Putin’s war and the German economic model by Dalia Marin

After the fall of communism, Germany has risen from Europe’s sick man to its leading economic power, largely by reaping the benefits of global supply chains. But now, as a new era of deglobalization dawns, Germany needs to think carefully about how to manage its reliance on international trade.

MUNICH – Will the German economic model survive Russian President Vladimir Putin’s war against Ukraine? As I recently pointed out in a lecture at Harvard University, answering this question requires looking back at recent economic history.

Germany’s economy was reshaped after the fall of communism in 1989. Trade liberalization with the country’s eastern neighbors has had three profound domestic implications. First, it led to decentralized wage bargaining. Second, it had a flattening effect on hierarchical management in German companies. And thirdly, it expanded the German production networks to Central and Eastern Europe.

First, the opening up of former communist Europe—where labor costs were lower—changed the balance of power between German unions and the employers’ association. With the unions losing bargaining power, wage negotiations shifted from the national level to the company level.

Because of this new structural wage restraint (the so-called wage moderation) unit labor costs in Germany fell by 30% between 1995 and 2012. Germany was the only country in Europe to record such declines. While the Hartz labor market reforms of 2002-05 are often blamed for lowering German wages, the data suggests that they played no role in this development.

With the opening of the former communist countries, a decentralized administration was also introduced. With increasing internationalization and competitiveness of trade, innovation and the generation of new ideas became more and more important. In order to encourage creativity among employees, German companies delegated decision-making powers to lower levels of management.

This approach proved to be very effective. German business culture became increasingly committed to quality, and the strengthening of lower levels of management led companies to introduce more products that customers valued. The typical (medium-sized) German company that adopted decentralized management increased its export market share by a factor of three, while companies that stuck to centralized management generally did not record such gains.

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Eventually, the opening up of formerly communist Europe led to expanded manufacturing networks that reduced costs and helped Germany deal with a severe skills shortage. Germany’s eastern neighbors offered a wide range of skilled workers, especially engineers. In 1998, 16% of the population of these countries had a university degree, compared to 15% of Germans.

In addition, growth in the stock of human capital in Germany (based on measures in five categories of educational attainment) had slowed to an annual rate of 0.18% in the 1990s, compared with 0.75% in the 1980s. So when German companies invested in Central and Eastern Europe, they employed three times as many people with academic degrees and 11% more research staff in their subsidiaries than in their parent companies.

By the late 2000s, the resulting supply chains had reduced costs and increased productivity by over 20% in German multinationals. Germany has developed from being the sick man of Europe in the 1990s to the economic power it is today.

Will these economic arrangements survive Russia’s invasion of Ukraine? To answer this, it helps to review the period after the global financial crisis of 2008. While transnational supply chains were a major driver of globalization after the fall of communism, and particularly after China’s entry into the World Trade Organization in 2001, they stopped expanding after 2008. Rising global insecurity led to an accelerating trend towards outsourcing to high-income countries, including Germany. The risk of non-delivery of key inputs prompted companies in high-income countries to reassess their production networks.

While the global financial crisis ended hyperglobalization, the COVID-19 pandemic appears to have triggered deglobalization. The coronavirus led to an unprecedented level of global uncertainty, amplifying the legacy of the 2008 shock. Kemal Kilic of LMU Munich and I estimate that COVID-19 has reduced global supply chains by 35%, measured in terms of imported inputs from developing countries as a percentage on all inputs.

Now Putin’s war is accelerating the deglobalization that COVID-19 started. The war has sent shock waves through the world economy and further increased global insecurity. Worse, Russia’s aggression appears to be just a violent manifestation of a broader authoritarian trend.

A world of increasingly confident autocracies is hardly conducive to trade, global supply chains and foreign direct investment. China’s recent moves are particularly worrying. China has sanctioned imports from Lithuania in retaliation for that country hosting a Taiwanese representative office, and has imposed tariffs on imports from Australia after Australian officials criticized Chinese blocking of investigations into the origins of the pandemic.

Unfortunately, arming trade has become all too commonplace and, combined with the shock of Putin’s war and the ongoing uncertainty from the pandemic, will prolong disruption to supply chains. The longer these 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, 50% of German companies with supply chains in China are currently rethinking their business activities.

The German economic model is not dead yet. However, its high reliance on international trade implies that today’s changing economic and geopolitical environment will present Germany with greater challenges compared to most other developed countries. The best way for Germany to maintain its post-Cold War economic model is to diversify its trading relationships so that it is no longer unduly exposed to instability in any particular country or region.

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