Germany in An Interconnected World Economy

Germany in an
Interconnected
World Economy
EDITOR
Ashoka Mody
I N T E R N A T I O N A L M O N E T A R Y F U N D
©International Monetary Fund. Not for Redistribution

© 2013 International Monetary Fund
Cataloging-in-Publication Data
Joint Bank-Fund Library
Germany in an interconnected world economy / editor, Ashoka Mody. –

Washington, D.C. : International Monetary Fund, 2013.
p. : ill. ; cm.
Includes bibliographical references.
1. Germany – Economic conditions. 2. Economic development – Germany.

3. Germany – Foreign economic relations. 4. Financial crises – Germany.
5. Labor market – Germany. I.Mody, Ashoka. II. International Monetary
Fund.
HC286.G47 2013
Disclaimer: The views in this book are those of the authors and should not be
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Contents
Foreword v
Christian Kastrop
Preface ix
Ashoka Mody
1 Tests of German Resilience ..................................................................... 1

Fabian Bornhorst and Ashoka Mody
The Postwar Catch-Up ..........................................................................................................3
The Slowdown .........................................................................................................................5
Reemergence ...........................................................................................................................9
The Great Recession............................................................................................................ 19
References .............................................................................................................................. 32
2 The Crisis’s Impact on Potential Growth in Germany:

The Nature of the Shock Matters ......................................................... 35
Martin Schindler
Introduction ........................................................................................................................... 35
Background: Concepts and Related Literature ......................................................... 38
Methodology and Results ................................................................................................ 41
Germany’s Growth Sources through a Growth
Accounting Lens................................................................................................................... 47
Conclusion .............................................................................................................................. 50
References .............................................................................................................................. 51
Appendix ................................................................................................................................ 52
3 German Productivity Growth: An Industry Perspective ................. 55

Hélène Poirson
Introduction ........................................................................................................................... 55
German and United States Productivity: Stylized Facts ........................................ 60
An Industry Perspective .................................................................................................... 64
Conclusion .............................................................................................................................. 72
References .............................................................................................................................. 73
Appendix ................................................................................................................................ 76
4 What Does the Crisis Tell Us about the German Labor Market? ..... 77
Martin Schindler
Introduction ........................................................................................................................... 77
Background ............................................................................................................................ 78
Recent Developments........................................................................................................ 80
Understanding German Labor Market Dynamics.................................................... 85
Conclusion .............................................................................................................................. 92
References .............................................................................................................................. 94
Appendix ............................................................................................................................... 96
iii

iv Contents
5 Growth Spillover Dynamics: From Crisis to Recovery .................... 97

Hélène Poirson and Sebastian Weber
Introduction ........................................................................................................................... 97
Growth Linkages and Spillovers: Related Literature .............................................100
Empirical Approach...........................................................................................................105
Results ....................................................................................................................................109
Channels of Growth Spillover Transmission ............................................................123
Conclusion ............................................................................................................................130
References ............................................................................................................................131
Appendix ..............................................................................................................................133
6 Do Fiscal Spillovers Matter? ................................................................149

Anna Ivanova and Sebastian Weber
Introduction .........................................................................................................................149
Literature...............................................................................................................................151
Framework............................................................................................................................155
Simulation Results .............................................................................................................158
Conclusion ............................................................................................................................186
References ............................................................................................................................187
Appendix ..............................................................................................................................189
7 Current Account Imbalances: Can Structural Policies

Make a Difference? ...............................................................................199
Anna Ivanova
Introduction .........................................................................................................................199
Literature Review ...............................................................................................................202
Baseline Model....................................................................................................................205
Structural Policies and the Current Account ...........................................................208
Long-Standing Structural Differences and the Current Account.....................212
Interaction of Structural Factors and Fundamentals ............................................215
Implications for Germany ...............................................................................................217
Conclusion ............................................................................................................................220
References ............................................................................................................................221
Appendix ..............................................................................................................................223
8 Discussion ..............................................................................................239
Comment on Chapters 2 and 3 ....................................................................................239
Malte Hübner
Comment on Chapter 4...................................................................................................242
Werner Eichhorst
Felix Hüfner
Carsten-Patrick Meier
References ............................................................................................................................256
About the Contributors ...............................................................................................257
Index ...................................................................................................................................261

Foreword
Germany in its postwar history has a remarkable economic story to tell, not just
about success but also about failure, about ground won and lost. The successful
post-war recovery, although driven by a clear free-market confession, has also
been part of the German policy approach of Ordnungspolitik, which includes a
clear commitment to economic fairness, social safety nets, independent wage
negotiations between employers and employees, and strong regulations prevent-
ing the misuse of economic power in the most economically relevant areas.
Then we saw a first slump, starting in the mid-1960s, due to global develop-
ments, such as the crises in the coal and steel industries and the loss of the Bretton
Woods currency regime at the end of the decade. The slump was prolonged by
home-made problems, not least when trying to keep non-competitive sectors alive
with high subsidies. Today coal is still active in Germany despite high production
costs, and nobody knows if all plants really will be shut down as planned at the
end of this decade. Renewables, also heavily subsidized, might not do the trick
alone after the closing of all nuclear power plants soon after the Fukushima event.
The 1970s brought more trouble with the oil and wage shocks, and they saw
the failure of an anti-cyclic macro policy that was also (mis-)used as a tool for
goodies of all kind; the cyclical deficits were never paid back in the good times.
Last but not least, the decade saw the huge build-up of an over-generous social
safety net, at first supported by high growth and stable population figures but
soon becoming fragile as birth rates and potential growth rates began shrinking—
something that has continued to this day. And the issue hasn’t left us to this day:
the question of how to push potential growth is still the most relevant.
The 1970s also, as a result, had to manage a level of deficit never seen until
the late 1960s, driven by following the new gross investment “(‘golden’) fiscal
deficit rule”: that is, the Keynesian-motivated new debt rule, which replaced the
old conservative rule that required any deficit to be repaid by revenues created
through investment. The new, weakened focus of indirect repayment through
growth and taxes, while it may not be completely wrong in economic terms,
proved to be a seed of failure. It too could easily be misused, not only as an instru-
ment of political compromise of any incoming new term of legislation but also
during economic downturns, when cyclically short-term-communicated deficits
“surprisingly” turned out to be structural—the classic TTT (timely, temporary,
targeted) mistake mentioned in every economic textbook.
The 1980s started with stagflation and debt that had already accumulated
quite high and grew further in spite of the changing tide of economic thinking in
the direction of neoclassical/monetarist concepts (Phillips-Curve and rational
expectations) which—at least in communication—were reflected in the political
economy, where non-Keynesian/Ricardian effects were heralded, culminating in
statements like, “The economics driven by rational behavior needs no macro.”
v

vi Foreword
Nevertheless, despite the strong wording, Germany did not really take up the
supply-side economy concept and almost completely missed the structural/social
reform period of the 1980s that many other European countries entered, such as
the Netherlands and Scandinavia. One cushion Germany had at that time was the
relatively favorable export side of its economy, even though the deutsche mark
slowly but steadily appreciated, taxing away part of gained competitiveness and
making structural reforms even more pressing.
Before the situation grew too serious, unification brought a big boom. It was
construction-driven, and while it did not lead to a general bubble it led to huge
overcapacities, which lowered growth in the second half of the decade. The boom
wiped the structural reform agenda off the political Top Ten list. Because of its
complex and sophisticated system of (federal) checks and balances, therefore
politically somewhat “slow,” Germany’s federal government had to spend its lim-
ited available political capital on unification, leaving no room for other issues.
Seen from outside, it might have been possible to use unification as a catalyst
for reform, but the political economy could never deliver. Political capacity was
bound by and led to short-term solutions based on already endangered social
systems and even higher debt, instead of fundamental reforms and a tax-based
financing of unification.
The mid-1990s saw Germany taking over Europe’s “red lantern” on economic
indicators. The “German Disease” was on the front pages of tabloids and The
Economist.
The late 1990s brought changes: wage developments were continuously mod-
erated, both specialized SMEs and big industries cleared their books, and profits
went up. The supply side won, the demand side lost. The nucleus of the next
export boom was born, as German SMEs became the little champions offering
emerging markets the technology they needed. Adding to that were Social
Security and labor market reforms, tax relief for corporates, and a whole program
for renovating Germany, even if, as measured against the bold proposals of
economists, the program didn’t look so convincing and was heavily blurred by
political compromise at the time of design.
But time would show that it was not just the German overperformance but
also the underperformance of competing countries (and therefore a no-longer-
appreciating currency) that did the trick for the new German economic (export)
miracle. For the average German, the crisis of 2008 and the years following—the
worst world crisis since the 1930s—was and still is something he would watch
with some surprise on television, but it never came closer. And this time Germany
was lucky, with a well designed macro-strategy that also delivered on the psycho-
logical side and was firmly anchored by the new fiscal rule, the so-called “debt
brake.” It was quite a new experience, too, one never seen in the decades before,
when the typically pessimistic but now optimistic (over-optimistic?) Germans
kick-started lagging internal demand and consumption at the height of the crisis.
This book on Germany by Ashoka Mody and current and former IMF and
internationally regarded experts is one of the most detailed reviews of recent
German economic history. It not only offers an excellent empirical analysis based

Foreword vii
on long-term developments but frames that analysis in the context of our actual
post-crisis, globalized world. It points clearly at Germany’s successes, but it also
points out the remaining weaknesses as well as those upcoming if the reform
momentum is lost.
Germany has a role to play, not just in Europe but in the interconnected
global economy. This should not be forgotten. And that role is not only for its
national economy but for the whole region, its trading partners, and its export/
import markets. Germany’s macro- and microeconomic policy does matter, even
if measurable spillovers are small. So there is a point in sustaining its reform
momentum and not getting lost again on the macro-, structural, supply-and-
demand, and all underlying (micro-) factors.
Germany indeed should push the structural reform agenda, for example
through public investment, reforming the health and service sectors, removing
existing market barriers, speeding up research and development, and bridging the
existing market gap in founding new-tech companies. It should also adopt family-
and birth-friendly policies together with better approaches to migration. Last but
not least, Germany should engage in a full renovation of its education system,
while keeping its already well working instruments (“dual education”) that pre-
vent youth unemployment.
And, of course, there is the issue of debt and deficit. The new German debt
brake, which now is also enshrined in the European fiscal compact, might move
the countries concerned to an adequate soundness of public finance and foster
long-term sustainability and the quality and efficiency of public finance as neces-
sary complements.
The reader might use this book to build up his own picture of Germany. The
description and analysis are valuable for rethinking different policy approaches,
and for reaching the best solutions (or perhaps the second- or third-best, as poli-
ticians of all stripes will most naturally and legitimately ensure) to current and
upcoming problems, including the next “black swan” problems, in a world that
is interconnected and leveraged.
It is my hope that the authors of this book keep an open-minded eye on
Germany and continue to offer analyses and advice, since in Germany as with
other medium and large sized countries a more inward look sometimes tends to
become dominant. This is no longer affordable in a globalized, interconnected
world. Nobody can do better alone, not with the real and monetary market world
and not with the public sector. Maybe this is one of the main crisis lessons. All
the more, then, do we have to strive for credible, convincing, and communica-
ble—but most of all problem-solving—economic concepts and strategies, not
just on a national but on an international scale.
Christian Kastrop
Deputy Director-General, Economics Department, and
Director of Public Finance, Macroeconomics and Research Directorate
German Federal Ministry of Finance

