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Conversation with Chancellor

My conversation with the German Chancellor - Sequel

Anna Hejka, founder and CEO of Heyka Capital Markets Group focusing on fund management and investment banking services for CEE especially Poland.

Anna Hejka Gerhard Schroeder

February 1999

In spite of understandable preconceptions of our European friends related the expansion of the European Union, Poland has already become an integral and supportive part of the common labor market supplying jobs to approximately a quarter of a million illegal "gastarbeiters" from the EU and creating over 400 thousand jobs within the EU.

The World Economic Forum in Davos, the gathering place of important government, business and media players, as well as members of art and academia, provides an excellent opportunity to expand one's understanding of global events. Many formal and especially informal meetings set against the background of parties, dinners and skiing in majestic Alps can reveal unexpected interactions and emerging trends that will shape the way the world is going to evolve. The palpate camaraderie of members of this elite club, created by the historic vision of Mr. Klaus Schwab, fosters open communications among different nations, races, religions, and professions leading to creative solutions in the service of peace and economic development.

I was also very interested in deepening my understanding of Poland's largest neighbor and, in recent years, the strongest promoter of Polish interests in Europe. During the last decade, Germany has become Poland's most important trading partner, while Poland has overcome Russia as the largest trading partner of Germany in the former "Soviet Block". Germany accounts for approximately 37.5% of Polish exports and 25.9% of imports, while Poland amounts to approximately 3% of each total German exports and imports. Therefore, it is in Poland's vital interest to see strong Germany.

With this perspective, I was personally disappointed with comments of Ms. Ursula Engelen-Kefer, Deputy Chairman of the Management Board of Deutscher Gewerkschaftsbund, who criticized the "ruthless" Anglo-Saxon labor market causing Mr. J. Adair Turner, Director-General of Confederation of British Industry to wince repeatedly in utmost surprise. She repeated Mr. Oskar Lafontaine's pre-election promises of "not allowing disassembly of welfare state and introduction of inhuman neo-liberal policies, which would amount to Americanization of social life in Germany". SPD promised increases in pensions, family, health and disability benefits, pharmaceutical subsidies, winter-pay for construction workers, and protection from layoffs.

As a result, public sector, employing 20% of workers in Germany, consumes 60% of the state budget. However, the results of the new government's actions are not encouraging to the same workers the system was supposed to protect. At the beginning of January, the German Economic Institute predicted GDP growth to slow down to only 1.4% in 1999, while the Federal Labor Office announced that just in two months the number of unemployed increased by 500 thousand people. Ms. Ursula Engelen-Kefer also seemed to have forgotten that France was able to cut its unemployment to the lowest level since 1993 through an increase of part-time work, growing reliance on temporary or short-term contracts and cuts in employers' contributions for low-paid workers.

Increased state involvement in economic and social life can only lead to inefficiencies and ultimately hurt society. Unemployment is only one example of this phenomenon. Hidden costs affect average unit labor cost of industrial worker, which amounts to US per hour in the European Union, while it represents less than US in the US. Moreover, the real disparity is even larger as the recent analysis of the IFO Institute in Munich states that "even with dramatic growth in work productivity it would take a minimum of 10 years before Europe surpasses the productivity of America."

European Union's taxes and contributions surpass 90% of pay, while they are at 38% in the US. Electrical energy subsidized by the state is 47% more expensive in the European Union than in the US, highway transportation is 40% more expensive, while rail transportation and fuel are three times more expensive. Subsidies amount to 43% of price of agricultural products, while 70% of agricultural production has guaranteed prices and sales. Construction, mining, energy, fuel, transportation, and telecommunications are also subsidized.

Consequently, Europe remains in industrial age, while the US has moved into information technology age where 25% to 35% of GDP is supplied by know-how. Not surprisingly, not Europe but the US creates over 80% of world's new technologies and scientific breakthroughs.

Germans work 500 hours less per annum than Americans do. However, unemployment in the US amounts to 4.3%, the lowest level in the last five decades, while German unemployment will remain around the current level of 11.5% in 1999. In addition following elections, Germany experienced a particularly sharp decline in confidence among companies with the IFO index dropping from 98.6 in July to 91.7 in November. The head of the German unions forgot that when a government is incapable of reforming a system stifling economic activity, something else is prone to give to adjust the imbalance.

Integration and flexibility of the United States of America led to three times greater labor migration between the US states than between German Laender. The fact that internal migration flows do not respond sharply to relative unemployment levels in Germany does not mean that there are no other types of economic adjustment, which eventually help to equilibrate inter-regional imbalances. Immigration from outside Germany has substituted internal labor mobility in the past. Therefore, our European friends fear that the EU's eastward enlargement will open up prospect of more inward migration, while the advent of Euro is likely to generate greater pressure for more labor flexibility. Yet, the actual direction of labor movement may prove surprising to majority of EU's politicians.

