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    Consequences of the Ukraine war: The German economic model is not dead – but endangered

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    Will the German economic model survive President Vladimir Putin’s war against Ukraine and the halt to Russian gas supplies without total loss? A look back at recent economic history helps to answer this question.

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    Germany’s economy was reshaped after the fall of the Wall in 1989. Trade liberalization with its eastern neighbors had three profound domestic effects. First, it led to decentralized wage bargaining. Second, it flattened hierarchical management in companies. Third, liberalization expanded German production networks into Central and Eastern Europe.

    The opening of former communist Europe – where labor costs were lower than in the West – changed the balance of power between unions and employers’ associations. The companies could now credibly threaten to relocate their production to Eastern Europe. With the erosion of union assertiveness, wage negotiations shifted from the national to the company level.

    Trade liberalization with Eastern Europe caused German wages to fall

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    The result: In Germany, unit labor costs fell by 30 percent between 1995 and 2012. The Federal Republic was the only country in Europe where there were such large declines. While the Hartz labor market reforms are mostly blamed for lowering German wages, economic data suggest that the Hartz reforms actually played no significant role in this development. It was trade liberalization with Eastern Europe that contributed to this result.

    The opening of Central and Eastern Europe went hand in hand with the introduction of decentralized management in German companies. In the face of increasing internationalization and intensified competition, innovation became more and more important. To encourage creativity among workers, German companies delegated decision-making to lower levels of management—an effective approach, as it turned out.

    There was an increasing emphasis on quality, and strengthening lower management levels meant that companies released more products that customers loved. The typical German company that relied on decentralized management increased its export market share by a factor of three, while companies that retained centralized management generally failed to achieve such gains.

    After opening up, Germany’s eastern neighbors helped Germany to cope with the shortage of skilled workers.

    Dalia Marin

    In addition, the opening of the former communist countries led to expanded production networks in Eastern Europe. They lowered costs and helped Germany to cope with the shortage of skilled workers. The eastern neighbors offered the Federal Republic a wide range of skilled workers, especially engineers. In 1998, 16 percent of the population in these countries had a university degree, compared to 15 percent in Germany.

    In addition, growth in the human capital stock in Germany had slowed to a rate of 0.18 percent in the 1990s, compared with 0.75 percent in the 1980s. When German companies invest in Central and Eastern Europe, they employ three times as many people with academic degrees and eleven percent more research staff in their subsidiaries than in their parent companies.

    By the end of the 2000s, the productivity of German companies had increased by 20 percent.

    Dalia Marin

    By the end of the 2000s, the supply chains resulting from the opening of Central and Eastern Europe had reduced costs and increased productivity in German multinationals by a good 20 percent. In this way, Germany was able to develop from the formerly sick man of Europe into today’s strong economic power.

    Supply chains have been moved back to developed countries since 2008

    But will the German economic model built on international integration survive Russia’s invasion of Ukraine? Here’s an interesting look at what happened after the 2008 global financial crisis. While international supply chains were a motor of globalization after the fall of communism and even more so after China joined the World Trade Organization in 2001, this trend reversed from 2008 onwards. Growing global uncertainties led to supply chains being relocated back to rich industrialized countries, including Germany.

    While the financial crisis ended hyperglobalization, the Covid-19 pandemic appears to have started the process of deglobalization. The economist Kemal Kilic and I estimate that Covid-19 has reduced supply chains by 35 percent, measured as the percentage of input factors imported from developing and emerging countries in the total amount of all primary products used.

    The Ukraine war is accelerating deglobalization
    © picture alliance/dpa/AP

    Now Putin’s war is accelerating deglobalization. It sent shockwaves through the global economy. Worse, Russia’s aggression appears to be just one particularly violent expression of a broader trend toward authoritarian rule. This trend is not conducive to international trade, global supply chains and foreign direct investment.

    China’s recent moves are worrying in this regard. Beijing has halted imports from Lithuania in retaliation for Vilnius allowing Taiwan to open a representative office under its own name in Lithuania’s capital. China also imposed tariffs on imports from Australia after Canberra called for an independent commission of inquiry into the origins of the coronavirus.

    International trade has turned into an arena of political struggle, coupled with the shock of Putin’s war and the ongoing uncertainty from the coronavirus pandemic, all of which will prolong the disruption in supply chains. However, the longer the disruptions last, the more likely it is that companies will completely reorganize their supply chains.

    US Treasury Secretary Janet Yellen has already suggested adding friend shoring to the list of strategic options alongside reshoring and onshoring. Friend shoring is already under way in Germany. According to a survey by the Ifo Institute, every second German company with supply chains in China is currently rethinking its business model. The German economic model is not dead yet. But compared to many other rich industrialized countries, it faces greater challenges.

    The best way to meet the challenges is if Germany diversifies its trading relationships so that it is no longer overly dependent on the instabilities in a particular country or region.

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    Source: Tagesspiegel

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