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Shocks to the system: the German political economy under stress.

The German economy is recovering hesitantly from the sharp post-unification boom and recession. Two features of recent West German performance are novel: there has been an unprecedented loss of jobs in industry, and manufacturing profitability has been pushed to its lowest level ever and is now low relative to other OECD economies. Serious problems with labour costs and innovation would be expected to show up in a weakening in the trend of export performance. That this has not yet happened is the consequence of the existence of an apparently robust innovation system which enables companies to pursue high quality incremental innovation strategies. However, the experiment of transferring the West German model to the East has proved extremely costly and has not so far established the basis for self-sustaining growth. Problems in profitability, investment and employment in West Germany reflect the failure of the bargaining system - unions, employers, Bundesbank and public sector - to negotiate the sharing of the burden of unification.

Introduction

There are three broad interpretations of Germany's current economic problems and prospects.(1) According to the first, the problem is one of aggregate demand caused by poor handling of the macroeconomic consequences of unification and exacerbated by the deflationary effects in Germany's markets of the efforts of European Union countries including Germany itself to meet the Maastricht convergence criteria. This interpretation suggests that as the fiscal consolidation targets are met, aggregate demand growth will recover and growth in Germany will return to trend. A less sanguine view is that recent performance reflects longstanding supply-side deficiencies. Innovation is hampered by an institutional environment inimical to risk-taking and entrepreneurship. The problem is compounded by high labour costs due to a combination of an over-blown welfare state and a rigid labour market. The prescription is radical deregulation of the labour market and a 'building down' of the welfare state. A third interpretation is that although a coherent and distinctive German model functioned effectively throughout most of the post-war period, it is no longer viable because the institutional structure is itself unravelling: employers are leaving the employers' associations, companies are unable or unwilling to provide adequate training places for young people and failures of corporate governance abound. By extrapolating these trends, such observers see no alternative but a shift to a deregulated regime.

Whilst there is some truth in all three views, each is misleading. The aim here is to provide an evaluation and diagnosis more firmly rooted in an understanding of German institutional structures. Section 1 examines West German economic performance in the 1980s and 1990s along three dimensions: export performance and competitiveness; profitability, investment and the welfare state; and employment and unemployment. Section 2 sets out the institutional basis for the West German innovation system and its relationship to important dimensions of labour market regulation. The role of wage bargaining and macroeconomic policy in the wake of unification is taken up in section 3. Section 4 analyses the problems with the transfer of the West German model to East Germany. The concluding section argues that the resolution to Germany's economic problems is not straightforward but solutions are more likely to be found within existing institutional structures than outside them.

1. West German economic performance

The growth of per capita GDP in West Germany since the end of the 1950s has been in line with that of other high income OECD economies (e.g. Van de Klundert and Van Schaik, 1996, Carlin, 1996). By the close of the 'Golden Age' in 1973, West Germany had a per capita GDP almost 80 per cent of the level of the US. The gap continued to close slowly through the 1970s and 80s. Maddison's purchasing power parity estimates show that by 1992 West German GDP per capita was 90 per cent of the US level, with GDP per hour worked 95 per cent of the US level (see Tables 1A; 1B, Maddison, 1995).

1.1 Competitiveness and export performance

The analysis of export market shares provides information on the ability of West German industries to compete on world markets: a weakening of performance could reflect a deterioration of cost competitiveness or a decline in the quality advantage of German products. West Germany's cost competitiveness in manufacturing (shown by the series for relative unit labour costs in [ILLUSTRATION FOR CHART 1 OMITTED]) fluctuated around a roughly constant level from the early 1970s to the mid 1980s, but deteriorated sharply in 1986-7 and again through the 1990s. This reflected weak productivity growth as well as wage behaviour and the path of the nominal exchange rate. In both the US and West Germany, manufacturing productivity growth was slower in the 1980s than in the 1973-79 period. Yet the slowdown was more marked in West Germany with annual hourly productivity growth nearly 1 percentage point below that in the US (Table 1C). The British productivity 'miracle' in the 1980s had the effect of taking average productivity growth for the entire 1973-89 period just above that of West Germany - but of course this still leaves British productivity levels well below those of West Germany.

The results of a 'shift-share' analysis by the OECD for the period 1980 to 1992 show a modest increase in Germany's export market share over the period, contrasting with declines in the US and the UK. West Germany's success was attributable to strong competitive performance rather than to changes in the commodity or geographical composition of world trade especially favourable to Germany (OECD, 1995, p.156).

[TABULAR DATA FOR TABLE 1 OMITTED]

[TABULAR DATA FOR TABLE 2 OMITTED]

More precision about West German export performance comes from an econometric study which sought to uncover the determinants of trends in export market shares for the OECD economies using a panel of 12 manufacturing industries over the period from 1976 to 1992 (Carlin, Glyn and Van Reenen, 1996). The expected negative relationship between the change in export market share and the change in relative unit labour costs (RULC) was found. However, West Germany's relative unit labour costs for manufacturing as a whole rose substantially (by 0.9 per cent p.a.) over the period whilst its export market share edged upwards (by 0.1 per cent p.a.) (see Table 2). In the regression analysis, West Germany was the only country with a significantly positive trend in export market share once cost competitiveness was included. Tests suggested that West German exports were not especially insensitive to costs, indicating that they were enhanced by some other factor.

An obvious candidate is a quality advantage that is not captured in the statistical measure of RULC. Technology variables can be used to try to pin down such an effect. One such variable, the relative investment share, did show up as a significant determinant of OECD export market shares in addition to RULC. This variable can be seen as capturing the effects of embodied technical progress additional to those reflected in relative productivity growth (which is already included in the RULC term). But it cannot account for export performance in West Germany, since relative investment was low over this period (see Table 2). Another peculiarity of the West German case is revealed by industry level analysis: once relative labour costs are taken into account, it is the only country without a significant negative trend in export market share in any industry. This suggests that exporters across a wide range of industries were able to innovate successfully (Table 2).

The analysis suggests that there is some feature of the German economic system which helps to sustain export performance in the face of deteriorating costs. Oulton (1996) suggests that human capital may be part of the story. Mason, Van Ark and Wagner's (1994) study of the food processing industry in several European economies indicates that in German plants, human capital may be a substitute for physical capital, which would help to explain the compatibility of strong export performance with relatively weak investment.

The system of innovation described in section 2 provides a broader explanation of the way in which innovation and human capital formation within industries has enabled the West German economy to maintain exports. This is not inconsistent with the regression analysis which suggests that German export performance would be enhanced by a fall in relative unit labour costs and by higher levels of investment. We return in section 3 to the interaction between the wage bargaining system and the determination of the nominal exchange rate which produced such a sharp deterioration in relative unit labour costs and in profitability in the 1990s.

1.2 Profits, investment and the welfare state

The net rate of profit in manufacturing fell sharply in the recession of the early 1980s and then slowly recovered to peak in 1986 at the late 1970s level. It remained stable at just below this level from 1987 to 1991 [ILLUSTRATION FOR CHART 1 OMITTED]. The gross profit share in manufacturing had then almost regained the level of the second half of the 1970s (Table 3). Thus the West German data do not suggest that export market share was being maintained at the cost of a persistent decline in profitability. However, comparative data throw a different light on the issue. It is clear from Table 3 that profitability in West Germany relative to other advanced economies had deteriorated by the early 1990s. The dramatic decline in profitability in the 1990s thus exacerbated a situation in which profits were already rather low relative to competitors.
Table 3. Comparative profitability in manufacturing

 (Gross profit share in gross value added(%))
 1974-78 1979-83 1984-88 1989-93

W Germany 25.9 21.6 24.2 22.0
France 24.7 21.7 27.3 33.1
Italy 28.9 31.6 34.9 31.9
UK 18.2 18.4 22.8 20.9
Europe (10 countries) 24.6 25.0 29.1 28.6
US 24.6 23.4 26.6 28.5
Japan 34.9 34.1 35.7 34.9
OECD (15 countries) 25.9 26.1 30.1 29.6

Source: Glyn (1996).



