German Economy Watch: Employment and Unemployment in Germany January 2008

Germany's unemployment rate fell to the lowest in almost 15 years last December as manufacturers of products ranging from cars to industrial equipment continued to hire staff to work off a backlog of orders. The German jobless rate, as prepared using the National Labour Survey methodology and adjusted for seasonal variation, dropped to 8.4 percent, the lowest level since March 1993, according to data from the Federal Labor Office in Nuremberg released at the end of last week.

The above charts are striking, as is the entire recent performance of the German economy in terms of job creation, but before we go any further I think at this point it is also worth taking into account the following information release on German unemployment statistics from the EU Statistics Office, Eurostat (full reference at the foot of this post):

Monthly data for Germany from the Labour Force Survey (LFS) is only available since early 2005, and this is not sufficiently long a time series to enable reliable seasonal adjustment using standard techniques. Eurostat considers the minimum length of a series for testing the extraction of the seasonal pattern to be four years for the monthly unemployment data. It is thus unlikely that seasonal patterns in the unemployment directly measured by the LFS are sufficiently known until early 2011. Until then an alternative method, such as using information from auxiliary sources, needs to be applied.

I introduce this quote at this stage in the argument, since it is important to note that nothing - or virtually nothing - here is what it seems to be. Germany has recently introduced a whole new methodology for measuring unemployment - a monthly (as opposed to an earlier annual) labour force survey (more below) and this fact alone already makes inter-temporal comparisons of unemployment data tricky, to say the least.

Nonetheless there can be no doubt that unemployment is falling, and quite rapidly, in Germany. It is how to interpret this data which is what we need to think about. In its most recent monthly report for example the Federal Labour Agency said seasonally-adjusted unemployment had dropped by 78,000 to 3.4m, almost twice the average monthly fall in the past year. Altogether, more than half-a-million people have come off jobless benefits in the past year. The internationally comparable (ILO harmonised) jobless rate, whose publication lags one month behind the national data, stood at 7.9 per cent in November - the lowest level since the end of 2001 – thanks to robust economic growth, an increase in hiring, and a fall in the number of people claiming unemployment benefits.

More surprising to many of us who are watching the current course of the German economy than the figures themselves was the publication of a series of business sentiment surveys which appear to show continued resilient hiring intentions among managers even as the German economy shows visible signs of slowing. These suggest the improvement in the data we are receiving for the labour market should continue, and that the decline in the numers of unemployed - which has now been taking pace for some 21 months - should continue at least into the near future. The Ifo institute’s employment barometer, for example, stood at 106.8 points in December, markedly above the average registered over the past 12 months. So what is actually happening? Well my guess is that nobody really knows. And I do not pretend to have the magic lantern here, but I have spent considerable time over the past 24 hours trying to find some light at the end of the cavern, and what follows is a provisional account of my finding.

The Hartz Reform

Now the more astute among you will have noticed that in the above chart for unemployment rates, I present Germany's unemployment as measured on two different concepts. The first is the new German Labour Force Survey Methodology - which as I have already pointed out was only introduced last October - and the second is measured using the internationally comparable ILO methodology. The basic difference is that the ILO methodology uses the idea of actively seeking work, while the Federal methodology has previously been based on the concept of simply being registered, irrespective of whether or not the intention is to find work. Naturally the level as measured using ILO criteria (although this is a rather complex issue) has tended to be lower. But the even more astute among you will have noted that over the last two years these two measures have gradually come together. As far as I can see this growing similarity between the two readings is the result of a confluence of two factors. Firstly the new methodology the Federal Statistics Office introduced last October (2007), and secondly the series of reforms which have come to be known as the "Hartz Concept".

Now as regards the first, starting from the release of 31 October 2007 the Federal Statistics Office has replaced their earlier, temporary, method of calculating harmonised monthly unemployment for Germany by a new method. This new method bases the unemployment estimates on the new continuous (monthly) German Labour Force Survey (LFS), and in so doing Germany has brought itself into line with the methods used for the other Member States of the European Union.

The reason for this change is that Germany's earlier methods of gathering employment and unemployment data was, to put it rather mildly, in something of a mess. Now regulation EC 1991/2002 of the European Parliament and of the Council of 8 October 2002 made the continuous, quarterly LFS mandatory for all Member States from 2003, although it did specifically provide, among other things, a transitional period for Germany, a period which could last until 2005.

