Putin’s War and the German Economic Model

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MUNICH – Will the German economic model survive Russian President Vladimir Putin’s war against Ukraine? As I noted in a recent lecture at Harvard University, answering this question requires revisiting recent economic history.

Germany’s economy transformed after the fall of communism in 1989. The liberalization of trade with the country’s eastern neighbors had three profound effects in the country. First, it led to decentralized wage bargaining. Second, it had a flattening effect on line management in German companies. And third, he extended German production networks in Central and Eastern Europe.

On the one hand, the opening up of ex-Communist Europe – where labor costs were lower – changed the balance of power between trade unions and the German employers’ federation. With the loss of the bargaining power of unions, wage negotiations moved from the national level to the company level.

As a result of this new structural wage moderation (called Lohnzurückhaltung), unit labor costs in Germany fell by 30% between 1995 and 2012. Germany was the only country in Europe to experience such declines. While the Hartz labor market reforms of 2002-05 are often blamed for lowering German wages, the data indicates that they played no part in this development.

The opening of ex-communist countries also introduced decentralized management. As trade became more internationalized and competitive, innovation and the generation of new ideas became more important. To encourage more creativity among workers, German companies have delegated decision-making power to lower levels of management.

This approach has proven to be very effective. The German corporate culture increasingly championed quality, and empowerment of lower levels of management led companies to introduce more products that customers liked. The typical (median) German firm that adopted decentralized management tripled its export market share, while firms that retained centralized management generally did not experience such gains.

Finally, the opening up of ex-Communist Europe led to the expansion of production networks, which reduced costs and helped Germany deal with a severe skills shortage. Germany’s eastern neighbors offered a large pool of skilled workers, especially engineers. In 1998, 16% of the population of these countries had a university degree, compared to 15% of Germans.

Moreover, the growth of Germany’s human capital stock (based on measures in five educational attainment categories) had slowed to an annual rate of 0.18% in the 1990s, from 0.75% in the 1980s. Thus, when German companies invest in Central and Eastern Europe, they employ three times as many university graduates and 11% more research personnel in their subsidiaries than in their parent companies.

By the end of the 2000s, the resulting supply chains had reduced costs and increased the productivity of German multinational companies by more than 20%. Germany, which was the sick man of Europe in the 1990s, has become the economic power it is today.

Will these economic arrangements survive Russia’s invasion of Ukraine? To answer this, it is useful to revisit the period following the global financial crisis of 2008. While transnational supply chains were a major driver of globalization after the fall of communism, and especially after the entry of the China into the World Trade Organization in 2001, they stopped growing after 2008. Heightened global uncertainty has led to an accelerating trend of relocation to high-income countries. , including Germany. The risk of non-delivery of key inputs has prompted companies in high-income countries to reassess their production networks.

While the global financial crisis put an end to hyper-globalization, the COVID-19 pandemic appears to have triggered de-globalization. The coronavirus has introduced an unprecedented degree of global uncertainty, compounding the legacy effects of the 2008 shock. Kemal Kilic of LMU Munich and I estimate that COVID-19 has reduced global supply chains by 35%, measured by imported inputs from developing countries as a share of total inputs.

Today, Putin’s war is accelerating the de-globalization that COVID-19 has unleashed. The war sent shockwaves throughout the global economy and further heightened global uncertainty. Worse still, Russia’s aggression appears to be just a violent manifestation of a larger authoritarian tendency.

A world of increasingly assertive autocracies is hardly conducive to trade, global supply chains and foreign direct investment. China’s recent moves are particularly worrying. China has sanctioned imports from Lithuania in retaliation for the country hosting a Taiwanese representative office, and imposed tariffs on imports from Australia after Australian officials criticized Chinese obstruction in the investigation of the origins of the pandemic.

Unfortunately, the weaponization of trade has become all too common and, with the shock of Putin’s war and the continued uncertainty of the pandemic, will prolong the disruption of supply chains. The longer these disruptions last, the more likely it is that companies will completely revamp their supply chains. US Treasury Secretary Janet Yellen has already suggested adding friend-shoring to the list of policy options, alongside reshoring and onshoring. In Germany, friend-shoring is already underway. According to a survey by the Ifo Institute, 50% of German companies with supply chains in China are now rethinking their operations.

The German economic model is not yet dead. But its heavy reliance on international trade means that today’s changing economic and geopolitical environment will present Germany with greater challenges than most other developed countries. The best way for Germany to sustain its post-Cold War economic model is to diversify its trade relations so that it is no longer too exposed to the instability of a particular country or region.

Dalia Marin, professor of international economics at the School of Management at the Technical University of Munich, is a researcher at the Center for Economic Policy Research and a non-resident researcher at Bruegel.

Copyright: Project Syndicate, 2022.
www.project-syndicate.org

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