The trend in the profit (or wage) share has long been used in the German policy debate as a key indicator of the sustainability of welfare state policies and collective bargaining outcomes (Council of Economic Experts Annual Report (SVR), various years). For example, the maintenance of profitability and the absence of a rise in inflation in the face of increased social security contributions would be interpreted as indicating that wage settlements (or productivity) had adjusted appropriately to the increased burden. In turn, a fall in the profit share is interpreted as entailing lower employment both directly and indirectly through its impact on investment. From this perspective, the issue of whether Germany is able to afford its welfare state, which is frequently raised in terms of the magnitude of non-wage labour costs, is another dimension of the complaint that profits are inadequate.

There has been an increase in the burden of social security contributions (which are shared equally between the employer and the employee) over the past two and a half decades: from 26.5 per cent of gross wages in 1970 to 35.8 per cent in 1990 and 40.9 per cent in 1996 (OECD, 1996a, p.76). From 1970 to 1990, the main increase came from higher health contributions (a rise of 4.6 percentage points compared with a rise of 3 percentage points for unemployment benefit and 1.7 percentage points for pension contributions). The increase from 1990 to 1996 was partly due to the new long-term nursing care contribution of 1.7 per cent of gross wages, but was mainly influenced by the consequences of unification, which led to a particularly large rise in unemployment benefit contributions.

Hauser identifies the key to the sustainability of the welfare state as follows: 'there is one fundamental prerequisite for ensuring that external shocks or internal social trends do not endanger the German welfare state. This is that the extent of solidarity amongst members of the society must not diminish.' (1995, p. 54). An increase in pretax and benefit income inequality is one way in which social solidarity could be placed under strain, since it sharpens the distinction between those who are contributing to the welfare state and those who are receiving benefits. This problem was avoided in West Germany in the 1980s where, in contrast to the UK, there appears to have been little change in aggregate earnings inequality (Hauser, 1995, OECD, 1996b). However a major strain on solidarity was imposed by the dramatic increase in transfer payments that followed unification. Since 1991, the West German economy has transferred over 4 per cent of its GDP to the East. Despite this East Germany has had to borrow from the rest of the world. This is reflected in the turnaround in external payments - from a current account surplus of 2.1 per cent of West German GDP in the 1980s to a deficit of 1 per cent of German GDP since unification. Cuts in take-home pay, in welfare state services or in profits in West Germany remain unavoidable if East Germany remains this dependent.

Both the Bundesbank and the Council of Experts see profitability as a determinant of investment and this is confirmed by econometric analysis. Cross country studies of investment in which a profitability variable is included (surveyed in Glyn, 1996) show West Germany as the only country for which profitability is invariably significant. The gross capital stock in manufacturing declined in 1994 [ILLUSTRATION FOR CHART 1 OMITTED] and a sustained period of poor profitability would be expected to weaken fixed investment yet further. It is also likely that poor profitability would reduce the investment by firms in training and in research and development.

1.3 Employment and unemployment Employment

The late 1980s saw a large increase in population in West Germany due to a wave of immigration of Eastern and other ethnic Germans. Employment increased by two and a half million between the employment peaks of 1980 and 1992, with three quarters of the increase coming between 1989 and 1992. By contrast, from 1961 when the Berlin Wall was built up to 1980, employment grew by only half a million. But the sharp recession in the 1990s saw an equally dramatic fall in employment, by 1.3 million in the economy as a whole and by the same amount in manufacturing, amounting to a loss of 14 per cent of manufacturing jobs in West Germany between 1991 and the first half of 1996 [ILLUSTRATION FOR CHART 2 OMITTED].(2) West German manufacturing had employed more workers in 1992 than the combined manufacturing sectors of East and West Germany in 1995.

Compared with the two previous cycles in West Germany, employment fell further in the early 1990s recession, job losses were more heavily concentrated in [TABULAR DATA FOR TABLE 4 OMITTED] manufacturing and stabilisation and recovery of employment is taking a great deal longer (OECD, 1995, pp. 5, 7). Second, it appears that employment reductions have been concentrated on the lower skilled employees and that companies are engaged where feasible in the relocation of activities intensive in the use of less-skilled labour from Germany to the low wage neighbouring countries in Eastern Europe. Investment surveys in the 1990s reported a sharp increase in the intention of large German firms to move production abroad to lower cost locations. These surveys also found that small and medium sized firms which supply inputs for the large ones intend to relocate activities in parallel with the large firms (SVR, 1995, p. 172).

In the 1980s, West Germany participated in the general upturn of foreign direct investment (FDI) outflows (especially within the advanced countries) and there is no evidence that they were more sensitive to relative costs in the 1980s than they had been in the 1960s and 1970s (Barrell et al., 1996). Its performance differed from other advanced economies on the inflow rather than the outflow side of FDI (OECD, 1995). In the second half of the decade, there was an upswing in inflows to the European Union and to the US, but not to West Germany or Japan. It may be difficult for foreign companies to compensate for high and rising relative labour costs by making use of the supporting set of institutional structures outlined in section 2.

The pattern of employment reductions as between more and less skilled workers is important for the interpretation of current German economic problems. Although those without formal qualifications are a shrinking share of the West German labour force, it seems that this group suffered from an especially large rise in unemployment in the 1990s. Comparing 1993 and 1984, when overall unemployment rates were identical, there was an increase of 3 percentage points in the unemployment rate of the least qualified (Buttler and Tessaring, 1993).

Assuming that West Germany was subject to the same technological and trade factors shifting the demand for labour away from the unskilled as other countries, then the presence of some institutional barriers to wage differentiation would have been expected to have produced a greater reduction in employment of workers with lower skills than elsewhere. Yet in the 1980s there was no marked difference as between the US and Germany in the unemployment (or employment rate) patterns for the least qualified group (fewer than 4 years of high school - US; no formal qualifications - West Germany) (Table 4). The male non-employment rate for this group (aged over 25) was 32 per cent in both Germany and the US (1984-1990), with the German group a slightly lower proportion (12 per cent) of the population (Nickell, 1996, note 2).

There has been considerable debate about the causes of the fall in the relative employment rates of people with different levels of education or skills which were common in OECD economies in the 1980s (Wood, 1994, Sachs and Shatz, 1994, Nickell and Bell, 1995). In some of them (especially the US and the UK), the relative wages of the low skill group fell sharply as well. Unfortunately there is less clarity about trends in West Germany. Data from the German Socio-economic Panel covering the whole economy show no change in the gap between the average earnings of the least and most highly qualified groups between 1984 and 1992 (Gosling, 1996), which is consistent with the picture of an unchanged earnings distribution coming from the same data source (OECD, 1996b, Table 3.1). The current controversy over these trends (Moller, 1996, Steiner and Wagner, 1996) suggests that there may have been some increase in earnings dispersion over the 1980s but much less than was the case in the US and the UK.

