Much Ado about Nothing? Recent Labour Market Reforms in Germany – a Preliminary Assessment

Abstract

The article examines the macroeconomic effects of the recent labour market reforms in Germany. The reforms increased the downward pressure on wages and led to rising income inequality. Many German economists welcomed this effect, because they consider lower wages and higher wage dispersion major prerequisites for stronger employment growth. The theoretical analysis shows that a strategy of wage restraint might make sense in a small open economy, where exports play a dominating role. However, in a large and less open economy the negative effects of wage restraint on domestic demand are likely to outweigh the positive effects of enhanced competitiveness as could be observed in Germany in recent years. A comparison of the most recent two upswings confirms that the labour intensity of growth has not risen since the reforms. At the same time German wage restraint has contributed to increasing trade imbalances in the euro area. Keywords: Labour market reforms, wage restraint, employment, business cycle 1. Introduction The decisive economic policy issue for the German government in 2003 was how to overcome the deep and persistent economic slump the German economy had dived into after 2001. Low if any growth, surging public deficits and rising unemployment rates then were the dominant economic tendencies. The economic policy debate focused on solutions to all these problems. Since high unemployment had proved very persistent in recent cycles, a major policy change was called for by most German economists. Instead of focusing on stimulating the goods market, the remedy to these problems was sought in the labour market. These developments led to a government reform programme called Agenda 2010.1 The target was to create a more flexible labour market that should stimulate employment and growth. At the end of 2004, the economy took a turn for the better although at the beginning the upturn was rather weak. However, in due course growth accelerated and employment expanded rapidly, too. The question is whether the Agenda 2010 has made a contribution to this positive development. The paper attempts to find a preliminary answer since the upturn was not yet over at the end of 2007 when this paper was completed. In order to derive meaningful results, one has to compare employment performance across business cycles. The present cycle in which reforms have already been implemented is compared to the preceding cycle at the end of the nineties well before the Agenda 2010. Several aspects of labour market performance are analysed. The basic conclusion of this article is that the upturn was not triggered by labour market reforms. Although the employment record of the latest upturn has been slightly better than that of the preceding one, growth has not been more labour intensive and differences have been rather small. At the same time the reforms have had an adverse effect on domestic demand. Thus the assessment of the reforms remains mixed. 2. Some theoretical considerations on labour market reforms The predominant diagnosis since the early nineties has been that the German labour market was too rigid to deal with challenges of the global economy (OECD 1994; SVR 2002; Sinn 2003). The roots of the rigidity are seen in an overly generous social security system and in a wage bargaining system where trade unions have an excessive influence especially in the low wage segment. According to this view, both institutional settings have contributed to high and persistent unemployment. The generous social security system is said to have diminished the incentives for the unemployed to look for a job (SVR 2002, Ziffer 433 ff.; Sinn et al. 2006). The unemployed draw higher utility from their leisure than from employment given the relatively high benefit level. According to this view, rational unemployed persons see no need to accept job offers that would lead to only marginally higher incomes. In other words, the reservation wage is seen as too high leading to prolonged periods of unemployment. …