Basically in all the countries of the European Union, the LFS is used to derive quarterly results, however, in order to provide unemployment rates and data with a monthly frequency, short-term trends from unemployment registers are also used to update the much more detailed findings of the quarterly LFS. Now, prior to 2005, the Labour Force Survey was only conducted on an annual basis in Germany. During one week every spring, information concerning labour force status was provided by respondents during detailed interviews. This methodology was considered to be totally unsatisfactory when viewed from the persective of establishing a harmonised EU unemployment measure, consequently the German system has been in transition, and it is this transition that can best be seen in the way in which the German rate has steadily come closer to the ILO methodology one.

However, as luck would have it, precisely in January 2005, at exactly the time the new continuous LFS commenced in Germany, the German Federal Government introduced an extensive reform of the social security system, areform which included among its objectives the bringing together under one roof of unemployment and social welfare benefits. The measures involved are usually referred to as Hartz IV. Since the Hartz concept effectively involved a redefinition of what constituted unemployment, and more importantly who would be entitled to benefit, it was already anticipated at the time of framing the legislation that there would be significant effects on the registered level of unemployment at the system was introduced.

Therefore, the assumption was from the outset that the register of unemployment as measured in the annual LFS would not give a very accurate reading of the level of German unemployment over an unspecified period, and that this period of uncertainty and undecideability would commence in precisely January 2005. During the transitional period it was not considered practical for the Federal Labour Agency ito maintain a separate time series, and thus the compromise solution was adopted that they would continue to use the old definitions of registered unemployment.

Under those circumstances it proved impossible to produce reliable harmonised monthly unemployment rates for Germany. While work was ongoing to make the continuous LFS suitable for the production of monthly unemployment figures, Eurostat and Destatis looked for a temporary alternative. For this purpose Destatis expanded the ILO Monthly Telephone Survey (MTS) that had been running from April 2003 as a pilot survey to 30 000 interviews per month. The MTS would run until April 2007. Eurostat agreed to use, for a limited time, the results from the Monthly Telephone Survey for estimating the harmonised unemployment rate for Germany. When the temporary measure of basing the unemployment estimation on the Monthly Telephone Survey was introduced the effect was a downward shift in the time series for the total unemployment rate for Germany. And, of course, it is this effect that we are now seeing.

Within Europe, the German Labour Force Survey is the largest household survey of its kind. The average sample size per month is around 30 000 dwellings, with completed interviews of persons of working age approximately 35 000 on average each month. The survey is part of the German Micro-Census and has a very high response rate (approx. 95% annually) compared to other Member States and a relatively low rate of proxy6 answers (approx. 27%). All households are visited and interviewed by specially trained interviewers using portable computers, but those respondents who so wish can complete the questionnaire on their own on paper.

The replacement of the provisional unemployment figures based on the Monthly Telephone Survey by the estimates from the LFS results in a major upward revision. The LFS measures a significantly higher level of unemployment in Germany than the MTS. The chart below - which was prepared by Eurostat, shows the level of unemployment in Germany from 2000 to September 2007, showing the previous Eurostat estimates based on the Monthly Telephone Survey as well as the revised estimates based on the Labour Force Survey.

Some indication of the chaos and confusion which all this has caused can be seen in this extract from the Federal Statistics Office report on the changeover. According to the Federal Statistics Bureau

The number of unemployed as determined according to the ILO concept in January 2005 (3.99 million) was by about one million below the number of registered unemployed in the same month according to the Social Security Code (5.04 million). According to the results of the telephone survey, about 1.2 million persons were recorded as unemployed who indicated not to be registered as unemployed. On the other hand, 2.2 million respondents who, as indicated by themselves, were registered as unemployed were not unemployed according to the ILO concept. As is shown by experience acquired in the pilot surveys, the resulting difference between unemployment (ILO concept) and registered unemployment (Federal Employment Agency) is larger in winter than on an annual average due to seasonal factors. Also, it is assumed that the statistical “Hartz IV effect” contributed to the difference observed in January this year. While the Hartz IV reform increased the registered unemployment according to the Social Security Code, as observed by the Federal Employment Agency, beyond the level that is usual at this time of the year, the ILO unemployment figure is not influenced by such statistical effects caused by changes in law.

