Labor Market Reform, Productivity, and Exports: An Analysis using Germany’s Hartz Reforms

By George Hu

Abstract: This paper examines the impact of Germany’s Hartz reforms on country and industry level trade outcomes, particularly trade balances. Utilizing product-level bilateral trade data from the UNComtrade data set along with industry-level data from EUKlems, we conduct two related analyses examining the impact of the Hartz Labor Market Reforms on German economic trade outcomes. First, on the country level, the paper finds that the Hartz reforms on average boosted German bilateral exports, net exports, and net exports as a percentage of GDP with its trading partners. Second, on the industry level, sectors with higher levels of labor productivity also tend to exhibit higher levels of bilateral exports and net exports to trading partners.

I: Introduction

Economists have extensively documented the impact of trade on various macroeconomic outcomes in advanced Western economies as free trade agreements and import competition, especially from developing economies, have multiplied over the past 20-30 years. In fact, mirroring the heated current political rhetoric surrounding both trade and growing inequality, economists have especially focused on studying the impact of increased trade and import competition on societal inequality, especially in advanced economies. Indeed, a large body of the literature, including Autor et al (2013), Autor et al (2014), and Bernard et al (2006) suggests that increased trade and import competition from developing countries have often led to higher income, wage, and wealth inequality on the regional, industry, and individual levels in both the United States and various countries in Western Europe.

However, despite the diversity and plethora of literature documenting such effects, literature surrounding (i) potential policy measures to remedy the inequality incited by increased trade and (ii) the impact of domestic firm or industry-level reform on international trade outcomes proves more uniform as well as less abundant. Specifically, many papers from the literature covering trade’s impact on societal welfare and inequality either omit discussion of policy remedies or suggest that the beneficiaries of trade compensate the shortchanged despite the political difficulties of undertaking such an action. Likewise, although research papers analyzing the impact of relevant industry, firm, and labor market-level reforms on various macroeconomic outcomes including trade do exist, economists and the economics literature remain largely divided over the effectiveness and international applicability of proposed reforms. Overall, while the economists have built a clearer understanding on how exactly the recent increase in international trade has affected levels of inequality in developed countries, a working knowledge concerning how an economy can best remedy the negative effects of increased international trade remains limited.

Aiming to address the apparent imbalance between understanding of international trade’s exacerbating impact on inequality and the understanding of how to counteract these developments, this paper seeks to begin to build an answer for the following question: how do labor market reforms and labor productivity impact country and industry level trade outcomes, specifically exports and trade balances? Considering this question, the paper utilizes German industry and product level data from 2002-2007,[1] a period in which domestic labor market reforms were gradually beginning to take effect. Focusing on Germany from 2002-2007, the paper conducts two related empirical analyses: (i) a country-level analysis which estimates the impact of the Hartz reforms on Germany’s bilateral exports and trade balances, and (ii) an industry level analysis estimating the effect of labor value added[2] on bilateral industry exports and trade balances. In the two analyses, we find evidence that the Hartz reforms increased both exports and the German trade balance, and that industries with higher labor productivity tend to more frequently export and display more favorable (i.e. positive) trade balances. The results may suggest that productivity-boosting labor market reforms may help developed countries mitigate certain negative consequences associated with increased trade on the firm and industry level, but the question of whether such reforms can help remedy trade-induced increases in societal inequality on the individual/worker level requires further research.

The remainder of the paper is organized into four sections. Section II first provides a historical and technical background on the Germany economy and the Hartz reforms. It then proceeds to review two largely independent strands of the economics literature that the paper seeks to link: (i) the impact of the Hartz reforms on German labor market and macroeconomic outcomes, as well as (ii) the relationship between firm/industry productivity and trade outcomes. Section III details the data collected for both country and industry level analysis, before specifying the empirical models that we test/run. Section IV presents the paper’s regression results for both country and industry level analyses, before considering potential direct extensions to our analyses. Lastly, section V concludes and considers the paper’s external validity and policy implications, while also proposing ideas for further related research.

