The pathway to Germany’s low unemployment

Following the fall of the Berlin Wall in 1989, Germany was reunified a year later. The German government at the time argued that unification could be achieved without major costs.

The truth, however, was that reunification came at a significant cost to the German economy in the short term, though Germany is now the economic success story in Europe.

The lessons of how the German labour market coped with the stresses of reunification have some relevance for the rest of Europe today.

Before unification the unemployment rate in West Germany had been 5 per cent.

However, at an early stage in the unification process it was decided that the deutschmark and the ostmark would be exchanged at parity, which resulted in wage rates in the single currency being the same in East and West.

Given that productivity in the East was dramatically lower than in the West, the result was the closure of much of the old East German economy, resulting in unemployment rates of over 20 per cent in some of the Eastern Länder .

Brave choice

The decision to move immediately to a unified labour market was a brave one. It meant that, instead of growth in the East being driven by lower costs, Germany as a whole had to grow more rapidly to provide jobs for the large number of people in the East who suddenly found themselves unemployed.

In turn this had consequences for everyone in the new united Germany.

In the immediate aftermath of unification there was a major building boom, which also sucked in workers from outside Germany, including from Ireland. This helped minimise the immediate impact of unification on unemployment.

However, by the middle of the 1990s unemployment everywhere in Germany had risen to levels not seen for decades.

In 1997 the unemployment rate was almost 10 per cent (in the first graph, above), very similar to the rate in Ireland. However, Ireland’s unemployment rate was falling rapidly whereas Germany’s was rising, even though the European economy was booming.

German unemployment eventually peaked at over 11 per cent in 2005, when Ireland's was below 5 per cent.

Germany had a major labour market problem in the late 1990s. Today the situation is reversed. German unemployment, at 5 per cent, is around half of the Irish or EU rate.

How did it achieve this major transformation?

The first and most important point to make is that the adjustment process necessary to return the German economy to full employment had proceeded from immediately after unification even if the benefits of the adjustment took time to appear in the headline numbers. This reflects the fact that the German economy is a bit like a supertanker – it takes a long time to turn around.

Wage rates

A key factor in eventually returning Germany to full employment was that, over a period of around 15 years, German wage rates grew much more slowly than wage rates elsewhere in the EU15 (the second graph, above).

This was the price that the German population had to pay to return the country to the pre-unification level of unemployment.

If wage rates had fallen more rapidly in the early 1990s, or if Germany had been able to devalue, the adjustment might have been accomplished more rapidly.

Nonetheless, a key lesson is that if an economy like Germany in the 1990s is suffering from high unemployment, in spite of good growth in external markets, competitiveness needs to be improved.

A second important factor in returning Germany to full employment was the so-called Hartz package of reforms introduced in 2004.

These involved cuts in benefits and measures to make the labour market more flexible.

Lower benefit rates may have contributed to a rise in inequality but these changes also played a significant role in returning Germany to full employment. (Now that the labour market has fully adjusted some elements of the Hartz reforms have been modified by the current German government).

The German experience shows that unification of two countries or regions may require a major cut in everyone’s standard of living to ensure that the smaller, low productivity region grows sufficiently rapidly to ensure full employment.

Any reunification of Ireland would require major sacrifices by the population on the island as a whole to make it work. A second lesson is that wage rates need to be competitive.

In Ireland the necessary adjustment after the economic crash has probably already been completed, albeit in a much shorter time than was the case with Germany.

Flexible labour market

The third lesson is that the labour market needs to be flexible. While this was a prescription for some countries in the current crisis, such as Spain, neither the Irish Government nor the troika suggested major changes in Ireland – which already had quite a flexible labour market.

A fourth factor in the German labour market success was that Germany was able to build on an exceptionally successful exporting sector to grow out of unemployment, just as is the case with Ireland.

Greece, however, does not have a healthy export economy, and a different approach may be needed.

There is one other vital factor in the German labour market success story which is not often recognised by German politicians. In undertaking the painful adjustment over a prolonged period the German economy had the huge advantage that its neighbours in the EU, as well as in the rest of the world, were growing rapidly.

This suggests that Europe needs a significant fiscal stimulus to complement the other policy measures that proved successful in returning the German economy to full employment.