient to examine the evolution of the nominal budget deficit instead of, say, an inflation- adjusted measure. The reason is that during a period of declining inflation the real value of the government's interest obligations on medium and long-run debt rises; this requires compensating cuts in the nominal deficit (Minford, 1985). Table 10 contains information about the federal deficit, which figures more prominently in the public debate than the total public sector deficit. Three measures of the federal deficit are differentiated though each of them tells essentially the same story. First there is the gross deficit which from the receipts' side is mainly determined by tax revenues. This deficit has fallen from its record high of DM 47 billion down to DM 36 billion by end of 1986. The second deficit measure, the net deficit, implies counting the rather large profit transfers from the Bundesbank as ordinary receipts. The federal net deficit has been cut by a third between 1982 and 1986. Finally, if the very modest base money finance and changes in the 134 Martin Hellwig and Manfred Neumann

Table 10. Federal deficit (DM billion)

Financed by

Gross Bundesbank Net Drawing on Base money Debt deficit profit deficit deposits creation issues Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

1981 42.1 2.3 39.9 0.1 2.4 37.4 1982 46.7 10.5 36.2 -0.4 -2.7 39.4 1983 42.0 11.0 31.0 -0.8 0.4 31.3 1984 40.0 11.4 28.7 1.1 2.1 25.5 1985 35.8 12.9 22.9 -0.7 -1.4 25.1 1986 36.1 12.6 23.5 0.8 2.3 20.4

Source: Monthly Report of the Deutsche Bundesbank. Note: Base money finance includes seigniorage and cash advances by the Bundesbank. government's money balances are taken into account, one arrives at the borrowing requirement in credit and capital markets. The latter has been halved in comparison to 1982. Next consider the total budget deficit of the public sector; see Table 11. The federal government influences the budget deficits of the lower levels of the government as well as of the social security funds (statutory pension insurance funds, Federal Labour Office, and statutory health insurance funds) in various ways from both the expenditure and the revenue side. This implies that the federal government, in principle, has some scope for 'window-dressing' by shifting a part of the federal deficit to lower level authorities. The available figures on the net public sector deficit, however, show again that the process of gradual phasing out of deficits has made substantial progress. In 1985 the net public sector deficit was down to DM 37 billion or less than 2% of GNP. If one is prepared to entertain the conjecture that the present values of the income streams of fixed public sector investment and of the underlying public debt finance are equal it makes sense to compute the excess of this deficit over the public sector's concurrent net fixed capital formation. The resulting 'excess deficit' amounted to DM 31 billion in 1982 but had been eliminated by 1985. We acknowledge, however, that this indicator should not be stressed, as the underlying conjecture is hardly valid. A considerable part of public sector expenditure on net fixed capital formation is likely to reflect the acquisition of durable consumption goods, e.g. public swimming pools. To sum up, the Kohl government has largely achieved its main macroeconomic task of consolidating public sector finance. Though the net deficit has not yet been eliminated, it has been reduced sufficiently Germany under Kohl 135 Table 11. Public sector deficit (net)

DM billion As % of GNP

Net capital Excess Net capital Excess Total- Total-

formation " deficit formation ~ deficit Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

1970-72 7.4 29.3 -21.9 1.0 3.9 -2.9 1980-82 60.3 39.2 21.1 3.8 2.5 1.4 1981 70.2 39.5 30.7 4.5 2.6 1.9 1982 65.2 34.0 31.2 4.1 2.2 2.0 1983 56.4 29.8 26.8 3.4 1.8 1.6 1984 49.2 29.2 20.0 2.8 1.7 1.1 1985 37.0 29.0 8.0 2.0 1.6 0.4 1986 36.9 32.1 4.8 1.9 1.6 0.3