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Preface
The papers in this volume were written by IMF staff. But at all stages, this was
a collaborative enterprise with the German authorities. Early versions of the
papers were discussed at the Bundesbank, where critical comments and alterna-
tive viewpoints were offered. That consultative process culminated in a major—
and unprecedented—conference at the Federal Ministry of Finance during the
2011 Article IV Consultation with Germany. Christian Kastrop made that event
possible. For that initiative and for the many vigorous conversations, even on
controversial issues, I am most grateful to the German authorities.
At the conference, a number of senior German scholars joined the discussions
as commentators and session chairs. Their comments are included as part of this
book. Thanks are due in particular to the session chairs, Christoph Schmidt,
Klaus Eckhardt, Ansgar Belke, and Beatrice Weder di Mauro, who kindly took
time to moderate the exchange following the papers.
The conference closed with a lively panel discussion. Juha Kähkönen, then
Deputy Director in the IMF’s European Department, moderated that discussion.
The distinguished participants included Markus Kerber, then Head of Department
of Fiscal and Economic Policy at the Federal Ministry of Finance (now CEO and
Director General of Federation of German Industry, BDI), Thomas Mayer,
Deutsche Bank Research, and André Sapir, University of Brussels and Bruegel.
Finally, I must acknowledge with much gratitude the contributions of Fabian
Bornhorst in making this volume possible. He was legitimately a co-editor but his
modesty has prevented him from agreeing to share that credit with me. I also
recall with great affection my many colleagues who joined this venture and many
other such intellectual and operational adventures.
Ashoka Mody
ix


CHAPTER 1
Tests of German Resilience

FABIAN BORNHORST AND ASHOKA MODY
In the nearly 70 years since World War II ended, the German—earlier the West
German—economy has enjoyed dynamic phases, interspersed with periods of
slow, even anemic, growth. Germany’s continuing ability to maintain competitive
manufactured exports has been crucial to its resilience and dynamism, but it has
not always been sufficient. This dependence on exports as the economic driver of
the German economy helps in understanding its postwar evolution, including its
recovery following the post-Lehman collapse. It also points to the challenges that
Germany faces: the calls to do more for the European and global economy and
the risk that the rise of manufacturing capabilities in emerging markets will even-
tually wear down Germany’s stronghold. In this introductory essay, we review
Germany’s growth record over four phases and sneak a look into the future.
• For about a decade and a half after World War II, until the early 1960s, the
economy responded spectacularly by making up lost ground. German com-
panies exploited their traditional advantage in capital and durable goods
production for sale to a growing world economy and also to meet pent-up
domestic demand.
• In the next four decades—until about 2003—economic performance
gradually became less impressive. The catch-up potential necessarily waned
and the oil shocks of the 1970s raised costs and reduced global demand. By
the mid-1980s, with rising wages, West Germany was losing its competitive
edge. The unification of West and East Germany in 1990 provided a short
boost, but then the German economy again went into a swoon.
• Starting around 2004, a strong global economy, combined with reforms that
helped Germany regain competitiveness, provided a new opportunity to
German exporters. With success came a historically large current account
surplus, which was criticized for contributing to global imbalances. But the
growth dynamic was summarily interrupted in early 2008 by the onset of
the “Great Recession,” when the collapse in global trade also swept
Germany.
Fabian Bornhorst is an economist in the IMF’s European Department. Ashoka Mody was deputy
director in the European Department and then the Research Department of the IMF when this
chapter was written.

2 Tests of German Resilience
• The recovery from the collapse has once again demonstrated German resil-
ience. German companies deepened their export links to the growing
economies of Asia, and policymakers have supported stabilization and
growth through measures to maintain employment and a sizeable fiscal
stimulus.
New challenges have to be faced. Some are not unique to Germany. With its
reliance on exports, a high savings rate, and a current account surplus, Germany
shares similarities with Japan, to the extent that one country can be like another.
Looking ahead, like their Japanese counterparts, German exporters face height-
ened competition, especially from Asia but also from Emerging Europe. And as
in Japan, a rapidly aging population will imply a smaller workforce and changes
in savings and investment patterns with far-reaching consequences. But Germany’s
challenges arise also from its unique role in Europe: in particular, Germany’s
expected contribution to the European recovery and a resolution of the euro area
crisis remain controversial.
As this preview suggests, throughout the postwar era, (West) Germany has
benefited greatly from its relationship with the global economy, but there have
been lingering questions whether the German contributions to global and
European growth have been commensurate. From its early catch-up phase,
Germany’s formidable export engine has been its consistent driver of growth. But
with almost equal consistency, Germany has run current account surpluses, with
imports lagging exports. As a consequence, despite the size of its economy,
Germany’s ability to act as global locomotive has been limited. Germany has
contributed to global well-being in important ways—notably through its foreign
direct investment and, in particular, the production linkages its companies have
built throughout Europe. Nevertheless, the calls on Germany to do more remain
vigorous, especially as the European crisis has persisted.
The argument in this book is that the German economy has evolved along a
particular historical trajectory that tends to reinforce its growth patterns. The
innovative manufacturing sector has remained a consistent source of growth, but
it has been heavily dependent on external demand. The volatility of external
demand, in turn, has caused German GDP growth to be relatively volatile by the
standards of advanced countries. Such volatility has likely been a factor in keeping
domestic demand growth—especially consumption growth—at surprisingly low
levels. As a consequence, the domestically oriented segment of Germany’s econo-
my has lagged. This has been so especially in the production and delivery of ser-
vices. In turn, this has reinforced the drive for foreign markets. Looking ahead, a
more domestically driven growth dynamic will be good for Germany and for the
global economy.
The key challenge for Germany, then, is to generate new domestic sources of
growth. One recent episode—reunification—raised domestic demand, but that
boom proved unsustainable as the economic problems associated with unification
surfaced. Labor market reforms in response to the ensuing period of stagnation
were a bold response, and have proven largely successful. But much of the gain in
competitiveness translated into further growth in manufactured exports and

Bornhorst and Mody 3
current account surpluses. Therefore, despite the notable service sector advances
achieved since the mid-1990s, a further broad-based impetus to services growth
is required. Absent such an effort, German growth will remain constrained, and
Germany will tend to run current account surpluses while playing only a modest
role in spurring growth elsewhere.
Just as the German economy is similar to that of Japan—dependent on
exports, running current account surpluses, and generating limited international
growth spillovers—the contrast with the United States is marked. The United
States is characterized by more reliance on domestic consumption and, as a con-
sequence, persistent current account deficits but high international growth spill-
overs. Despite popular characterization of the U.S. financial sector’s casino capi-
talism, both the U.S. GDP and its stock market have been less volatile than in
either Germany or Japan. In part, this reflects the greater reliance on domestic
consumption, which tends to be more stable than exports. But the United States
has also been diversified, with innovations in globally leading technologies giving
it an edge in productivity growth, especially in the services sector. In the future,
Germany will perhaps draw on approaches to fostering innovation practiced in
the United States, while also maintaining its greater emphasis on social safety
nets, where lessons may be available from the Nordic countries.
In this introductory chapter, we step back from the themes of immediate
policy focus to provide a broad overview of German economic growth and inter-
national connections over the past half century. The intent is to describe the
historical trajectory that has brought Germany to its present balance of strengths
and weaknesses, and to use that analysis to explore the best way forward. Much
of the work underlying this book and its principal policy conclusions was devel-
oped for the IMF’s Article IV consultation with Germany in 2011 (IMF 2011).
The book serves to present the more extensive background analysis in an inte-
grated form.
This chapter is presented in four main parts, reflecting the four relatively dis-
tinct phases of German growth. First, the immediate postwar period witnessed a
rapid catch-up with the United States and, importantly, reestablished its export
prowess, which has remained Germany’s wellspring ever since. Second, growth
slowed starting in the early 1960s, and the oil shocks of the 1970s and unification
in 1990 proved to be particularly onerous. Third, the reemergence from this
setback on the back of extended global prosperity was aided by wage moderation
and broad-based domestic reform. And fourth, the collapse triggered by the Great
Recession and the subsequent recovery have brought Germany to a new phase
with new challenges to tackle.
THE POSTWAR CATCH-UP

Emerging from World War II, West Germany set the pace for much of Western
Europe as it embarked on a remarkable catch-up. A massive reconstruction effort
was mounted and the depleted capital stock was rebuilt. Growth in those imme-
diate postwar years was in the double digits (Figure 1.1).

Annual growth 5-year average

12
1973 1991 2004
10
−2
−4
−6
1950 1960 1970 1980 1990 2000 2010
Figure 1.1 Germany’s Growth Performance since 1950 (Percent)

Source: German Statistical Office.
Note: From 1950–1991 data for West Germany. Data prior to 1970 based on different National Accounts
methodology and thus not fully comparable.
Aid flowing to Europe through the European Recovery Program (also known
as the Marshall Plan) was an important catalyst in addressing infrastructure bot-
tlenecks and reviving trade. Germany also reclaimed its historic advantages as an
exporter of capital and durable goods. Between 1948 and 1950, the pent-up
demand for consumption and investment drew in substantial imports, but
exports started growing rapidly right from the start, with exceptionally high
annual growth rates (Table 1.1). By 1950, exports had exceeded imports, and the
German trade surplus established then has persisted, with some ups and downs,
ever since. By 1960, West Germany’s shares of world exports and imports exceed-
ed those of the German Reich before World War II (Giersch, Paque, and
Schmieding, 1992).
Eichengreen (2006) describes this as a period of extensive European growth,
with Germany in the vanguard. He defines extensive growth as that which
deploys relatively well established technologies: “It is the process of raising output
by putting more people to work at familiar tasks and raising labor productivity by
building more factories along the lines of existing factories” (Eichengreen, 2006,
p. 6). Millions of refugees arrived in Germany and, in the immediate postwar
TABLE 1.1
West Germany’s Foreign Trade

(Average annual percentage change)
1948–1950 1950–1960
Import volume 26.8 15.0
Export volume 84.4 16.1
Source: Giersch, Paque, and Schmieding, 1992.

period, internal labor mobility was also high. Nearly full employment conditions
were achieved, with the unemployment rate down to below 1 percent in 1960. In
reorganizing production and rebuilding the capital stock, efficiency gains were
significant and quickly realized.
Several factors facilitated this outcome. Not only was plentiful labor available,
the workers were also industrially literate—or were readily trainable through the
traditional vocational training systems. Such systems met the need of the moment
precisely because the challenge at hand was not to build new widgets but to build
known widgets in larger quantities with incremental technical improvements in a
learning-by-doing process. At the same time, an extensive network of relationship-
based banking systems provided the needed patient capital to finance the invest-
ments. This confluence led to modest wage demands, which allowed profitable
firms the resources and the confidence to invest in their workforce and in growth.
Germany was particularly well suited to take advantage of these conditions.
Giersch, Paque, and Schmieding (1992, p. 89) write: “Germany’s traditional
strength in the production of capital goods paid off handsomely in the 1950s, when
these goods were in particularly high demand on the world market. In addition, the
change in relative prices testifies to the improving quality and sophistication of these
exports goods.” In a similar vein, Eichengreen (2006, pp. 93–94) elaborates:
The country already possessed the relevant range of industries, from coal and steel
to transport equipment and electrical machinery…. Small and medium-sized firms
competed with legions of other small and medium-sized firms, requiring them to
price aggressively and reduce costs in order to survive. In turn this rendered German
firms highly competitive on international markets. Exports rose from 9 percent of
national income in 1950 to 19 percent in 1960. External conditions were also
propitious for German recovery. Investment demand was high throughout Europe,
aiding German firms specializing in the production of capital goods. The Korean
crisis stimulated demand for capital goods worldwide. And just when Germany’s
expanding industrial sector began diversifying into the production of consumer
goods, private consumption surged across Europe, reflecting rising incomes and in
turn helping to sustain the growth of German exports….Investment and exports
were the fast-growing components of aggregate demand, and government and pri-
vate consumption the slow-growing ones.
Thus, while all of Europe did well during this period, Germany did particu-
larly well. Other countries that grew about as rapidly included Austria, which had
close economic ties to Germany, and Italy. While Germany was leveraging off an
established industrial capability, Italian growth was due to the shift of resources
from agriculture to industry.
THE SLOWDOWN
The precise timing of the shift is difficult to pin down, but the growth benefits
of the German miracle leveled off in the 1960s. The indicators are clear. From an
average growth of about 9 percent in the early 1950s, GDP growth fell to about
4.5 percent by the mid-1960s (Figure 1.1). German growth, which had set the

pace for Europe in the immediate postwar years, now fell below the European
average growth rate (Figure 1.2). The rapid process of German catch-up with the
United States stalled, and even began a modest reversal in the 1980s (Figure 1.3).
The slowdown was to be expected. Growth could not persist at the early giddy
levels and, as Germany became richer, the convergence possibilities diminished,
while the latecomers started their own catch-up process.
8
10th–90th percentile of OECD economies
7
Germany
6 European economies (excluding Germany)
5
−1
1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 1.2 Growth in a Comparative Perspective, 1970–2010 (Five year average, percent)
Sources: IMF, World Economic Outlook; and IMF staff estimates.
Euro area rangea Ireland

110 Spain, Greece, Portugal France
Germany Italy
100
90
80
70
60
50
40
30
20
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 1.3 Per Capita GDP Relative to the U.S., 1960–2010 (Real per capita GDP to
U.S. per capita GDP, in percent, PPP constant prices)
Sources: Organisation for Economic Co-operation and Development; and IMF, World Economic Outlook.
Note: PPP: purchasing power parity.
a
Maximum excludes Luxembourg.