II: Background and Literature Review:

II.1: The Hartz Reforms: Background

While the German economy has stood out as one of Europe’s and the OECD’s best performers over the past decade after the Great Recession, from 1990-2005 the country’s poor economic performance earned it the nickname “the sick man of Europe” (Dustmann et al, 2014). Whereas today metrics including the 3.4% Unemployment Rate, 64.1% government debt to GDP ratio, and annual GDP growth of 2.2% (2017) underline the robust health of the country’s economy, during the 1990s and early 2000s the unemployment rate in Germany remained persistently above 8%, while GDP grew anemically and consistently below 2% annually.[3] Though at first most economists attributed the country’s poor economic performance in the 1990s to the costs associated with reunification and reintegration of the former GDR (Gaskarth, 2014), the persistence of economic stagnation through the introduction of the European Monetary Union into the early 2000s reflected more serious structural issues in the economy and its regulatory institutions. Specifically, politicians and economists alike questioned the continued viability of the German welfare state and its social market economy, which continued to rely on an export-oriented manufacturing industry, in the face of increased import competition and accelerating global economic integration (Odendahl, 2017).

In response to the structural economic challenges that continued to hinder the country’s economy in the early 2000s, German policymakers and politicians resolved to overhaul the regulations and institutions which oversaw the country’s labor market. In particular, the Bundestag, under pressure from then-Chancellor Gerhard Schröder, passed the Hartz reforms, four separate measures which constituted the primary portion of Agenda 2010, a government initiative designed to restore economic growth and lower unemployment (Bauer and King, 2018). As the brainchild of the government’s Committee for Modern Services in the Labor Market chaired by the Volkswagen personnel director Peter Hartz, the reforms were gradually enacted into law from 2003-2005 (Woodcock, 2018).

The Hartz I and II reforms came into effect on January 1, 2003. These first two reforms focused on subsidizing and further incentivizing unconventional employment and entrepreneurial activities by introducing a new federal grant to entrepreneurs (Ich-AG) and offering tax relief to individuals employed in part-time roles, or “Minijobs” (Odendahl, 2017). Next, the government proceeded to implement Hartz III on January 1, 2004. Complementing the subsidization of unconventional work, the 3rd reform aimed to reform the “Job Centers” which assisted the unemployed in reentering the labor market (Woodcock, 2018). Finally, Hartz IV, the most substantial and significant of the four reforms, passed into law on January 1, 2005. Whereas the prior three reforms provided financial support to unconventional employment arrangements and vocational (re)training programs, Hartz IV reduced the scale of the German welfare state by cutting back the government’s financial assistance to the unemployed. In particular, the reform lowered the long-term unemployment benefit (Arbeitslosenhilfe) payment rate from 53-57% of an individual’s prior salary to the welfare benefit (Sozialhilfe) payment rate of €382 per month (Odendahl, 2017). Furthermore, the reform reduced the time frame during which a worker could apply for full unemployment benefits (Arbeitslosengeld I) worth 60-67% of prior salary from 12-36 months to 12 months (Woodcock, 2018). That is, after 2005, a recently unemployed worker could receive Arbeitslosengeld I for only 12 months after his/her loss of employment.

Although the economic impact of the Hartz reforms remains debatable amongst both policymakers and economists, the passage of the Hartz reforms undeniably coincided with an upswing in Germany’s macroeconomic fortunes and net export performance. As Appendix Figure 1 exhibits, the German unemployment rate, after reaching a high of 11.7% in 2005, fell to 6.4% by October 2008 and only reached a high of 8.3% in February 2009 during the depths of the ensuing Great Recession (Federal Office of Statistics, 2018a). Likewise, as shown in Appendix Figure 2, after running a trade deficit for much of the 1990s, the German trade surplus grew from under 2% of GDP in 2002 to 5.6% in 2008. Finally, as Gaskarth (2014) notes, German GDP growth gradually began to increase from its average of 1.6% annually from 1995-2001, recording growth of 3.7% in 2006 and 3.3% in 2007 (OECD, 2018). While it is not immediately clear whether the Hartz reforms’ implementation played a role in driving these changes, the reforms were quite immediately followed by an economic upswing.