Source: National Accounts (Statistisches Bundesamt). to halt the upward trend in the debt/GNP ratio (see Table 12). As a percentage of GNP the deficit is down to less than 2%, which is less than net fixed capital formation by the government. The main approach to effecting the consolidation was a programmed slowing down of expenditure growth. The public sector's share in GNP declined by more than 3 percentage points while the. ratio of total taxes (including social security contributions) declined by about 1 percentage point. Table 12 also shows how the reduction in the public sector's share was achieved. It turns out that the main burden of adjustment was put on transfers and, in particular, on social security payments. The share of transfers in GNP was cut by more than 2 percentage points between 1982 and 1986. The relative cuts in social security payments appear to be smaller but, from the point of view of an individual who is unemployed or retired, they were much more severe as the number of people on social welfare rose considerably in 1983. The public sector's absorption of goods and services, in contrast, was reduced by little more than 1% of GNP. Unfortunately, this was not achieved just by cutting public consumption but also by cutting public fixed capital formation. The latter development is in flat contradiction to the promises of the Kohl government.

4.4. Tax reform and subsidization In line with the original plan the Federal Government made no major move towards tax reform until it had become clear that budget consoli­ dation from the expenditure side was progressing satisfactorily. As a consequence, the overall tax ratio remained close to 24% in 1985, and 136 Martin Hellwig and Manfred Neumann Table 12. The public sector as a percentage of GNP

Expenditure

Goods and services Transfers Debt Debt Deficit Total Capital Total Soc. Sec. interest Taxes Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

1981 34.3 4.5 23.8 3.2 25.3 19.0 2.3 42.4 1982 37.6 4.1 23.3 2.8 25.8 19.4 2.8 42.5 1983 39.1 3.4 22.5 2.5 24.9 18.9 3.1 41.9 1984 39.9 2.8 22.2 2.4 24.5 18.8 3.0 42.2 1985 40.5 2.0 22.1 2.3 23.9 18.5 3.0 42.2 1986 39.6 1.9 22.0 2.3 23.4 18.1 2.9 41.7

Sources: National Accounts (Deutsches Institut fur Wirtschaftsforschung); Monthly Report of Deutsche Bundesbank; Annual Report of the Council of Economic Experts. Notes: (i) Public sector is all levels of government and social security funds, (ii) Deficit not equal to sum of expenditures minus taxes because other revenue sources not shown. the share of income taxes in total taxes rose from 47 to 49%, (due to the progressivity of income tax rates; see Table 13.) In 1985, however, a reform of the income tax was introduced, de­ signed to reduce tax rates in two stages. The first stage became effective in 1986. There the main emphasis was on lowering the average tax burden by raising certain kinds of basic allowances; as a result the overall tax ratio declined by half a percentage point. A further decline of up to 1 percentage point is expected to occur in 1988, when the second stage of the reform will become effective. This second stage will involve a general lowering of marginal tax rates. Clearly, this tax reform does not imply a fundamental change but just a correction of distortions which build up when the income tax schedule is not indexed. Nevertheless, the reform serves a useful pur­ pose as it will lower the progressivity of the income tax schedule over a broad range and, moreover, will contribute to reducing the wedge driven by the tax system and the system of enforced social security contributions between gross wage costs and net wages. As a percentage of wage cost the wedge reached 46 percent by 1986; it thus exceeded the comparable burden of official levies on labour in important com­ petitors, like Japan, the US or the UK. In contrast to tax reform, no effort has been made to cut the extensive net of subsidies during recent years. On the contrary, the Kohl govern­ ment has raised total subsidies, on average by about 8 percent. There is no need to examine the diversity of subsidies in detail. The main problem is that the bulk of subsidies are not effectively designed to promote a more rapid reallocation of resources among industries or Germany under Kohl 137

Table 13. Taxes and social security contributions (%)

Share of Overall income taxes Soc. sec. Wage Period tax ratio in total taxes payments tax Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

1970-72 23.2 41.2 24.2 10.7 1980-82 24.1 47.4 27.8 13.3 1982 23.7 47.6 29.9 13.5 1983 23.6 46.8 30.4 13.8 1984 23.5 46.9 31.0 14.2 1985 23.7 49.0 31.3 14.6 1986 23.2 49.1 41.4 14.4

Source: National Accounts (Deutsches Institut fur Wirtschaftsforschung; Monthly Report of the Deutsche Bundesbank, January 1986).

regions. Instead most subsidies have become a permanent source of income to declining industries; prominent examples are coal mining, shipyards and agriculture.

