Key policy recommendations from the OECD’s latest Economic Survey of Germany indicate that innovation, education and more competition in the domestic market would help Germany emerge from the economic crisis with a stronger and more balanced economy. Labour market policy should now pave the way for necessary structural changes while fiscal policy needs a specific exit strategy with focus on consolidating public finances over the coming years.

Despite a historic slump in economic activity and turmoil in its financial sector, the German labour market remains in relatively good shape. Unlike many other OECD countries, Germany has not had to cope with major imbalances in household or corporate balance sheets, nor with real estate bubbles. However, Germany has suffered as top exporter from the breakdown in international trade during the crisis. Germany is now emerging from the deepest crisis in the post-war period. The OECD expects German GDP to increase by 1.3 in 2010 and 1.9 percent in 2011.

The report argues that German’s large current account surplus is largely the result of subdued domestic investment rather than increased household savings. The export boom was to a large extent driven by reduced costs resulting from outsourcing and domestic wage moderation. The report adds that German industry has lost ground in innovation and in particular in the development of new products.

Broadening the basis for innovation

Germany should focus on structural reforms to make domestic investment more attractive and to encourage more innovation in the services sector and export industries, the report says.

“Innovation is key to boost competitiveness and domestic demand at the same time“, said OECD Secretary General Angel Gurría presenting the report in Berlin.

The report sets out a detailed list of measures that could help Germany achieve more innovation and growth. They include better market access among liberal professions, easing red tape when creating and winding up businesses and better access to venture capital.

The government should introduce tax incentives to encourage companies to invest in innovation, complementing existing R&D grant schemes. Innovation will be a driver for growth and job creation, but it needs to be supported by the necessary structural change. This includes measures to increase the flexibility of the labour market. Employment protection should be adapted to make the laying off of regular job holders more predictable for employers without reducing the overall level of protection. However, a further liberalization of fixed term employment could convey the development of a dual labour market and should be reconsidered.

Reforms are also needed in education. While many OECD countries are now providing tertiary education for more than 40 percent of school leavers, tertiary attainment in German is stagnating at just above 20 percent. Despite its strong dual system of vocational training, Germany will need to increase tertiary education. Graduates tend to earn more and, as they grow older, have a lower risk of unemployment. The vocational education system should also put stronger emphasis on teaching a broader range of skills in order to prepare young people for a rapidly changing work environment.

“Germany needs more highly educated workers with a broader set of skills to achieve higher productivity, higher income and longer employment“, Gurría said.

Adjusting labour market and fiscal policy as the recovery takes hold

Flexible working time arrangements and more generous rules for existing short-time work schemes helped to shield the labour market from the worst of the economic downturn. While these arrangements helped companies keep their core staff during the crisis, if prolonged too far, they run the risk of preventing much needed structural changes. The report argues that Germany should phase out the additional benefits for the short-term work schemes and give companies more incentives to use the schemes only for jobs which they are able to sustain after the crisis.

Although public deficits increased in 2009 and will continue to do so this year, they are smaller than in many other large economies - helped by extensive consolidation in the years before the crisis. With the new fiscal rule written into the constitution, Germany is more firmly committed to an exit-strategy from high deficits than many other countries. To consolidate budgets and contribute to long-term growth, the survey argues for cutting unnecessary expenditures and for increasing taxes which are least harmful for growth. OECD evidence shows that relying more on indirect taxation (notably property taxes and consumption taxes) rather than on direct taxation (such as social security contributions and personal income tax) is a growth-friendly strategy.

Reforming the financial sector

German banks were among the first and the most severely affected by the financial crisis. The government acted swiftly to support banks and set up institutions such as the Financial Market Stabilization Fund (SOFFIN). Because lack of credit could threaten the recovery, the government needs to continue to ensure that banks are adequately capitalised and to provide, as a last resort, public capital to those institutions that cannot obtain private funds. Consolidation in Germany’s banking sector should continue, in particular among the state-owned Landesbanken.

OECD/ Expatica

Head photo credit: Jakob Montrasio