At the end of the 1980s, the apparent ascendancy of the Japanese and German economies was one of the more astonishing developments of the modern era. The defeated powers of World War II had literally risen from the ashes, while the victor — the United States — was widely believed to be sinking into a permanent state of decline. Yet nothing could have been further from the truth. Japan’s bubble economy burst, and the combination of German reunification and European integration ushered in a long period of structural malaise in Germany. Meanwhile, America did what it does best — reinvent itself on the back of an extraordinary renaissance of productivity-led restructuring. I suspect that this debate is about to come full circle: First Japan and now Germany — the world’s second and third largest economies — are on the mend. Meanwhile, a saving-short, asset-dependent US economy may struggle to stay the course.
In the rush to embrace the new powers of globalization — especially China and India — we risk losing sight of the old stand-bys. The United States, Japan, and Germany still collectively account for 43% of world GDP as measured in dollar-based market exchange rates. In purchasing power parity terms — an IMF-based metric that attempts to adjust for disparities in foreign exchange rates — the combined weighting of the three economies is 30%. Either way, there can be no mistaking the dominant role the powerhouses of the industrial world still play in driving the global economy and world financial markets.
Germany won’t be buried by European economic integration
Nor do I buy the view that we should forget about Germany and bury it in some amorphous pan-European aggregate. Notwithstanding the advent of the euro, the ECB, and meaningful progress on the road to pan-regional economic integration, individual European countries still have very distinct economic identities.
A high-productivity-growth German economy is a case in point — as is the Italian economy with its steadily declining productivity trend. The just-released Global Competitiveness survey of the World Economic Forum underscores a similar conclusion: German business competitiveness is ranked second only to the United States and well above that of the UK (#8) and Japan (#9) — to say nothing of France (#16), Spain (#30), and Italy (#38). And, of course, Germany still accounts for the dominant share of European GDP — 28% of the 12-country Euro area as measured on a PPP basis. It may not be fashionable in Europhile circles, but I have no problem still looking at Germany as one of the top three powers in the global economy.
Don’t be distracted by China and India
Yet in recent years, I am just as guilty as anyone — if not more so — in turning my attention as a global economist to China and India. Both of these nations are in the midst of stunning transitions that could well remake the global economic order over the course of this century. And China and India are already having major impacts on the mix of world trade, as well as the global pricing of labor and commodities. But they remain far from the pinnacle of prosperity enjoyed in the rich countries of the industrial world: Per capita GDP in China is still only about 5% of the combined average in the US, Japan, and Germany, and India’s standard of living is less than half that of China’s. Compared to the tortoises of the developed world, the developing world’s hares seem to be running at lightening speed. But as Aesop reminds us, slow-moving leaders with a massive head start should never be taken for granted.
Enjoying this article? For two recommended articles like this every day, plus the latest investment news and opinion from MoneyWeek, sign up to our FREE daily email, Money Morning. CLICK HERE
The leaders aren’t exactly standing still either. As I travel the world, I sense something big is brewing in the mix of industrial world economic activity. Four years ago, there were whispers of revival in Japan. They came mainly from the business sector, where a massive restructuring was gathering momentum. Anecdotal at first, these reports turned out to be an accurate portent of a stunning turnaround to come in the Japanese economy. Today, there are similar whispers in Germany. I have been to Germany twice in the past three weeks, and in meetings with a wide range of German business managers, the verdict was nearly unanimous — a powerful restructuring is now bearing fruit. Like the case in Japan a few years earlier, this could well be the start of a reawakening in the world’s third-largest economy.
Germany and Japan: what the data can tell us
The official data flow has yet to capture the full extent of these turnaround stories. Japanese GDP growth has accelerated to a 2.6% average annual rate in the past three years — double the anemic post-bubble trend evident since the early 1990s. But the economy still remains far too close to a deflationary quagmire. The German economy is turning in a very good year in 2006 — a 2.1% increase in real GDP, or nearly double the 1.25% average gains of 2004-05; however, with a large VAT tax hike looming, there is understandable concern of a sharp payback in 2007. Our forecast of 0.7% German GDP growth for next year reflects just such a possibility.