4.5. The economy's reaction Finally, let us try to derive a general assessment of the consolidation policy of recent years. The important question to be answered is whether this policy approach, on balance, was beneficial or harmful. It goes without saying that to derive a definitive answer requires an explicit empirical model of the economy, rich enough in detail and sufficiently tested. No such model is available, anywhere; our answer is therefore necessarily tentative. We distinguish long-run and short-run effects. From a longer-run point of view, a policy of consolidation is doubtless beneficial to the supply side since it reverses the replacement of produc­ tive real capital by unproductive government debt. Once the longer run is reached, the flow of goods and services will be permanently higher than otherwise. But to receive the benefits requires incurring a potentially large burden of costs during the transition period. According to conventional wisdom, any policy of consolidation is likely to contract real aggregate demand in the shorter run. This Keynesian conclusion, however, is misleading as it neglects the role of expectations. A more adequate analysis differentiates between the direct demand effect of cutting the growth of government expenditure and the indirect effect of an induced change in expectations. The direct demand impact of slower public expenditure growth is clearly negative though it will be less severe in real terms if the cut does 138 Martin Hellwig and Manfred Neumann not come as a surprise. The indirect effect on aggregate demand of the initial reduction in expenditure growth occurs through an improvement in expectations if the measures taken are understood to be part of a credible medium-run programme of consolidation, designed to per­ manently reduce the share of government in GNP. A programmed, permanent cutting of the government's share implies a lowering of the Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 burden of government debt and permanently lower taxation in the future. Agents who understand this will anticipate a fall in the long-term interest rate as well as in taxation. With the initiation of the programme, therefore, permanent income and the marginal efficiency of fixed investment will rise while interest rates will begin to fall. A priori it is impossible to know which of the two effects will dominate, the direct expenditure effect or the expectational effect. The latter effect is expansionary; but it will dominate only if the consolidation pro­ gramme is widely accepted by the public as a credible new policy which breaks with the past. Our interpretation of the events surrounding the fiscal consolidation of 1982 in Germany is that it led to a rise in output. The turn-around of public opinion from pessimism to optimism was impressive. The IFO indicator of consumer confidence, for example, jumped from 85 to 100% at the end of 1982 and general business climate improved remark­ ably. We conclude, therefore, that on balance the expansionary expecta­ tion effects of the consolidation programme dominated the contraction­ ary direct effect. The available empirical evidence bears out this judgement. Shortly after the institution of the Kohl government the German economy turned around by the start of 1983, and it is most noteworthy that the recovery was not export-led, in notable contrast to the recoveries of 1967-68 and 1977-76. New orders received from inside the country began to rise during the last quarter of 1982. Total production and real GNP followed in the first quarter of 1983. New orders received from outside the country, in contrast, did not begin to rise until early 1983, and real exports picked up later on, in the second quarter of 1983. A similar picture emerges if one compares the growth of key aggre­ gates before and after the switch to consolidation; see Table 14. The cumulative growth of real exports between 1982 and 1984 (8%) was considerably less than during the two years before the turn-around of the economy (12%). This suggests again that the return to growth of the German economy originated from inside the country rather than from outside. The most important contribution was provided by a remarkable recovery of domestic private demand. Within two years Germany under Kohl 139

Table 14. Real consumption and investment expenditures before and after 1982-83

%cumulative change during

Item 1980-1982 1982-1984 Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 Total Consumption -1.1 3.1 Fixed investment -16.1 8.8 Private sector Consumption -1.8 3.2 Fixed investment -15.8 12.2 Public sector Consumption 1.0 2.7 Fixed investment -18.1 -10.5 For comparison GNP -1.0 4.9 Exports 11.6 7.9