The significance of this phase, therefore, lies in two developments, both of

which contributed to the slowdown but had longer-term implications lasting into
the present. First, the gains possible from extensive growth tapered off and a new
phase of intensive growth created new demands on German firms. Eichengreen
(2006, p. 6) defines intensive growth as “…growth through innovation. A larger
share of the increase in output is accounted for by technical change, and less by
the growth of factor inputs.” Thus, it was not merely a matter of narrowing
growth opportunities but also a change in the character of those further possi-
bilities and, hence, the resources needed to exploit them.
Second, important changes occurred in the organization of the labor market.
The rapid growth drew in much of the surplus labor, and with near full employ-
ment conditions, the labor market started tightening by the early 1960s. West
Germany went from a state of capital shortage to one of labor shortage, which,
despite the pursuit of active labor immigration policies (Gastarbeiter), led to
demands for higher wages. Reduced profits implied lower investment and growth.
Moreover, as wages started rising, employment prospects steadily worsened during
the 1970s. The response to this conjuncture was central to shaping the period from
the 1970s through the late 1990s. Dew-Becker and Gordon (2012, p. 17) write:
… policies adopted to fight unemployment had adverse effects on employment per
capita (see Nickell, Nunziata, and Ochel, 2005). To deal with individual hardship
caused by higher unemployment, governments increased the generosity and dura-
tion of unemployment benefits. To limit the increase in unemployment itself, they
attempted to regulate layoffs through employment protection legislation (EPL). To
spread the available jobs across the population, they resorted to legislation favoring
early retirement and shorter hours of work, so-called “work sharing.” (Alesina,
Glaeser, and Sacerdote, 2006)
New headwinds gathered momentum in the 1970s with the oil crises and the
collapse of the Bretton Woods system, which abruptly changed the external envi-
ronment for West Germany. Much of the industrial world experienced the angst
of declining productivity growth as the pool of innovations appeared to run dry.
Germany felt the first taste of competition from newly industrialized economies.
German growth slowed to an average of 2.5 percent during the 1970s and 1980s.
Domestic consumption remained subdued, and as a consequence import demand
was low. Despite the greater competition faced by German exporters, current
account surpluses continued (Figure 1.4).
German unification in 1990 brought further challenges. The integration of
the much less competitive economy of Eastern Germany proved to be economi-
cally costly and had a long-lasting influence on economic developments.
Unemployment increased substantially, and public finances came under pressure.
GDP growth in the 1990s averaged just about 1.5 percent per year.1 Unification
did bring about a temporary current account deficit because of a boom in pub-
licly led investment, and the trade-to-GDP ratio, already on a mild downward
path from the mid-1980s, fell sharply (Figure 1.5).
1
That is, about half of the potential growth rate of the U.S. economy.

10
10th–90th percentile of OECD economies
Germany
United States
5 Japan
China
−5
−10
1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 1.4 Current Account Balance in Comparative Perspective, 1970–2010 (Three

year average, percent of GDP)
100
Germany
90
Emerging and developing economies
80
Advanced economies
70
60
50
40
30
20
10
0
1960 1970 1980 1990 2000 2010
Figure 1.5 Trade Openness, 1960–2010 (Value of imports and exports, percent
of GDP)
By the end of the 1990s, Germany was dubbed “the sick man of Europe.”
Growth came to a standstill, and the economy underperformed for much of the
early 2000s (Figure 1.6). Despite high unemployment, the institutional responses
of the previous decades had raised wages to unsustainably high levels, and for the
first time in decades Germany lost a competitive edge (Figure 1.7). Indeed, even
as the global economy recovered in the early 2000s, Germany failed to respond,
reinforcing the view that Germany faced serious problems. Pessimism about

Difference between actual and forecast (basis points, right-hand scale)

8 GDP growth 1000
GDP growth forecast (one year ago for the current year)
6 800
600
4
400
2 200
0 0
−2 −200
−400
−4
−600
−6 −800
−8 −1000
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Figure 1.6 Growth Expecations in Germany, 1992–2012 (One year consensus forecast
vs. actual growth, percent)
Sources: Consensus Forecasts; IMF, World Economic Outlook; and IMF staff calculations.
4.0
1991–2000 2001–2010
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Austria France Italy Germany Netherlands Spain
Figure 1.7 Change in Unit Labor Costs, Germany and Selected European Countries,
1991–2000 and 2001–2010 (Average annual percentage change)
Source: Organisation for Economic Co-operation and Development.
economic prospects became widespread, with growth expectations trailing the

actual growth rate for several years into the ensuing global boom.
REEMERGENCE
The “reemergence” period, from 2004 to 2008, is a relatively short one, more so
when compared to the previous period lasting nearly four decades, which we
treated above in summary fashion. Yet this short period is noteworthy because of

the rapid turnaround experienced and because, along with the post-Great
Recession recovery, it defined the prevailing sense of German dynamism. The
transformation not only reestablished the German economy’s strengths but also
brought calls from the international community for Germany to play a more
active role as a “global citizen.” However, as German growth accelerated following
years of secular decline, Germany developed large current account surpluses—
large even by its own historical standards. Thus, while it came to be regarded with
new respect, it was also caught in the storm of “global imbalances.” The essays in
this book reflect on both the dynamics of this reemergence phase and on
Germany’s role in the international economy.
We focus on four themes characterizing this period, reflecting the break and
renewed sense of confidence as well as the significant continuities. First, manu-
facturing productivity growth remained solid, and services productivity growth
picked up modestly. Second, wage restraint was widespread. Third, global growth
buoyancy was key to maintaining export growth. And, to a large extent, current
account surpluses were more a consequence of global developments and less of
“distortionary” domestic policies.
In Chapter 3 of this book, Hélène Poirson shows that productivity performance
varied greatly across sectors. Manufacturing productivity continued to grow respect-
ably, not just in absolute terms but also relative to international benchmarks.
Productivity growth was relatively low in the newly emerging sectors of communi-
cations and information technology and was also relatively low in the services sector.
These sectoral distinctions are important, because they highlight the challenge
ahead. Despite Germany’s manufacturing prowess, the share of manufacturing
value-added in German GDP has steadily declined over the past several decades
(Figure 1.8). This is not surprising. With the rise of lower-cost manufacturing in
the newly industrializing nations of East Asia, manufacturing has played a small-
er role in all advanced economies. Germany is remarkable only to the extent that
the manufacturing share of total value-added remains somewhat higher than in
Japan. Nevertheless, it is salient that Germany’s high manufacturing productivity
growth cannot be a dependable source of greater well-being in the future as
manufacturing inevitably continues to cede ground to international competitors.
In this respect, Poirson’s analysis has an optimistic note. She finds some evi-
dence of a rise in services productivity starting in the early 2000s. However, her
analysis does not establish a clear trend. And since the Great Recession created so
much dislocation, any trend may only be discernible in a few more years. Poirson
offers advice that is in line with that of other students of productivity growth:
greater use of information technology in the delivery of services and more impe-
tus to small and innovative service firms through incubation in higher centers of
learning and greater access to venture capital. More controversially, she suggests a
role for the government in procuring services with a public-good purpose, espe-
cially where that may help establish open standards.
The second theme of this period is wage restraint. Wage moderation has
become central to characterizing Germany—and hence to the policy measures it
must adopt in deference to its global commitments. It is the case that German

40 Germany Japan United States
35
30
25
20
15
1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 1.8 Importance of the Manufacturing Sector, Germany, Japan, and the U.S.,
1970–2010 (Value added manufacturing in percent of total value added, three year
average)
Sources: Organisation for Economic Co-operation and Development; and IMF staff calculations.
wages have been relatively steady in the past several years (Figures 1.9 and 1.10).
Yet, as described above, the restraint followed years of significant wage increases.
Thus, even after the restraint, German wages are among the highest in Europe.
What is remarkable about the recent years is the rapid rise in wages elsewhere in
Europe. The Irish rise is particularly explosive. But wage increases elsewhere in the
European periphery clearly outstripped productivity growth in those economies.
There is an open question why German wage increases were modest during
this phase. One explanation is the introduction of labor market reforms, in
60 140
Average salary per worker 2010 ('000 EUR)
50 120
Percent increase, 1995–2010 (right-hand scale)
100
40
80
30
60
20
40
10 20
0 0
nd
ria
ce
ly
l
ga
nd
an
ai
ec
Ita
iu
an
la
st
Sp
rtu
rla
lg
re
Ire
Au
Fr
Be
er
Po
he
G
et
N
Figure 1.9 Wage Levels and Wage Growth, Selected European Countries, 1995–2010
Sources: Organisation for Economic Co-operation and Development; and IMF staff estimates.

60
55
50
45
1991 1996 2001 2006 2011
Figure 1.10 Wage Share in Germany, 1991–2011(Gross wages as percent of GDP)

Sources: World Economic Outlook; IMF staff estimates.
particular the Hartz reforms, introduced around 2003 in association with a

broader reform package to regain competitiveness.2 Posen (2007) concludes that
the key reform was the reduced duration of unemployment benefits. This
increased the labor supply, with the effect of dampening wage growth.3 In
Chapter 4 of this book, Martin Schindler argues, as do Burda and Hunt (2011),
that the remarkable stability of German unemployment during the Great
Recession was due not just to the work-sharing schemes, discussed below, but also
to the longer-term effects of the Hartz reforms.
While a proper retrospective of the Hartz measures and wage moderation must
necessarily be undertaken elsewhere, two cautionary notes on the policy measures
are worth considering. First, Dew-Becker and Gordon (2012) point out that
starting in the mid-1990s, similar reforms were undertaken throughout much of
Europe. This was in response to the rigidities that had become increasingly evi-
dent and onerous following the efforts to protect employment in the mid-1970s.
The Hartz-like reforms that were undertaken throughout much of Europe had
the broad effect of raising employment per capita. The essays in Buti (2009),
especially that by Boeri (2009), indicate that more competition was also a feature
of Italian labor reforms, with the growth in the incidence of temporary workers.
That Germany seems to have harnessed these reforms particularly effectively
is, in our view, due to a second consideration. German firms were facing
2
Slow German growth in the early 2000s, while the world economy was beginning to embark on a
new dynamic phase, led to a concerted policy effort to renew growth. After years of political deadlock
on key reform initiatives, the Agenda 2010 reform program agreed in the early 2000s led to wide-
ranging changes in the labor market institutions, a reorganization of the economy, and changes to the
pension system.
3
Posen is less convinced of the effectiveness of other elements of the reform package, including the
so-called active labor market policies (see also Jacobi and Kluve, 2006).