An unambiguous difference between West Germany and the US in the 1980s is the strong growth of real wages of the lowest paid in West Germany - whether measured by lowest decile earners or those without formal qualifications - compared with falls in the US (Moller, 1996, OECD, 1996b, [ILLUSTRATION FOR CHART 3.3 OMITTED]). The fact that this produced no worse an unemployment outcome than in the US can perhaps be explained by the fact that the least qualified group in West Germany had a higher level of basic education than the comparable groups in the US or UK, which made adaptation to increased demands in the labour market easier (Prais, 1995, Nickell, 1996). In addition, there was a big increase in the entry to the labour market of more highly qualified cohorts during the 1980s reflecting policies to promote human capital formation dating back to the late 1960s (Moller, 1996). Hence a less pronounced increase in the relative demand for and a more elastic relative supply of qualified labour than in other countries would produce the observed outcome.

We can now pull together the threads to summarise the effects of the wage determination system on the provision of jobs. The analysis of competitiveness identified relative unit labour costs and relative investment as determinants of export market performance. More detailed analysis confirms that for manufacturing industries the same two factors are significant determinants of changes in a country's share of total OECD employment in the industry (Erdem and Glyn, 1996). Hence lower average manufacturing wage costs in Germany would increase employment in the tradeables sector directly and also indirectly through raising investment since, as noted above, an improvement in German profitability would boost investment. Secondly, to halt the growing relocation of jobs to lower wage countries and the rising unemployment rate of those without qualifications, a reduction in the wage costs of semi-skilled and unskilled German workers appears necessary.

Least is known about the impact of the wage bargaining system on service sector employment. International evidence on the relationship is inconclusive. On the one hand, cross country regressions suggest that there is negative relationship between the growth of total hours worked in services and the increase in the product wages of the lowest paid decile in the economy. Low real pay rises or even cuts in real wages (as in the USA) for low paid workers were associated with the fastest growth of work in services (Glyn, 1995b). Yet this appears to conflict with evidence from micro data where there is no clear employment effect of changes in the minimum wage (e.g. Card and Krueger, 1995, Machin and Manning, 1995).

The interpretation of the West German situation is further complicated by two factors. First, service sector activity may be understated for West Germany. Labour market survey evidence on occupations points to a substantial shift over the 1980s (of 7 percentage points) in the proportion of employees in the industrial sector who were engaged in service activities (DIW, 1996a, Table 2). The second qualification regarding the apparently low level of work done in services in West Germany relates to the lower level and slower growth of women's participation as compared with both the US and the UK (see Table 5C). Apparently a greater supply of services is provided in the home: for example, half-day school remains prevalent in West Germany. Women's participation is steadily rising - evidence from the German Socio-economic Panel shows a sharp fall over the 1990s in the share of non-employed women who want to remain outside the labour force (from 50 per cent to 32 per cent) (DIW, 1996c) - but it is not clear how a fall in low wages in services would influence the employment of women.

Unemployment

West German unemployment performance has until very recently been impressive: on the OECD's standardised definition, unemployment remained below the European average and below that in the US (see Table 5A for period averages to 1995). On the commonly used national definition of the unemployment rate, however, both the level and the trend are worse (Table 5A, [ILLUSTRATION FOR CHART 2 OMITTED]. This difference [TABULAR DATA FOR TABLE 5A OMITTED] [TABULAR DATA FOR TABLE 5B OMITTED] partly reflects exclusion of the self-employed from the national definition of the labour force but more important for the difference in trend is the use of registered unemployment rather than the 'actively looking for work' criterion of the labour force surveys.
Table 5. Indicators of Employment, Unemployment and Participation

C. Participation Rates of Women (percentages)

 Women Prime-age females
 (aged 25-54)

 1974-79 1980-89 1990-93 1979 1990

W Germ. 51.3 53.6 58.0 55.4 64.1
US 55.4 63.5 68.7 62.3 74.0
UK 56.0 60.2 65.2 63.3 72.9

Source: OECD Employment Outlook, OECD Labour Force Statistics.
Table 5. Indicators of Employment, Unemployment and Participation

D. Youth Unemployment

 Youth unemployment Youth (15-24 yrs)
 ([less than]25 yrs) as % of total unemployment rate
 (%)

 1974-79 1980-89 1990-93 1979 1990

W Germ. 25.1 25.4 15.0 4.0 5.6
US 48.6 39.8 32.3 11.8 11.2
UK 35.5 37.6 30.2 10.3(*) 10.1

Source: OECD Historical Statistics, OECD Employment Outlook, OECD
Labour Force Statistics.

Note: * break in series between 1979 and 1990.



The difference of criterion captures a notable feature of employment adjustment in the 1980s specific to West Germany, namely the use of negotiated reductions in employment of older workers who go into official unemployment for a few years before moving on to retirement benefits. The quid pro quo in these negotiations is the agreement of companies to maintain training rates. This is reflected in West Germany's low rates of youth unemployment, the low and falling employment rate for those over 55 and the concentration of long-term unemployment (a spell of one year or more) amongst older people (Tables 5B, 5D). The result is a tranche of older people registered as unemployed although they are not looking for work. Following a spell of unemployment, the old age pension can be drawn early.

The long-term unemployed in West Germany have quite specific characteristics. They are more likely to live in the north than the south of the country, to be unskilled, to be older and/or to be in poor health. In 1995, 40 per cent of the long-term unemployed were over 55 years old (OECD, 1996, p. 104) and of those over 45, 54 per cent were without qualification and 51 per cent had health problems that affected their ability to work (Bogai et al., 1994, p.76). These characteristics suggest that unemployment is the result of structural change - the running down of declining industries and the shift in workforce composition toward skilled employees (IMF, 1995, p.27).

Social solidarity underpins the income support system in Germany and this reflects the view that individuals are only to a limited extent responsible for their loss of job. Each alternative source of income - unemployment benefit, unemployment assistance, social assistance and the state pension - is related to the level of net income, either of the individual when in work or, in the case of social assistance, of the local 'low wage and salary group'.(3) In addition, there is a constitutional guarantee to provide all inhabitants, including non-nationals, with a socially defined 'dignified' standard of living for an indefinite period. Unemployment benefits are at a level of 60 per cent (67 per cent for persons with children) of former net earnings (excluding bonuses etc.) and are available for up to 32 months. Once this entitlement lapses, unemployment assistance at a rate of 53 per cent (57 per cent) of former earnings can be drawn for an indefinite period. For people on these benefits, the effective net replacement rate is between 70 per cent and 80 per cent. For the unemployed receiving social assistance rather than either type of unemployment benefit, the net replacement rate is 50 per cent to 60 per cent.

A job offer can be refused if it is likely to reduce the chances of returning to a similar job as was held before or if the wage is below that set in collective agreements or below the current benefit level. For the first months of unemployment, a job that does not require the vocational qualifications of the unemployed person can be refused. This is seen to play a role in sustaining the incentive for people to make the investment in initial training (see section 2). Especially for older unemployed workers, the incentive for and obligation to seek work is relatively low. Just over 40 per cent of the sample of long-term unemployed (Bogai et al., 1994) had a clear orientation toward finding another job and one quarter saw the period of unemployment as marking the transition to retirement.

The West German unemployment record should be interpreted in connection with the issue of the sustainability of the welfare state raised earlier in the discussion of profitability. The development of an increasing unemployment problem in the last few years on top of the underlying rise in fiscal burdens due to demographic factors and the continuing burden of transfers to East Germany suggests that a renegotiation of the social bargain is necessary. If working lives are to continue to get shorter, those not working may have to accept lower levels of benefit and standards of living.