Trends in GDP growth don’t tell the full story. Beneath the surface, something important is stirring on the productivity front in both economies — for my money, the ultimate arbiter of an economic turnaround in any nation. Japanese productivity growth averaged 2.1% over the 2003-05 period — nearly double the 1.2% trend over the 1995 to 2002 interval. There has also been a pickup — albeit more recent — in German productivity; output per worker has expanded at a 1.7% average annual pace in the five quarters ending mid-2006 — more than double the anemic 0.7% trend from 1998 to 2004. The improvements in Japanese and German productivity mirror a comparable trend that has been evident in the US for a much longer period of time — a 2.8% average annual increase over the 1996 to 2005 period, or a doubling of the anemic 1.4% trend recorded over the 22-year 1974 to 1995 interval.
Cyclical shifts bring long-term opportunities
Undoubtedly, a portion of the recent improved productivity growth in both Japan and Germany is traceable to a cyclical, or transitory, acceleration in economic activity. Some of that cyclical impetus will be unwound if, in fact, aggregate economic growth slows in both economies in 2007, as we are currently forecasting. Yet history suggests that an adverse shift in the cyclical climate could well turn into an opportunity. In studying corporate restructuring for now close to 20 years, my experience tells me that once the business sector gets religion in facing up to competitive challenges, cyclical pressures in operating conditions invariably lead to an intensification of cost cutting and other forms of restructuring. The US is a case in point: Corporate restructuring began in earnest in the first half of the 1980s, but it wasn’t until the mild recession of the early 1990s that those efforts intensified and finally bore fruit in the form of a powerful and sustained productivity revival beginning in the mid-1990s.
Enjoying this article? For two recommended articles like this every day, plus the latest investment news and opinion from MoneyWeek, sign up to our FREE daily email, Money Morning. CLICK HERE
Elga Bartsch has come to the same conclusion regarding prospects for German restructuring in 2007 in the face of her forecast downshift in German GDP growth next year (see her 21 July 2004 report, “German Restructuring in a G3 Perspective”). She believes Corporate Germany will rise to the occasion and intensify its cost-cutting efforts in such a climate. Having spoken with a broad cross-section of focused and very determined German business managers over the past few weeks, I am very sympathetic to this view. I also believe that the improved flexibility of German labor markets, together with a long-overdue increase in the IT content of Corporate Germany’s capital stock, will provide important tailwinds to German productivity in a tougher cyclical climate (see: Is Germany making a comeback). Robert Feldman has made a similar point with respect to Japan (see his 9 June 2006 research note, “Equities, ULC, and the BOJ”). Meanwhile, there’s new twist to America’s miracle: Even productivity bulls like Dick Berner are starting to wonder whether the US can stay the course of its decade-long productivity bonanza.
And so the story comes full circle. Both Japan and Germany currently seem to be where the United States was in the early 1990s — upping the ante on corporate restructuring, thereby sowing the seeds of an early-stage productivity revival. At the same time, the US may well have “maxed out” on its restructuring and productivity story; the “capital deepening” associated with the transformation to an IT-enabled production platform is well advanced and the heavy lifting on corporate cost-cutting may be more in the past than in the future. And, yes, the US, with its massive current account deficit, faces its own set of tough cyclical challenges — especially as saving-short consumers now come to grips with the bursting of America’s “last asset bubble.” There is a certain sense of déjà vu in all of this — but this time with a very different twist: America is widely thought to be at the top of its game as the global economic hegemon, while Japan and Germany have long been written off as has-beens. Just as the tables were turned a mere 15 years ago, a similar about-face could well in the offing.
What a repositioning of the Big Three means for the rest of the world
A repositioning of the Big Three economies has potentially important implications for global rebalancing. A post-bubble retrenchment of the American consumer should undoubtedly provide cyclical relief to the US current account deficit. But the sustainability of any such improvement depends on whether the rest of the world — in this case, Japan and Germany — can convert productivity gains into consumer-led growth dynamics. The jury remains out on that count. Without progress on labor market reforms and retirement security, households in Japan and Germany may remain predisposed toward saving. But if those problems can successfully be tackled and consumption support starts to kick in, the outcome could be a huge plus for global rebalancing.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum