The Economy of Germany: Power Of The Mittelstand

This is Germany, the fourth largest economy in the world with the largest export surplus, though it's easy to forget that as the Federal Republic of Germany entered the 21st century, it was known as the sick man of Europe, averaging a GDP growth rate of just 1.2% per year between 1998 and 2005. How did Germany turn it all around to become something of an economic outlier amongst developed economies? To answer this, we must first look at Germany 70 years ago. Why did post-war West Germany matter? To understand the modern German economy, you have to start with one of its predecessors. The end of World War II saw the country split, a capitalist West and a communist East, the West being roughly two and a half times the size, with a similar population ratio. At the end of the war, Germany lay in ruins, production was down by a third and millions were left homeless. Yet the 1950s saw the emergence of the German economic miracle, averaging 8% growth per year to become the largest economy in Europe. A widely cited claim is that West Germany benefited from the US post-war reconstruction funds, known as the Marshall Plan, which is true, but doesn't tell the whole picture. For example, Britain received a third more aid than West Germany, 2.7 billion dollars against 1.7 billion, with West Germans receiving roughly 33 dollars per person. Significant, but not enough to explain West Germany's economic miracle. And this is where Ludwig Erthard comes in. Nicknamed the father of Germany's economic miracle, Ludwig was an economist by trade. Towards the end of the Second World War, he wrote a daring economic paper hypothesising what would happen if the Nazis lost the war. And this didn't go unnoticed by US army intelligence, quickly rising the ranks to become the architect of West Germany's economic transformation as economics minister and then chancellor. His most radical moves involved reducing the money supply by 93% overnight to restore faith in the currency, as well as doing away with price controls. Something which had led to a large black market economy, though perhaps he is most well known for helping to establish Germany's own take on economics. The social market economy, combining free market attitudes with social security protections. Ludwig's bold moves paid off, with the economy improving dramatically. By 1958, industrial output was four times higher than it had been a decade earlier. For factors we'll be discussing later, West Germany went on to become an exporting powerhouse. But to go back to the original question of how Germany became the sick man of Europe, this has a lot to do with reunification of East and West. Whilst West Germany became an economic superstar, East Germany, the large chunk of the country under communist rule, well, they didn't do so well. It's estimated that by the year the wall came down, East German productivity was roughly half that of West Germany. Up until the early 1970s, East Germany had continued to grow, but increasing centralisation of the economy and an inability to innovate made the system much less competitive, leading to stagnation and decline. Though to be fair, they were starting from a much lower base. Taking a look at this table suggests total per capita war damage was a lot higher in the East, particularly due to harsher war reparations by the Soviets and the dismantling of industries. By the time of reunification, this created a bit of a problem. So, what was the economic impact of reunification? To prevent a mass migration of the whole of East Germany to West Germany, the West German government promised to raise the East up to the same standard, and crucially, this included wages, within 5 years. Now, one of the very first things that the new state did was to abolish the East German Central Bank and hand over control to the West German Central Bank, the Bundesbank, meaning they had to get rid of the East German currency in favour of the much stronger, institutionally sound Deutschmark. However, this created a fundamental dilemma, what level to set the exchange rate at? Officially, the East Germans had historically tried to fix their weaker currency at 1 to 1, which was a bit of an economic fairy tale, though if the new state tried to reflect the true market rate, it would completely destroy the wealth of East Germany, an already fragile economy, so to compromise, they capped the amount of money you could exchange at a rate of 1 to 1, with any exchange beyond that at a less favourable rate. Whilst this was a valiant attempt to solve an immediate issue, it now meant that East German businesses had to compete with West German ones at the same exchange rate, something a lot of them simply couldn't do. The solution was to facilitate massive movements of money or fiscal transfers from the wealthy West to help develop the East. As any economist will tell you, monetary union without fiscal union is, well, a bit of a disaster. It's estimated that the government has spent over 2 trillion dollars on these transfers over the years, something funded in part by the Solidarity Tax, which is an additional tax on income at around 5% for most citizens, though this is set to be abolished for the majority as spending has gone down over the years. Now, the main trouble with reunification was that it put an enormous strain on the German economy, throwing it out of equilibrium as two very different economic systems try to integrate, something often cited for Germany's sick man of Europe status in the 90s and early 2000s, where debt rose from 40% to 67% and unemployment peaked at over 11% in 2005. Yet today, Germany is an exporting powerhouse, as this graph shows. Note, this doesn't mean that they export the most. A simple way to look at it is that the net difference between exports and imports gives it the largest positive surplus in the world. Leading us to ask how? How did Germany turn its economy around? The simple answer to this is labour market reform. You see, in the 90s and early 2000s a lot of German industry was part of a trade union, where wages for entire sectors would increase based on collective bargaining. Over time, this had made the German export industry less competitive, even after accounting for typically superior quality. Recognising this, labour market reforms were implemented to provide employers with more flexibility and options to move away from collective wage increases. This enabled German wages to grow at a slower pace than productivity compared to other Eurozone countries, something accepted by German workers due to the unique construct of German industry, as we're about to find out. How the middle stand is key to Germany's export success. People across the world have heard of big German brands, whether that be Mercedes, Volkswagen, Siemens or Bosch, to name just a few, though around two-thirds of exports come from the nation's small to medium-sized enterprises, otherwise known as the Mittelstand. These are family-owned businesses, which make up the core of German industry. Forget the big brands, these businesses are the German economy, geographically spread out, with 70% being based in small cities or rural communities. As family-owned businesses, they focus on factors like customer value, being close to clients, relying on in-house technical competence and fostering very good relationships with their employees, a trust which has helped negotiate the slower wage growth we mentioned earlier, and something also shown by the extremely low number of workers moving companies, at sub-3% per year, the ultimate indicator of employee satisfaction. These businesses think in decades, not financial quarters, rejecting taking on debt to grow, preferring cash investments instead, something which acted as an advantage during the financial crisis, when banks had stopped lending. Interestingly, this aversion to debt is a cultural trait, with the German word for debt being the same as that for guilt. A commitment to quality and long-term planning also means these companies invest more in research and development, registering 5 times more patents per employee than larger companies. Instead of outsourcing components, they will often build these in-house, and yes, whilst this is more expensive, it also gives them complete control and quality assurance. The extent of their success is highlighted by how many are considered to be hidden champions, a company amongst the top three globally for its speciality, with little public recognition. Of an estimated 2,700 companies with these traits worldwide, almost half are German. The reason for this is their business strategy. Le Mittelstand proactively targets sectors too complex for the smallest companies, but not big enough for larger corporations, becoming indispensable market leaders in business-to-business transactions. Now, a common challenge industrial nations face is access to skilled labour, an issue Germany has a unique solution to, how Germany's education system helps drive exports. You see, unlike many of its European counterparts, Germany is not obsessed with sending its children to higher education. Instead, they operate a dual system, where those less academically inclined are placed on apprenticeships, with an emphasis on practical qualifications, spending more time in the workplace than the classroom, becoming highly skilled, dependable employees from a very young age, with less social stigma against those who don't choose to go to university, creating a steady supply of workers to power German industry across the country. However, for all the success of German business, some credit has to be given to Germany's favourable currency position. So how does the Euro benefit Germany especially? Well, in a normal situation, an exchange rate is like nature's way of keeping a country in balance. If exports are too high, demand for the currency increases, making the currency more expensive, with exports becoming less internationally competitive. But, and there is a big but here, this natural order has been distorted. You see, by adopting the Euro alongside the likes of Greece and Portugal, Germany's exchange rate making exports artificially cheaper. Meanwhile, other Eurozone countries have more expensive exports, making them less competitive. This helps to explain the magnitude of Germany's current account surplus, alongside the fact that because the nation is an industrial power, a lot of its imports are commodities, like raw materials. The price of these materials has fallen over recent years as the world exited a commodity super cycle, meaning German exporters were able to import cheaper imports. Moving away from some of its successes, what are the challenges facing the German economy? Well, perhaps its greatest challenge stems from its success, its massive trade surplus. Whilst posting a trade surplus is generally considered a good thing, not the German kind. This is twofold. Firstly, Germany is a fundamental part of the Eurozone, though not the entire thing. The nation runs large surpluses with a number of its neighbours, sucking in vast quantities of Euros, which don't always find their way back into other Eurozone nations. Critics have suggested this suppresses growth, threatening the long-term stability of the currency block. Secondly, export success also means Germany is highly dependent on other countries buying its products. For example, a downturn in global trade in 2019 was a factor in Germany posting economic growth of half a percent. Combine that with fears over protectionism and this creates a threat to the economic growth model. Connected to this is criticism that Germany's domestic consumption rate is too low, something which poses a barrier to stimulating domestic demand in the economy. But to be fair, this is partially a result of the harsh lessons learned through periods of hyperinflation. It's also worth noting that Germany has an ageing population. Now, whilst this isn't something unique to the nation, it is more severe than most. The population is expected to start falling before 2030, when more people aged over 65 will be in employment than under 20. A challenge for future demand, if not labour supply, due to increasing automation. So overall, the German economy has demonstrated an ability to bounce back from the worst of setbacks, something it has been able to survive due to excellent market policies and its little-known heroes, the Mittelstand. Its trade surplus is a hallmark of success, but also the source of one of its greatest challenges. Raising the question, can you have too much of a good thing? And now it's over to you. Do you think Germany staged a great economic comeback? Does the Euro benefit Germany more than others? Let us know your thoughts in the comments below. And if you think we've earned it, consider subscribing and leaving a like. It really helps grow this channel. And as always, see you in the next video.