2. West German micro performance and its institutional supports

The continued strength of the West German industrial sector in international markets does not lie in industries normally defined as high technology. Its revealed comparative advantage is dominated by strength in medium technology (Lindlar and Holtfrerich, 1996). This does not mean, however, that West German industry is weak in innovation. Porter's (1990) study of innovation patterns across advanced economies described the German focus on incremental product and process innovation, often at a scientific leading edge, in established technologies especially in engineering and chemicals. The products were found to be relatively complex, involving sophisticated production processes, after-sales service and frequently, long-term customer links. The emergence of this type of production specialisation in the 1980s - referred to as diversified quality production - has been described by Streeck (1991). By contrast, the US was internationally competitive in three industry segments: (i) radical innovation in newly emerging technologies (e.g. biotechnology, microprocessors), (ii) sophisticated internationally competitive services (e.g. management consultancy, advertising and related media services, international banking), and (iii) large complex systems, especially where the technology is rapidly changing (e.g. telecommunications, defence and airline systems, large entertainments and software systems, large aircraft production).

An explanation of persistent West German export strength consistent with both the quantitative evidence described in section 1 and with Porter's qualitative analysis is that from the 1980s West German firms were able to implement strategies of high quality incremental innovation (HQII) across a broad spread of industries. We will argue that such a strategy is possible in Germany (but not in the majority of other OECD countries) because it rests on specific relationships within and between companies which, in turn, have to be supported by institutional arrangements of the kind that are found in West Germany. Without those institutional arrangements - the industrial relations system, the education and training system, the technology transfer system, the financial system - this strategy would be available to few firms. As in section 1, attention is confined here to West Germany rather than to the reunified German economy. The relevance of the arguments in this section for the interpretation of reunification is taken up in section 4.

2.1 German institutional comparative advantage in high quality incremental innovation (HQII)

2.1.1 Relations between managers and employees in HQII companies.

The type of work organisation needed for HQII and the requisite employee skills cause potential problems of motivation and monitoring for top management. Management has to allow their employees - engineers, technicians and skilled manual workers - considerable autonomy in organising and coordinating work. The industrial sociology literature suggests that the complex nature of production, product modification and development in HQII puts a premium on decentralised problem-solving (Sorge and Warner, 1987, Maurice et al., 1986). The requisite employee skills are based on general industry-technology competences. On the basis of these competences, employees need to build up an understanding of the specific product and process technologies of the company. These company-specific skills are acquired through individual, group and inter-unit problem-solving within the company.

The problems faced by management in firms engaged in HQII strategies relate to (i) the autonomy and decentralised coordination of work organisation which makes managerial monitoring and incentive pay impractical and makes easier the collective 'hold-up' of management by employees (Williamson, 1985), (ii) company-specific skills which cannot be codified by management and make firing costly, (iii) industry-technology skills which give employees options on the external labour market and (iv) transactions costs which rule out explicit contracts.

A solution to these problems, in the form of a relational contract between the company and the workforce, requires a degree of consensus decision-making. Such a contract commits management to pursue strategies that maintain employment security and real earnings growth consistent with adequate profitability; it commits employees to cooperative behaviour. The West German works council system provides a framework for this relational contract. Asymmetric information problems on both sides require an employee representative body such as a works council with sufficient power to monitor management and ensure it carries out its side of the bargain. It must also operate in a system of peer monitoring to guarantee workforce cooperation. The collective payoff to the employees is the translation of improved productivity into greater employment security and benefits.

The works council needs sufficient powers to demand information and block management action, in order to assure employees that management is sticking to the agreement. But how can employee representatives be sure in the absence of external guarantees, that management will not revoke such powers? On the other hand, can management be sure in the absence of external guarantees that employee representatives will not abuse their bargaining power? The rules of the industrial relations system must be such that these opposing doubts are assuaged.

The industrial relations system: West German labour markets are relatively regulated both de facto and de jure (Owen Smith, 1994, Berghahn and Karsten, 1987). Works councils, elected by employees, have legal veto powers ('codetermination rights') over management decisions on redundancies, overtime, work organisation and training. In the event of disputes, both sides have recourse to external unions and employer organisations who have more or less shared understandings of 'proper' behaviour. In addition, unions and employer organisations play a large part in decision-making in labour courts, where disputes are ultimately resolved. Thus, critically for our argument, it is possible in the German framework for there to be a works council arrangement that gives employees decision-making power which in certain circumstances they might be tempted to abuse - in the knowledge that should this happen, there is an external governance structure to which the employers can turn. If employers behave inappropriately, works councils have the same external assurance.

Companies employ not only engineers, technicians and skilled employees, but also semi-skilled workers. Although their electorate includes semi-skilled workers, works councils in practice probably give more weight to the concerns of skilled employees and technicians. Indeed it is increasingly common for technicians or white collar employees to chair works councils (Muller-Jentsch, 1994). Thus in cases of redundancies, it may well be semi-skilled employees whom the works council will 'allow' to lose their job. As will become apparent in section 3, this is significant for macroeconomic policymaking.

The education and training system: Training in marketable skills poses well-known incentive problems. In West Germany such training is fostered through a system that requires cooperation from companies, universities and research institutes (Soskice, 1994, Prais, 1995, Wagner, 1997). Although there is still dispute as to why companies are prepared to invest so heavily in transferable skills (Harhoff and Kane, 1996, Soskice, 1994), the works councils and the wage determination system, backed up by unions and employer associations, make poaching of skilled labour relatively costly even without explicit sanctions. In addition the vocational training 'expert community' sustained by unions and employer associations allows curriculum development, advice, information flows and monitoring to operate in a company-friendly way (OECD, 1994). Professional associations of engineers and chemists play a similar role in enabling a close involvement of companies in higher level education and training.

Most semi-skilled employees in industrial and commercial companies will have done an apprenticeship, but in the small firm Handwerk sector (e.g. in repair shops, bakeries, building trades, etc) rather than in the company in which they are employed. The Handwerk sector trains more than double the number of apprentices that end up with skilled employment in that sector. While the level of training is not as advanced as in the industrial and commercial sectors, it is seen by employers as providing good self-organisational and responsibility skills. The incentive for young people to undertake such an apprenticeship (at a low training wage) is that they will be given preference over an applicant without vocational qualifications in being employed as a semi-skilled employee outside the Handwerk sector; collective bargaining then assures relatively good earnings, comparable to those of a skilled employee in the Handwerk sector. Collective bargaining agreements also contribute, via low apprenticeship wages and the possibility of using apprentices for semi-skilled work during their training to make apprenticeships attractive to Handwerk employers (Soskice, 1994, Wagner, 1997).

2.1.2 Relations with other companies and the research system

The second major category of relationships that a company engaged in high quality innovation strategies must manage are those with its suppliers. The term 'suppliers' covers both component and equipment suppliers, as well as suppliers of a wide range of services and of 'know-how'. Leaving aside suppliers of standardised goods and services, two types of suppliers can be distinguished in a stylised manner - those with whom long-term relationships can be formed and those that are engaged in radical types of innovation and with whom it is difficult to form such a relationship.

Companies engaged in German-type innovation strategies had an increasing need over the 1980s to develop long-term relational contracts with a set of key suppliers for the joint development and customisation of components and equipment (Herrigel, 1993). The organisation of work with these suppliers requires both companies to give considerable autonomy to employees engaged in collaborative work. For both companies, the competences involved in collaborative work are based on the same or closely related industry-technologies, and the development over time of relation-specific skills (e.g. knowledge by the supplier of the specific requirements of the purchasing company). The feasibility of a long-term supplier relationship of this type is that there is reasonably widespread agreement on standards in the industry-technology across companies.

Close cooperation between German companies on a wide range of areas is possible because of a strong emphasis on narrowly differentiated products, which require company-specific competences. In addition, different subbranches of industry have clearly circumscribed product areas. While it is difficult to get evidence, it has been suggested that there are tacit understandings limiting head-on price competition and the poaching of customers (Herrigel, 1993). The role of legalised cartels in Germany is well documented (Audretsch, 1989, OECD, 1996c).