Source: National Accounts (Statistisches Bundesamt). private fixed investment rose by 12% (up from -16%) and private consumption switched from -2 to +3%. The general aim of the govern­ ment of getting back to real growth by restraining consumption and promoting private fixed investment was achieved within a surprisingly short period. As a result, the general performance of the German economy has markedly improved over recent years; see Table 1. Real GNP growth turned from being negative to a healthy positive rate in 1983, since then it has returned to the level of medium-run capacity growth, 2.5% a year. This indicates that any artificial overstimu­ lation has been avoided. As we noted above, the labour market too began to improve after a while. However, the increase in employment by about 450,000 jobs since 1983 was not enough to offset the decrease of the preceding downturn, let alone provide for the increase in the labour force. Thanks to a determined monetary policy, based on preannounced and maintained monetary targets, the rate of inflation has come down, from 5% in 1982 to less than 2% in 1986. If one does not adjust, as one should, for the temporary impact of oil price-led energy prices, about 2% in 1986, the improvement appears even more impressive. This may have contributed to the fundamental reevaluation of the prospects of the D-Mark by international investors. The weighted real exchange rate of the D-Mark (against 14 major trading partners) 140 Martin Hellwig and Manfred Neumann switched from continuous depreciation since 1980 to appreciation by mid-1985: the cumulative effective revaluation exceeds 10%. The effects are clearly visible. While real imports continue to rise, real exports have been falling since mid-1986. Hence the doubling in Germany's current account surplus in 1986 (DM 77.8 billion) was exclusively caused by the favourable shift in the terms of trade. The reduction of Germany's Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 energy bill alone accounted for DM 45 billion.

