IZA DP No. 1059 Can Gerhard Schröder Do It? Prospects for Fundamental Reform of the German Economy and a Return to High Employment Irwin Collier DISCUSSION PAPER SERIES DISCUSSION PAPER March 2004 Forschungsinstitut zur Zukunft der Arbeit Institute for the Study of Labor Can Gerhard Schröder Do It? Prospects for Fundamental Reform of the German Economy and a Return to High Employment Irwin Collier Free University of Berlin and IZA Bonn Discussion Paper No. 1059 March 2004 IZA P.O. Box 7240 53072 Bonn Germany Phone: +49-228-3894-0 Fax: +49-228-3894-180 Email: [email protected] Any opinions expressed here are those of the author(s) and not those of the institute. Research disseminated by IZA may include views on policy, but the institute itself takes no institutional policy positions. The Institute for the Study of Labor (IZA) in Bonn is a local and virtual international research center and a place of communication between science, politics and business. IZA is an independent nonprofit company supported by Deutsche Post World Net. The center is associated with the University of Bonn and offers a stimulating research environment through its research networks, research support, and visitors and doctoral programs. IZA engages in (i) original and internationally competitive research in all fields of labor economics, (ii) development of policy concepts, and (iii) dissemination of research results and concepts to the interested public. IZA Discussion Papers often represent preliminary work and are circulated to encourage discussion. Citation of such a paper should account for its provisional character. A revised version may be available on the IZA website (www.iza.org) or directly from the author. IZA Discussion Paper No. 1059 March 2004 ABSTRACT Can Gerhard Schröder Do It? Prospects for Fundamental Reform of the German Economy and a Return to High Employment The year 2003 has witnessed several major reform policy initiatives in Germany intended to contribute to a solution to Germany's high unemployment problem and to improve the long- run sustainability of its social welfare policies. These economic reforms are discussed within a larger macroeconomic context. JEL Classification: J68, E65, O52 Keywords: labor market reform, social policy reform, unemployment Irwin Collier Department of Economics Free University of Berlin Garystraße 21 14195 Berlin Germany Email: [email protected] 1 Can Gerhard Schröder Do It? Prospects for Fundamental Reform of the German Economy and a Return to High Employment Irwin Collier1 “If we are not successful in significantly lowering the unemployment rate, then we would neither deserve to be reelected nor would we even be reelected.” Gerhard Schröder, Der Spiegel, Aug. 23, 1998. In 1998 Gerhard Schröder had the luxury of running against the economic record of the last years of Kohl government. Candidate Schröder was quite aware that later in 2002 he would have to run on his own economic record. The German electorate yearned for a substantial reduction in unemployment, but all it got was an insignificant change. When Gerhard Schröder first became the Federal Chancellor in September 1998 the number of unemployed was 3.97 million. Four Septembers later in 2002 the number of unemployed had only declined to 3.94 million. One prong of the 2002 election strategy of the Schröder team to deal with its unemployment problem was to attempt to shift the blame for the continued labor market stagnation to the weak state of the world economy. The other prong of the strategy was to appoint a blue-ribbon commission for the reform of the German system of employment offices. The commission claimed and perhaps even believed itself that its 13 module reform package would be capable of reducing the number of unemployed by half and that this goal could be achieved by the end of 2005. One can easily sense just how desperate the Schröder reelection campaign staff must have felt regarding the vulnerability of their unemployment flank in the months before the 2002 elections. 2 However history was to smile on the Schröder campaign as nature and international politics provided well-timed and much needed distractions from Germany’s unemployment problems. The flood of August 2002 in East Germany was the sort of crisis needed to demonstrate that this federal chancellor could lead and dispense federal favor at will, while the international tensions over the growing Iraq crisis provided an opportunity for striking a pose for peace. A triad of economic problems The German proverb that misfortune seldom arrives alone completely captures the essence of present German economic difficulties. The chronic failure to achieve the full utilization of the nation’s productive resources, in particular as seen in the high levels of unemployment we observe, is but one of three interrelated economic problems facing Germany. The second problem is that the mainsprings of the postwar