German industry associations which operate in parallel with the employers' associations play an important informal part in the external governance of relational contracts between HQII firms (see Casper, 1996a,b). This extends from having a knowledge of reputations of companies through to development of standard contract frameworks and the provision of evidence of breach of contract acceptable to a German court. Technical standard-setting is carried out on a consensual basis by business associations and this is an important way in which they exercise power over members.

The need for the second type of relationship arises when an innovating company may have to go outside the established network of companies with which it works especially if it is to get the new technologies it requires to stay at the forefront of world competition. Hence, German companies would like to form relationships with companies possessing what we can call 'radical competences' because they lie outside the established industry-technology. This may, however, be difficult because the internal organisation of the HQII company is based on existing industry-technology standards and decisions are made on a consensus basis. Imposing different standards is inherently problematic, since it may require changes in a variety of practices in the company. Secondly, the reputations of radical competence companies are difficult to validate because they have no reputation within the industry.(4)

The German solution in this situation is an institutional one: the radical competences have to be translated into competences that are based on agreed industry standards, via the industry standard-setting mechanism. This is more or less the task of the type of technology policy which the German government has promoted through the 1980s and 1990s.

The technology transfer system: The West German system of technology transfer is of great importance for German companies and innovation. As noted above, the major technological-relational problem of the German strategy of HQII is how to translate basic scientific advances into a form suitable for the company's own process or product technology. Because employees work with considerable autonomy to develop work procedures and expertise, a 'package' or 'plug-in' approach whereby newly-hired employees with particular 'radical skills' can be inserted into the company is generally infeasible. This is because there is seldom a standard interface into which these radical skills, or more generally, the packaged new advanced technology components can be plugged. Standards for the introduction of new technology can only evolve through consensus. This is necessary to ensure that the new technology can be used throughout the company with minimum devaluation of existing skills.

An additional source of difficulty relates to the incentives for combining radical with existing patterns of organisation. The engineer or company possessing the 'radical' competence has a different incentive structure from the engineer in the incremental innovation company. This is because the 'radical' engineer (or company) has no prior relationship with the incremental innovation company, and therefore has no specific asset invested in the relationship. In addition the radical engineer is unlikely to have a further relationship in the future. Hence the incremental innovation company will find it difficult to develop an implicit contract.

How does German technology policy deal with this? First is the identification and assessment of those new technology areas in which competences are needed. The assessment of new technology takes place within standing committees which link university departments and research institutes with business associations and large companies.(5) Professors have a long-term incentive to act broadly in the interests of companies because they get partial research funding and consultancies from large companies and their doctoral students gain access to research help and top-level careers.

Given the identification of the new technology areas, the building up of competences takes place jointly within networks including the relevant technical university departments, the Fraunhofer(6) and industry research institutes, and critically, in the research departments of companies. The resources for the program come primarily from the federal government, but they are distributed via the business associations and research institutes with limited government involvement. Companies might have an incentive to say they needed subsidies for research which they would have undertaken themselves in the absence of a subsidy. In so far as this is a collective action problem across companies, this is less likely to arise in the German framework than in the US or UK because there is considerable knowledge across companies of each other's competences and technological situation. Thus some degree of peer-monitoring can take place.

The process of technology transfer creates a cluster of competences within industry and the research community. Because these companies have similar incentive structures to those of potential client companies (our incremental innovators), it is easier for the latter to engage safely in implicit contracts with them. This is reinforced by the availability of informal mediation by business associations in the event of disputes. Companies need to discuss innovation strategies, especially in relation to products or models, but will be afraid that another company in the industry might profit competitively from them. The German institutional framework makes this less problematic than in the US or UK because there is some pressure on companies not to compete head-on against each other, but instead to concentrate on market niches.

If the introduction of new technology is to reach effectively through the industrial sector it must be based on the widespread acceptance of the relevant interface standards. This is incompatible with standard-setting through market competition (as in the US or UK) or imposed by the large companies and/or the research community (as in France). Hence, standards are set on a consensus basis in Germany which takes time and a great deal of negotiation. But it permits - once common standards for a new technology have been developed - the relatively rapid diffusion of the new technology.

2.1.3 Relations with owners and financiers

From the analysis of the relationship between managers and employees and between companies in the HQII system, it follows that this system of innovation would require a specific structure of ownership. For instance, high levels of investment by employees in company-specific skills would be undermined if there were a threat of hostile takeover. Hence a structure of stable shareholding is required in which transfers of control occur through negotiated deals rather than through trading on the stock exchange. This is characteristic of the structure of ownership of West German quoted companies, which in turn comprise a far smaller proportion of the enterprise sector than is the case in the US or the UK (OECD, 1995, pp.87-90). We have already noted above that for the employees to be committed to the incremental innovation process they must trust management with the consequence that the managers' incentives must be aligned with the long-run performance of the company and not the short-run performance of the share price. High-powered remuneration packages for managers in Germany are rare (OECD, 1995, p.107).

It is clear that the standard remedies for the principal agent problem between owner and manager are not often observed in West Germany. The fundamental reason is that the principal agent problem is of relatively minor importance in the West German context. There is typically an owner with a sufficiently large stake in the firm to have a clear incentive to monitor the performance of management. But the owner will need information to do this effectively. The relevant information is partly held within the company, but partly by other companies which have close relations with the company in question and more widely by research institutes and other associations with a broader knowledge both of companies within the industry and of the industry technology trends. Thus the critical condition is that related companies and research institutes are prepared to reveal this information truthfully to the owner. Behind this condition lies a deeper one that the nature of product market competition between companies not be too intense.

In conclusion, the West German system makes available long-term finance to large companies via stable shareholdings. In addition, banks provide long-term debt finance to small and medium sized companies (Mayer and Alexander, 1990, Vitols, 1995). Such an ownership and control structure is consistent with consensus decision-making within the company, the transfer of inside information between companies and the lack of high-powered managerial incentives. But it requires that companies engage only in strategies which owners can monitor directly or indirectly, reinforcing the bias toward incremental rather than radical innovation. Owners and banks do not have the expertise to evaluate advanced technologies themselves. They are prepared to monitor indirectly by consulting other companies and research institutes in related technological areas and where the degree of cooperation between firms within an industry is sufficient to make truth-telling by potential competitors incentive-compatible.

2.2 Problems and prospects

So far we have argued that German companies have a comparative institutional advantage in high quality incremental innovation in well-established technologies. Other product strategies - radical innovation in newly emergent technologies, innovative services and complex systems - require the more deregulated environment of the US and the UK. The strength of Japanese companies is different again: Japanese companies are highly effective at translating US radical innovations in high technology sectors into commercial manufacturing, as long as the scientific level is not too deep. They are also able to innovate rapidly in consumer durable markets, and to integrate new technologies into both products and processes. By contrast with the German focus on the highest quality end of product markets, the Japanese focus is on medium quality, with an emphasis on economies of scale and so-called mass customisation; they are weak at science-based incremental innovation in established industries (e.g. in chemicals) (Westney, 1993).

