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How Labor Market Reforms Underpinned Germany’s Resilience
December 14, 2012 | Contribution by KLAUS F. ZIMMERMANN

By Klaus F. Zimmermann, Director of the Institute for the Study of Labor (IZA, Bonn)

"The biggest economy in the euro area, Germany's, is in a bad way. And its ills are a main cause of the euro's own weakness. [...] Thus the biggest economic problem for Europe today is how to revive the German economy."


This excerpt from The Economist in June 1999 illustrates that not so long ago, the "sick man in Europe" was Germany. The phenomenon of successive, recession-related waves of unemployment that ended up accumulating was considered to be a European problem, and Germany served as the prime example for the pattern of high and rising unemployment. The country faced severe problems in its labor market, which have often been linked to the high level of employment protection, high labor costs, and the strictly regulated labor market. During the 1990s, a number of policy measures addressed these problems, but the outcome was far from satisfactory — the adjustments merely addressed the symptoms.

Jump to the present, and the picture is dramatically different. Although Germany has been hit relatively hard by the Great Recession in terms of its impact on GDP, the crisis has, unlike in other countries — like the United States, the United Kingdom, and Japan — never translated into an employment decline (see figure). Quite to the contrary, the size of the German working population held at a record level of more than 40 million people through both 2008 and 2009 and even went on to exceed 41 million.

U.S. jobs hardest hit by Great Recession even though GDP wasn't


Why did Germany's labor market buck the trend and respond only mildly to the Great Recession? A recent article in the new IZA Journal of Labor Policy (Ulf Rinne and Klaus F. Zimmermann, 2012) argues that the underlying factors are related to major labor market reforms — some of which may be replicated by other countries.

Germany's labor market reforms

Starting in 2003, structural labor market reforms making low-skilled labor productive helped put the economy into a relatively strong position when the crisis arrived in Germany. While the long-term unemployment rate could be substantially reduced, skilled labor in the best-managed and successful companies, typically in the export sector, became increasingly scarce. This is important to recognize as the crisis in Germany mainly affected export-oriented companies, in particular manufacturing, and not the consumption sector. Firms affected by the Great Recession had a strong interest in retaining their qualified workforce against the background of population ageing and the expected future shortages of skilled labor.

The behaviors of social partners (trade unions exercising wage restraint and, more important, using the collective bargaining process to arrive at much more flexible labor arrangements) and automatic stabilizers also helped cushion the crisis' labor market impact. Firms affected by the crisis reacted mainly at the intensive margin to retain their workers. Next to the reduction of overtime hours and other instruments of working time flexibility if available at the firm level (for example, working time accounts), short-time work was the instrument through which this could be managed at reasonable costs.

The labor market reforms are therefore a key factor in explaining Germany's remarkable resilience to the Great Recession. They resulted in a better functioning of the labor market with an increased effectiveness of labor market instruments, improved incentives for the unemployed to take up jobs, and greater labor force participation rates.

Replicating Germany's success

Is the German model transferable to other developed countries? Some aspects of this model are certainly transferable. A substantial part of the country's success story during the Great Recession is its recent reform efforts that have helped putting Europe's "sick man" back on track. These long-term labor market reforms can definitely serve as a role model for other countries. But some aspects are likely to be less transferable. With regards to short-time work, it presumably helped that firms already had experience with using it. In addition, the crisis appeared in Germany as a sector-specific and transitory external demand shock.

However, two other countries — Austria and the Netherlands — also had similar experiences to Germany, and the combination of several features seems to be related to successfully navigating the crisis. They all experienced a transitory shock in external demand; they all expected to face long-term shortages of skilled workers; and they all had short-time work schemes available during the crisis.

One general conclusion that can be drawn from cross-country comparisons of labor market responses to the economic crisis is that countries with existing policy measures to quickly adjust fare relatively well. And previous reform efforts pay off, also and maybe in particular during a crisis. In that light, each country must develop its own strategy for labor market reforms. But it is certainly not a bad idea to take the German model as a reference.

For further information, see: Rinne, Ulf and Klaus F. Zimmermann (2012): “Another Economic Miracle? The German Labor Market and the Great Recession,” IZA Journal of Labor Policy 1, Article 3, 121. [OPEN ACCESS]

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