It is striking how the assessment about the German economy has changed over the last 2 years. Even one year ago, many investors regarded Germany as a hopeless case viewing it a rigid economy, unable to compete in the world economy given its expensive workforce.

Weak growth since the bursting of the tech bubbles seemed to confirm this pessimistic view of the German economy. From 2002 until 2004 the German economy barely contributed to growth in Euroland.

However, a closer inspection of the German economy during that difficult period ought to have shown that the ‘bad news’ coming out of Germany was in some respects masking a more positive evaluation ‘good news’ in disguise. The reason for this was that growth was hampered by a difficult adjustment process that weighed on the economy in the short-run but also sowed the seeds for a fundamental improvement that would eventually translate into stronger growth.

Structural change on many fronts. The deep restructuring of the corporate sector that took place in the German economy was a reaction to a change in the financial system and the effects of globalisation/European Union enlargement. The change in the financial system meant that the cost of capital increased while globalisation/EU enlargement meant that the bargaining position of German unions was weakened significantly.

Rising costs of capital. In the past German companies were implicitly subsidised by the banking sector. The position of the state owned bank sector meant that German companies could lend in the past at lower than market rates. The introduction of the Euro, the loss of the state guarantees for the public sector banks and the new Basle II regulations meant, however, that banks were required to increase their lending margins and demanded higher interest rates. The higher cost of capital meant that companies had to cut back their investment until they become profitable enough to borrow at the now higher costs of capital.

The end of Germany Inc. Another important change in the German financial system refers to the inevitable end of the cross-shareholdings among the big German companies with banks playing a major role in corporate governance. This network of cross-shareholdings has ceased to exist and capital markets are now, as elsewhere, vital for the German corporate sector. This change in ownership implied higher cost of equity as capital markets in general demand a higher return than banks.

Inevitably employees were (and still are) bearing the burden of the adjustment. Part of the adjustment process necessitated a prolonged period of wage restraint. As the return on capital had to be increased, employers put pressure on wages demanding more work for less money in many cases. Given the (real) threat to shift production abroad, unions and employees in general accepted a freeze or even decline in wage.

Adjustment complete. The German corporate sector has now finished its adjustment to the higher cost of capital as reflected by the sharp increase in investment spending. Gross fixed investment has risen now by 10% over the last 2 years. Employment is also rising strongly: more than 500,000 new jobs were created last year.

A new growth engine in Euroland. The German economy is growing strongly and even the VAT hike has not caused any serious damage to the economy. In 2006 Germany contributed more to growth in Euroland than France and Italy combined. Interestingly, the German economy has grown more strongly than the US economy over the last 3 quarters.

Germany a globalisation winner. The pressure on wages and the rebound in productivity has led to a dramatic decline in unit labour costs. Unit Labour Cost in the manufacturing sector are now almost down to the level right after unification. The continuing success of German exporters should therefore not be a surprise. Germany is also benefiting in particular from the strong growth seen in the BRICs. Exports to China, for example, have risen by more than 300% since 2000, exports to Russia have even risen by around 500%.

The right mix of products. Germany is not only benefiting from an improved competitiveness but also from the right mix of products. In many industries German exports are complementary to what the BRICs are producing.

But labour is so much cheaper in Central Europe/China? True, wage costs in Central Europe and other emerging economies are still significantly lower than in Germany. However, wage costs are only one factor that dictate where to invest and produce. Infrastructure, the legal framework, the pool of educated workers are all also important factors. Moreover, the sheer size and the sophistication of industrial clusters on Germany means that productivity of the average worker is much higher in these clusters than if certain production processes are shifted abroad. Germany still has many very excellent industrial clusters that are well equipped to hold their ground in global competition. The fact that companies are now investing and hiring strongly is proof of this. Moreover, the increasing interest in Foreign Direct Investment into Germany is another indication of the German industrial renaissance.

There will always be change. As impressive as the turnaround of the German economy is, the structural changes and the adjustment to the globalised economy will have to continue, albeit not in such a disruptive way as in the past couple of years. However, all other industrialised countries will have to adapt as well to the continuous changing environment. What the German example has shown is that it can be successfully done.

This is the text of a speech delivered by Peter Sutherland at The Wurzburg Conference – Informal Council on Competitiveness