Does it matter that West German companies are unsuccessful in new high technology producing industries? A neutral assumption would be that the world demand for radical innovations in new technologies is constant relative to the demand for incremental innovations in established technologies (which new technologies eventually become). If this is the case, then it makes little sense to engage in costly policies to promote companies engaged in radical innovation in Germany if they can be more efficiently established in the US or the UK. It would only make sense if it helped HQII companies located in Germany to absorb radical innovations more easily. But we have seen that the fundamental problem of absorption between radical and incremental innovation companies relates to differences in incentive structures between the two types of company. The main thrust of German technology policy in the 1980s and 1990s, as suggested above has been to build structures to bridge this gap. German technology policy seeks to transform newly emerging technologies as soon as possible into a form in which they can be absorbed by German HQII companies i.e. amenable to the incentive structures of German companies.

A striking example of this has been the development of so-called mechatronics. With the emergence of the microprocessor in the late 1970s, and its quick adoption by the Japanese, German mechanical engineering was at a disadvantage. But by the mid-1980s the techniques of semi-conductors had been mastered by German technology policy sufficiently that mechanical engineering companies had transformed themselves by incorporating microprocessor technology (Ziegler, 1995). It may be best to judge German industry in emerging new technologies in terms of its capacity to absorb these technologies once their initial 'bubbling' period settles down.

Are German export markets in HQII products and services vulnerable to US or Japanese competition? There is perhaps more concern now about American competition and less about Japanese than was the case two or three years ago. As far as US competition is concerned, much has been made of the dramatic improvement and potential of computer-driven systems engineering. With access to libraries of modules, engineers are able to design new products, incorporating advanced and innovative elements, down to the level of implementation of manufacturing processes. Critically, the manufacturing process is not seen as an organisational obstacle since so much can be blue-printed (Mason and Finegold, 1995, 1996). However, in our view, the success of such computer-aided engineering depends on widespread adoption of interface standards. Thus, at least in the foreseeable future, US companies seem unlikely to break into HQII markets because the customers in those markets typically have idiosyncratic requirements which require customisation by firms with knowledge of the customer.

For a quite different reason, there is no reason to believe that Japanese product strategies will lead to the loss of German export market share. In those market areas in which potential substitution might occur, Japanese companies typically produce down-market from German companies. Thus demand will of course switch if relative prices and quality change; but there is no inherent reason why - as is often implied - Japanese companies should gain market share when relative prices are constant. Rather the contrary, we might expect that as the advanced world becomes gradually better-off, positive income effects should benefit German higher quality and more sophisticated goods.

3. Macroeconomic policy dilemmas

We now turn to macroeconomic policy, and in particular to the relationship between the Bundesbank and the wage-determination system. The normal reliance on monetary policy in an economy characterised by fiscal inactivism is coloured in Germany's case by the need for a containment strategy against inflationary wage settlements. There is no formal system of joint discussions at national level between the two sides of industry and between them and the government or the Bundesbank. Despite this, the West German system has usually worked informally to provide a high degree of economy-wide coordination (Soskice, 1990). Unfortunately there are periodic breakdowns, such as the one from which the German economy is currently suffering the consequences. Two factors contributing to the breakdown can be identified: the problems of sharing the costs of unification discussed in section 1 and the increased job security of highly skilled workers in the HQII system discussed in section 2.

The main focus of wage bargaining in Germany is the industry at regional level. German unions are organised on an industry basis, so that with minor exceptions they do not compete for members. The largest and most important union is the engineering union, IG Metall. The unionisation rate is not especially high at 40 per cent but it has risen from 35 per cent in 1970 and nearly all large and most medium-sized companies in manufacturing are heavily unionised. Of great importance to wage setting is the fact that some 80 per cent of employers belong to employers' associations whose members are obliged to pay (at least) the negotiated wage to their employees. There is no legal minimum wage. Annual wage rounds are set by a key leading settlement, usually in engineering. Before that settlement - which other industry settlements broadly follow - a great deal of informal discussion will have taken place. Although there are extensive contacts particularly on the employers' side with the government and the Bundesbank, the discussions are primarily within the engineering union, the employers' association and between the two.

Company agreements supplementary to the industry agreement follow negotiations between senior management and the works council. Strikes are prohibited in company-level negotiations. Both the industry employer organisation and union are keenly aware that a generous settlement in one company can lead to pressures for increases elsewhere and that companies using high wages as a recruitment strategy can be destabilising for local labour markets, especially if incentives are set up for skilled workers to move. Yet both the employer organisation and the union want, for different reasons, to allow the company some flexibility. Employer organisations believe in giving companies as much freedom as possible to develop internal incentive structures, so long as it does not have damaging externalities. Unions want to help works councils since the negotiation by the works council of a supplementary increase strengthens the position of its members, who are usually union activists, among employees.

Nonetheless, there can be tension between unions and works councils. Although works councillors in large companies are seen by workers as being 'the union in the plant' and frequently sit on union executive boards, their interests are not identical with those of the industry unions. De facto, the works council tends to represent skilled workers more strongly than it does less skilled workers as noted in section 2. Skilled employees in large companies are significant investments as far as the company is concerned, so that their employment security is high. The interest of works councils is thus to maintain high wages for its skilled employees and, if the company is in difficulties, to allow it flexibility by cooperating with semi-skilled or unskilled redundancies. By contrast, the interest of the industry union is to maintain both high wages and employment for the whole membership. As argued in section 2, developments in the system of production in West Germany over the past decade and a half are likely to have increased the power of works councils.

To understand the Bundesbank's task in holding down inflation it is necessary to bear in mind not only the power of unions and works councils but also of the various tiers of regional and local government. Faced by potential inflationary demands from these powerful actors, the Bundesbank's strategy is to make threats which the actors then take into account. To contain union wage demands and to stiffen the resistance of the employers' association, the Bundesbank's threat is to raise nominal interest rates and possibly produce an appreciation of the exchange rate. The latter cuts profits and employment in the engineering industry. However, its effect on works councils and skilled workers is more muted: their employment is relatively secure, and exchange rate appreciation raises their real wages. Public sector workers with considerable employment security are as protected as skilled workers in industry, and also benefit from exchange rate appreciation.

Thus the Bundesbank threat strategy has its limitations. Moreover, if inflationary wage increases occur, the Bundesbank will need to rebuild its anti-inflationary reputation. It is therefore unwilling to respond to the economic slack it causes by symmetric cuts in interest rates. If punishment is to be meted out, policy settings can only be relaxed very gradually and this fails to provide the necessary confidence about the growth of demand to drive up investment. This differentiates the Bundesbank's behaviour from that of the Federal Reserve Bank, for example, where the absence of powerful unions makes a punishment phase unnecessary so that a fall in inflation to some target level is the signal for the relaxation of monetary conditions.

External demand stimuli have pulled West Germany out of recession in the past. From the deep recession of the early 1980s growth was sustained by the Reagan boom and by the appreciation of the dollar. The boom from the end of the 1980s to 1992 was due again to export growth and then to the huge injection of demand caused by unification. Before examining the problem of exiting from the current recession, we need to sketch its causes.

The unemployment rate was falling in 1989 for the sixth successive year as the unification boom gathered momentum and pushed employment growth to its highest rate since the 1950s. A range of tax increases was implemented in 1991 to help finance the cost of unification, with further rises for 1992 and 1993 also announced in 1991. The unions sought and achieved substantial money wage increases in each of 1990 (4.8 per cent), 1991 (6.0 per cent) and 1992 (5.8 per cent). Employer acquiescence may be accounted for by the fact that profits had been rising through the prolonged upswing. Econometric analysis confirms that wage behaviour in West Germany changed with unification: workers chose to shift forward a higher proportion of tax increases than had previously been the case. Tullio et al. (1996) conclude from their study that 'high wage growth in the West, especially in 1991, is a sign of at least a temporary breakdown of the social consensus which had been one of the pillars of post-World War II German economic policy' (p.24).