increasing competition in international markets and were able to reach an accom-

modation on wage demands, much in the manner that occurred during the
immediate postwar years. The pressure from international competition and glo-
balization forced German enterprises to integrate with (Eastern) Europe and Asia
in worldwide supply chains. Such links have been somewhat pejoratively
described as the evolution of Germany as a “bazaar economy,” with German
companies increasingly engaged in “outsourcing” (e.g., Sinn, 2006). However,
this was clearly the way forward, both for Germany and for emerging Europe.
Why companies in other countries were less successful in using this opportunity
and how the differences in the particulars of reforms and the corporate response
played out across Europe remains an important topic for further analysis.
With wage moderation and despite the high level of wages, our analysis (see
IMF, 2011; and Chapter 7) suggests that Germany’s export engine hummed dur-
ing these years because of two factors. First, Germany specialized in a range of
quality products that were in high demand during this period and for which
German exporters faced limited competition. German firms have specialized in a
large variety of capital goods, consumer durables, and pharmaceuticals, and they
enjoy significant world market shares in these products (Figure 1.11). Germany
was able to hold market share, allowing exports to ride the global trade wave
(Figure 1.12). Second, because Germany was unable to gain global market share,
German export success depended crucially on global prosperity. Before the crisis
hit in 2008, global GDP and trade, in particular outside the euro area, expanded
at an unusually strong pace (Figures 1.13 and 1.14), and Germany was well posi-
tioned to take advantage of that growth.
12
World market share in specialized
CHN
10 DEU
USA
product varieties
6
ITA
4 JPN FRA
NLD
2 KOR ESP
MYS IND
POL
IRL PRT
0 GRC
0 100 200 300 400 500
Number of specialized product varieties
Figure 1.11 Product Specialization and Market Share, 2007 (Product varieties and
market shares)
Sources: IMF staff estimates based on Standard International Trade Classification 4 level trade data for 2007.
Note: CHN: China; DEU: Germany; ESP: Spain; FRA: France; GRC: Greece; IND: India; IRL: Ireland; ITA: Italy;
JPN: Japan; KOR: Korea; MYS: Malaysia; NLD: Netherlands; POL: Poland; PRT: Portugal; USA: United States.

500
World trade effect Increased market share
400
300
200
100
−100
na d ia a s y e in ly al e ia n s d
hi lan Ind ore and an eec pa Ita tug anc ays apa tate lan
C Po K erl erm Gr S r r l J S r e
h Po F
M
a d I
et G
ni
te
N U
Figure 1.12 Decomposition of Export Growth, 2001–2008 (Percent increase)

Source: IMF staff estimates.
Note: Increase in exports between 2001–08, as percent of exports in 2001, decomposed into the effect of
world trade growth and that of increased market share, computed with Standard International Statistical
Trade Classification 4 level trade data.
7
EME and DCa US UK Eurozone World
6
5
4
3
2
1
0
−1
−2
1979–88 1989–98 1999–2008 2009–11
Figure 1.13 GDP Growth Rates: World and Major Regions, 1979–2011 (Average
annual percentage growth).
a
Emerging markets and developing countries.
These developments paralleled the emergence of so-called intra-European

imbalances, whose sources and implications have been generally misinterpreted.
German surpluses vis-à-vis other European economies grew through the 2000s,
and Germany is sometimes called on to reverse these surpluses by allowing its
wages to rise faster. Aside from the fact that there are no direct ways in which
policy can cause wage increases, the analysis focusing on German policies as the
reason for intra-European imbalances does not take into account competitiveness
gains realized by countries outside of Europe. Thus, Germany continued to

16
14 World U.S. Euro area
12
10
0
1991–1998 1999–2008 2009–2011
Figure 1.14 Import Growth Rates, World, U.S., and Euro Area (Average annual
percentage growth)
Sources: Netherlands Bureau for Economic Policy Analysis (CPB); and IMF staff estimates.
maintain its traditional exports to Europe, where it was able to fend off
competition from Asian sources. But while it continued European imports of
intermediate goods, especially from Visegrad countries (Czech Republic, Hungary,
Poland, and Slovakia), German imports increasingly tilted toward products pro-
duced most cost-effectively by China (Figure 1.15), which became Germany’s
second most important import partner in 2011, after the Netherlands, overtaking
France. In other words, German exports stayed largely insulated from Asian and
lower-wage European competition due to Germany’s specialization, but much of
−2
−4
China Visegrad Rest of the ESP, GRC, Rest of United
countries World ITA, IRL, PRT EU-27 States
Figure 1.15 Change in German Import Sources, Selected Countries and Regions,
2000–2009 (Change in Germany’s import shares between 2000–2009)
Note: Visegrad countries include Czech Republic, Hungary, Poland, and Slovakia.

advanced Europe—including the periphery—faced the new reality of global

low-wage competition, including when selling to Germany. This suggests that
even if higher German wages were to reduce German exports to Europe, those
exports would most likely be replaced by imports from Asia, thus making little
dent in the European current account deficits.
There is the more complex issue of Germany’s current account surplus vis-à-vis
the rest of the world. Here there are two separate questions: First, why did the
surplus rise to such high levels by 2007–8? Second, even absent that rise, is the
surplus too large by some benchmark? In Chapter 7, Ivanova deals with both
these questions. On the first, she concludes that the rise in surplus was mainly
cyclical. In other words, there was a parallel increase in Chinese, Japanese, and
German surpluses that largely mirrored the increased U.S. deficits. The point she
makes is that these shifts occurred over a short period of time and so could not
principally reflect structural (e.g., labor market policies, regulation) causes. More
precisely, her econometric analysis is unable to attribute the rise in the German
imbalances to particular policy choices.
Ivanova does note that as German exports boomed, corporate profits rose
handsomely but investment stayed moribund. Thus, there was a big increase in
the domestic savings-investment imbalance, which mirrored the current account
surplus. Corporate profits also rose elsewhere, for example in China and Japan.
But in China and, to a lesser extent, in Japan, investment also picked up. Why
investment in Germany remained so low during these buoyant years is a mystery,
although demographic trends combined with the prevailing pessimism about the
viability of the German business model in the early 2000s may point to the
answer (IMF, 2012).
On the second question—whether the German external surplus is too large by
some benchmark—Ivanova does find that Germany’s current account surplus
implied by fundamentals is somewhat smaller than its observed surplus. But she
cautions that the difference is small and the policy measures to engineer it are
imprecisely known. That said, she concludes that measures to raise both domestic
investment and employment generation (and hence consumption) would be the
right way to go.
There remains the longer-standing question of Germany’s low consumption
growth. After the early postwar years of satisfying pent-up demand, consumption
growth tended to fall along with GDP growth. Moreover, as Figure 1.16 shows,
there was an inverse relationship between consumption growth and the unem-
ployment rate. In the 1970s, unemployment became a structural problem, and
during every downturn until the mid 2000s the unemployment rate rose signifi-
cantly, whereas subsequent recoveries did not see meaningful reductions. The
depressed labor market outlook lowered consumption growth, and by placing an
additional burden on the fiscal sector it limited the scope for fiscal policy to
stimulate domestic demand (Figure 1.17).
With weak domestic demand, the role of exports in generating growth became
particularly important in the 2000s. And, while incomes rose, so did household
income uncertainty. Despite GDP growth, unemployment remained stubbornly

12
05 06
10 07
04 08 98 00 99
03 97
Unemployment rate
95 85
02 96 01 87 86
8 88
09 10 11 94 84 89
93 90
6 83 92 91
82
78 77
4 81 79
80 76
75
2
74 72
73
71
0
–2 0 2 4 6
Private consumption growth rate
Figure 1.16 Unemployment and Consumption in Germany since 1971 (Unemployment

rate and annual private consumption growth rate)
14
Germany
12
West Germany
10
0
1950 1960 1970 1980 1990 2000 2010
Figure 1.17 Unemployment in Germany since 1950 (Unemployment rate, percent)

high, amplified by the uncertainty over the outcome of labor market reforms. At
the same time, the unification shock and specialization of the manufacturing sec-
tor toward external markets raised growth volatility. Growth volatility had been
lower in Germany than in the United States until the end of the 1980s, but since
then it has been typically higher—and even higher than in Japan since the crisis
(Figure 1.18 and Carare and Mody, 2010).
High GDP volatility in Germany is therefore partly the result of the growth
model Germany pursues. Income is volatile, the level of uncertainty is high,
saving ratios are higher, and consumption growth is low. These dynamics are

4.0
Germany United States Japan
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1975–1979 1980–1984 1985–1989 1990–1994a 1995–1999 2000–2004 2005–2008 2009–2011
Figure 1.18 Output Volatility, Germany, U.S., and Japan (Average of 20 quarter
rolling standard deviation of year-to-year GDP growth)
a
German unification falls in this period.
reinforced by a longer-standing risk aversion, reflected in relatively high stock

market volatility (which has consistently been higher than in the United States)
and relatively low short-term risk-free rates (which have typically been lower than
in the United States except for a brief period after unification and in the most
recent crisis period) (Figures 1.19 and 1.20). Similar factors apply to Japan.
Weitzman (2008) suggests that persistent high stock market volatility and low
interest rates are a reflection of deep consumer uncertainty about structural
parameters of the economy.
35
30
25
20
15
10
0
1993–1997 1998–2002 2003–2007 2008–2011
Figure 1.19 Stock Market Volatility (Five year average of the VDAX, VIX, and VNKY)
Sources: Datastream; IMF staff estimates.
Note: VDAX: volatility index for the DAX (Germany’s stock index); VIX: volatility index for Standard and Poor’s
500 index; VNKY: volatility index for Nikkei index, Japan.


14
12
10
0
1980–1984 1985–1990 1990–1994 1995–1999 2000–2004 2005–2009 2010–2011
Figure 1.20 Short-Term Interest Rates since 1980, Germany, U.S., and Japan, 1980–
2011 (Yield on Government paper with residual maturity of one year)
Sources: Haver Analytics; IMF staff estimates.
THE GREAT RECESSION

Although Germany initially took a big hit, the recovery has strengthened its
reputation for resilience. With that success have come new demands on Germany
to play a more active role in resolving the problems of peripheral Europe. In this
section, we describe the German recovery, the policy measures that contributed
to it, the interaction of those measures (especially the incentives for work sharing)
and corporate strategies, and, finally, the possibilities and limits of Germany’s
ability to help beyond its borders. Four of the six subsequent chapters in this book
cover themes that deal with the analysis of this period and the policy approaches
that are implied.
The Recovery
In the immediate wake of the crisis, the fall in German output was substantial,
but the recovery was impressive. The decline in output, at over 5 percent, was
greater than in the United States and in France and about the same as in the
United Kingdom (Figure 1.21). Only with respect to Japan was the fall less severe.
Note that both the United Kingdom and Japan have continued to underperform,
as if their initial contraction represented, in part, some longer-term downward
shift. German exports fell by 14 percent, and German investment also fell pre-
cipitously. However, by the end of 2011, Germany had not only recovered past
its precrisis output level but, despite its greater initial fall, the German excess over
precrisis GDP was greater than in the United States or France.
It is important to recognize that the German output recovery impresses
mainly because it compares favorably with even weaker performances elsewhere
in the advanced world. Almost four years after the start of the crisis, the German
output level is now only a few percentage points above its precrisis levels.