Regional policy of the European Union will have to become more proactive, but budgetary constraints and local prejudices will limit its effectiveness. However, economic stresses in the Euro area could lead to calls for greater integration by the political leaders in spite of the current mental opposition among European Union's citizens. I found our Davos "Wake up Europe!" dinner, Europe 2050 Initiative: a call by European Global Leaders for Tomorrow for Visionary Leadership" organized by Fields Wicker-Miurin, Partner of A.T. Kearney UK, Hubert Joly, President of EDS France and Ulrich Schumacher, President and CEO of Siemens Semiconductor Group Germany very revealing. Chairman and CEO of French industrial company, a partner of German law firm and a British journalist expressed concerns about the inability to reform "Spanish peasants". Interestingly enough, four months later, during a regional Central European meeting of the World Economic Forum in Salzburg many Europeans at our technology table agreed with me as to the need of deeper restructuring of the economic policies and the benefits of further integration of the continent.

The enviable US job creation has been based on expansion of labor-intensive services so undesirable to Ms. Ursula Engelen-Kefer, who forgot that not all of them are in the low paid food retailing category as, for example, the IT industry is growing by leaps and bounds. Therefore, in the US services represent 72% of GDP, while they amount to only 65% and 62% in Germany and Poland, respectively. As a result of German labor policies, according to the European Statistical Office, there are approximately 200 thousand Germans working legally outside of their country despite lower wages and salaries elsewhere. German workers have voted with their feet and, despite the opinion of leaders such as Mr. Oskar Lafontaine and Ms. Ursula Engelen-Kefer, find more dignity in working than standing in line for unemployment benefits. Is Germany capable of reforming its labor market, restructuring its economy and remaining the economic engine of the continent?

We live in small and closely connected Europe. Poland has been affected by the poor performance of Germany in many different ways, some of them unforeseen and surprising to even veteran economists and cabinet members.

Poland has been implementing a harsh downsizing program in several industries, including mining, shipbuilding, steel, military sector, and textiles, as well as dealing with population growth of 3.4%. At the same time, Germany's population shrinks by 0.3% per annum. However, the average level of unemployment in Poland is starting to be lower than in Germany and its GDP growth is more than double. In the first part of the decade, in the midst of the difficult and unprecedented transformation process, Poland created approximately 6 million new jobs, while the entire European Union was responsible for less than two. "Polnische Wirtschaft", a condescending German term for the Polish economy, is slowly becoming the synonym of reliability, while I am wondering whether the "Euro-sclerosis" is really over.

In addition, regional development patterns have led to striking differences between former East German lands, where unemployment reaches 20%, and western regions of Poland with estimated unemployment at 7%. These differences combined with relative flexibility of the Polish labor market and the absolute rigidities of the German market have led to the first stage of economic adjustment. Resulting price sensitivity has propelled German shopping pilgrimages to Poland since the beginning of 1990s, during which Polish entrepreneurs sell an estimated US billion to US billion worth of cheaper yet comparable quality goods and services per annum.

The second stage of this adjustment process, though logical, has proven to be even more unexpected. Mr. Gerhard Schroeder, the German Chancellor, attended the Focus party and I was able to surprise him with information that proved to be totally new to all my Western European interlocutors in Davos. According to the estimates of the Domestic Labor Office, there are approximately 65 thousand illegal German gastarbeiters working in Poland in addition to two thousand legal workers. Poland also supplies estimated 150 thousand to half a million jobs to British, Austrian, Dutch, and French citizens not to mention workers coming from emerging markets. In addition, Poland's trade deficit with the European Union creates approximately 400 thousand jobs within the common market. For comparison, INSEE expects the French economy to create 90 thousand jobs in the private sector in the first half of the year.

One of the reasons of this phenomenon maybe the different character of unemployment in the two countries. In Poland, it affects mainly persons with low or no professional qualifications, while in Germany it is still, almost 10 years after unification, a regional problem. The first category of the illegal German "gastarbeiters" in Poland consists of engineers, chemists, and electricians from eastern lands. The second group takes advantage of the different price levels on both sides of the borders, such as mechanics who bring German cars to be repaired in Poland. The "volksdeutsch" (German descendents living outside of Germany), who in the 1970's and 1980's received German passports, are the third group. They receive social security payments from the German government and take seasonal jobs in Poland.

These labor statistics indicate that Europeans have no real reason to fear Poland's accession to the European Union. In addition, the accession of Spain, with a population almost identical to that of Poland, to the European Union in 1986 did not cause major disturbances in the European labor market, despite the fact that its unemployment rate at 22% was twice the level in Poland today. In spite of understandable preconceptions of our European friends related the expansion of the European Union, Poland has already become an integral and supportive part of the common labor market.

