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 crucial question. 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. 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.
Companies strengthened the lower management levels
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.
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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.
In addition, the opening of the former communist countries led to expanded production networks in Eastern Europe. They lowered costs and helped Germany deal with the shortage of skilled workers. The eastern neighbors brought the Federal Republic a large supply 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.
From a formerly sick man to an economic powerhouse
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 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 the strong economic power it still is today. But will the German economic model built on international integration survive Russia’s invasion of Ukraine?
To answer the question, it is helpful to look at the period after the global financial crisis of 2008. 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.
Covid reduced supply chains dramatically
The risk of the loss of important input goods prompted companies in industrialized countries to reassess their production networks. While the financial crisis ended hyperglobalization, the Covid-19 pandemic appears to have started the process of deglobalization. The coronavirus created an unprecedented level of global uncertainty, amplifying the legacy of the 2008 shock. Economist Kemal Kilic and I estimate that Covid-19 has reduced supply chains by 35 percent as a percentage of those imported from developing and emerging economies Input factors in the total amount of all primary products used.
Now Putin’s war is accelerating the deglobalization that started with the coronavirus. The war sent shock waves 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.
diversification of trade relations
The examples show that international trade has turned into an arena of political struggle, combined with the shock of Putin’s war and the ongoing uncertainty caused by the corona 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 “friendshoring” to the list of strategic options alongside reshoring and onshoring. Friendshoring 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. However, due to its high dependence on international trade and the changing economic and geopolitical environment, it faces greater challenges than many other rich industrialized countries.
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.
The author: Dalia Marin teaches international economics at the TUM School of Management at the Technical University of Munich and is a senior fellow at the European think tank Bruegel in Brussels.
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