Good for the Near Term

Op-ed in Welt am Sonntag

November 15, 2009

The German government's past and present macroeconomic response to the financial crisis-including the ambitious Kurzarbeit program and the commitment to keep fiscal stimulus going for now-is probably the right one. After the public criticism that the prior coalition government heaped on other countries and the IMF who advocated fiscal stimulus 2008, it is ironic that Germany will have engaged in some of the greatest total deficit spending efforts by 2011. Still, rhetorical consistency should never prevent policymakers from doing the right thing.

There are ... two major reasons why the well-suited response of the German economy to the crisis may fail in the longer-run as much as it succeeded today. [B]oth ... suggest that ... the German policy agenda has to change soon.

The reason this activist approach is right is that Germany has suffered from the crisis primarily through a collapse in demand. When a macroeconomic shock hits an economy, policymakers have to assess how much of the shock is structural or to the supply side, and how much is due to changes in demand. Structural shocks that lastingly change the relative prospects for different economic sectors or inputs to production have to be adjusted to by the real economy, if slowly. In contrast, demand shocks should be offset by monetary and fiscal policy fully, so long as the government reacts to up cycles and booms as much as it does to downturns in demand.

Some countries in this crisis have been hit by structural as well as demand shocks. Those economies that were heavily dependent on real estate booms or growth in financial services have not only seen output decline sharply, but will have to reallocate capital and labor into other activities. Those countries that were consuming far more than investing for many years will have to get their export sectors going while their saving rates increase. The German economy clearly suffered from a decline in export demand and from losses on investments when financial markets were hit, but was largely untouched on the supply side in this crisis.

As a result, this crisis played to the German economic system's strengths. Large automatic stabilizers from tax declines and social benefits maintained household income. Discretionary fiscal stimulus went further in the same direction as needed. The Kurzarbeit programs limited unemployment to an astonishing degree, given the size of the output drop. Even the banking system, to the degree that Hausbank-type relationships meant small business loans were carried over past a short-term lack of liquidity, smoothed the process.

All of this works on the assumption that the same jobs for the same workers would reappear, the same businesses would resume sales, and those same workers and businesses would return to paying more taxes once world output resumes growing. In short, the German system and accompanying policy response is terrific if the shock is only temporary. Right now, that seems to be the case with global recovery underway, and with the prospect of most of German export industries (aside from auto production) largely unchanged from before the crisis.

There are, however, two major reasons why the well-suited response of the German economy to the crisis may fail in the longer-run as much as it succeeded today. One is economic and one is political-both are driven by long-term fundamental trends in the global economy. And both of them suggest that for all the justification of the present government sticking to the current course for now, the German policy agenda has to change soon.

First, in economic terms, the more one puts in the kind of structures and policies to keep workers and businesses in place during downturns, the more likely they will be stuck in place for the long-term. Yet, as technology changes and other economies develop, the sectors and skills that are rewarded with high wages change as well. While German manufacturing may sell successfully into a Chinese and emerging market upturn in coming quarters, sticking with those specific businesses in those specific sectors will just continue the downward pressure on German wages of recent decades. Keeping things in place through the crisis in demand must not reinforce existing structural rigidities beyond the crisis.

Second, not every economy can engage in export-led growth at the same time. Politically, Germany insisting simultaneously that the United States and other trade-deficit over-consuming nations must adjust and that Germany will remain Exportweltmeister is inconsistent at best. At worst, it will provoke backlash from other governments, trade protectionism, or pressure on the euro to appreciate further. An escalating cycle of that sort would destroy the export opportunities on which the German economy depends-but that would be a lasting change in structures, not just a fluctuation in demand that can be ridden out.