Germany after the Hartz reforms

Opinion piece (Foreign Affairs)
Christian Odendahl
11 September 2017

The odds were always stacked against Martin Schulz, the Social Democratic Party (SPD) challenger to German Chancellor Angela Merkel in the forthcoming election. Europe’s largest economy is doing so well that voters are simply reluctant to change leaders. After all, in 2005, when Merkel and her Christian Democrats (CDU) took over, German unemployment stood at 11 percent; economic growth had been practically zero for four years running; the fiscal deficit remained stubbornly above 3 percent, the limit set by Europe's fiscal rules; and public debt was rising. Today, after 12 years—ones that brought financial, euro, and refugee crises—Germany is at full employment, the economy and wages are growing steadily if not impressively, and the German government is running a budget surplus, thus causing public debt to fall fast.

Merkel has never claimed credit for that economic recovery. She did something craftier: she gave credit to her SPD predecessor, Gerhard Schröder, and his package of labor market and benefits reforms that was entitled “Agenda 2010” but is widely known as the “Hartz Reforms.” She knew, of course, that these reforms implemented in the early and mid-2000s remained highly unpopular among left-leaning voters and SPD members. By supporting the narrative that it was these reforms that turned the sick man of Europe into an economic powerhouse, Merkel put the SPD in a terrible bind: it could agree with her and claim credit for the recovery by sticking with the unpopular reforms, or it could promise to roll back the legislation and get blamed for putting Germany's economy at risk. 

Worst of all for the SPD, Merkel’s narrative was not even true. The Hartz Reforms did tackle weaknesses in Germany’s labor markets and benefits system. But they were not the main reason for the country’s subsequent economic recovery. In fact, their overall impact was modest.

Let’s start with what the reforms were really about. First, they changed the way the German labor market operates. For example, programs for unemployment aid and social assistance were unified into a single system to better help those on welfare find jobs or be retrained. They liberalized the labor market, particularly for temporary and marginal employment, in order to create more opportunities for the jobless. And they made job search and training centers more efficient. This part of the reform package has indeed greased the wheels of the job market and slightly brought down unemployment (estimates by economists Matthias Hertweg and Oliver Sigrist and Christopher Pissarides are that the rate fell around 1.5 percent). 

The second thing the reforms did was to curb the previously strong incentives to retire early and claim generous unemployment benefits before reaching retirement age. The employment rate among older workers aged 55–64 increased dramatically as a result, albeit from a very low base of less than 40 percent in the early 2000s, to almost 70 percent today. 

Third and most controversially, the reforms cut unemployment benefits in an attempt to increase the incentives to take up work. Previously, the German benefits system was set up to protect living standards indefinitely. Payouts could reach 4,250 euros (around $5,100) per month for up to 32 months, before being reduced to a still-sizable 50 percent of the previous net wage. Since the reforms, the German system has combined temporary protection of living standards for about 12 months with basic protection afterwards, strict means testing, and sanctions on those who refuse to take jobs. The effect of this part of the reform on unemployment has been controversial: although some studies have found a reduction in the unemployment rate as a result, others show a limited effect on the search for work

All three parts of the package contained important changes, but they cannot completely explain Germany's economic rebound after 2004. In fact, four other factors turned out to be more important. First, the long decline in the German construction sector that followed the post-reunification boom came to an end just as the Hartz Reforms came into force. Between 1994 and 2005, construction output fell from almost 8 percent of GDP to around 4 percent, acting as a drag on GDP growth throughout this period. After 2005, it remained roughly at the 4 per cent level, no longer subtracting from economic growth. 

Second, German businesses had undergone a long restructuring process around the start of the twenty-first century—adapting to globalization, changing management styles, outsourcing non-core businesses, and building supply chains in Germany and across Europe—which allowed them to cut costs. By the time the Hartz Reforms were implemented, that transformation was almost complete.

Third, when the reforms were introduced, unions and works councils had already been practicing wage restraint since the mid-1990s: in light of the high unemployment in Germany at the time, they agreed to preserve jobs rather than increase wages. The Hartz Reforms gave the screw another turn at the bottom of the wage distribution, but most of the wage restraint happened before that and was unrelated to the reforms.

Moreover, wage restraint was not the decisive factor for Germany's export successes after 2004. It coincided—and this is the fourth and arguably most important factor—with a worldwide economic boom, notably in emerging markets that needed high-end investment goods. This created the demand for German products and services that Germany seemed unable to generate on its own.

In other words, the Hartz Reforms were phenomenally well timed. They have little to do with Germany’s economic success, but it is obvious why, both in Germany and abroad, it is still popular to give them credit.