German revival seem to have run down, vibrant economic growth has become a memory and is not part of the historical experience shared by the young generation. Nothing less than the strength of the underlying trend of Germany’s ability to generate real income growth over the future long-run is the issue. The third of Germany’s economic problems involves the sustainability of its tax-transfer programs and systems of social insurance. Schröder’s Germany, much like Kohl’s Germany before it, is in very serious trouble on all three counts and there is a growing sense that the day of reckoning is nigh. The best way to get a sense of the scale of Germany’s economic problems is to place them within a longer historical or broader international context. The urgency of large steps becomes much clearer once the magnitude of the problems is truly grasped. 3 The upward trend in unemployment in Germany has taken close to a full generation to get where it is today (Figure 1). Instead of roughly symmetric up- and downward fluctuations in the number of unemployed around a flat average number of unemployed, Germany has experienced an unrelenting upward ratcheting of unemployment from recession trough to recession trough. While some of the increase in unemployment can be seen to be reduced in each subsequent economic upturn, no economic recovery since the mid 1970s has been adequate to stabilize unemployment, much less reverse the upward trend that can be easily constructed by connecting either the peaks or the troughs in Figure 1. The high unemployment experienced in the East German states can be seen to have acted as a disproportionate upward shift to the trend and underscores the chronic increase in unemployment. Rather than reversing the trend, the Schröder government in its second term has also fallen victim to the trend increase in unemployment. One of the problems of suffering a chronic condition is that the deterioration can be so gradual as to go unperceived. Gerhard Schröder’s hand for reform was strengthened considerably following the announcement of the results of the OECD’s Programme for International Student Assessment (PISA) in December 2001. Germany was unceremoniously lumped into a group of nations found to be statistically significantly below the average of the OECD countries.2 Less than a year later, the president of the ifo Institute in Munich, Professor Hans-Werner Sinn, brought a similar point home with regard to Germany’s relative economic growth performance.3 Schlusslicht (taillamp) was able to replace the metaphor of the Reformstau (reform jam) as the recurring theme of television talk shows and newspaper editorials. Examination of the average growth rates for well over a decade now in the EU-15, U.S. and Japan in Figure 2 reveals an enormous variance from high-flying Ireland to the liquidity- trapped Japan. Alas it is true. The last place of the EU-15 for average economic growth goes to 4 Germany. It is small consolation that the sick man of Europe has only managed to hobble slightly faster than the sick man of Asia. << Insert Figures 1-3 approximately here>> Having looked back in time and across much of the European continent, there is more bad news if we look into the German future as far as professional demographers claim to be able to see. Figure 3 reveals the workings of a demographic infernal machine that certainly has the potential to destroy existing unfunded systems of public pensions, health care insurance and insurance for long-term care. Plotted in Figure 3 are the historical as well as projected number of senior citizens (defined as those 65 years of age and older) and juniors (below the age of 20 years), both relative to the population in the working ages between 20 and 64 years of age. Similar trends are witnessed across the world so it is useful to put the German demographics in a comparative context. As the present time Germany’s senior ratio is higher than 49 of the 50 U.S. states. While one is not surprised that Florida is, statistically speaking, grayer than Germany, most people are surprised to learn that within only a couple years, the senior ratio in Germany will actually pass that of Florida. These demographic trends pose problems for the sustainability of all systems of social insurance that are funded on a pay-as-you-go basis, i.e. the benefits paid out in a calendar period equals the contributions paid in by contributors during the same period. Either social insurance contribution rates need to be raised or entitlements cut for beneficiaries in order for such systems to stay in balance as the ratio of beneficiaries to the population paying into the system gets larger. This demographic trend is of central importance for pensions and long- term care systems and it is an important part of the story for the future development of aggregate health care costs (there is also a medical cost explosion worth worrying about).