5. Conclusions German economic policy has achieved two major tasks during recent years: the virtual elimination of inflation and a remarkable reduction of public sector deficits as well as of the government's share of GNP. In this way monetary and fiscal policies have contributed to the economy's return to normal growth. In contrast hardly any progress has been made on the problems of unemployment. This may not be surprising in view of the fact that economic growth is comparatively low in Germany. But, as we see it, both of these problems have common sources. One of them is the rigid structure of wage policies and the overall labour market, which perpetu­ ate and even exacerbate the distortions of the early 1970s. Since that time, wage policy, labour legislation and court practise have raised the barriers to entry into the labour market and slowed economic adjust­ ment to a changing environment. Another factor hampering more rapid economic development lies in the dismal state of industrial policy and deregulation, which we have insufficient space to discuss in this paper. Here we agree with Vaubel (below) that the government has done little or nothing to improve the working of the market. It should eliminate a multiplicity of distorting regulations and remove legal and administrative barriers to entry into a variety of markets, from trucking to telecommunications. It seems fair to conclude that, apart from the successful consolidation policy, preservation of inherited structures rather than fundamental reform has been and still is the dominant principle of economic policy in Germany. In this respect the Kohl government has proved to be as conservative as the preceding Schmidt government. But, of course, we must not overlook the fact that any major economic reform will redis­ tribute wealth and power and hence will raise strong political opposition. Especially with respect to labour market reform, a large part of German society seems to reject the results of standard economics as being fundamentally inegalitarian. We therefore expect the prevailing high level of unemployment to persist until the demographic factors begin to improve in the 1990s. Germany under Kohl 141 Discussion Roland Vaubel University of Mannheim Hellwig and Neumann devote much space to the economic events preceding the change of government in 1982, notably to the current Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 account deficits in 1979-81 and the weakness of the D-Mark around 1980. They attribute the decrease of the German current account balance vis-a-vis non-OPEC countries (which, in the mercantilist tradi­ tion, they call a 'deterioration') exclusively to the appreciation of the D-Mark in 1977-78. In so doing they ignore the influence which fiscal policy exerts on the current account balance. Yet, the public sector deficit rose from an average of 1.4% of GNP in 1977-78 to 3.1% in 1979-81. (On a cyclically-adjusted basis, the corresponding figures are from 1.1% in 1977-78 to 2.4% in 1979-81). Correspondingly, the increase in the current account balance from 1982 onwards was partly due to the policy of fiscal consolidation in Germany. Turning to the weakness of the D-Mark, Hellwig and Neumann suggest that this occurred because the decrease in the current account balance vis-a-vis non-OPEC countries was misinterpreted as a sign of diminishing international competitiveness. However, I find it hard to believe that the D-Mark was weak because the market got it wrong. I have more sympathy with an alternative explanation which, for example, the Council of Economic Experts has provided: the so-called 'millstone hypothesis'. The EMS hung like a millstone around the D-Mark's neck and prevented it from rising because it temporarily destroyed all expectations of further DM revaluations. The D-Mark's parity, which is controlled by the government not the Bundesbank, prevented, and was rationally seen to prevent, the Bundesbank from pursuing a more disinflationary monetary policy than the other EMS central banks. After all, this may have been Schmidt's most important motive in promoting the EMS. It gave de facto control over the monetary policy of a de jure autonomous central bank. Hellwig and Neumann ask themselves why the more moderate wage increases after 1981 had so little effect. But their Table 3 demonstrates that the effect on employment was not small at all. From 1983 to 1986, employment increased by 450,00, whereas from 1973 to 1981 it decreased by almost 800,000. The increase in employment is all the more remarkable as it was attained in a period of anti-inflationary monetary and fiscal policy, whereas the decrease of employment occurred during a decade of inflationary policies. Hellwig and Neumann put much emphasis on the fact that the decline of real gross investment relative to GNP, which took place after 1973, 142 Martin Hellwig and Manfred Neumann was primarily due to government and private residential construction. However, they overstate their case. Real private investment in equip­ ment and construction relative to GNP fell from 12.6% in 1962-73 to 11.5% in 1974-85, and, therefore, contributed only a quarter of the decline in the investment/GNP ratio from 1962-73 to 1974-1985. The fact that the share of private non-residential investment in GNP has Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 failed to rise to pre-1973 levels under the Kohl government is noteworthy and worrying. To some extent it is probably due to high US interest rates, but it may also reflect the German government's failure to significantly reduce business taxation in Germany. This takes us to my central theme: the economic policies of the Christian Democrat-Liberal coalition which came to power in 1982. In my view, only a minority of those Germans who voted for the present coalition regard themselves as conservatives. They favour market- oriented economic policies because they believe that the market is a mechanism of discovery and more conducive to material progress than government planning or intervention. Government, not the market, tends to conserve existing economic structures. However, the new government did not deliver the general turn­ around ('Wende') in economic policy which it had promised. Hellwig and Neumann scarcely mention its failure either to stop the growth of subsidies to declining industries or to deregulate the labour market. It has also been insufficiently radical in other respects. First, it has failed to remove entry barriers for potential private competitors to federal agencies and public enterprises, e.g., with respect to telecommunications and other postal services and domestic air trans­ portation. Second, its privatization programme has failed to get off the ground (e.g. Lufthansa). Third, it has made little attempt to deregulate the housing, energy and service sectors. Finally, it has done nothing to reform the system of codetermination in industrial management. Thus the government, which had been elected on a pro-market platform, turned out to be much more conservative than expected. It is in this sense that it pursued 'conservative economic policies'. In the field of economic policy, Stoltenberg's fiscal restraint and consolidation was probably the only major promise kept by the Kohl government. Hellwig and Neumann emphasize that this was achieved not only by reducing government consumption, but also through cuts in transfers and public fixed capital formation. While it is true that total social transfers have fallen as a proportion of GDP, one should not lose sight of the fact that total social transfer spending by all entities is more than 5% higher than in 1978-81 (in real terms). Hence, their criticism of the Kohl government on this count is prob­ ably too harsh. On the other hand, they do not give enough emphasis Germany under Kohl 143 to the fact that the Kohl government has been insufficiently adventurous in setting the markets free.