Well I think we can leave this part of the story there. Unemployment either was always much higher than was officially recognised, or never rose as much as it appeared to at the start of 2005. Choose your own version. But what we should be aware of is that the reduction in unemplyment which appeasr to be taking place in Germany needs to be handled with a good deal of care.

The Hartz Concept

According to Wikipedia, the Hartz Concept may be defined as follows:

The Hartz concept is the name given to the recommendations resulting from a commission on reforms to the German labour market in 2002. Named after the head of the commission, Peter Hartz, it went on to become part of the German government's Agenda 2010 series of reforms, known as Hartz I - Hartz IV. The reforms of Hartz I - III took place between January 1, 2003 and 2004; Hartz IV began on January 1, 2005.

On February 22, 2002, the "Hartz Commission" was founded; its real name was die Kommission für moderne Dienstleistungen am Arbeitsmarkt - the Commission for Modern Services on the Labour Market. Its 15 members were led by Peter Hartz, then Volkswagen's personnel director.

The commission came up with thirteen "innovation modules" suggesting changes to the German labour market system. These were then put into practice as Hartz I - IV.

In January 2005, Germany's unemployment rate - as predicted in advance by many observers - rose instead of falling. As suggested above, this rise was not due to any sudden and rapid deterioration in Germany's economic situation. Rather it was due to a kind of statistical effect, and in part, as the unemployment figures come down and down in Germany we are seeing some sort of "obverse" reflection of this statistical effect, and this is why the data needs to be treated with so much caution, especially given the role which inflation wage push concerns in Germany - via the good offices of the Bundesbank - are playing in policy making at the ECB at present. Indeed, ECB President Jean Claude Trichet specifically singled out German postal workers when he indicated his ongoing intentions to exercise inflation vigilance rather than monetary loosening in the face of the eurozone's growing economic headwinds.

Under the new legislation introduced in that month, all people deemed capable of work but without a job found themselves with the obligation of registering as unemployed with the Federal Labour Offices. This marked a change since previously such registration had not been necessary for recipients of social assistance (and the whole issue of registration or non-registration lies at the heart of the methodological disputes about German unemployment). When the Hartz concept was introduced the Institute for Employment Research (In-stitut für Arbeitsmarkt- und Berufsforschung (IAB)), the Federal Employment Services' research institution, forecast the number of people affected by this measure would be approximately 300,000. In reality the problem proved to be even worse than the forecast, since in January 2005 the Federal Employment Service announced the unemployment figure to stand at 5,037,000, an increase of over half a million on the December 2004 number (with roughtly 225,000 of these being attributable to the Hartz reform).

Now one of the key features of the reform concerned unemployment benefit, since entitlement to maximum benefits was considerably reduced. Starting on January 1st 2004 the maximum period of entitlement to such benefit was reduced to 32 months as a transitional measure. But for new claims presented after January 31st 2006 the entitlement generally lasts for a maximum of 12 months, and for persons older than 55, for a maximum of 18 months. A very simple calculation should show us that for anyone registered on 1st January 2004, benefit will have run out around September 2006. I think we are lead to the unescapable conclusion that some portion of the frenetic rise in the German employment levels of late is a by-product of the increasing number of people who are facing the imminent prospect of having their benefit terminated. This could also be a factor in squaring why all the extra employment, far from producing optimism, is leading to a growing feeling of pessimism in the consumer sentiment indexes. Especially given the nature of much of the employment being created (see below) and the general economic conjuncture in which Germany finds itself.

The high withdrawal rates for additional income earned while unemployed - which Hartz introduced - have been and still are a crucial problem. The problem hangs around the difficulty that - by differentiating between income from a regular job on the first labour market on which the high withdrawal rates have to be applied - and income from doing community services (so called 1-Euro-jobs, see below) for which lower rates hold, a bias towards jobs in the second labour market has been enforced. This of course is part of the intention.

