Germany Finally Fit for the Euro

Germans have a half-deserved reputation for interpreting rules more rigidly than they were meant to be. On this basis, Germany would finally qualify to join the euro by the end of 2018 again.

Excellent fiscal data for the first half of 2018 suggest that the German ratio of public debt to GDP will fall to 60% at the end of this year — from 64.1% last year. Germany would thus hit exactly the Maastricht debt threshold.

Driven by a 7.2% surge in income and wealth taxes, as well as the 4.2% year-on-year gain in payroll taxes, Germany’s overall tax revenues rose by 5% year-on-year the first half of 2018. Strong increases in employment and a gradual advance in wage inflation underpin the encouraging revenue trend.

Although expenditure growth will likely pick up substantially, the fiscal result for 2018 looks set to come in at a surplus of 1.7% of GDP, after a 1.2% surplus in 2017. Along with a 3.6% rise in nominal GDP, that brings Germany’s debt-to-GDP ratio down to 60%.

The rewards of reform

Germany’s fiscal strength has one big reason. No, it’s not German exports. Nor is it due to the euro’s exchange rate. And it’s not austerity either. After all, Germany’s fiscal policy has been mildly expansionary since 2015.

Instead, Germany is reaping the rewards of its 2003-2005 labor market reforms. Core employment (i.e., subject to payroll taxes) has surged by 25% since early 2006, breaking a downtrend that had begun in 1993.

Upon the 1999 start of the euro, Germany had been the sick man of Europe. As German budget deficits surpassed the 3% level from 2001 through 2005, Germany’s debt ratio had exceeded 60% even before the post-Lehman recession.

It’s the labor market, stupid

That Germany’s post-reform strength lies in the labor market rather than in its export performance or in the occasional exchange rate gyrations became very visible during the great financial crisis of 2008/09. While German exports fell by 14.3% in real terms in 2009 and GDP contracted by 5.6%, core employment stayed almost stable with a mere drop by 0.1%.

Encouraged also by a small fiscal incentive, German companies chose to hold on to almost all their qualified workers throughout the temporary, but sharp fall in demand.

During the much milder recession of 2001, companies had taken the downturn as an opportunity to reduce the workforce. In the reformed labor market, they value their workers more than before.

Germany not investing enough?

That Germany should spend more is a common refrain in global policy discussions. While often overdone, the point is valid. Germany certainly has the money to spend more.

The constraints which stand in the way of more dynamic investment are lengthy planning procedures and a dearth of construction workers, which can be addressed only gradually.

Conclusion for the rest of Europe

Countries with structural rigidities and a chronic fiscal problem, such as Italy and France, need to reform their labor market and make their countries better places to invest and create jobs.

Whereas France is going the right way, Italy has started to backtrack on earlier reforms.