Japan France Germany U.K. United States

104
102
100
98
96
94
92
90
88
2008 2009 2010 2011
Figure 1.21 GDP during the Great Recession, Germany and Selected Economies (Real
GDP, 2007=100)
Sources: IMF, World Economic Outlook; and IMF staff calculations.
Germany has recovered, but it would be a mistake to characterize Germany as

“booming.” The slow pace of the recovery in Germany and elsewhere and the
persistent sense of crisis in the eurozone have meant that this period continues to
be described as the Great Recession.
With respect to employment, the German story is more remarkable.
Employment did not fall much and is significantly above its precrisis levels
(Figure 1.22). Forecasters, including the IMF and the German authorities, did
not see this coming. In mid-2009, when the unemployment rate stood at about
9 percent, the projections were pointing to a continued rise into double-digit
rates. In retrospect, the German performance is noteworthy not only in com-
parative terms (with other major advanced economies still struggling well below
their precrisis employment levels) but also in absolute terms; the gain in employ-
ment relative to that before the crisis is a major achievement.
Three factors stand out in explaining the German recovery. First, active and
coordinated policy measures taken across the globe were crucial in preventing a
free fall and fostering a resumption of growth. Eichengreen and O’Rourke
(2010) highlight the fact that the initial output collapse in what was subse-
quently dubbed the Great Recession was, in fact, more severe than in the Great
Depression of the 1930s. They attribute the more rapid pace of recovery this
time around to a keener perception of the danger of inaction. With the G-20
economies acting in a rare moment of policy coordination to support the
global economy, the significantly greater monetary and financial stimulus on
this occasion prevented another Great Depression. There was equally a major

Japan France Germany U.K. United States

104
103
102
101
100
99
98
97
96
95
94
2008 2009 2010 2011
Figure 1.22 Employment during the Great Recession, Germany and Selected Economies
(2007=100)
effort to backstop the financial sector in order to prevent its meltdown.

Germany played its role in the coordinated action, through both its financial
sector operations and its fiscal stance. In the financial sector, lifelines were pro-
vided to banks through the newly constituted SoFFin.4 Although there were
some initial concerns that the German authorities might be reluctant to use
fiscal stimulus, the German stimulus between 2009 and 2011 was above the
average of that in the advanced G-20 economies and only modestly less than
that in the United States or Japan (Figure 1.23). Indeed, as Krugman (2010)
pointed out, German government consumption between 2007:Q4 and 2010:Q2
rose at a significantly faster clip than in the United States. It may well be that
such expansion of consumption had a greater multiplier effect than the tax cuts
did in the United States.5
4
The Sonderfonds Finanzmarktstabilisierung (SoFFin) was created in late 2008 to stabilize the financial
system by providing bank guarantees, funds for bank recapitalizations, and the transfer of risky assets
by creating “bad banks” (IMF 2010).
5
Allen (2005) argues that there has been a historical aversion in Germany to Keynesian demand-
oriented remedies in favor of a policy more driven by the goal of expanding the economy’s supply
capacity (see also Carlin and Soskice, 2009). Yet, this has also meant a significant social safety net,
which provides so-called automatic stabilizers to protect the vulnerable and thereby operates to stabi-
lize the economy. Moreover, as this crisis showed, further discretionary stimulus is pragmatically used
in Germany, even if it is often downplayed in public discourse.

0
es
ed
n
alia
rea
da
ly
m
an
pa
nc
Ita
do
tat
na
nc
Ko
str
Fra
rm
Ja
ing
dS
va
Ca
Au
Ge
Ad
dK
ite
20
Un
ite
G-
Un
Figure 1.23 Fiscal Stimulus During the Great Recession, Germany and Selected
Countries (2009–2011, cumulative, percent of GDP)
Source: IMF, Fiscal Monitor, November 2010.
Second, some parts of the world, in particular Asian economies, recovered

quickly, and their demand boosted Germany’s exports. China’s investment-driven
growth was a major source of world growth (as the advanced world struggled) and
played directly to Germany’s strength. Chinese imports of German goods ranged
from cars to high-speed rail. And although the Chinese share of German exports
was small before the crisis, its incremental contribution to German exports during
the recovery phase was substantial (Figure 1.24). China advanced to become
50
Total exports Exports to China
40
30
20
10
−10
−20
−30
2005 2006 2007 2008 2009 2010 2011
Figure 1.24 Growth of German Exports to China, 2005–2011 (Average annual

percentage change)
Sources: Deutsche Bundesbank; and IMF staff estimates.

180
Private consumption
170
Employment
160
150
140
130
120
110
100
90
80
1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 1.25 Employment and Consumption, Germany, 1970–2011 (Levels, 1970=100

and 1991=100)
Germany’s sixth most important export destination country in 2010, almost on

par with the United Kingdom and Italy.
Finally, the labor market played a key role. Its resilience is important in
itself—both for minimizing the social costs and for the consumption gains it
brought to support the economy. However, looking ahead, the strength of the
consumption trends remains unclear. The recovery has been driven primarily
by exports, especially to areas beyond the eurozone. In turn, exports have
pulled up investment. The steadiness of employment notwithstanding, the
contribution of consumption to growth has been erratic from quarter to quar-
ter; over the period 2009–2012:Q2 it has been about 30 percent. This is not
a surprise. As Figure 1.25 shows, the relationship between employment and
consumption growth has weakened since reunification. Note also from
Figures 1.18 and 1.20 that GDP and stock market volatility have risen sharp-
ly during the Great Recession, with the United States still the lowest, and
Germany and Japan maintaining their historically higher uncertainty. Thus,
while incomes have grown, so has uncertainty, with the net effect yet to be
resolved.
Labor Market Performance

The factors behind the strength of Germany’s labor market are discussed in this
volume by Schindler (Chapter 4). He concludes that the outcome is a mix of at
least four different factors. First, much attention has been paid to government
subsidies to maintain employment while reducing the number of hours worked.
In Germany, this was implemented through the Kurzarbeit scheme. When the

crisis hit, the government increased both the duration and the coverage of
subsidies. This allowed work to be shared and human capital to be maintained.6
Boeri and Bruecker (2011) point out that similar approaches were adopted in a
number of countries, but with less success. They argue that complementary
institutions are needed to make this policy effective, pointing especially to
employment protection legislation and collective bargaining. Schindler, in
Chapter 4, points to a second factor. He notes that the strategy and response of
German firms was important. Firms and workers had prior agreements that
they could deviate from collectively bargained work arrangements to avoid lay-
offs, and introduced work-time accounts at the firm level. For workers in the
core labor market, this was a reasonable approach: in the face uncertainty in
export markets, they opted for job security and flexibility at the firm level.
Thus, work-sharing schemes were already a part of the relationship between
German firms and their workers. Burda and Hunt (2011) note, moreover, that
because workers had credits on these accounts, firing them in the midst of the
downturn would have required compensating them for the credits. In this set-
ting, the subsidies were helpful in reinforcing the preexisting contractual rela-
tionship. Third, as Schindler concludes in Chapter 2, for Germany the Great
Recession was mainly an external export shock, not a supply shock. Despite the
uncertainty, firms largely saw this as a temporary shock and relied on accumu-
lated work time and short work schemes instead of layoffs. With the recovery,
this judgment was vindicated. Burda and Hunt (2011) argue that the precrisis
expansion of exports was viewed by firms as temporary, so firms held back their
hiring—this is consistent with the relatively low level of corporate investment
in the boom years, as Ivanova has noted. Thus, firms did not have as much of
a need to fire people.
Looking beyond the near term, Schindler in Chapter 4 suggests that
German unemployment had begun a secular downward trend prior to the cri-
sis, possibly triggered by the Hartz reforms. The evidence for this conclusion is
still preliminary, although it is plausible since these reforms increased labor
flexibility both among the core work force and also at its margins. Once again,
it helps to look beyond Germany. As noted above, other European countries
adopted similar labor market reforms in the mid-1990s. Boeri (2009) finds that
similar reforms to the Italian labor market led to favorable labor market
responses in that country: he estimates that the level of unemployment consis-
tent with non-accelerating inflation came down. However, Boeri goes on to
argue that Italian firms’ essential lack of dynamism implied that employment
did not respond in meaningful numbers. Here again, Germany’s historical
strengths and corporate-labor relationships distinguish it from other European
nations.
6
This would be of particular importance if skilled labor was in short supply. In chapter 3 of this vol-
ume, Schindler notes that the firms’ more intensive use of the core labor force, combined with an
adjustment in the temporary workforce (typically less skilled) is consistent with such considerations.

Germany’s International Role

Germany’s economic size and its recovery from the Great Recession have led to
calls for more German support to global growth, especially to the euro area. We
do not deal here with the broader issues of euro area governance and financial
arrangements to support “bailouts.” Rather, our focus is on the specific role that
German economic policy can play in fostering growth and stability in the euro-
zone. In this context, three sets of issues arise7:
• Germany as a growth “locomotive,”
• German fiscal policy as stimulus for Europe, and
• The support provided to peripheral nations through the Target 2 system.
Germany’s ability to act as either a global or even a European locomotive is
limited. This follows from the theme that this essay has developed, namely,
that German growth has itself depended to a large extent on global growth.
While there is some optimism that growth will become more domestically
driven with structural improvements in the labor market, the evidence for
that, as discussed above, is at best preliminary. For a nation to act as a growth
locomotive for others, it must originate growth impulses. This, in essence, is
the finding of Hélène Poirson and Sebastian Weber in Chapter 5 of this vol-
ume. Growth spillovers from Germany to the rest of the world remain limited
because domestically originated growth is limited. Rather, Germany acts as a
transmitter of global trade impulses, mainly from the United States and Asia
to Europe. German supply chains that seek inputs for the delivery of
Germany’s own exports extend to its eastern trading partners. But these supply
chains are set in motion by demand that predominantly originates outside of
Europe.
For Germany to assume more of a locomotive role would require autonomous
sources of demand from within the country. There are no easy policy steps to
achieve this outcome. Ultimately, efforts to raise German growth potential in a
manner that raises labor participation and emphasizes the production and deliv-
ery of services are likely to raise both German economic welfare and the contribu-
tion to global growth.
But what if Germany used its fiscal space to stimulate demand for goods and
services produced in the periphery? Would that not provide much needed tempo-
rary relief? The answer is, in principle, yes. However, Anna Ivanova and Sebastian
Weber in Chapter 6 of this volume conclude that the quantitative effect would be
small. Spillovers from an activist fiscal policy in Germany to the periphery are
small, because trade links are weak. The chapter shows that the arithmetic works
against fiscal spillovers, because the quantitative effect is further reduced if the
German domestic multiplier is less than one, and is further diluted since only a
7
We have addressed above the issue of intra-European imbalances. As noted, a policy that weakens
German competitiveness may reduce German surpluses but not necessarily improve the current
account positions of the peripheral countries.

800 Germany Netherlands
600 Belgium France
Italy Greece, Ireland, and Portugal

400
Finland Luxembourg
200
−200
−400
Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Figure 1.26 Target 2 Balances, Germany and Selected Euro Area Countries, 2005–
2012 (EUR billion)
Sources: IFS; National Central Banks; and staff estimates.
share of domestic spending is diverted to imports, of which only a small share

benefits the periphery.
While support to European growth, either through general economic
activity or through fiscal policy, is likely to be limited, as part of the
Eurosystem Germany has somewhat unwittingly played an important role in
providing financial stability and hence preventing a more serious growth col-
lapse. This has occurred through the so-called Target 2 system. Target bal-
ances are the mechanism through which national central banks within the
Eurosystem lend to each other. Target positions are intended to smooth over
temporary liquidity needs of the member countries, and the system has
typically been close to balance. Since 2007, however, imbalances have
grown steadily, and as of this writing Germany has a large creditor position
(Figure 1.26), while a number of countries have become net debtors
(Bornhorst and Mody, 2012).
In effect, as the crisis deepened, capital flows in the eurozone reversed. The
creditor countries (especially Germany and the Netherlands) opted not to roll
over their financial exposure to much of the rest of the eurozone (especially to
the most stressed economies), including to the cross-border interbank market.
This was yet more evidence that the flows in the first place had not generated
productive investments. The process gained momentum in the fall of 2011,
and with the debtor nations unable to meet these repatriation obligations, the
only vent to ease what would have been unbearable pressure was the ECB’s
Target 2 system (Figures 1.27 and 1.28). Essentially, the ECB mediated excess
balances in the creditor central banks to banking systems of the stressed
economies.