The Bundesbank sought to punish the unions for excessive wage increases and the government for excessive levels of borrowing. Its behaviour is likely to have also been influenced by defeat at the hands of the government over the conversion rate for Ost Marks into Deutschmarks and the failure of its proposals for a revaluation of the D-mark in the exchange rate mechanism in the wake of reunification.(7) These episodes dented the Bundesbank's reputation since they made it clear that at the end of the day it was not in control of underlying economic policy.

By 1993, the Bundesbank had pushed the economy into recession with output in West Germany falling by nearly 2 per cent. High interest rates kept the nominal exchange rate high: the appreciation between 1991 and 1995 was 15 per cent; relative unit labour costs increased by 20 per cent. Wage inflation declined sharply but the Bundesbank was only prepared to reduce interest rates gradually in spite of the very sharp recession in West Germany [ILLUSTRATION FOR CHART 3 OMITTED]. The weakness in aggregate demand was, in turn, reinforced by the consequences for the other European economies of Bundesbank interest rate policy within a quasi-fixed exchange rate system and by Germany's wish to meet the Maastricht conditions, which has required a tightening of fiscal policy in the face of recession.

The German economy may no longer be able to rely on an export-led recovery. The economy is very large and half of its trade is with the rest of Europe, which is tied to German monetary policy and constrained to restrictive fiscal policy by the Maastricht criteria. Although the appreciation of the D-mark in early 1995 had unwound by late 1996 and there were signs that receding uncertainty about monetary union in Europe was putting downward pressure on the D-mark, a substantial depreciation seems unlikely given the slim chance of a major appreciation of the dollar or yen.

4. The unification strategy and the problems of transferring the West German model

The West German government's confidence about the engagement of western and, specifically, West German companies, in East Germany lay at the heart of its strategy for unification. The motive for large companies to undertake major investment projects through the purchase of East German enterprises hinged on the assumed value of the East German enterprises' markets in Eastern Europe and the Soviet Union. East Germany appeared perfectly situated to take the fast-track to transition since incorporation into the Federal Republic eliminated macroeconomic and political risk faced by western investors elsewhere and opened up access to funds and expertise for modernising the infrastructure and creating an efficient local administration. Of the 500 large West German firms surveyed about their investment intentions in 1990, more than 60 per cent were preparing for major investment activity in East Germany and another 20 per cent were intending to invest in the near future (Brander, 1990).

Buoyant expectations for investment in East Germany rapidly disappeared as the magnitude of the economic collapse in Eastern Europe and the Soviet Union became clear. West German companies shelved their plans for large projects as demand from East Germany could be met from their own plants at home. Far from providing the gateway to new markets for an investor, East German enterprises lost their markets at home and abroad within a year of unification. Rather than selling a portfolio of enterprises employing 4 million and valued at DM600 billion by its first West German president, the privatisation agency obtained only some DM73bn in privatisation receipts for sales of firms and assets employing less than 1.5 million.

The original strategy for transition in East Germany took for granted that the production profile and patterns of organisation of West German companies would be reproduced in the East along with the transfer of the industrial relations and welfare systems. The early agreements for rapid wage equalisation in East Germany (condoned by the government and the employers' associations) were implemented with little controversy or public comment in spite of the visible collapse of the East German economy (Paque, 1993, p. 22).(8)

From section 2 it follows that the successful transfer of the West German economic system to the new Federal States would require a minimum presence of West German HQII companies. The privatisation agency (the Treuhandanstalt) focused on western, especially West German, companies as new owners that would be able to provide the know-how necessary to turn around East German enterprises. To attract purchasers, the Treuhand not only had to provide financial inducements but also to break up multi-plant firms and to cut employment drastically.(9) The result was a transformation of the enterprise sector in which manufacturing's share of employment in the economy went from close to 40 per cent at the end of the GDR era to just 16 per cent in 1995 and in which large firms were replaced by small and medium-sized ones (see Table 6C).

Key features of the evolution of the East German economy since unification are presented in Table 6. From a level of GDP per capita of less than one-third the level in West Germany in 1991, East Germany had caught up to one-half the western level by 1995. By that time average wages were 71 per cent of the West German level and household living standards 85 per cent (see Table 6B). The unemployment rate was nearly 15 per cent in 1995 with estimates pointing to disguised unemployment of another 11 per cent. The magnitude of the dependence of the East German economy on the West is captured in a level of net imports of 61 per cent of GDP in 1994 (down from 75 per cent in 1991) (Table 6A).

By 1995, privatisation and the replication of formal institutional structures were largely complete. Infrastructure convergence was well underway. Given the weakness of private incentives to invest in the East, the government provided generous investment subsidies. Estimates suggest that roughly half of total investment has been financed by the public sector through spending on infrastructure and via subsidies to private firms. Private investment has been on average subsidised by one third (Schmidt, 1996). This produced a level of investment per head of the population nearly 45 per cent above that of West Germany in 1994 (Table 6B). Within manufacturing there is evidence of a significant cross-sectional relationship between the cumulative amount of investment and the extent of productivity catch-up by the sub-industry to West Germany (Boltho et al., 1996). For manufacturing as a whole, productivity convergence was substantial: from 20 per cent of the West German level in 1991 to 53 per cent in 1995. Unit labour costs in manufacturing fell from nearly double the West German level immediately after unification in 1991 to a level just under 30 per cent above in 1993; but there has been no further improvement since then. This is in spite of the increased wage flexibility in the East which has seen the postponement of wage equalisation schedules and the growing practice of firms paying below negotiated wage rates (DIW, 1994a).

There is no guarantee that this very small manufacturing sector can form the basis for increased employment and hence for economy-wide productivity convergence.(10) There are two worrying indicators of structural weakness. First, the industry composition of manufacturing output is skewed toward sectors (e.g. construction materials) which are sheltered from import competition and which are not likely to form a base for exports from the region. Secondly, the viability of the firms remaining after the extensive process of 'down-sizing' remains problematic. According to the Bundesbank data on enterprise balance sheets, by 1994 just over half of manufacturing firms posted a profit or broke even (Bundesbank, 1996). This is consistent with enterprise surveys which show that in the spring of 1995 one half of all firms continued to find it difficult to remain competitive in the market (DIW, 1996b).

The establishment of the formal systems of training, technology transfer and commercial and development banking, the creation of an efficient infrastructure and local administration, the orientation of privatisation toward attracting West German firms to the new Federal States and the provision of huge investment subsidies have not yet generated the basis for a self-sustaining growth process in East Germany. The critical mass of West German firms necessary to create the 'HQII-equilibrium' is not [TABULAR DATA FOR TABLE 6 OMITTED] present. This has consequences for the way in which the transferred institutions operate. Large West German firms are key providers of training places in the west; they also play a pivotal role in the process of technology diffusion, as well as in the process by which financial institutions elicit information about small and medium sized enterprises. The paucity of large firms in East Germany means that the state has to play a much greater role than in West Germany. In training, for example, the regional government often has had to take on the full cost of vocational training (Culpepper, 1996).

It is now clear that a substantial segment of the East German labour force has not been able to 'step into' a system of production based on HQII strategies. In addition to maintaining investment subsidies, a delinking of some institutional arrangements from those in the West will be necessary for self-sustaining growth. As noted above, flexibility in wage setting is already observable: the tariff wage does not set a floor for wages in East Germany. A binding constraint is, however, provided by the level of unemployment benefit and social assistance payments. To compete with workers in Poland and the Czech Republic, East German workers would have to accept wages below the levels of income provided by the welfare system. If employment is to be boosted, the government will either have to contemplate using wage subsidies to bridge this gap or reduce benefit levels.