Many voices have been raised in Germany to argue that with the introduction of class II unemployment benefit a kind of "wage dumping" process was initiated since the unemployed people were effectively forced to accept any job no matter the wage, solely to keep their benefits. The fact that one of the results of the introduction of the Haryz concept is that more people work in jobs with low incomes seems to me to be undeniable. This is exactly what the reform aims for: the creation of a low wage sector in which people with low-skills, who have been disproportionately unemployed, can find a job. A quite separate question revolves around why there are so many low skilled persons in Germany, and around the macro economic consequences of a structural increase in such forms of employment, and these will to some extent be addressed below.

Before moving on to this we might note in passing that it is far from surprising that Hartz has lead directly into the current debate about whether or not it is desireable to establish a statutory minimum wage in Germany, since I feel many of the people who endorsed Hartz never really understood what the underlying issue was, nor why Germany's economic performance was giving the results it was. Of course, as far as the present argument goes, what needs to be born in mind is that such a minimum wage would in fact conflict with the core objectives of the Hartz social and labour market reform and in this sense would be counterproductive, since precisely the kinds of work which is now being created would disappear, and the consequence would be that the people concerned went back to unemployment rather than the creation of a larger number of better paid jobs.

One Euro Jobs?

The so called One-Euro-Jobs – the official name is MAE (Mehraufwandsentschädigung, compensation for additional effort) - are forms of community-related employment available to the unemployed at very low salaries (hence the "one euro" label), sufficiently low as to not imply the total loss of benefit. The underlying philosophy is that they should be thought of as a graduated step into work. In fact recipients of type II unemployment benefit are virtually obliged to accept such jobs or face benefit curtailments. Rejection is normally followed by benefit cuts (in the first instance by 30 percent, but repeated refusals ultimately lead to a statutory minimum of rent plus food stamps). In Berlin, One-Euro workers get 1,50 Euro an hour (although sometimes this may be as low as 1,20 Euro). Normally such workers work 30 hours per week. They are entitled to earn around 180 Euros MAE on top of Alg2 (Type II benefit) plus rent. The One-Euro agencies or contractors get 500 Euros per month for each MAE job (for management expenses and qualification efforts).

It is a legal requirement that the One-Euro-Job is “additional”, i.e. such employment should not put regular jobs at risk. One-Euro-Jobs do not constitute an employment contract so employment rights (like sick pay, holiday pay or the right to go on strike) do not apply (hence the low levels of social security registration being noted, see below).

In Germany a total of 176.000 MAE jobs had been created by the middle of 2005. I have no recent data on MAE jobs, so if anyone reading this can update me, I would be grateful. One thing which immediately becomes clear to me at this point is the large difference which exists between Germany and Southern European countries like Spain and Italy in this regard, since in Southern Europe the MAE type jobs are being systematically filled by new migrants (care for the aged would be the obvious example here), while in Germany it is the native born population which is being moved over into such activities, this seems to fit in with the general picture we have been receiving from Research organisations like the Lisbon Council about the poor quality of much of the human capital which Germany faces going forward, and some of the difficulties this represents in the context of a rapidly ageing society.

Where we are now?

The first thing to recognise is - whatever data interpretation issues we may have - the Hartz reforms have resulted in a real decline in unemployment, and a significant increase in the volume of new jobs created. According to first provisional calculations of the Federal Statistical Office , the number of people in employment in Germany in 2007 averaged 39.7 million. This represented an increase of 649,000 people employed or a rise of 1.7% over the 2006 number. So the increase in employment is real enough. This increase follows a rise of 242,000 persons (or +0.6%) on 2005, so the rate of increase accelerated, and the average number of persons in employment reached its highest level since German reunification.

The problem we have, and this is the point of all the rigmorole I have gone into above, is in deciding - from a macroeconomic viewpoint - what significance can be attach to this process? Certainly there is a fiscal impact, and this we are seeing, as part of the burden of supporting the poorer sections of German society falls on the citizens themselves. This is clearly a net plus.

Also it is important to note that the average increase in employment in 2007 was largely driven by an increase in the number of employees, which rose by 595,000 persons (+1.7%) to just under 35.3 million compared to the previous year. Hence the number of employees was only slightly below the all-time high registered in 2001 (35.3 million, but note the date here, as it is significant, as we will see below). The positive effects of the reform and Germany's economic expansion also had an impact on the number of jobs subject to social insurance contributions, which after falling for several years, once more started to increase in 2006:

However we should note that, as a proportion of total employment, these social security covered jobs have been declining steadily, year by year (and indeed during 2007 the percentage has remained very near the 2006 level of 67.5% according to my own very rough and ready calculations). So what we are seeing is a very large increase in temporary, part time, or other more fragile forms of employment, which, welcome as it is, needs to be but into perspective if we are to think about the robsutness of the German recovery, and the ability of domestic consumption to sustain economic growth at some point in the future.

