I am stepping into a topic I am not completely familiar with, and I hope that the German barflies amongst us will step in with authoritative comments and more links, but it is certainly worth a mention and a discussion.

On 1 January, a new reform package, called “Harz IV” (named after the guy that led the effort to prepare the reforms, Mr Harz, a former VW executive if I remember correctly) came into force. The main effect is to reduce the payouts to unemployed people, especially for the long term unemployed, and to make it generally more difficult to refuse a job offer, hower inconvenient, if you are unemployed. There has been strong protest, especially in the East, but the government held firm and this is now in force, a significant part of the reforms that are supposed to make Germany’s “rigid” economy more competitive.

And now the FT brings to us the position of Peter Bofinger, a well-known economist and one of the “wise men” (a group of top independent economic analysts), who basically says that these reforms are not really the solution to Germany’s problems:

Mr Bofinger, a “wise man” since March, argues that mainstream German thinking has led to a nation of consumers saving aggressively rather than spending, in fear of the future. Germany is expected to be at the bottom of the European growth league this year.

“We are now one of the most competitive countries in the world,” Mr Bofinger told the Financial Times. “The problem is that we have been very much focused on external demand . . . Germany is not like Ireland or Denmark. It is a country where the domestic market counts much more than the external market.”

To some observers, Mr Bofinger is simply a maverick in demanding stronger wage increases to boost internal demand – a similar stance to that of Oskar Lafontaine, the leftwing finance minister who resigned in 1999.

(snip)

Meanwhile ordinary Germans have yet to see the fruits of years of labour market, tax and social security reforms: figures yesterday showed unemployment still rising.

“France is really lagging in reforms – but its economy is doing rather well,” Mr Bofinger said. Reforms are needed, he agreed. The problem is that demand for German exports is not feeding through into higher wages and thus internal demand. “With the exception of Japan, our salaries are increasing less than in any other OECD country. Net real wages are stagnant or even declining.”

He proposes a return to a “productivity-orientated wage policy” across the eurozone. Wages, he suggests, should rise by the rate of productivity growth plus about 2 per cent – the rate of inflation targeted by the European Central Bank. For less competitive eurozone members, that would still mean moderate wage rises. But Germans would be substantially better off while “improvements in competitiveness that have been made in the past few years would be maintained”.

The interesting theme is one we have heard recently in Argentina as well (and which was also pushed by the Socialists in France in 1997-2002): financial reform should not be an end to itself, and the cure can kill off the patient (but “he dies in good health”, as one wag put it). Domestic demand, coming from wage increases and the like, can have a much more positive effect on growth and prosperity than financial orthodoxy. Morale boosting measures, whether voluntary (postive discourse, accompanied by symbolic or real feel-good measures, such as the 35 hour week) or not (France winning the world cup in 1998 is a typical example) have a much bigger effect…

While I have trouble accepting that idea (in many ways, it is similar to the Reagan “voodoo economics”, trickle down, etc… – spend like hell, and growth will catch up and justify it all), it appears to work in some circumstances. The trick is to find the right ones.

Basically, you should have lower than expected demand and a not-too-unsound budgetary balance that allows you to spend more without worrying too much about long term consequences, and ideally an external shock to justify it all. Bush actually had the perfect scenario back in 2001 (9/11 was a shock to the population and the economy, which could be compensated for by injecting extra public spending – and the budget was in surplus), but he blew it in favor of highly partisan – and highly ineffective tax cuts for the rich. On the other hand, if it is not done properly, for instance if the financial situation is already so dire that your effort is half-hearted and nobody believes it is sustainable, then it gets only worse.

The lesson for Germany is that it should not worry so much about the outside world anymore. The euro has made its “domestic market” so much bigger that it should abandon the psychology of a smallish, open economy. Europe, like the USA, is a big, not so open economy (not so open simply in the sense that trade with the rest of the world does not represent such a big share of GDP – 10% or so insterad of 30% for Germany alone and much more for samll countries like Belgium or singapore).

Live your life, stop worrying!