600
Financial flows ex target (+ outflow)
Change in target claims (+ increase)
400
Current account
200
−200
−400
2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1 2011:Q1 2012:Q1
Figure 1.27 Current and Financial Account of Germany, Finland, and the Netherlands
since 2005 (Billions of euros, rolling four quarter sum)
Sources: Haver Analytics; IFS; IMF staff calculations.
600
Financial flows ex target (+ outflow)
400 Change in target claims (+ increase)
Current account
200
−200
−400
−600
2005:Q1 2006:Q1 2007:Q1 2008:Q1 2009:Q1 2010:Q1 2011:Q1 2012:Q1
Figure 1.28 Current and Financial Account of Greece, Ireland, Italy, Portugal and
Spain since 2005 (Billions of euros, rolling 4 quarter sum)
Sources: Haver Analytics; IFS; IMF staff calculations.
The Emerging Challenges

We end this review with a cautionary gaze into the future. We ask two questions.
Can Germany continue to assume leadership in high-end manufacturing as the
basis for its economic strength? And, how important could the consequences of
population ageing be?
Over the past few decades, advanced economies have gradually ceded ground
in manufacturing to newly industrializing economies. The initial challenge came

in labor-intensive products, such as garments, shoes, and consumer electronics,

where cheap labor played an important role. But over time, as their wages have
risen and their industrial competency has grown, the new competitors have
expanded their line of products and raised their quality standards. While the first
televisions from Korea came in boxes with Japanese brand names, today Korean
televisions can carry their own premium. Similar progress has been achieved in
semiconductors and automobiles. The entry of China as the export machine has
rendered this process even more dynamic. The gap between emerging and
advanced nations is narrowing fast, and know-how is increasingly mobile.
Germany has so far warded off this challenge. First, German specialization has
been particularly resistant to international competitive challenge. Thus, German
producers have continuously built on their strengths to maintain their lead in
their product niches. Also, they have recognized the opportunities from the open-
ing up of lower wage economies and brought them in as partners who supply
various inputs and assembly services. But will this be sufficient? The United States
also enjoys specialization in a large number of products, but it has been losing
market share in the past decade. Similarly, Japan has been ceding ground in an
increasing range of products. It would be a surprise if even the areas of
traditional German dominance do not face stepped-up competition in the next
generation.
The threat from ageing is well recognized. As this essay has highlighted,
Germany and Japan share a number of common features. Japan, however, has
aged much faster. As Figure 1.29 shows, the ratio of Japanese over age 65 shot up
in the two decades from 1990 to 2010 and now stands at about 22 percent. This
has resulted in important changes in the Japanese economy.
24
Germany Japan United States
22
20
18
16
14
12
10
1990 1995 2000 2005 2010
Figure 1.29 Population Ageing, Germany, Japan, and the U.S., 1990–2010 (Popula-
tion over 65 years, in percent of total population)

Recent research (Braun, Ikeda, and Joines, 2007) shows that the single most
important cause of the decline in Japanese savings rates is lower savings as people
get older. Yet this has not necessarily meant a consumption boom. Rather, even
with the fall in savings, Japan has experienced subdued demand and deflation.
The relationship between ageing and deflation is, of course, more tenuous, but it
is presumably related to the shrinking workforce (Figures 1.30 and 1.31). Germany
is about to go through a more intensive ageing phase, following Japan. The
40
Percent 65+ 2010 Percent 65+ 2050
30
20
10
0
United States Germany Japan OECD
Figure 1.30 Population Ageing, Germany, U.S., Japan and the OECD, 2010–2050
(Population over 65, in percent of total population)
Source: Organisation for Economic Co-operation and Development Labour Force and Demographic Database,
2010.
250
Forecast France
Japan Germany
200
UK US
150
100
50
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Figure 1.31 Working-Age Population, Germany and Selected Countries, 1950 to

Present and Projected (1950=100)
Source: United Nations.

10th–90th percentile of OECD economies Germany
80 Nordic economies (DNK, FIN, SWE, NOR) Average

75
70
65
60
55
50
45
40
35
30
1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 1.32 Female Labor Force Participation, Germany and Nordic and OECD
Countries, 1970–2010 (18–64 years old, percent)
10th–90th percentile of OECD economies Germany
Nordic economies (DNK, FIN, SWE, NOR) Average

90
85
80
75
70
1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 1.33 Male Labor Force Participation, Germany and Nordic and OECD
Countries, 1970–2010 (18–64 years old, percent)
pressures are rising as the population ages, and migration, even by the most opti-
mistic scenarios, cannot fill the emerging gap in the working-age population. This
will call for policies, possibly following the Nordic model, directed toward
increasing the labor force participation especially of women (Figure 1.32 and
1.33). This in turn implies adjustments to effective tax rates to enhance female
labor supply along with supportive child care policy.
Conclusion: Germany in an Interconnected World

Despite economic ups and downs, Germany has held a commanding position in
the global economy over the past half century. This position primarily reflects

an industrial strength that has been tested in global competition over decades
and has proven resilient to severe setbacks. Most recently, the period after
German unification saw the economy in doldrums with seemingly intractable
high unemployment rates. Yet the German economy has continually displayed a
capacity to regenerate itself. Its emergence from the Great Recession—and espe-
cially the ability to generate jobs—has been widely, and rightly, lauded. In turn,
this resilience is due to a network of innovative firms that have adapted to
global changes, for example through increased sourcing from Eastern Europe
and exploiting new market opportunities in Asia. It is also due to the ability of
firms and labor to find common ground. Finally, it is due to a pragmatic bent
in policymaking.
Following World War II, Germany experienced a particularly robust
reconstruction phase. This was followed by an extended period of slowing
growth. First, there was a natural slowing after the rapid postwar catch-up.
Then the external shocks of rising oil prices and the collapse of the Bretton
Woods system caused further deceleration. The unification episode was
unique to Germany. After a short-lived unification boom in the early 1990s,
growth fell again. When in the 1990s the world economy began a new expan-
sion phase, the German economy appeared ill-prepared to take advantage of
the favorable environment. But by the mid-2000s, economic reform and
corporate and labor responses to the changed circumstances led to a German
reemergence. Since then, the German economy has displayed considerable
strength and maturity, not least by robustly navigating the crisis of 2008–9.
In particular, German employment levels weathered the recent crisis surpris-
ingly well.
With its success, Germany has been called on to assist the global recovery,
questions about its current account surplus have resurfaced, and Germany’s wage
moderation and proposed pace of fiscal consolidation following the recovery
from the 2008–9 crisis have, at times, been regarded with concern. However,
while proposals for more rapidly raising German wages or delaying fiscal con-
solidation have a plausibility, a closer examination suggests that they could com-
promise German strengths with dubious short-term stimulative value for other
countries.
The real German challenge is to strengthen its areas of weakness. Although
significantly down from their peak levels, unemployment rates remain elevated,
including when judged by Germany’s own past history. These high rates, along
with the emergence of relatively low-paying and temporary jobs, also act as a drag
on German consumption growth. The key is to counteract medium-term growth
constraints in a way that also supports sustainable rebalancing via higher domestic
demand growth. Meeting this challenge will require a new generation of pragma-
tism in policy decisions. A greater emphasis is needed on innovation that extends
Germany beyond its traditional manufacturing strengths and on a new model of
social safety nets, drawing possibly on the Nordic experience, to increase labor
force participation needed to counter rapid ageing. Such actions would also be
good for Europe and the global economy.

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Economic Review, Vol. 97, No. 4, pp. 1102–30.


CHAPTER 2
The Crisis’s Impact on Potential

Growth in Germany: The Nature
of the Shock Matters
MARTIN SCHINDLER
While the German economy, with a GDP decline of 4.75 percent in 2009, was
among the hardest hit during the financial crisis, the impact of the crisis on its
potential output is estimated in this chapter to have been comparatively mild and
transitory, with virtually no potential output loss in the long term. This outcome
reflects both a more flexible economic structure, resulting from past reforms, and,
importantly, the nature of the shock—a temporary drop in external demand. The
temporary nature of the shock meant that no large-scale structural shifts in employ-
ment were necessary, so employers were inclined to retain workers and adjust hours
per worker instead. This incentive was buttressed by policy measures during the
crisis, but more importantly also by longer-standing labor market improvements
regarding hourly flexibility. With employment levels and, especially, hours, returning
to pre-crisis levels, the impact on potential GDP was limited, and the evidence sug-
gests that a medium-term convergence of potential output to its pre-crisis trend is
likely. However, there is little indication that long-term potential growth will rise
above its meager historical rate of about 1.25 percent. Increasing potential growth
in the medium and long term will require sustained efforts to reverse the declining
secular trend in Germany’s productivity growth and to raise its low total factor pro-
ductivity (TFP) growth.
INTRODUCTION
Germany’s economic structure has changed dramatically over the past four
decades. Until about the mid-1990s, the contribution of external trade to aggre-
gate growth—in either direction—was similar to that in most other advanced
The author has benefitted from comments and suggestions by Ashoka Mody, Hélène Poirson, Anna
Ivanova and participants at the Germany in an Interconnected World Conference at the Ministry of
Finance in Berlin (May 2011), especially the paper’s discussant, Malte Hübner. Roberto Garcia-Saltos,
Petar Manchev, and colleagues at the IMF’s Research Department Economic Modeling Unit provided
helpful advice on implementing the Matlab code. Susan Becker provided excellent research assistance.
35

36 The Crisis’s Impact on Potential Growth in Germany: The Nature of the Shock Matters
1.5
1971–1995 1996–2010
1.2
0.9
0.6
0.3
0.0
Germany Japan United States United Euro area
Kingdom (excluding
Germany)
Figure 2.1 Foreign Contributions to Growth (Annual percentage points)

Sources: IMF; World Economic Outlook; and IMF staff calculations.
economies.1 Since the mid-1990s, however, the importance of foreign trade in

cyclical fluctuations (in an accounting sense) has increased dramatically in
Germany, exceeding that in other advanced economies by far, even as its real
GDP growth rate ranked among the lower rates during that period. That is, dur-
ing 1996–2010, annual growth on average was almost exclusively driven by
increases in net exports, with domestic growth contributing a negligible amount
(Figures 2.1 and 2.2).
The increased importance of external trade also featured prominently during
the recent crisis. More so than elsewhere, Germany’s crisis contraction and its
recovery were correlated with fluctuations in external demand. (Figure 2.3) In
particular, the downturn was markedly different from that in most other econo-
mies in that it almost exclusively reflected a decline in net exports: between
2007:Q4 and 2009:Q1, real GDP declined by a cumulative 5.8 percent, of which
5.1 percentage points were due to the cumulative decline in real net exports.2, 3
1
Time-series data exhibit a V-shaped pattern, with the German foreign contribution to growth more
elevated in the 1970s and 80s, though still substantially below the more recent uptick in the trade
surplus. The increase in the foreign contribution to growth is even more pronounced in relative terms,
i.e., the foreign growth contribution relative to total growth. For a more detailed analysis of Germany’s
historical growth drivers, see Vitek (2010), which also illustrates the increasing importance over time
of foreign demand in German business cycle fluctuations, especially during the Great Recession.
2
Exports of goods and services dropped by over 15 percent in real terms during that period, with the
impact on net exports somewhat offset by an import decline of just under 6 percent.
3
The theme of strong external growth drivers alongside relative moderate contributions from domestic
sources raises deeper questions regarding their causal connection: has weak domestic demand led firms
to focus on external markets? Or has a dominant external sector, e.g., through its increased volatility, led
individuals to raise (precautionary) savings and lower their consumption? Or are there unrelated causes
for the two? This is an important theme that, however, cannot be addressed in the context of this chapter.