Conclusions

This paper has examined German economic performance and problems through the lens of institutions. Its conclusions are broadly in line with those of many business leaders in Germany who see the need for change in terms of increased flexibility within the existing system of industrial relations and vocational training, of corporate governance and of technology transfer.

We can summarise in four points.

1) West Germany remains the exporting powerhouse of Western Europe. The focus is on specialist high-quality goods, the result of incremental innovation in established technologies, often at an advanced scientific level. Innovation permits high cost increases. This performance rests on an interlocking set of institutions: an industrial relations and vocational training system which allows for a cooperative anti highly skilled workforce reaching from manual employees to engineers; a corporate governance system which provides companies with long-term finance; and a structure of inter-company relations which enables technology transfer, deep relational contracts, and consensus-based technical standard-setting - in an environment in which less than intense domestic competition is balanced by strong competition in world markets. The technology transfer system enables the incorporation of elements of new technologies - developed in countries where the institutions favour high risk radical innovation - into products and processes based on established technologies.

Even leaving aside the most critical problem - that of profitability - the German model has to confront the need of companies to be able to adjust rapidly in response to changes in world markets. Radical deregulation is not the answer: for it would throw the baby out with the bath water by threatening those institutions which provide West German companies with comparative institutional advantage. What many companies need is greater internal flexibility - they would like to give clearer career ladders to employees, especially skilled workers, than is possible under the collective bargaining agreements. Whether or not this would give greater or less power to works councils is an open question; but it would certainly reduce the power of the industry unions. Having invested heavily in human capital, companies see the 'shareholder value' debate from a long-term perspective in terms of moving valuable resources to their best use within the company, rather than as a tool for downsizing as shareholder value has become in the USA.

2) The second area of change concerns the relative position of less skilled and educated workers. 90 per cent of young Germans either serve an apprenticeship or go through higher education or both; but apprenticeships range from very advanced (as in a bank or a large company) to elementary. In a rough and ready way those 40 per cent of apprenticeships served in the artisan sector (Handwerk) are associated with a lower level of school achievement and lead to a lower skill acquisition. Despite this, these young people are well trained not only in relevant skills (garage mechanic, electrician, plumber, baker, shop assistant, etc.) but also to take responsibility and to organise themselves. Many work in skilled positions in the Handwerk sector, and many move to semi-skilled employment outside, where these qualities are also valued. Because this 'track' offers relatively secure prospects, young people work hard at school, encouraged by parents, to get such an apprenticeship (if they cannot do better). The importance of this system of lower level education and training for the stability of German society cannot be overestimated, for it prevents the development of ghettos, poverty, sink schools and the like. The problem is this: on the one hand, employment for these workers is under threat to the extent that it becomes possible for German companies to relocate activities which use less skilled labour intensively to much cheaper locations (especially in Eastern Europe). On the other hand, the implied fall in relative earnings reduces the attraction to young Germans of investing in these apprenticeships.

3) Points (1) and (2) concern West Germany. The imposition of the West German institutional framework on the East has not yet produced the type of West German economic landscape its proponents had hoped for. The flaw in this extraordinary experiment was the absence of a sufficient base of West German companies. Without the accompaniment of enough companies, technology transfer and serious vocational training cannot work, and banks will not lend because applicants for finance have neither reputation nor security. There is no easy way out. Many commentators blame the trade union wage agreement. But since companies do not have to stick to tariff wages, the real employment problem is that the lowest wages companies can pay are set by the effective social security floor. This, however, is above the wages which need to be paid in Poland or the Czech Republic. Thus unsubsidised employment creation will be limited to the service sector and to activities which depend on a relatively sophisticated infrastructure.

4) Finally, the macroeconomic problems; in the late 1980s and until early 1993, West German unemployment was low. Moreover, the economy remains successful in keeping youth unemployment low. On any reasonable analysis of Germany's 'present discontents', their cause does not lie primarily in microeconomic inflexibilities, but in a combination of aggregate wage determination and macroeconomic policymaking. High wage increases between 1990 and 1992 prompted by the unwillingness of workers to bear the high cost of unification; an exceptionally tight monetary policy from 1992; and a restrictive fiscal policy from 1994 to meet the EMU entry conditions all contributed to dramatic declines in profitability and the precipitate loss of employment. West German macro management has never been comfortable with discretionary reflation, but in previous deflationary episodes, exogenous reflationary shocks have come to the aid of the German economy - the Reagan boom in the early 1980s, and unification expenditures in the early 1990s. In the mid 1990s, it is hard to see where external reflation is going to come from.

The temptation for many commentators has been to see this situation as one of folly - on the part of the unions in refusing wage reductions and/or of the Bundesbank in rejecting an expansionary monetary policy and/or of the German government in its rigorous enforcement of the Maastricht conditions. But such a view fails to take account of the seriousness of the profitability situation of West German business and of the tight and difficult institutional constraints on these actors. Most centrally, the Bundesbank faces - in its goal of low inflation - powerful organisations (the unions and public sector employers) whose own hands are partially tied by their constituents (works councils and the municipal and regional governments, which are often social democrat and close to the unions), with strongly embedded legal positions. The insistence on fiscal and monetary rectitude after EMU by both the Bundesbank and the Christian Social right wing of the governing coalition (represented by Waigel) reflects as much a fear of domestic German inflationary forces as of the misbehaviour of other member states.

The government cannot use fiscal policy to reflate, or to respond to union proposals for employment creation in exchange for wage moderation. The fulfilment of the Maastricht conditions is one reason. More fundamentally, the coalition and the Bundesbank are unsure of the ability of the unions to deliver wage restraint. This partly reflects a tilt in power over the past fifteen years from unions toward the big works councils, which are not greatly threatened by Bundesbank reactions. Thus aggregate wage moderation, let alone a reduction in real unit labour costs adequate to restore profitability and maintain employment, is indeed difficult for the unions to deliver.

NOTES

(1) For clarity, West Germany is always used when reference is made to the territory which was the Federal Republic before reunification, East Germany refers to the territory of the former GDR and Germany refers to the combined territory of West and East Germany.

(2) As Chart 2 makes clear, manufacturing employment in 1995 had fallen to well below the levels of the late 1980s, ie before the substantial increase in employment between 1988 and 1991.

(3) An excellent description of the operation of these institutions in Germany can be found in chapters 2 and 3 of OECD (1996a).

(4) Horst Kern is responsible for this argument.

(5) Details are provided in Lutz (1993) whose book on German technology policy, is the most analytic and practical account available.

(6) The Fraunhofer Institutes are industrial research organisations financed partly by government and partly by contract research.

(7) A realignment within the ERM would have raised real wages in Germany and dampened wage inflation. By reducing the need for higher interest rates in Germany, the pro-cyclical tightening of monetary policy in much of Europe would have been avoided. Other ERM members were, however, opposed to a realignment.

(8) An interpretation of union and employer association behaviour based on the rapid replication of the 'West' in the 'East' is easier to reconcile with early investment plans than is the view that West German organisations were engaged from the outset in an attempt to eliminate competition from East German suppliers.

(9) The Treuhand cut employment for two reasons: (i) to create saleable units and (ii) to control its own deficit. An explicit employment subsidy was used in connection with sales of assets but none was used when jobs were cut for the second reason. From the Treuhand's perspective, it was prudent to lay-off workers who would go into retraining, job creation schemes or even unemployment at the expense of another authority (Carlin, 1994).

(10) Simple regressions relating GDP p.c. to the share of manufacturing in total employment in Western Europe s regions confirm the importance of manufacturing for the attainment of high living standards (Boltho et al., 1996).

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