In addition, as of the end of 1998, Poland provided the European Union with the largest trade surplus of any country in the world executing 73% of its exports and three quarters of imports with the common market. Poland supplied the EU with profits of E10 billion as compared to United States' E7 billion and a deficit of E28 billion, E21 billion and E0.8 billion with Japan, China and Russia, respectively. Polish mining, steel, textiles, shipbuilding and military sectors are aggressively downsized. In terms of agriculture, where the European Union already has a trade surplus, the accession will increase consumption of food products by an average Pole as, for example, current meat consumption in Poland represents only two thirds of EU's consumption per capita per annum. Strong and heavily subsidized (US billion per annum as compared to US billion in the US) EU's farmers will continue to win the battle with fragmented and pauperized Polish peasants.

The performance of Euro versus US dollar is hindered by the poor economic performance of Europe's economies in view of the robust growth in the US. Supply economics, liberalization and unification of the United States of America have brought the flexibility and economy of scale necessary to achieve these impressive results, especially in view of the cyclical downturn in the global economic activity. At the same time, unless liberalized, the double-whammy of Euro-sclerosis, in terms of system rigidities and human aging, will continue to hurt European performance in the future. Due to low population growth, the dependency ratio in Germany will increase by almost 20% by the year 2020.

Low education leads to low productivity and low value added in the economy, yet the combined 1st, 2nd and 3rd level of gross education enrollment ratio in Germany is 81% as compared to 96% in the US. In addition, the number of thousand Internet hosts per million inhabitants in Germany remains very low at 8 as compared to 40 in the US, although the development of the liberal Neuer Markt augurs well for the future of the German market.

It is the excessive scale and growth of public spending that limits economic activity. At the beginning of 1998, James Gwartney, Robert Lawson and Randoll Holcombe proved that beyond any reasonable doubt. Their research of OECD countries between 1960 and 1996 indicates that when public spending did not exceed 25% of GDP, GDP growth averaged 6.6%. However, when it amounted to 25% - 30%, GDP growth declined to 4.7%. An increase in public spending to 30% - 40% pushed GDP growth further down to 3.8%. When public spending exceeded 60% share, GDP growth dropped to only 1.6% per annum.

Three OECD countries managed to limit their public spending as a percentage of GDP. All three of them recorded an accelerated economic growth. In 1960 to 1977, Ireland increased public spending from 28% of GDP to 43% and the average GDP growth amounted to 4.3%. In 1977 to 1986, this ratio increased further to over 52% and the economic activity slowed down to 3.4%. In 1987 to 1996, Ireland radically improved health of its public finances and the average GDP growth increased to 5.4%. New Zealand's ratio of public spending to GDP increased from 34.1% to 48.4% in 1974 to 1992 and the economic growth of the country averaged 1.2%. In 1992 to 1996, public spending was cut to 42.3% and GDP growth accelerated to 3.9% per annum. Finally, in Great Britain the share of public spending increased from 32.2% to 47.2% in 1960 to 1982 and GDP growth averaged 2.2% per annum. In 1982 to 1989, public spending declined to 40.7% and the average GDP growth increased to 3.7% per annum.

The negative impact of increased public spending on the growth of economic activity was also discovered by research done in 60 other countries. A 10% increase in public spending share of GDP was associated with a 1.15-% decline in average economic growth. This research indicates that the key to strong economic growth and, therefore, improvement of living standards lies in limiting public spending share of GDP and focussing the state's activities on its basic functions. Conversely, the maintenance of welfare state requires high level of public spending. In 1992, the Swedish public sector consumed 71% of GDP and the Finnish one 62%. To finance this level of spending these governments had to issue Treasury bonds. As a result, domestic debt reached 83% of GDP and public deficit a staggering 13% of GDP without bringing the expected results. In Germany despite DM100 billion of construction subsidies in 1994 to 1995, the number of apartment owners remained at the level of 1993 before the subsidies were introduced.

It was a child who dared to say that the King was naked. Therefore, as irrelevant as the opinion of the associate members may seem now, it may be important to such country as Germany to listen to their opinions. The Poles and the Czechs have already been asking the relevant question of what kind of Europe we want to join. The answers are not encouraging and the initial enthusiasm (over 80% of the population in favor of joining) is quickly dwindling. The most recent opinion polls show support of only 50% in Poland, while the Czech society is almost evenly divided with 35% in favor and 30% against the idea of becoming a full member of the European Union.

A true leadership is a combination of vision, the ability to inspire others and effectiveness in achieving goals. It requires educating voters and not only fulfilling popular expectations. It requires taking initially unpopular measures for the benefit of society such as the Balcerowicz plan in Poland or New Zealand's agricultural reform, where slashing subsidies and liberalizing economic rules proved extremely effective. Many German citizens, including Mr. Wolfgang Clement, Minister-President of Land Nordrhein-Westfalen, are concerned with the ossified, sclerotic economic system, which is protecting the inefficient and burdening the entrepreneurial, as well as leading to the disintegration of society due to social and economic exclusion.

Mr. Chancellor, I appreciate your responsibility to the German nation and your gratitude to Poland and the Czech Republic for leading to the formal unification of Germany. The question is when you are going to follow with deeds.