Schindler 37
4.0
1971–1995 1996–2010
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
United United Euro area Germany Japan
States Kingdom (excluding
Germany)
Figure 2.2 Average Real GDP Growth (Annual percentage points)

8
6 Domestic
Net exports
4
2
0
–2
–4
–6
–8
–10
France Germany Japan Sweden United United
Kingdom States
Figure 2.3 Growth Composition during Crisis and Recovery

Note: The bars represent cumulative contributions to growth from domestic and external sources during
2008:Q2–2009:Q1 (left bar) and 2009:Q1–2010:Q3 (right bar).
The reliance on external demand affects how growth shocks are transmitted to
potential GDP. Generally speaking, any given change in actual GDP may reflect
either a fluctuation of actual GDP around a stable potential GDP path (that is,
fluctuations in demand) or a change in potential GDP (that is, fluctuations in
supply), or both. The assessment of what type of shock is the source of the
observed fluctuations in GDP therefore has strong implications for the assess-
ment of the extent to which potential GDP may be affected.

Building on the notion that external demand has been the main driver of
German business cycles—at least since the mid-1990s—the analysis in this paper
concludes that potential growth was only minimally affected by the crisis, in
contrast to many other countries during the crisis (including the United States)
and in contrast to the effects typically associated with past financial crises.4 Thus,
the demand shock has pulled down actual GDP, but it has not set in motion firm
activities that would substantially alter Germany’s growth potential in the medi-
um term, as reflected particularly in the moderate crisis impact on capital stock
and employment. Consistent with this, a robust recovery in actual GDP has
pulled up potential growth, which has been seen to overshoot its long-term rate
in the medium term, making up for the small potential growth losses during the
crisis. The key result is that there is likely to be no permanent loss of potential
GDP relative to the pre-crisis trend.
On a more somber note, however, the underlying assumption of a low long-
term potential growth rate of only about 1¼ percent leaves Germany lagging
behind many of its peers, especially the United States, which, despite a more
severe crisis impact, is set to continue to grow at a faster rate than Germany.
Given Germany’s adverse demographic pressures, only continued structural
improvements to raise productivity and the supply of labor can lift German GDP
to a higher trajectory.
This chapter provides some background on the existing literature on potential
GDP, including its definition and selected findings; describes the methodology
and the main results; and presents these results within the context of a growth
accounting exercise that decomposes German growth into that deriving from
total factor productivity dynamics, (physical) capital accumulation, and employ-
ment growth. An appendix provides further details on the underlying model that
was used to estimate potential GDP.
BACKGROUND: CONCEPTS AND RELATED

LITERATURE
Potential GDP has been defined in different ways in the related literature.
Some authors provide an essentially statistical definition, such as Gordon
(2008, p. 1) who “uses the adjectives ‘potential’ and ‘trend’ as synonyms to
describe the long-run growth rate of real GDP… after cyclical elements of the
observed data are factored out by a statistical de-trending procedure.” Others
define potential output more conceptually as the full-employment level of
output, that is, “the level of output at which the economy’s resources are fully
employed” (Mankiw, 2002, p. 246), where full employment is understood to
mean that capacity utilization and unemployment rates are at their “normal”
4
For example, Furceri and Mourougane (2009) estimate that financial crises have on average perma-
nently reduced potential GDP by 1.5–2.4 percent in OECD economies during 1960–2007.

Schindler 39
or “natural” levels. In the latter definition, potential growth is typically viewed

as the maximum growth rate that is sustainable without an acceleration of
inflation.
The different definitions of potential output are reflected in different approach-
es to measuring or estimating it. The more statistical definition has the advantage
of being easily implemented through various statistical de-trending methods,
such as simple averaging or the Hodrick-Prescott filter. Definitions relying on
economic concepts require the use of economic models that help to estimate dif-
ferences between actual and potential output, often based on estimates of equilib-
rium levels of labor and capacity utilization rates. The approach in this paper falls
on the side of the latter approach.
Applied to Germany, a simple averaging of annual growth rates suggests a
long-term potential growth rate of 2 percent annually during 1970–2011
(Figure 2.4). However, the German reunification represents an important struc-
tural break—prior to that, annual growth averaged 2.7 percent, while it has been
averaging a lower rate of 1.3 percent during the post-unification period. The
secular decline in potential growth is consistent with, but sharper than, Gordon’s
(2008) estimates for the United States. Based on simple growth averaging
between “benchmark dates” (Figure 2.4), Gordon finds a decline in the United
States from nearly 3.5 percent in the early 1970s to about 2 percent in 2007–08.
Notably, this decline is much more moderate than in Germany—according to
these simple estimates, Germany’s potential growth was broadly on par with the
United States in the 1970s and 1980s, but is now substantially lower. That said,
the analysis that follows in this chapter suggests that this gap may once again
8 United States averages (Gordon, 2008)

Annual
6 Pre-/post-reunification averages
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
−2
−4
−6
Figure 2.4 Germany and the United States: GDP Growth (Percent)
Sources: IMF, World Economic Outlook; Gordon (2008); and IMF staff estimates.

shrink as the damage that the financial crisis has caused to medium-term
potential growth is likely to be more substantial in the United States than in
Germany.5
Over longer horizons, such trend-based estimates should conform closely
with what would be obtained based on the economic definition of potential
output, since on average an economy should not operate at a level substan-
tially different from its potential over long periods. Thus, over long horizons,
simple trend estimates are likely to be reasonable estimates of potential output
and can serve as inputs in the type of modeling approach used here to anchor
the estimates. However, as shown below, more substantial differences often
arise over shorter frequencies, where atheoretical methods may be unable to
sufficiently differentiate between changes in actual output and changes in
potential output.
A number of studies have examined potential output in Germany. Based on
a production function methodology, De Masi (1997) estimates potential growth
in Germany at 2.25–2.5 percent, which is consistent with the long-term growth
rate reported above, given her 1980–1997 sample. Also following a production-
function approach and considering the 1986–2003 time period, Baghli, Cahn
and Villetelle (2006) find a secular decline in potential growth rates in Germany,
although their post-unification average of about 1.9 percent is somewhat higher
than the average calculated above, reflecting the absence of post-2003 data,
especially the low growth rates until 2005 and the more recent crisis (see also
Cahn and Saint-Guilhem, 2007). That potential output growth estimates are
subject to considerable uncertainty is exemplified by Horn, Logeay, and Tober
(2007) who find, for various versions of their model, annual potential growth
rates during 2006–2010 of 2.4, 2.1 and 1.3 percent, respectively, owing to dif-
ferent assumptions on total factor productivity (TFP) dynamics and the level of
the NAIRU.6 At the lower end are both the Sachverständigenrat (2011) and
Deutsche Bank Research (2011) studies, which find potential growth to be on
the order of 1.25 percent, at least starting in 2000 (and about 1.5 percent during
the 1990s).7
5
The notion that Germany’s potential output held up well during the crisis but lags from a longer-
term perspective also holds in a broader cross-country comparison. For example, as the discussion in
Section D of this chapter indicates, German potential GDP growth from 2000 until the onset of the
crisis fell behind that of the United States, the United Kingdom, Japan, and the Euro Area as a whole.
As also shown there, TFP growth, the main driver of a country’s long-term growth potential, is low
in Germany compared to other OECD economies.
6
Also, while Horn, Logeay and Tober (2007) utilize data dating back to 1970, they do not explicitly
model a structural break at the time of reunification. (NAIRU = Non-Accelerating-Inflation Rate of
Unemployment).
7
Consistent with the main message of this chapter, both Sachverständigenrat (2011) and Deutsche
Bank Research (2011) expect potential growth to be little affected by the crisis. El-Shagi (2011) comes
to a similar conclusion.

Schindler 41
TABLE 2.1
Model Input Data

Variable Description Source
Real GDP Gross Domestic Product (SA/WDA, Bil.Chained.2000. Statistisches
Euros) Bundesamt
Core Inflation HICP: Total excluding Energy and Unprocessed Food Haver
(SA, 2005=100)
Capacity Utilization Harmonized Capacity Utilization: Manufacturing European
(SA, percent) Commission
Inflation Expectations CPI percent chg. 6–10 years ahead, interpolated to Consensus Forecasts
quarterly frequency
Unemployment Unemployment Rate (SA, percent) Statistisches Bundesamt
Sources: See third column.
Note: SA: seasonally adjusted; WDA: work day adjusted; Bil.Chained.2000: billions of 2000 euros, chained; HICP: Harmonized
Index of Consumer Prices; CPI: Consumer Price Index.
METHODOLOGY AND RESULTS

Following Benes and others (2010), potential output is estimated here using a
Bayesian methodology, namely, the regularized maximum likelihood following
Ljung (1999). Benes and others have produced a template for such a model-
based, multivariate filtering technique which avoids some of shortcomings of
previous approaches. It also provides a common yet flexible framework in which
different countries can be more easily compared. The multivariate model incor-
porates relevant empirical relationships between actual and potential GDP,
including unemployment, core inflation, and capacity utilization. The model is
applied here to quarterly data for Germany from 1991:Q1 to 2010:Q4. For com-
parison purposes, some estimates for the United States are also shown.
The model is in many ways a standard, reduced-form macroeconomic model
built around three gaps: an output gap, an unemployment gap, and a capacity
utilization gap. These gaps are pinned down by a number of identifying equa-
tions, including an inflation equation that relates inflation to the output gap
through a Taylor-rule relationship; an unemployment equation that estimates an
Okun’s law relationship; and a capacity utilization equation to exploit the infor-
mation that capacity utilization rates can provide in the estimation of the aggre-
gate output gap. Thus, to run the model, five standard data series are needed
(Table 2.1). The appendix contains a more detailed summary of the main model
features, as does Benes and others (2010).
The methodology requires taking a stance on prior beliefs regarding a number
of variables. Consistent with past economic patterns, a key assumption fed into
the model’s estimation is that demand shocks are the primary source of real GDP
fluctuations in Germany. As discussed above, Germany’s economy has been
increasingly (export) demand driven, and especially so during the most recent
crisis. An accurate understanding of potential GDP in Germany must take into
consideration these facts.
In the model, the importance of demand versus supply shocksU
is implemented
through the (relative) priors on the standard deviations of εGt (demand) and ε Yt

Multivariate model (demand) Multivariate model (supply)

7.0
Hodrick-Prescott filter Moving average (12 quarters)
5.0
3.0
1.0
−1.0
−3.0
−5.0
−7.0
1997:Q1
1997:Q4
1998:Q3
1999:Q2
2000:Q1
2000:Q4
2001:Q3
2002:Q2
2003:Q1
2003:Q4
2004:Q3
2005:Q2
2006:Q1
2006:Q4
2007:Q3
2008:Q2
2009:Q1
2009:Q4
2010:Q3
Figure 2.5 Output Gaps Based on Alternative Methodologies (Percent of potential
GDP)
Sources: IMF staff estimates.
(supply) (see the appendix regarding where these variables enter the model). For
example, a prior belief that supply is more volatile than demand would lead the
model to assign much of the observed volatility of real GDP to potential GDP
fluctuations. Put differently, actual and estimated potential GDP would move in
sync, and the output gap would be less volatile. Conversely, if most GDP volatil-
ity is attributed to demand shocks, then potential GDP (supply) would remain
more stable, resulting in a more volatile output gap.
Both the model assumptions and the choice of methodology matter, affecting
the results that are obtained. Alternative methods of calculating potential GDP
(and the resulting output gaps) include simple filters that take a moving average
of actual GDP and methods based on the Hodrick-Prescott (HP) approach (see
Hodrick and Prescott, 1981), which estimates a statistically smoothed series.8
Also, within the framework used here, as discussed, different priors on the distri-
bution of shocks to GDP (demand versus supply shocks) matter.
Notably, with the exception of the fairly crude moving-average approach, all
approaches deliver fairly similar results historically—they do differ, however, in
their output gap dynamics during the current crisis (Figure 2.5). That is, all
atheoretical approaches assign most of the variation in actual GDP to supply
variations (i.e., variations in potential GDP) and thus exhibit a similar pattern as
that resulting from the multivariate approach with supply-sided priors. Given the
nature of the shock that Germany experienced during this crisis, these other
approaches are likely to be misleading. That is, not utilizing information on the
underlying economics, including especially the nature of the shock, provides a
very different view of the evolution of potential GDP than otherwise.
8
That is, the HP-filter does not use economic information in its estimation. It also suffers from end-
of-sample measurement problems.