Marcus Miller Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021 University of Warwick

An interesting feature of this paper is that it reiterates the 'German view' of fiscal policy that, under certain circumstances, fiscal contraction can increase output (a negative multiplier). It is a view that was presented to us at the last Panel by Fels and Froehlich (1987), and since I discussed it at some detail then, I shall be brief here. Suffice it to say that this view is extraordinary in a country where the ratio of net government debt to GDP was 21.7% in 1984, as compared to an average of 30.7% for the G7 countries. Moreover, the primary surplus is now larger than the difference between the real interest rate and the expected growth rate, which suggests that the debt-income ratio can, if anything, be expected to fall. One cannot, therefore, help feeling that there has been an element of overkill in the process of fiscal consolidation. Note that Germany has had a process of fiscal consolidation and has high unemployment, while the US has followed a seemingly reckless fiscal policy, but has low unemployment. It is possible to argue that this is consistent with the work of Blanchard and Summers (1986), who argue that demand shocks can have per­ manent effects, essentially because the response of existing insiders (a 'supply shock'), will act to consolidate the effects of a demand shock. It is surprising that the authors do not discuss this alternative view of European unemployment. This is especially important, for German views on the effectiveness of fiscal and monetary policies impinge on the rest of us, since they act as a pace-setter in the setting of these policies in Europe. I am also somewhat dubious of the argument that one reason for German unemployment is that unions used the wrong wage-setting rule, i.e. the authors' claim that unions press for wage increases in line with productivity growth which has only occurred through labour- saving technical progress. Were this the true reason for the high level of German unemployment, the 'cure' would be trivial. All we need to do is to re-educate the 'experts' who advise the unions, and, presumably, we can then dispense with fiscal consolidation! A puzzling feature of this paper is the extent to which German unemployment is blamed on wage rigidity - many of us outside Germany have been brought up to believe in and admire the flexibility 144 Martin Hellwig and Manfred Neumann of wages in Germany (there are several empirical studies which appear to justify this view). Finally, most of the German private sector institutes are now urging the government to bring forward its plans for tax reform. Can we now hope that we will get fiscal expansion in Germany, albeit disguised as a supply-side reform? Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

General Discussion Some unhappiness was expressed regarding the authors' view that 'irrational' unions pursued wage increases in line with productivity growth, even though this had resulted from labour-saving technical progress. Charles Wyplosz argued that this view sat rather uneasily with the assumption that only unanticipated fiscal policy mattered, a result that is usually predicated on the belief of a fully rational private sector. Patrick Minford pointed out that the evidence that there was very little regional dispersion was not consistent with the view that wages grew in line with productivity growth. Instead, the authors should use a model of fully optimising unions which would generate, inter alia, no regional dispersion, which is broadly consistent with what we observe. Martin Hellwig responded by arguing that what we know from collective choice theory doesn't enable us to define any simple objective functions for unions. There is a wide range of behaviour which would be consistent with the underlying theory. Some reservations were also expressed about the absence of econometric evidence in the paper. William Branson argued that many of the assertions in the paper regarding the wage-setting process were not self-evidently true, and needed to be justified by the use of regression analysis. Martin Hellwig's response to this was to argue that he didn't believe that one learned much from econometric exercises, and that, given the change in the behaviour of unions, it would be difficult to identify the appropriate wage equations. Considerable scepticism was also expressed regarding the validity of the assertion that German unemployment arose from inappropriate wage-setting policies. Olivier Blanchard and Steve Nickell pointed out that there was evidence suggesting that German unemployment could not be explained by the 'wage gap' (see Bruno and Sachs, 1985). Many members of the Panel were also dissatisfied that no evidence had been offered for the proposition that fiscal consolidation actually increased output. Hellwig's response was that they did not believe that this proposition was universally valid - only that it appeared to be true of Kohl's fiscal consolidation programme. As for the 'success' of the policy of pursuing a budget deficit in the US, it is possible that this Germany under Kohl 145 occurred because the American public were fooled into believing that the government was pursuing supply-side policies.

References Downloaded from https://academic.oup.com/economicpolicy/article/2/5/103/2392311 by guest on 30 September 2021

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