For center-right politicians, doing so helps their long-standing narrative that liberalized markets, stringent economic incentives, and tight limits on welfare benefits are ultimately the best economic policy mix, even for workers. It also helps them argue that structural reforms (a notoriously ill-defined term) are better for a slumping economy than fiscal stimulus or expansionary monetary policy. Likewise, businesses favor an environment where light-touch labor regulation allows them to employ workers flexibly and to contain wage costs. They are all too happy to support the narrative that the labor reforms in Germany were decisive.

For their part, center-left politicians in Germany are stuck between claiming credit for the alleged economic successes of their reforms, and the continued unpopularity of those reforms. According to a recent poll, roughly half of German voters would like the reforms to be revised or improved upon, while just 23 percent are against such corrections.

The importance of the Hartz Reforms’ long-lived appeal can hardly be overstated, though. For one thing, no other narrative has so persistently shaped the response to the eurozone crisis as the idea that some countries struggle because they have lost their competitiveness (another notoriously ill-defined concept). In order to grow and reduce unemployment, the story goes, they need to reform like Germany and cut wages.

If the eurozone becomes more German, however, it will consume and import less. In turn, it will export capital (the current account surplus of the eurozone already stands at 3 percent). The world could barely absorb the capital exported by Germany and others before the 2007–08 financial crisis; it will almost certainly be unable to absorb what would be exported from the entire eurozone. Indeed, a more Germanic eurozone sows the seeds of the next financial crisis elsewhere. 

In Germany, the SPD remains trapped in the ambiguous legacy of these reforms. The problem is not just that Merkel and her allies argue that the reforms engineered Germany’s economic rebound. It is also that critics such as the left-wing party Die Linke posit that the reforms put an end to Germany’s social market economy and pushed millions into insecure, low-wage jobs, which is also demonstrably false. The number of workers on temporary contracts or in marginal employment has indeed risen. But income inequality has not increased much since the reforms were introduced, and there were already a staggering number of people working in the low-wage sector in 2004 (then and now, roughly 23 percent of the workforce). Even if the Hartz Reforms were reversed entirely, many Germans would continue to work in low-wage or precarious jobs.

Reform-minded politicians in Europe, such as French President Emmanuel Macron, should learn lessons from the real story of Germany’s success. First, do not jump too easily to the conclusion that a rigid labor market is responsible for low growth or high unemployment. In Germany’s case, that was only one factor, and not even the most important. Second, reforming labor markets works best if accompanied by expansionary macroeconomic policies or a booming world economy. Germany got lucky by reforming when demand for its exports was growing. Third, more flexible labor markets do little, if anything, to boost productivity. But it is productivity that ultimately determines living standards. Labor market reforms should be complemented with a productivity agenda for those most affected by them, not least to build political support. Fourth, Germany adapted well to globalization in part because labor unions were willing to sacrifice wage increases in order to maximize employment. But unions need to be strong enough to demand appropriate wage increases. Striking the right balance is not easy, but it should be a key concern for policymakers. 

For its part, the SPD needs to find a way out of the Hartz trap. Without bringing the center-left voters that the Hartz Reforms alienated back into the SPD fold, Schulz does not stand a chance of replacing Merkel as German chancellor. But the positive narrative about the Hartz Reforms remains deeply entrenched in Germany. Thus, the best strategy for the SPD would be twofold.

First, it should set up a high-profile expert panel to assess which parts of the economy were worth reforming, where the reforms went wrong, and what the economic effects really were. Such an assessment should then form the basis of the party's official view of the Hartz Reforms. This should be politically easier than in the past, as Schröder, the main SPD champion of the Hartz Reforms, became a full-time lobbyist for the Russian government, thus undermining his standing in Germany.

Second, the SPD should set up a new package, an “Agenda 23” for the 23 percent of Germans working for low wages. Such a package would give unions a stronger role in setting wage floors; lower taxes and social security contributions for those on low wages (Germany currently charges such earners a whopping 13 percent more in taxes and contributions than the OECD average); place limits on labor contracts that harm workers; support union membership and coverage in sectors where the workforce is currently less organized; and ramp up investment in productivity among the low-skilled, all the way from school to working age, improving their human skills and training as well as physical capital.

Whether the SPD will be able to push such changes through after the forthcoming election is unclear. The numbers suggest that the SPD would enter another coalition with Merkel as a weakened political force, and it might struggle to push the dominant center-right CDU on labor market and investment policies. On the other hand, only a strong coalition agreement with visible social-democratic content would motivate SPD members to sign off on any coalition at all.

It is remarkable how a simple story—that Germany's labor market reforms turned it from the sick man of Europe into an economic powerhouse—gained such popularity, when few economic theories would predict that such a set of reforms would be the only, or even the main, reason for such success. The economic impact of these reforms was modest; German businesses and trade unions as well as the worldwide economic boom did most of the heavy lifting. Now it is up to the rest of Europe and the German Social Democrats to realize as much.

Christian Odendahl is chief economist at the Centre for European Reform.