Almost all observers agree that the major English economic shortcoming lies in the excessive dependence of the UK economy on the financial sector. In fact, those who have been betting on the same horse for decades, as all British governments have done, play a risky game.

The great financial crisis of 2008/2009 revealed that the enormous concentration of financial services in the City of London (in English, ‘industry’ is also used for these types of economic endeavour) is well capable of taking hostage the rest of the economy if it is not built on a solid foundation. The current weakness of many banks and investment funds demonstrates this very well. Imagine that the current bubble in the stock and bond markets would burst: the consequences for the financial sector would again be extremely severe and the economy in countries such as Great Britain would be significantly affected.

The defenders of the ‘German path of development’ will point to the benign effects of a functioning manufacturing sector. They are correct, under specific circumstances. A well-functioning and strong economy with a diversified product range is much less vulnerable to outside fluctuations in demand because of its diversification.

But this is not the case for Germany. A country that specializes in the production of capital intensive goods for the world will always be severely affected by fluctuations in investment. The development of industrial production shows this problem. Figure 1 depicts that Germany stands at the undisputed top for industrial production, but in 2009 it had to experience how deep the sudden decline can be (see figure 1).

Figure 1.

The decline of English industry

In the wake of the global financial crisis, German production plummeted fast and deep compared to both the UK and France. Germany recovered quickly, which was primarily due to the rapid reaction of governments to the crisis with Keynesian policies. Also, let us not forget that Germany’s high dependency on its industry is directly due its mercantilism, which is not a model for other countries.

This also reflects itself in the industry’s contribution to value creation, which is extremely high in Germany compared to the two other countries (see figure 2). Germany probably is the only developed country in which the share of industry has not declined in the past twenty years. France shows a more typical development, but even compared to France, the contribution of manufacturing to GDP of ten percent in the UK is very low.

Figure 2.

Here, however, a German paradox appears. The most important contribution that a high share of industry is supposed to bring for overall economic development is consistently high productivity growth. In order to benefit from productivity growth, wages must increase accordingly, so that demand also grows. Otherwise, incentives for new investment will become too small.

Those who fail in this – such as Germany – in order to achieve export surpluses on the basis of wage moderation run the risk of forfeiting the positive effects on productivity growth because companies interpret export success for what they actually are: a windfall under uniquely favourable circumstances. This is not a sustainable path of economic development. It means, among other things, that companies will not invest as much as might be expected. Their strong sales abroad compensate for their low investments at home.

Domestic demand kept British industry going

Let us have a look at the development of wages. There is no doubt that wages in the UK rose much stronger than in France and in Germany,  except for a brief period at the beginning of the nineties (see figure 3). This applies to both nominal and real wages.

Figure 3.

Both real hourly wages and the real compensation of employees rose very especially strongly in the first years of the new century compared to both Germany and France (see figures 4 and 5). However, after the financial crisis of 2008/2009, nominal wages stagnated and real wages declined.

Figure 4.

The real compensation of employees (see figure 5), this is wages plus employment effects, however, has held up relatively well even after the financial crisis, which is, as will be shown in the fourth part, due to a British peculiarity, namely a negative savings rate of households.

Figure 5.

The sharp decline in real wages per hour (see figure 6), which came into being through a temporarily high inflation rate, was offset by the decline in the savings rate into negative territory on the demand side.

Figure 6.

When we consider the real wages per hour relative to productivity since 1999 (see figures 7, 8 and 9), the German approach manifests itself in all clarity once again. By 2007, the increase in real wages was almost completely in sync with productivity in the UK and in France. Up to this point, Britain had clearly the highest productivity growth, which is surprising given the small size of its manufacturing sector.

Figure 7.

Figure 8.

In Germany, on the other hand, real wages per hour hardly increased (see figure 9) and remained far behind the level of productivity of 2007. Today, German wages remain below those in the UK by as much as about 15 percent. This is the result of the German policy of wage moderation. On the one hand, it is responsible for the huge export success, on the other hand, it stalled the German domestic economy. Nowadays real wages per hour and productivity per hour progress more or less in sync, but this is not a real improvement. It shows that there is no willingness in Germany to let real wages, which plummeted in the first years of the new century, catch up again.

Figure 9.

You can read in the fourth part which policy measures are necessary in order to bring the economies of the countries back to a sustainable path of economic development.