Nonetheless, despite the relative economic success that occurred during the Hartz reforms’ aftermath, the economic effectiveness of the reforms rightly remains an important subject of both political and economic debate. Even before economists had a chance to evaluate their macroeconomic impact, the Hartz reforms proved politically contentious. In August 2004, over 100,000 people took part in “Monday Demonstrations” protesting the impending implementation of the Hartz IV reform across over 100 municipalities in the country. Furthermore, according to political pundits, discontent with the reforms may have also played a role in inciting Chancellor Schröder and the SPD’s defeat to Angela Merkel and the CDU in the 2005 elections (Landler, 2005).

In all, two contrasting political narratives about the reform’s impact on the German economy emerged over the following years. On the one hand, the view championed by Angela Merkel, her finance minister Wolfgang Schäuble, and the CDU/CSU maintains that the reforms contributed significantly to subsequent German economic success by increasing the country’s economic “competitiveness” in an era of increasing world trade (Odendahl, 2017). According to most mainstream politicians, by following a Fördern und Fordern (Support and Demand) policy of aiding the unemployed on the condition that they quickly return to work, Hartz IV enabled market mechanisms to lower wages and related labor costs key to sustaining output and export growth in key industries including manufacturing. On the other hand, critics of the reforms abound on the political extremes, particularly from the left. Beyond the expected sharp political claims that the reforms represent a neoliberal measure designed to favor large corporations at the expense of the worker, critics of Hartz IV claim that the reforms replaced chronically high unemployment with increasing inequality and worker dissatisfaction with their new and often low-paying jobs. To critics, the country’s emergence from stagnation to growth stemmed mostly from changing global import demand and macroeconomic trends, not the reforms, while the decrease in the unemployment rate only overshadowed increases in inequality and the rise of workers employed in low-paying part-time roles.

II.2: The Hartz Reforms: Literature Review

The economics literature surrounding the Hartz reforms has primarily focused on their impact on German labor market outcomes, and findings corroborate elements of the two political narratives pursued by supporters and critics of the reforms respectively. First, economic research has indicated that the Hartz reforms helped lower the unemployment rate by improving labor markets’ efficiency, dynamism, and flexibility. To begin, building off and confirming earlier work completed by Fahr and Sunde (2006), Hertweck et al (2012) find that labor market inflow rates have substantially increased since the introduction of the Hartz reforms in the mid-2000s, and their analysis proceeds to use an empirical matching function to show that the reforms had improved “matching efficiency” by around 20%. Complementing Hertweck et al (2012), Bauer and King (2018) also claim that the reforms brought down the country’s structural unemployment rate by more efficiently and effectively reallocating labor to employers and tasks which vocational training had better prepared individuals to undertake. Lastly, Burda (2016) notes that alongside increased matching efficiency and effectiveness, the reforms also spurred employment growth by complementing the already increasing degree of wage flexibility across industries as well as encouraging growth in part-time work.

Alongside research that appears to confirm the Hartz reforms’ positive impact on reducing unemployment, encouraging entrepreneurial job creation, and increasing labor “competitiveness”, a complementary strand of economic research has also found that the reforms have likely helped to exacerbate domestic inequality levels, particularly by worsening worker’s post-unemployment wages. Utilizing a confidential data set from the German Social Security administration, Detragiache et al (2015) claim that after the reforms, the wages of workers reentering the labor market after short-term unemployment relative to the wages of workers reentering from long-term unemployment fell by around 10 percent. In effect, Detragiache et al’s result suggest that the reforms, due to its lowering of long-term unemployment benefits, may have induced the short-term unemployed to accept less than optimal jobs, lest they remain unemployed for over 12 months and are forced to receive the meager Sozialhilfe welfare payments. Woodcock (2018) generally reaffirms Detragiache et al’s findings in a study utilizing data from the German Institute for Employment Research (IAB). In his paper, Woodcock (2018) specifically finds that the Hartz reforms substantially reduced the post-employment wages of both short and long-term unemployed workers. He proceeds to demonstrate that this reduction in wages arose from two main factors: (i) the selection of displaced workers into low-wage firms and (ii) the sorting of displaced workers into lower quality “matches” with employers.

