Europe's shrinking giants

Feb 15th 2005
From The Economist Global Agenda


The economies of Germany and Italy both shrank in the past quarter. But Germany’s prospects look less grim than those of its southern neighbour





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EUROPE’S biggest economy got a little smaller last quarter. Germany’s GDP shrank at an annualised rate of 0.9% in the last three months of 2004, according to first estimates released on Tuesday January 15th. The economy thus failed to live up to the diminished expectations of analysts, who anticipated some growth, however weak, in Europe’s supine giant.

Germany’s is not the only big European economy stretched flat on its back. Italy’s GDP also fell, at an annualised rate of 1.2%, in the fourth quarter. The euro area as a whole managed to grow at an anaemic annual pace of about 0.8%, pulled along by France, which grew by 2.8%, and Spain, which reported healthy growth of 3.2%. The euro-area countries share a common currency, but not a common fate.

Germany’s plight is perhaps the most puzzling. The typical German recovery is led by exports, and 2004 was a vintage year for world trade. Germany carried off the prize for the world’s leading exporter (of goods, if not of services) for the second year in a row. But Germany’s impressive performance overseas failed to stir much demand at home. The stimulating effects of foreign sales normally multiply throughout the domestic economy. But this time, the “export multiplier”, as economists call it, came to nought.

What went wrong? According to Goldman Sachs, an investment bank, Germany’s “silent corporate revolution” may be partly to blame. The much noisier overhaul of Germany’s welfare system, pursued by Gerhard Schröder, the chancellor, may also have been a factor. German firms have squeezed extra hours out of their workers, but for no extra pay. In June, for example, Siemens lengthened the working week from 35 hours to 40 in two plants, without raising wages. Wage moderation has also prevailed in Germany’s public sector. Workers, therefore, had no extra money to spend: retail sales fell in December, for the third month in four. The shops, in turn, had no reason to hire. Thus the sales assistants they might have employed remained on Germany’s jobless rolls, which topped 5m in December, where they linger, waiting for Mr Schröder to cut their benefits.

The contrast with France is quite stark. Buoyed by low interest rates and high house prices, the French have shed their reluctance to spend. Goldman Sachs reports that French household consumption, in real terms, increased by 8.7% between 2000 and 2004. In Germany, it grew by just 0.8%. The French economy has thus enjoyed several spurts of growth in recent years. It is, says Charles Dumas of Lombard Street Research, an economic consultancy, a race between the French hare and the German tortoise.

There are now some hopeful signs of the German tortoise coming out of his shell. The country’s corporate revolution has weakened labour’s claim on the national product, leaving more room for profits. That, and low interest rates, should encourage firms to invest and, eventually, with luck, create jobs. German makers of machinery and the like reported strong interest in their products in December. Indeed, orders from German customers reached their highest level since records began in 1991. The mood of analysts and institutional investors is also lifting, according to Germany’s Centre for European Economic Research (ZEW). Its widely-watched index of economic sentiment, released on Tuesday, showed a clear improvement in February, following a similar rise the month before.

Reasons for optimism are harder to find in Italy. For years, the Italians congratulated themselves over il sorpasso, their national income’s surpassing of Britain’s (since reversed). The tightly-knit clusters of textile firms that dotted the Emilia-Romagna region inspired a new interest in industrial ecology, as governments everywhere tried to cultivate their own thriving industrial districts.

Many in Italy now think their industrial ecology is facing a wave of extinction. The Italians, like the Germans, fear the competitive threat from eastern Europe and East Asia. Neither country can possibly compete with the low-wage labour such countries offer. But the Italians, unlike the Germans, thus seem to have concluded that restraining labour costs is futile.

Such defeatism is misplaced. Competitiveness is not simply a matter of low wages. In the Czech Republic, for example, manufacturing wages are less than a fifth of those paid in Germany. But Czech workers are also much less productive. Thus the labour costs of making a unit of output, according to Goldman Sachs, are 72% of the costs incurred in Germany.

Besides, competitiveness is a matter of degree, not kind. Raising competitiveness a notch raises an economy’s prospects incrementally. As Germany has gained a grip on the cost of its labour, it has maintained its share of world export markets, even as Italy’s has declined. The Italians therefore need to emulate Germany’s silent corporate revolution—although not much in Italy happens noiselessly. The revolution’s rewards may be slow and incremental. But that is better than adding to the country’s slow and steady losses.