Discount store Aldi, a German retailer. Germany has the largest low-wage sector in western Europe © Alamy

Germany’s current account surplus, the balance of trade between exports and imports, is set to hit almost $300bn, or 7.8 per cent of gross domestic product, the world’s largest. This has drawn criticism from the Trump administration and international organisations such as the IMF.

They point to the increasing global imbalances between countries with deficits and surpluses, and the risks that high levels of overseas assets pose for the stability of financial markets.

Germany’s response is to insist on the benefits of free trade for all, the demand for high-quality German products and the needs of an ageing society.

Those arguments are not entirely convincing as high exports could partially be offset by stronger domestic demand, and higher wages would enable Germans to save for old age.

Germany is an extreme instance of the combination of high export rates and depressed domestic demand. Despite its size, it has this in common with Benelux and Scandinavian countries, also strongly export driven. Part of the explanation for Germany’s export performance is the undervaluation of the euro, but this does not explain low wage growth over the past two decades and sluggish domestic demand.

So why does Germany behave this way? Key to understanding the obsession of German policymakers and business leaders with export-driven growth is the effect of re-unification in 1990. The re-unified German economy was first hit by a major recession in 1992-93 when 500,000 manufacturing jobs were lost and the labour market of the former East Germany collapsed.

Unemployment there hovered around 19 per cent in the 1990s, despite generous early retirement and retraining schemes. By 1999 Germany was being labelled the “sick man of Europe”.

There were two important responses to this. First, manufacturing companies in western Germany and their trade unions started major restructuring efforts to regain competitiveness. This was negotiated in company-level agreements and based on the condition that employment for the core workforce of those companies was secured and that wage increases remained moderate.

The second response was to restructure the east German labour market. Wages in the deindustrialised regions of the east fell to low levels, reflecting weak industry structures and productivity.

Wage and income inequality rose across Germany during the 1990s. The size of the low-wage sector in Germany also grew, rising from 15 per cent in 1995 to 22.6 per cent in 2006, roughly where it remains today. It took Germany until 2015 to introduce a moderate minimum wage. As a result, Germany today has the largest low-wage sector in western Europe, even bigger than that of the UK.

Contrary to what is sometimes claimed, the labour market reforms of the early 2000s, named after Peter Hartz, former head of human resources at Volkswagen, did not cause Germany’s low-wage economy.

But they did reinforce pre-existing trends by cutting unemployment insurance to a comparatively meagre 12-18 months of income-related benefits. This added to pressure on big manufacturing companies to avoid lay-offs and, in turn, on unions to accept low wage increases.

In the east, the cuts in unemployment benefits and other aspects of the Hartz reforms pushed the low and medium-skilled long-term unemployed into low-paid service sector jobs. In-work benefits were introduced in a way that encouraged part-time work for the low and medium-skilled.

Wage increases have been held down by other policies. Income tax splitting for married couples results in a reduction in women’s working hours and low wage earners in Germany face the highest effective tax rate among the OECD club of mostly rich nations.

Finally, the debt brake, which came into force in 2011, puts additional pressure on the federal and regional governments to prioritise savings over investment. Compared with other European countries, Germany has a particularly bad record of public investment.

Rebalancing the economy is necessary and would benefit Germany and its trading partners. The country needs higher domestic investment and better pay, especially in the service sector. Although a tight labour market might push wages up a little, the German strategy is seen as successful at home and is firmly enshrined in laws and institutions. This means that real change will require a significant, and painful, shift in policy.

The writer is research director of the Institute of Economic and Social Research and professor of public policy at the Hertie School of Governance

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