Cracks in Germany's united wage restraint front are making for an interesting debate, writes DEREK SCALLY

GERMANY IS beginning to question the economic orthodoxy of wage restraint as the key to long life and happiness. After two decades preaching from this gospel, the euro zone crisis has turned some influential German economists agnostic and put wind in the sails of the non-believers in their ranks.

There were always good economic reasons for German wage restraint. The economy was badly exposed when its post-unification bubble burst. A sharp rise in labour costs in the early 1990s, coupled with lower-than-expected productivity in eastern states – long-term patients on subsidy drips – sent Germany into a downward competitiveness spiral of deep recession in the early part of this century.

The prescription for the German patient: structural reforms, including deep welfare cuts, greater labour market flexibility and a widespread wage freeze. From 1999 to 2007, the last year before the euro zone crisis, unit labour costs in Germany fell by 16 per cent while they rose by 4 per cent in the rest of the EU.

With Germany now in rude health, economists are realising the medicine for the German patient has had drastic side effects on its neighbours.

Leading this diagnosis is Prof Gustav Horn of the traditionally union-friendly Institute for Macroeconomics and Economic Research (IMK). He has penned a widely-read article saying Germany’s economic strength was built “on the debts of others”. His thesis: Germany’s extended wage restraint strangled domestic demand and the imports market. Combined with, by German standards, an undervalued euro, this was a win-win situation for Europe’s largest economy.

What sounds like old news for many people around Europe, particularly in Ireland, is a far less widespread view in Germany. But a battle is now on to influence public opinion.

The wage restraint camp is fighting back, led by Cologne’s Institute of the German Economy (IW). It published a report this week, asking Is Germany too Competitive? and answered with an emphatic “No”.

In its analysis, Germany has the fifth highest unit prices in Europe, and thus cannot be accused of “wage dumping” at others’ expense. What’s more, the recent economic crisis has eroded much of its labour cost advantage, according to IW director Prof Michael Hüthner.

While other countries responded to the crisis with mass lay-offs, Germany enacted short-time legislation, allowing companies reduce workers’ hours, wages and non-wage costs. The knock-on effect, according to the IW study, was a drastic drop in productivity of about 19 per cent.

The reviews for the IW study have been mixed. Critics point out Germany’s short-time legislation has already turned to its advantage: while countries elsewhere scramble to rehire qualified staff, German companies could turn to existing staff.

A closer look at the study reveals Ireland has been left out of the IW comparison of labour costs between German and the rest of the EU. Given the Irish labour cost explosion in the Celtic Tiger years, surely that makes Germany seem even cheaper.

“The labour cost figures for Ireland were breathtakingly low; we didn’t quite trust them,” said Christoph Schröder, the researcher who complied the IW’s report. In the institute’s view, Ireland is a “beachhead for US industry in Europe” with its “very low tax rates” and is thus a distorting factor.

For Berlin’s German Institute for Economic Research (DIW), the recession has opened eyes in Germany to the dangers of export dependency and a wage restraint it has never encouraged.

“Germany experienced a collapse in economic growth even though we had no real instability in the finance markets – we imported the recession,” said Dr Ferdinand Fichtner, DIW chief economist. “That has made many people more conscious that export dependency and weak imports, driven by wage restraint, is not a healthy development.”

Amid this debate between Germany’s influential economic institutes, there are signs of shifting allegiances. Munich’s influential Ifo institute, for instance, appears to have moved away from its own convictions on wage restraint.

“After years of wage restraint, the time has now come to make somewhat higher demands,” said Ifo president Prof Hans-Werner Sinn, “though I take it the unions won’t overdo it.”

This is what makes the debate so interesting: it’s coming as pay talks begin in Germany’s metal-worker and auto industries, often seen as a barometer for other industries. The unions are calling for 3 per cent plus and “no concessions”.

While the IW in Cologne remains a fan of wage restraint, Ifo, DIW and IMK describe a healthy pay deal as essential for the German and wider euro zone economies.