Hartz IV Worked-As Far As It Went

Sometimes economists do make clear and valid predictions. If you asked economists in 2002 what was the first economic reform to do in Germany, a majority would have said improve labor supply, that is, the number and willingness of workers in Germany to seek employment at a given wage. In particular, most would have said that the first thing to fix under that heading would have been curtailing the duration of unemployment benefits, and that this would increase employment.

The logic of that recommendation is that when unemployment benefits last too long, otherwise able people have significantly reduced incentive to look for a new job. And once people stay out of work a long time, it tends to be more difficult to get them rehired in the labor force, even if they want to be. The cross-national evidence made it pretty clear that it was indeed the duration of unemployment benefits-not so much the generosity in the level of benefits or other terms of the benefit program-that predicted differences across countries and over time in average long-term unemployment rates.

The Hartz IV package of labor market reforms from April 2003 put this recommendation into practice in Germany. Most importantly, it largely equalized the payments of Arbeitshilfegeld and Arbeitslosengeld, which had the same effect as reducing the duration of high benefits. There were some initial problems with implementation and costs, and the adjustments made by the Grand Coalition in July 2006's Fortentwicklung Gesetz helped reduce these. But the fundamental thrust of the reform was clearly about enhancing labor supply by changing incentives. All the talk about other reforms of the labor market, and especially of active labor market policies and improvements in the Federal Labor Office were side shows, even if politics put them in.

The benefits of the Hartz IV reforms were not immediately obvious in 2003-05, (and not just because of the initial reaction of some people to some unintended perverse incentives). The issue was that supply side reforms of the labor market create additional incentive to look for jobs when job opportunities exist. It takes a growing economy to be creating enough jobs at a fast enough rate that labor demand can put to work the unemployed. This is a general characteristic of supply side, and particularly labor market, reforms: You do not see the payoff until a recovery takes place for reasons independent of those reforms.

In the United States, for example, the government passed welfare reform in 1996, which (like Hartz IV) limited the amount of time a specific group of workers could collect unemployment benefits in hopes of giving them incentive to look for work. Luckily, thanks to the extended strong recovery of the US economy in the 1990s, many of these formerly unemployed aid recipients were able to re-enter the labor force and get jobs-and we did not have to find out what would have happened had they been cast off of the welfare rolls with no job opportunities to go to.

The acid test for Hartz IV, thus, was how unemployment would respond when the German economy finally started growing. So after roughly a year-and-a-half of solid economic growth in Germany, we can now make an early assessment. The main news is good: Unemployment has fallen somewhat faster and earlier than it did in previous recoveries in the 1980s and 1990s, for the given amount of growth seen. Moreover, since wage settlements have been quite restrained until just recently, with Germany losing purchasing power due to relative deflation, this is consistent with an outward shifted labor supply curve (as economists say)-in other words, more people are willing to work at any market wage than they were previously. What remains to be seen is how many of these new jobs turn from temporary or part-time to full-time positions, and ultimately whether the composition of unemployment has changed such that a smaller share in Germany are long-term unemployed. There seems little question, however, that Hartz IV with some modifications in practice worked out the way the economists predicted, as far as that goes.

But how far is that? The bulk of reform recommendations to German policymakers from economists in recent years-and in fact the bulk of reforms undertaken or at least pushed for in Germany under both Merkel and Schroeder-have been focused on the labor market. To the degree that anything else has been prioritized in German economic policy, it has been attempts at fiscal restructuring (which is really all the health care plan is about). That is a pretty narrow focus, and neither fiscal nor labor reform alone is likely to generate sustainable growth in Germany simply by itself. The extra jobs created in this recovery, and the savings on public transfers they have generated, have not yet led to a consumption boom or to a significant catch-up with the business investment foregone in previous lean years. They certainly have not led to a surge in productivity growth beyond that which is normal in the first year of any recovery-and by adding lower-productivity workers back into the labor force may even drag down German productivity temporarily. Even if all the labor supply incentives are permanently improved in Germany, and a few hundred thousand formerly unemployed people will remain in jobs after this recovery ends that will not lead to ongoing growth.

Hartz IV was certainly worth doing, especially for the sake of those German citizens who have successfully made the transition back to employment. The success of Hartz IV, however, is not enough to truly benefit all German citizens and to restore the economy's future prospects. The economists and policymakers who emphasized labor supply reform in Germany were proven right in their predictions, but wrong in their priorities. It will take an equally hard look and incentive-based reform approach to Germany's corporate and financial sectors to get the broader economic benefits the German nation deserves and can attain. Some economic logic is unavoidable.