We also know that the number of German workers in part time jobs has been rising steadily as a percentage of the total workforce (see chart below).

Human Capital and OutSourcing

Now another way of looking at this whole situation is to ask what exactly is happening to Germany's human capital stock at the present time. It is evident that in the context of ongoing demographic shifts developing and maintaining the human capital is going to play a key role in determining future economic prosperity. Germany's median age is rising, and is projected to rise, quite rapidly, much more rapidly, say, than that of France.

At the same time the key 25 to 49 age group reached its maximimum weighting as a proportion of the total population back in the mid 1990s, and is now falling.

Meanwhile at the extremes - the oldest and the youngest ages, the paths completely diverge, as the proportion of the young population declines and the proportion of the older groups increases. The important thing to realise is that this change is permanent, it is not simply the passing through of a "baby boom", and German society needs to make long term changes to adjust to this reality.

In the above chart - which shows the relative changes between the 0 to 14 and the 65 to 79 populations, I have intentionally not made use of any of the future projections, since I want to emphasise that the argument we are persuing on this blog is that these age structural changes are having a real impact in the here and now, and not something which might hypothetically happen 30 or 50 years from now.

Human Capital Index

Precisely in order to address this sort of concern, and in an attempy to try to measure the development of human capital in European Union member states the Lisbon Council and Deutschland Denken! have created the European Human Capital Index - a ranking index of 13 the European Union member states. You can find the various editions of the index on this page here.

Essentially the index looks at each country's ability to develop and deploy its human capital resources. This is important since one of the core explanations as to why the population ageing process can take place in a reasonably painless fashion is that leveraging human capital resources can help less people be as effective economically as more people were previously (ie the economy can still grow even with a reducing workforce). This is one of those ideas which sounds awfully good on paper, but may turn out to be much more complicated to apply in practice, and one of the reasons for writing this lengthy post and thinking about this so much is that in those countries most directly affected at the present time - Germany, Japan and Italy - we seem to be observing not the promised surge in the quality of the aggregate human capital deployed, but rather a steady decline, and in particular as reflected in the wages and salaries paid as the median age rises. Indeed, it is rather noteworthy in this connection to note that as the speed of the expansion in Germany slows (January 2008), record numbers of employees are still being added to the labour force.

In order to try to carry out a quantitative comparison between countries the Lisbon Council defined human capital as the cost of formal and informal education - as expressed in euros - and multiplied this result by the number of people living in each country. They also adjusted their calculations to take account of ongoing demographic developments, provisioning for the loss of human capital due to declining workforces and shifting population patterns across the EU countries. What they found in their 2006 edition was as follows:

Some countries – notably Germany and Italy – are courting disaster by allowingtheir human capital to stagnate through high workforce exclusion andchronic underinvestment in education an training. Unless reversed, these trends will lead to a deterioration of human capital in those countries – countries which traditionally served as the engine of European economic success. That, in turn, will have devastating economic consequences for the citizens of those countries which can already be forecast today. For example, if current trends are not reversed, the citizens of Germany and Italy could find themselves with up to 50% lower gross domestic product per head (a standard measure of basic prosperity) than people in Sweden, Ireland or the United Kingdom by 2030 – an historic reversal of Europe’s traditional pattern of economic distribution, brought on in no small part by the poverty of contemporary policies towards human capital in those countries.

In fact Sweden topped the European Human Capital Index in 2006, while Germany and the Mediterranean countries marked the bottom (Germany was in tenth place out of thirteen, just above Portugal, Spain and Italy, in that order). Indeed the study found that high-skill immigrants tend to go to countries that are prosperous and offer attractive job opportunities.

As growth and wealth diverge, highly-skilled citizens from stagnating economies are unlikely to merely watch their standard of living decline relative to their European neighbours. German doctors working in the Nordic economies, or London’s pull on financial-service workers, are examples of a phenomenon that is likely to become more widespread – with ultimately negative consequences for countries that are unable to attract and retain their best and brightest workers. This migration of highly-skilled labour will amplify economic divergence, reducing economic growth further in the economies at the bottom of the table and enhancing the position of those at the top.

