Don’t Leave it to Angela Merkel to Define ‘Structural Reforms’

How rising income inequality contributed to Germany’s macroeconomic imbalances.

‘New growth agenda’ or ‘structural reforms’? This seems to be the new dividing line in the economic policy debate in Europe, opposing, in particular, the German Chancellor Angela Merkel and the new President of France, Francois Hollande. Although everybody agrees that Europe will need economic growth to solve its debt problem along with the mounting social and political tensions, opinions differ substantially on how to achieve growth.

While Francois Hollande has run his electoral campaign on the promise to renegotiate the fiscal compact and to develop an alternative to the current fiscal austerity policies all over Europe, Angela Merkel does not miss any opportunity to dismiss ‘the temptation to promote growth with debt once again’. Rather, for the German government there appears to be only one solution for sustainable long-term growth: ‘structural reforms’.

The interpretation of the term ‘structural reforms’ of the German government is highly problematic for two reasons. First, an argument for structural reforms is not an argument against expansionary (or less contractionary) fiscal policies. The reason is that structural reforms address long-term deficiencies of the economy, whereas fiscal policy deals with short-term cyclical issues.

However, as is well known, long and severe recessions which might be amplified or even caused by pro-cyclical fiscal policy are likely to increase structural unemployment and to decrease potential output. The longer people are unemployed the more skills and motivation they will lose; if enterprises go bankrupt due to a lack of demand, firm-specific knowledge is lost and entrepreneurial spirit as well; and since in a recession nobody is willing to invest the existing capital stock declines thus reducing the economy’s future growth potential. In short, pro-cyclical fiscal policy in an environment of weak aggregate demand is very likely to increase the seeming ‘necessity’ of ‘structural reforms’. In other words, the more Europe listens to Hollande, the less Merkel is needed afterwards.

Second, and equally important ‘structural reforms’ is merely a catchphrase that can mean almost anything. Clearly, the reduction of employment protection or unemployment benefits and other measures to reduce the bargaining power of labour are no more structural in nature than the introduction of a legal minimum wage or higher taxes on top incomes, wealth, and financial speculation aiming at reducing income inequality and improving the budget situation.

It is more likely that different sets of reforms are required for different countries, depending on their specific structural deficiencies. Moreover, structural factors can be expected to interact in a complex manner with the way fiscal policy is conducted in any particular country. Yet, the types of policies the German government currently seems to be recommending to everybody typically imply the deregulation of labour and product markets, the weakening of the bargaining position of workers and unions, and persistent cutbacks of the welfare state.

As is now widely recognised, the main structural cause of the euro crisis were the large and rising current account imbalances since the early 2000s. Those current account imbalances led to high foreign debt levels in today’s crisis countries and, by implication, the accumulation of foreign loans in the surplus countries, especially in Germany. Hence, appropriate structural reforms would have to address both, excessive current account surpluses and deficits.

But most empirical studies are unable to find any robust effects of product and labour market regulations on the current account. A recent International Monetary Fund (IMF) Working Paper, for instance, summarises the current state of the literature as follows:

[T]he role of the structural factors in the emergence of these imbalances remains an open question. The overall impact of the commonly recommended package of structural policies such as liberalization of product, services and credit markets, reduction in employment protection, removal of other labor market rigidities as well as reduction in business taxation remains unclear.

So why is it that the German government insists so strongly on one-size-fits-all labour and product market reforms? It might have to do with ideology or clientelism, but it is unlikely to solve the current problems.

In a recent paper, Simon Sturn and I review the current debates about the necessity of current account rebalancing within the euro area and conclude that proposals to tackle these imbalances via further and simultaneous labour and product market deregulation in all countries will not be successful. Rather, we argue that in the case of Germany both structural reforms aiming at lowering income inequality and more active fiscal policies will be necessary to reduce Germany’s excessive current account surplus.

In fact, it is highly doubtful whether the deregulation of the labour market in the 2000s can account for the currently very positive employment performance in Germany. The strength of the German labour market, which saved so many jobs in the downturn of 2008/2009, stems from its high ‘internal flexibility’, i.e., variations in regular working hours and overtime work, working time accounts, and publicly funded short-time working schemes, and not ‘external flexibility’ which relies on easier hiring and firing (see also here). So while deregulation policies do not explain the good employment performance in Germany, they likely contributed to the widening of inequality and the stagnation of domestic demand.

In particular, we argue that the implementation of reforms to make the labour market more flexible and unemployment and old-age benefits less generous has not only contributed to rising inequality but also to the higher precautionary savings of middle-class workers (see also here).

This reaction by households can in part be attributed to the specificities of the German production and labour market model, as emphasised by the ‘varieties of capitalism’ literature. In particular, the prevalence of vocational, i.e., firm-specific rather than general qualifications of workers, implies that policies aimed at raising the ‘external flexibility’ of the labour market together with rising income inequality increase the perceived and actual risk of skill depreciation for workers.

The risk of status loss for middle class families is corroborated by low female participation in the paid labour force, favoured by a tax system that subsidises the single (male) bread earner model and a very high gender pay gap. This makes the incomes of many families strongly dependent on the wage income of a single (male) worker.

Moreover, the low reactivity of monetary and fiscal policy to business cycle fluctuations and unemployment, which is due partly to the economic policy regime of the euro area but also to the institutional and ideological specificities of economic policy in Germany, further increases the risk of persistent status loss for workers: workers accumulate precautionary savings, which depresses domestic demand, because they cannot count on monetary and fiscal policy to fight unemployment in case of an unexpected adverse cyclical shock. Since the early 2000s large structural cuts in taxes, mainly benefiting high-income groups, and government spending have further contributed to both higher inequality and persistently low domestic demand.

We conclude in the paper that rising inequality has been one of the structural causes of the macroeconomic imbalances that have led to the global crisis after 2008 not only in the United States (see also here) but also in Germany. Structural reforms aimed at reducing inequality are necessary to overcome the structural macroeconomic imbalances, i.e. weak private consumption demand and a strong dependence on foreign demand of the German economy.

We should not leave it to Angela Merkel to define the meaning of ‘structural reforms’. Long-run, structural policies do matter (and they interact with short-run fiscal policies). But different sets of policies are required according to country-specific contexts. And current account surplus countries, of which Germany is the most important, will have a crucial role to play in the necessary structural adjustments within the euro area.

This article is part of the European growth strategy expert sourcing jointly organised by Social Europe Journal, the Friedrich-Ebert-Stiftung, the Bertelsmann Stiftung, the IMK of the Hans Boeckler Stiftung and the European Trade Union Institute (ETUI).