Germany’s Recession vs. America’s: Doing Worse, but Feeling Better

Douglas J. Elliott
Douglas J. Elliott Former Brookings Expert, Partner - Oliver Wyman

July 28, 2009

The world recession that began in the U.S. is hitting Germany much harder than us, due to a collapse in world trade that has damaged an economy that Germans constantly refer to as “the World Export Champion.” Their economy will have shrunk by about 8% by the time it bottoms, whereas America’s GDP should fall less than 4% from its peak. Intriguingly, the German public and elites feel much better about their situation than Americans do about ours. The key question is whether this represents: a justified faith in a system that works well for them; government measures that delay the pain; German complacency; or some combination of these factors.

I spent a week in Germany recently meeting with dozens of policymakers, academics, journalists, and policy analysts, as a guest of the Konrad Adenauer Foundation[1], a German public policy institute. The overwhelming impression I received was of a fundamental disconnect between the horrible recession and the calmness with which the Germans were facing it. This paper will briefly explore that disconnect, but is not intended as an overall criticism of Germany and its economy. An American observer should be humble indeed in these times about giving economic advice to other countries. However, it still seems to me that the extraordinary recent decline of the German economy should foster more serious questioning than has occurred to date. There seem to be three principal factors behind the phlegmatic German reactions.

First, the public has yet to feel the pain directly and is unlikely to do so until after the Federal elections on September 27th that will determine the make-up of the new parliament. Government programs are providing major subsidies to keep redundant employees on the payroll, at substantially reduced hours. This still has some cost for businesses, but they generally do not want to lay off significant numbers of employees prior to the elections, both out of a desire to support the more business-friendly parties and because they would not wish to be singled out by the politicians in the frenzy of a close election campaign. The clear consensus of those with whom we spoke was that there would be a massive spike in unemployment starting in the Fall.

I was told that a private poll found that only 6% of respondents had felt a significant direct effect from the recession. Another 20-30% had close friends or relatives who were affected, which still left a clear majority who just were not seeing the impact. In fact, about a third of respondents did not think they would ever see significant harm to themselves or others close to them from the recession. In addition to the delayed reaction caused by the temporary unemployment measures, the level of anxiety is almost certainly reduced by Germany’s generous social safety net, which provides a considerable degree of cushioning for those who do end up unemployed.

These polling figures contrast sharply with those for American attitudes. Here, fear is widespread, in part because unemployment has risen sharply already and is poised to go higher still. We have also been struck by the housing crisis that affects tens of millions of Americans directly or indirectly and which does not plague Germany. (Germany had a massive construction bubble after Reunification. The bursting of that bubble played a major role in preventing them from following in the over-optimistic path of the U.S., the U.K., and Spain in recent times.)

Second, Germans have great faith in their overall economic model. There is a very widespread belief, across the great middle ground of the political landscape, that their “social market” system is right for Germany. The term is amorphous, but refers to a consensus approach in which business is allowed to operate in a fundamentally capitalist manner, but with high levels of taxes/social contributions and a number of operating limitations. These limitations include such things as restricted opening hours for shops and a requirement that many corporate decisions are approved by a Supervisory Board that includes union representation.

Equally importantly, Germany is justifiably proud of its prowess in exports, particularly industrial machinery and automobiles. Somewhere between 40% and 50% of Germany’s GDP comes from exports, depending on when and how you measure it. This is more than three times that of the U.S., although it is important to note that Germany is a considerably smaller country and is closely integrated with its European neighbors, who are the largest importers of German products. (If the U.S. counted sales from the Northeast to California as exports, our figure would be sharply higher than it is.) Germans view their trade surplus as a sign of virtue and the source of overseas investments that will carry the country through a future in which their aging population cuts back on output and necessarily lives more on the fruits of past labor.

Third, Germans are somewhat puzzled when pushed by outsiders to make changes to their overall model. They believe it has worked extremely well for them and consequently were resistant in the past to all but the most compelling changes when foreigners were lecturing them about rigidities in their system, even though those foreigners were then enjoying better growth and lower unemployment than Germany. Now that it appears to Germans that the advice was coming from people who have massively messed up their own systems, they are even less inclined to change. In addition, I believe that there is a sense of resignation about being able to change very much while staying consistent with the social market approach and the reality of their business systems.

The largest vulnerability of the German economy is their heavy reliance on exports. However, there is great resistance to changing this. Germans often seem to interpret the suggestion to do so as a call to do a worse job of exporting, which would indeed be a mistake. The real advice is to free up their service sector more and to reduce the disincentives to consume. If domestic consumption and the service sector grew, Germans would become less dependent on the success of their manufacturing exports.

It seems ironic to an American that Germans, generally so careful, would build an economy so exposed to a single factor. There appears to be an almost unconscious belief that since the world crisis was not their fault, there is no need to change their model. However, this ignores the likelihood that other major countries will have problems in the future. Germany will remain exposed to the mistakes of others as long as exports dominate their economy. Even a great German driver in one of their best cars is exposed to the risks posed by drunk drivers on the road, which is one reason for the many safety features built into their autos.

In sum, the German views can be over-simplified, indeed caricatured, as follows. The U.S. and the U.K. created a catastrophe in the financial system, leading to a severe recession in those countries, which then spread around the world. The global recession created an “export shock” for Germany as world trade fell by about a quarter. The effects of that one-time shock should stabilize soon, allowing Germany to find its feet and then shift to growth, albeit slow growth. The economy will be 8% smaller at the bottom, but the basic German model of export orientation and a social market will remain intact and provide a good future. It makes sense for Germany to make a few changes around the edges, such as somewhat tougher financial regulation, but there is no need to pursue anything more sweeping.

To an American ear, it sounds unreasonable to be so little inclined to examine your core assumptions at a time when your economy is suffering twice as badly as the supposedly severely mismanaged U.S. economy and your experience is significantly worse than anything since the trauma of World War II and the immediate post-war period. It does not make it any more understandable that the only other major economy suffering so badly is Japan, which has been struggling for many years to find its way economically.

Of course, the Germans could be right in their two core premises: (a) the German way of doing things provides them the right balance of security and growth over the long haul and (b) the export shock will pass soon and they will be able to gradually move back to their pre-crisis growth rates. Only time will tell.

However, if I were a betting man, I would put my money on a significantly less complacent Germany in six months to a year. By that point, the Germans are likely to have discontinued their expensive labor subsidies, given their horror of budget deficits. That horror is exemplified by a recent constitutional amendment to phase them out over time. Unemployment will have shot up by at least a million people, largely undoing one of the proud achievements of the current government in bringing unemployment down from about 5 million to well under 4 million. This unemployment shock should bring home the magnitude of the crisis to most Germans, even with the strong safety net available to protect the unemployed. All of this will be worse still if, as I fear, the rest of the world does not resume its imports of German cars and machinery as quickly as is hoped. A slowdown in consumption could hold auto purchases down more than expected and it is likely that parts of the world over-invested in industrial machinery in the recent past and will take some time to resume buying in volume.

The German economy has done extremely well in some respects, particularly in exports, and the Germans have shown an admirable thrift. However, all economic models should be re-examined periodically and a period of extreme stress such as today seems an especially good time to review one’s assumptions.

[1] The Konrad Adenaeur Foundation is closely associated with the Christian Democratic Union, the party of Chancellor Angela Merkel. However, I do not believe this created a significant bias in the messages that we heard. The meetings included a wide range of people in and out of politics and the views expressed about the economy were consistent with media accounts of German views.