Human Capital Utilization

The Lisbon Council also found significant divergence in degrees of human capital utilisation across the European Union, with levels varying from those encountered in Italy - where a scoreof only 52% was registered - to the Netherlands - where the equivalent level was 64%. However they found that this gap had been reducing, since the spread had previously been even wider, with some countries at one point utilising only 40% of their available human capital.

They found that, over the last two decades, Human Capital Utilisation across the EU had risen to 58%, up from the earlier average of 50%. During that time, three countries were found to have exhibited particularly stellar performances, rising from the bottom all the way to the top – the Netherlands, Spain and Ireland.

At the other extreme the worst performer was found to have been Germany, where they found that Human Capital Utilisation had actually fallen or stagnated. As shown in the charts above, as populations more and more human capital is vested in the over 60s. If current retirement patterns do not change, the average level of German Human Capital Utilisation will fall to 52% by 2030 based on current demographic trends. If this happens, it will roll back and reverse all of the achievements in effective Human Capital Utilisation made over the last 20 years. This is why what is happening in Germany's labour market at the present time is so important.

And the point is that retirement patterns are changing, and more and more people over 60 are going to work - in Germany, Japan and Italy - but the kinds of jobs they are doing are generally ones with a much lower value content than those they did when they were under 55, and this is what is being reflected in the very weak upward movement in aggregate wages and salaries in these countries of late.

The employment rate of older workers (as shown in the chart above) is calculated by dividing the number of persons aged 55 to 64 in employment by the total population of the same age group. This age - while still not especially high for Germany - has been rising steadily of late, as has the average age of exit from the labour force (see chart below).

The magnitude of the demographic trends we are looking at varies greatly from one country to another across Europe. France, Ireland and Sweden, for example, have been able to maintain their birth rates around or near to replacement levels. In Germany and Italy, on the other hand, fertility has been unable to break out of the 1.3 tfr zone, and has been at very low leves for decades now, hence all the available alarm bells should be ringing. If current employment and immigration patterns continue, the thirteen countries analyzed in the European Human Capital Index will lose 12.4 million employees by the year 2030, a loss of close to 8% of the workforce. Of these, Germany will lose 5.2 million and Italy 3.5 million employees, jointly accounting for an incredible 70% of the total European drop. In Germany, the shortfall will be equivalent to about six age cohorts that should be working instead of retiring – or in other words the average effective retirement age would have to move to 66 by 2030, up from 60 today, in order to neutralize the demographic change. In Italy the shortfall is closer to seven age cohorts, and the effective retirementage would have to rise to 68 in 2030, up from 61 today.

But of course even as the proportion of people over 60 is going up, what we are seeing is that the economic value of their contribution is going down. So the very big question is really why this is happening? Why is Germany's human capital so evidently in jeopardy, just at the time when the German economy appears to be performing so exceptionally well in terms of new job creation. And in particular why is it that Germany is producing so many low-skill jobs at just the time when skill shortages in the higher value work seem to be presenting themselves on an ever increasing basis.

And again all of this takes on some importance in the context of the present debate about the dangers of wage push inflation as Germany's labour market tightens. If we look at the chart for total wage costs, we can see these have been pretty weak over quite an extended period of time now.

But if we come to look at the path of total wages over the last 12 months we will find that one important reason why German wage costs have remained so flat even while unemployment has declined has been that total wage cost increases have been offset to some extent by a one-off reduction in non-wage costs, but this is coming to an end as we enter 2008, which is one reason why all the parties concerned are extremely nervous.

In December 2007 the Bitkom industry association - which includes industry "heavyweights" like Deutsche Telekom, Microsoft Germany and SAP - produced a report which argued that two-thirds of German high-tech firms consider that their operations are being hampered by a lack of IT experts.

Indeed, we are faced with the curious anomaly that even though some 3.8 million Germans remain unemployed, the country's recent growth spurt has left businesses unable to fill an estimated 600,000 vacancies, including many high-skilled jobs, according to research last year by the IW economic institute in Cologne. Among these missing skilled workers are some 48,000 engineers, whose absence the Institute estimates cost Germany last year about €3.5 billion in lost output.