Although the economics literature concerning the Hartz reforms mostly considers their direct impact on the German labor market, some more recent research has extended this literature to investigate the effect of the reforms on broader macroeconomic outcomes. Complementing the analysis of Detragiache et al (2015) and Woodcock (2018), Fredriksen (2012) claims in an OECD report that the Hartz reforms helped to induce pervasive wage moderation on the lower end of the income distribution, resulting (rather atypically) in increased labor earnings inequality driven by changes in the distribution’s left tail. While Fredriksen (2012) considers the reforms’ impact on macroeconomic measures of country-level inequality, Odendahl (2017) examines the Hartz reform’s impact on a wide range of macroeconomic variables including the Unemployment Rate, GDP growth, exports, and government debt. Though he appears to favor the explanation that accelerating global economic growth and import demand drove much of Germany’s turnaround in the mid-2000s, he does also mention that the reforms could have induced increased exporting not only through increased industry-level “competitiveness” but also through the hindering effect of wage moderation on domestic consumption and investment.

II.3: Productivity and Trade Outcomes

Alongside the economic research analyzing the policy effectiveness of the Hartz reforms, this paper, especially the industry-level analysis, builds off another area of the literature which examines the relationship between productivity and trade. To begin, there exists a substantial literature covering the impact of increased import competition on firm innovation and productivity levels, especially in the context of advanced economies facing competition from developing countries. The effect of competition on innovation at large has remained difficult to generalize as well as contentious within the economics literature (cf. Aghion et al, 2005), and likewise no consensus amongst economists exists regarding the impact of import competition on firm productivity and innovation. On the one hand, Bloom et al (2016) find that increased Chinese import competition boosted European firms’ productivity, IT spending, and levels of innovation in the early 2000s. On the other hand, Autor et al (2016) reach the opposite conclusion when working with patent data from the United States.

On the other side of the literature, research considering the relationship between intrinsic firm and industry productivity characteristics and export/trade outcomes generally concur that more productive firms and industries tend to exhibit higher exports. Although their paper mainly focuses on the effect of exporting on firm innovation incentives, Aghion et al (2018) note that exporters within an industry very often overlap with the industry’s major innovators. Likewise, Bernard et al (2006) find that higher-productivity firms prove more likely to become exporters, especially when trade barriers are lowered. Thus, whereas the literature on the effect of import competition on overall firm productivity remains divided, there exists a clear consensus that firms with higher levels of productivity and innovation are more likely to export.

III: Data and Empirical Strategy:

To conduct the empirical analyses, this paper’s data, recorded on an annual basis, focus on German bilateral trade outcomes as well as various industry measures from the period 2002-2007. As the Hartz reforms became law over the period 2003-2005, the period 2002-2007 serves as an ideal 6-year window into analyzing the reforms’ effectiveness. Extending the timeframe for analysis further forward would result in the inclusion of data from the Great Recession of 2008/2009, while pushing the start of the timeframe backwards would also include macroeconomic shocks such as the establishment of the European Monetary Union (EMU) in 1999 and the entry of China into the WTO in 2001. Two separate data sets are collected for country and industry level analyses.

III.1: Country Level Analysis

For the country-level analysis, we take bilateral trade data on Germany, Austria, the Netherlands, and Sweden from the UNComtrade database.[4] Observations in these bilateral trade data are unique on the reporter-partner-commodity-year level,[5] where the reporter represents the country whose bilateral net exports are reported (i.e. either Germany, Austria, the Netherlands, or Sweden in this data set), the partner represents the reporter’s bilateral trading partner, and the commodity represents the type of good being traded. Appendix Figure 3 provides a more detailed image of our data’s structure. Regarding commodity classification, the bilateral trade data is aggregated at the HS2 1996 AG2 level; that is, all traded goods are classified into 98 distinct categories. As the data contain the trade value (in current USD) of both the bilateral export flow (export_id) and bilateral import flow (import_id) between a reporter-partner-commodity group during a given year, we also generate a bilateral net exports variable (netexports) which quantifies the annual net export flow within each reporter-partner-commodity group. Lastly, we add data on each reporter’s annual GDP (in current USD) and generate a net-exports to GDP (NXGDP) variable representing each bilateral net exports variable as a fraction of reporter GDP. Additional reporter-specific variables were created for the export, netexports, and NXGDP variables, and the relevant summary statistics lie below in Table 1:

Table 1: Summary Statistics for Country-level Data

Before specifying the details of our empirical strategy, we shall note that the temporal trends displayed in our data do indeed show a positive turn in German trade fortunes, especially after the 2003-2005 period. As exhibited in Appendix Figures 4a-4c, Germany’s average bilateral exports, average bilateral net exports, and average bilateral net export to GDP ratio all grew over the 2002-2007 period, with growth during the post-Hartz IV 2005-2007 period appearing especially prominent. However, one should clearly consider these coinciding linear trends with caution. Though these trends may well reflect the impact of the Hartz reforms on trade outcomes, they could just as easily result from increased domestic GDP growth or increased global import demand, amongst other things. Therefore, a more detailed empirical analysis appears necessary to more accurately estimate the reforms’ effect.

Ultimately, for our country-level analysis, we employ a fixed-effect/difference-on-difference empirical model, the full form of which is denoted below:

Of note, our main treatment variable is a dummy variable that equals 1 when a given bilateral trade observation has Germany as the “reporter” and occurs during or after 2005, when the Hartz IV reform took effect. We test the effect of our treatment on three outcome variables (mentioned earlier in this section): bilateral exports (i.e. export_id), bilateral net exports (i.e. netexports), and the bilateral net export to reporter GDP ratio (i.e. NXGDP), which track different aspects of a given reporter’s trade outcomes with a specific commodity to a specific trading partner in a specific year. Lastly, since the UNComtrade bilateral trade data do not provide many viable potential control variables, we include a litany of fixed effects (FEs) in place of explicit controls in our empirical framework. Specifically, our FEs include reporter FEs, commodity FEs, trading partner FEs, partner-commodity FEs, partner-year FEs, and year FEs. To consider some factors which FEs can capture, the year FEs allow us to effectively control for global macroeconomic trends such as growth and inflation (since all trade values are recorded in USD), commodity FEs enable us to account for the relative tradability of different commodities in international markets, and country FEs (i.e. partner & reporter FEs) effectively track the constant (time-invariant) differences across countries. Building off these foundational FEs, the partner-year FEs account for temporal shocks to foreign countries’ aggregate import demand as well as individual trading partners’ annual GDP trends, while partner-commodity FEs account for time-invariant differences in specific commodity demand across countries.

III.2: Industry Level Analysis

For analysis at the industry level within Germany, this paper builds off the UNComtrade data set used for the country level analysis. To begin, in order to effectively apply the gradual introduction of the Hartz reforms to industry-level analysis, we restrict the UNComtrade data to the bilateral data containing Germany as the reporter.[6] After restricting the UNComtrade data, we proceed to merge them with German industry level data from the EUKlems. From the EUKlems data the paper utilizes various useful metrics on industry level productivity, including the annual contributions in value added growth derived from (i) labor hours worked, (ii) non-ICT capital investments, (iii) ICT capital investments, and (iv) Total Factor Productivity (TFP) growth.[7] In addition, the paper also utilizes EUKlems data on total labor compensation as well as average per hour labor compensation by industry in Germany. The summary statistics of the EUKlems variables of interest are presented below in Table 2:

Table 2: Summary Statistics for Industry-Level data

German industry level data in EUKlems are aggregated using a relatively disaggregated version of the ISIC rev. 3 classification system. That is, the relevant macroeconomic measures of productivity, growth, compensation, and output are disaggregated into 38 “industry” categories, thus forming industry level data. Since data in the EUKlems data set are unique at the industry year level, whereas the data in UNComtrade remain unique at the reporter-commodity-partner-year level, we construct a crosswalk matching HS2 1996 AG2 commodity codes to ISIC rev. 3 industry codes before linking the two data sets. We utilize an m:1 merge on the two data sets, as industry level metrics from EUKlems will not vary by trading partner unlike the UNComtrade data on bilateral trade flows.

Before settling on a specific empirical strategy, a preliminary review of li