Well part of the answer to our question is possibly to be found in some recent research carried out by the Munich-based economist Dalia Marin. In a paper entitled "Is Human Capital Losing from Outsourcing? Evidence for Austria and Poland", Marin and her colleagues argue that:

"multinational firms in Austria and Germany are outsourcing the most skill intensive activities to Eastern Europe taking advantage of cheap abundant skilled labor in Eastern Europe. We find that the firms’ outsourcing activities to Eastern Europe are a response to a human capital scarcity in Austria and Germany which has become particularly severe in the 1990s."

(see detailed link and full references at the foot of this post, together with details of other related material - including a link to the PhD thesis of Marin's student Alexander Raubold, on which much of the resulting research seems to be based).

Now this finding when I discovered it some months ago really rather surprised me, although perhaps, with hindsight it shouldn't have. I had imagined, like many others doubtless also do, that Germany and Austria were outsourcing primarily unskilled, or lower skilled work (this is, for example, the situation in Sweden, see the Becker et al paper referenced below). But then reflecting a little on simple economic theory, and taking on board the fact that both Austria and Germany are now suffering relative shortages of young people, and the huge differential in skilled wages which exist between East and West , then it may well make sound economic sense for German and Austrian companies to employ relatively more intensive quantities (in terms of labour-capital ratios) of relatively cheap skilled labour in the East, and this does seem to be what has been happening.

Corporations’ outsourcing of skill intensive firm activity to Eastern Europe has helped to ease the human capital crisis in both countries. We find that high skilled jobs transferred to Eastern Europe account for 10 percent of Germany’s and 48 percent of Austria’s supply of university graduates in the 1990s.

The Austrian number seems really enormous, the German one less so, but it is still important. In addition Marin produces data which shows that German affiliates in the accession countries were paying (prior to 2004) 17 percent of their German parent wages but had been able to increase their productivity to 60 percent of the parents’ productivity level. Simple mathematics therefore suggests that they were able to reduce the labor costs by some 70 odd percent relative to their parent-firm cost in Germany.

On examining the pattern of multinational investment and outsourcing across sectors Marin found that German investment was predominantly engaged in manufacturing activity in Eastern Europe (almost 60 percent of total investment), of which manufactured goods and machinery and transport are the most important sectors. She also found that some 90 percent of German investment in machinery and transport were outsourcing (rather than local market oriented) investments.

Marin then went on to look at the levels of skill intensity for outsourced work and asked just how skill intensive the activity undertaken by German affiliates in Eastern Europe actually was when compared to their parent firm activity in Germany. She used two indicators to measure the skill intensity of German affiliates in Eastern Europe:

a) the share of workers with a university or college degree and
b) the share of personnel engaged in R&D or engineering activities in the manufacturing and service sector.

The data she studied suggest that the high-skill ratios of affiliates (the number of university or college workers in percent of total affiliate workers) are 2 to 3 times as large as that of German parent firms in the Eastern Accession Countries. The share of university or college graduates among affiliate workers in Eastern Europe was found to vary between a high of 86 percent (Czech Republic) and low of 8 percent (Slovenia).

The most skill intensive activity was being undertaken by affiliates in the Czech Republic (with a skill share of 86 percent), and Slovakia (skill share of 40 percent). This compares with an average share of university or college graduates of German parent firms of 18 percent only. Thus, measured by the number of university and college graduates, German affiliates in Bulgaria were found to be 12 times as skill intensive than their German parent firms, and affiliates in the Czech Republic 5.5 times as skill intensive. Only affiliates in Hungary were found to have a skill share below that of German parent firms.

A similar picture emerged when she looked at the skill intensity of German affiliates as measured by the share of workers engaged in R&D and engineering. The R&D personnel ratios of affiliates in Eastern Europe ranged between 4.0 percent (Slovakia) and 27.8 percent (Croatia and Russia). This compared with an average R&D personnel share of 13.6 percent of German parent firms. Thus, German affiliates in the Czech Republic are 1.7 times as R&D intensive as their German parent firms.

These are striking and puzzling numbers. German and Austrian multinationals tend to outsource the most skill and R&D intensive activities to Eastern Europe. Why is this happening? Well according to Marin:

Economic theory guides us to look at the factor endowment of these countries for an answer. If countries outsource the most skill intensive activities to other countries, then these countries must be poorly endowed with skills relative to their trading partners.When Germany and Austria’s endowment with skills is compared to Eastern Europe.....we find.....the Baltic States, Russia, Hungary, and Bulgaria are the most skill rich countries as measured by the share of the labor force with a tertiary education level. Germany’s education level lies below the OECD average and roughly matches that of the accession countries average. In particular, Germany is less skill rich than the Baltic States, Russia, and Hungary. In this ranking of countries Austria turns out to be the most skill poor country.

In order to examine Marin's thesis a little for my own satisfaction I thought it might be interesting to examine the services trade balance situation in the EU 10 economies. As is relatively well known most of these economies run a much stronger position on their services trade than they do on their goods trade. In order to examine this I broke the EU 10 down into two groups. A first group - Poland, Hungary, Estonia, the Czech Republicand Slovenia, who as can be seen are all doing reasonably well (these are absolute not proortional values - millions of euros - so it is the slope not the level of the line that matters). Poland is doing particularly well, which must be seen as some sort of indication of the quality of the human capital which it still has available at this point (remember, many of these countries can themselves soon face the problems which Germany now faces due to demographic ageing as the reserves are steadily used up).

Then we have a second group - Slovakia, Romania, Lithuania, Latvia, Bulgaria - which do far less well. Bulgaria - as Marin found - seems to have a lot of potential, but the data fluctuates cyclically, although the general ine is clearly up. Romania seems to do the worst, but none of the other three are particularly impressive. In general, of course, this data is far more interesting for what it reveals about the mid term underlying structural dynamics of the EU10, but it also does give an interesting picture of what is actually happening right now.

And especially when we come to look at the negative goods trade balance position of these countries (with the exception of Hungary - which now of course has an internal demand recession - and the Czech Republic).

Obviously, looking at the strong downward line for Romania, we have a clear warning of what is about to come in that country, but this is not our point of interest here. What we can see is that these countries are to some extent (given the importance of Germany in their overall trade) importing finished manufactured products from Germany and paying for these with service exports. This to a considerable extent reverses the normal trading dynamic between developed and emerging economies, and is why Marin described - in a cryptic reference to the tarde links between Mexico and the USA - what was happening as being Maquiladoras in reverse (Maquiladoras are affiliates of US multinationals in Mexico which specialize in the low skill intensive part of the value chain).

Conclusions

So what conclusions can we draw from all of this. Well arguably not the sort of standard ones you will find in the Economist or Bloomberg, or the Financial Times.

The data is the latest evidence that the German economy has proven resilient despite strong economic headwinds, defying the global financial market turbulences and credit squeeze, the sharp rise in the euro, rising raw materials and energy prices, and the marked US slowdown.

Conclusion, Have We Been Here Before?

To close, a few more charts. We can see from the most recent export y-o-y chart that export growth is now slowing significantly (see below), and that we are now entering the downward phase of the whole cycle.

We have, of course, been here before, after the collapse of the internet boom, so it may be worth reminding ourselves at this point what ectually happened last time round, ie the last time the acceleration in the Y-o-Y growth rates in German exports effectively stalled. That was back in early 2000, as we can see from the chart below. And what happened at that next? Well the fed was easing as the US entered recession, and the euro was to some extent rising, both of which put a strong break on German exports. And after export growth collapsed, German GDP growth wasn't far behind. So it isn't the rise in the currency alone that matters, you have to think about the whole environment which produces it. Why your currency is rising, while someone else's is falling. And of course, in German export terms, after the rise comes the fall. This is the cost of not being able to depend on your own internal demand, you have to depend on someone else's demand.

Secondly, we should also think about what happens to employment creation and unemployment as GDP growth stalls. The chart below offers a comparison of movements in the two main unemployment indicators for Germany - the ILO comparable one, and the national German one - from the early 1990s to date. As can be seen the stall in GDP growth produced the rapid rise in umeployment after the summer of 2000, as win-win became lose-lose. I don't see why the picture shoud be that different this time round. The ageing population component in the slowdown will - if anything - be worse this time (the median age is higher). The labour market arguments are outlined in much more depth in this post.