Schindler 43
France Germany Japan

12.0
United Kingdom United States
10.0
8.0
6.0
4.0
2.0
0.0
2001:Q1
2001:Q3
2002:Q1
2002:Q3
2003:Q1
2003:Q3
2004:Q1
2004:Q3
2005:Q1
2005:Q3
2006:Q1
2006:Q3
2007:Q1
2007:Q3
2008:Q1
2008:Q3
2009:Q1
2009:Q3
2010:Q1
2010:Q3
Figure 2.6 Unemployment Rates (Percent)
Sources: IMF; World Economic Outlook; and IMF staff estimates.
The projected potential growth patterns imply virtually no medium-term loss

in potential German GDP. The mild drop in potential growth in Germany, com-
bined with potential growth slightly above the precrisis trend growth in the
medium term, suggests that Germany may not suffer any medium-term losses in
its level of potential output. According to the model projections, by 2016 poten-
tial GDP should converge with the level of potential output that would have been
reached had precrisis growth rates prevailed throughout the projection period.9
By contrast, the sharper drop in potential growth in the United States, combined
with model-based potential growth projections that fall short of precrisis rates,
implies that the United States may suffer a substantial permanent loss in potential
GDP. Even at end-2016, U.S. potential GDP is estimated to be nearly 10 percent
below the level based on precrisis trends.
The mild potential GDP dynamics in Germany have been mirrored by a
similarly mild labor market response (Figure 2.6). A shock that leaves medium-
term potential GDP relatively unharmed in both its level and its growth reduces
the incentives for firms to shed employment, particularly when such labor hoard-
ing is supported by additional policy measures. The moderate and only short-
lived uptick in German unemployment partly reflects a shock that was temporary
and demand-sided. In turn, the low unemployment impact reinforces the positive
potential GDP dynamics: keeping unemployment down helps avoid many of the
9
Using a multivariate state-space model, El-Shagi (2011) reaches a very similar conclusion for
Germany and finds “that the crisis mostly opened the output gap and did not reduce potential GDP
(as suggested by other models)” (p. 737).

5
Euro Area Germany United States
3
−1
−3
−5
−7
2005
2006
2007
2008
2009
2010
2012
2013
2014
2015
2016
2011
Figure 2.7 Output Gaps (Percent of potential GDP)

Source: IMF, World Economic Outlook.
adverse short-term effects of unemployment on potential output.10 Thus, poten-

tial output and labor market dynamics form a consistent equilibrium. By con-
trast, the United States appears to have embarked on a different equilibrium path,
where a more supply-side shock has led to a larger impact on potential GDP and
reduced incentives for firms to retain employment. The different labor market
experiences observed in Germany and the United States therefore provide a con-
sistent mirror image to their estimated potential GDP dynamics.
The robust recoveries in actual GDP and capacity utilization imply an output
gap that was projected to be closed by end-2011 at the time of estimation11
(Figure 2.7). Given the fairly stable path of potential output, the drop in actual
GDP during the crisis led to a large negative output gap; conversely, the growth
recovery implies a shrinking of the output gap, closing in 2012 and remaining
near zero from then onwards. Capacity utilization follows a similar path (Figure
2.8). The broad output gap dynamics are similar across most sectors, with gaps in
most sectors still negative, though close to closed in some (Figure 2.9).
With a still negative output gap, inflationary pressures remain moderate
(Figure 2.10). Based purely on the projected output gap dynamics, core inflation
was projected to increase only moderately, to about 1.3 percent in 2011, from
10
Job creation is a more sluggish process than job destruction, suggesting some persistence in unem-
ployment even after a (temporary) shock has subsided; also, unemployment is often associated with
losses in human capital associated with unemployment spells. Both factors imply a reduction in effec-
tive labor supply and thus potential output. In “What Does The Crisis Tell Us About the German
Labor Market?”—Chapter 4 in this volume—I examine in more detail some of the factors behind the
moderate labor market response. In addition to the potential GDP dynamics, past reforms, including
the Hartz IV in 2005, were likely contributors.
11
The work underlying this chapter was completed in early 2011.

Schindler 45
4 Relative to historical average (1991:Q1–2008:Q1)

Relative to pre-crisis peak
2
−2
−4
−6
−8
Consumer Intermediate Capital goods Consumer
durables goods nondurables
Figure 2.8 Capacity Utilization Gaps (Percent)

Sources: Federal Statistical Office; Deutsche Bundesbank; and IMF staff estimates.
25
Agriculture Manufacturing Total Value Added Services
20
15
10
5
0
−5
−10
−15
−20
1991:Q1
1992:Q1
1993:Q1
1994:Q1
1995:Q1
1996:Q1
1997:Q1
1998:Q1
1999:Q1
2000:Q1
2001:Q1
2002:Q1
2003:Q1
2004:Q1
2005:Q1
2006:Q1
2007:Q1
2008:Q1
2009:Q1
2010:Q1
Figure 2.9 Sectoral Output Gaps (Percent)

Sources: Federal Statistical Office; Deutsche Bundesbank; and IMF staff estimates.
Note: Measured as log-differences between actual value added and an estimated linear time trend.
about 0.8 percent in 2010.12 Second-round effects on wages have also so far
remained moderate, not least reflecting a still-positive unemployment gap (i.e.,
actual unemployment above equilibrium). And lastly, aggregate capacity utiliza-
tion is set to remain substantially below precrisis levels. However, continued and
sharper commodity price pressures do represent an upside risk to core inflation.
Based on the model estimated here, the crisis impact on potential GDP is more
limited in Germany than in the United States. From a historical (post-unification)
average of about 1.3 percent, German potential growth declined moderately to
12
An increase in the output gap by one percentage point is associated with about a 2/5 percentage
point increase in inflation.

Output gap Core inflation (year on year)

8
Capacity utilization gap Unemployment gap
6
4
2
0
−2
−4
−6
−8
−10
−12
1995:Q3
1996:Q3
1997:Q3
1998:Q3
1999:Q3
2000:Q3
2001:Q3
2002:Q3
2003:Q3
2004:Q3
2005:Q3
2006:Q3
2007:Q3
2008:Q3
2009:Q3
2010:Q3
2012:Q3
2013:Q3
2014:Q3
2015:Q3
2016:Q3
2011:Q3
Figure 2.10 Germany: Gap Measures and Inflation (Percent)
Sources: IMF, World Economic Outlook; Deutsche Bundesbank; and IMF staff estimates.
about 1.0 percent in 2009. However, in the medium term, pulled up by a strong
growth recovery, potential growth is expected to move slightly above historical
rates, peaking at about 1.7 percent in 2013 before eventually converging back to
its long-term rate of 1.3 percent by 2016. By contrast, the U.S. economy is much
more closed; and the crisis there originated from the financial and real estate sec-
tors, suggesting a domestic supply shock. Thus, U.S. potential growth declined
more dramatically, to about 1.5 percent in 2009 from over 2.5 percent histori-
cally. In the medium term, potential growth in the United States is projected to
pick up to about 2¼ percent by 2016 (Figures 2.11 and 2.12).
3
Germany USA
0
2003 2005 2007 2009 2011 2013 2015
Figure 2.11 Germany and the U.S.: Potential Growth (Percent)


Schindler 47
125 Germany
Germany pre-crisis trend
120
United States
115
United States pre-crisis trend
110
105
100
95
90
2003 2005 2007 2009 2011 2013 2015
Figure 2.12 Germany and the U.S.: Potential GDP Relative to Pre-crisis Trends
(2007=100)
GERMANY’S GROWTH SOURCES THROUGH A

GROWTH ACCOUNTING LENS
Though the crisis did little damage to Germany’s growth potential, that potential
remains low in cross-country comparisons. Germany’s economic potential has sur-
vived the crisis remarkably intact. In contrast, U.S. potential growth may be reduced
by a significant fraction of its historical rates. Yet, even at reduced growth rates, U.S.
potential growth is still nearly twice Germany’s long-term potential of 1.3 percent.
What accounts for Germany’s low potential growth rate? The growth account-
ing approach, which decomposes GDP growth into that arising from TFP
growth, changes in the capital stock and employment growth, can yield valuable
insights (See Table 2.2). Building on the estimates by Bosworth and Collins
(2003) and applying their approach to quarterly data suggests that:
• short-term fluctuations in output are largely driven by fluctuations in TFP
(the residual); and
• longer-term trends in German growth prior to the crisis have been driven
by both TFP growth and capital accumulation. During 1991–2010, GDP
grew at an average 1.3 percent per year, of which 0.5 percentage points were
due to TFP growth, 0.6 percentage points due to growth in the capital
stock, and 0.1 percentage points due to employment growth.13
13
Different labor measures can be used, but do not affect the estimates substantially. When labor
input is measured as the labor force rather than employment, its contribution is higher at 0.2 percent,
but TFP growth remains at about 0.5 percent annually. Estimated average TFP growth rises to a
slightly higher value of about 0.75 percent annually when labor is measured as total hours, reflecting
a secular decline in total hours worked.

TABLE 2.2
Decomposing growth
(percent, quarter-on-quarter, annualized)
GDP TFP Capital Labor
2000:Q1–2005:Q4 0.9 0.4 0.5 0.1
2006:Q1–2008:Q2 4.7 2.2 0.9 0.2
2008:Q3–2009:Q1 –5.5 –6.0 0.5 0.0
2009:Q2–2010:Q2 3.9 3.3 0.3 0.3
2010:Q3–2010:Q4 2.1 1.1 0.4 0.4
Average 1991–2010 1.3 0.1 0.6 0.1
Note: TFP: total factor productivity.
6
5 Staff estimates EU Klems Conference Board
4 GGDC OECD
3
2
1
0
−1
−2
−3
−4
80
84
94
96
98
00
06
82
86
02
04
88
90
08
10
92
19
19
19
19
19
20
20
19
19
20
20
19
19
20
20
19
Figure 2.13 Germany: Total Factor Productivity Growth Estimates (Percent).

Sources: IMF staff estimates.
Note: GGDC: Groningen Growth and Development Centre; Klems: growth and productivity accounts.
These estimates are broadly consistent with a variety of other estimates. The
EU KLEMS project, the Conference Board, the Groningen Growth and
Development Centre (GGDC) and the OECD are the main alternative sources
of TFP estimates. While these measures differ somewhat in detail, they provide
broadly similar estimates and are highly correlated.14 In particular, they all point
to a secular downward trend in TFP growth that only briefly picked up in the
run-up to the crisis. Consistent with our estimates of a limited impact of the
crisis on potential GDP, the post-crisis TFP estimates exhibit a sharp rebound15
(Figure 2.13).
14
Differences in a number of variables and parameters can affect TFP estimates, including capital and
labor shares and capital stock estimates, with the latter especially sensitive to different assumptions
(such as the initial stock and the rate of depreciation).
15
According to staff estimates, TFP declined by more than 5 percent in 2009, but grew by nearly 3
percent in 2010.

Schindler 49
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
Ki den
d tria
A m
Au tes
Be lia
m
G rm her an
an (O s
F D)
N Fr )
Ze ce
D and
C rk
n
ly
f
m ny land
ad
ai
af
Ita
do
iu
a
ra
(IM EC
n
G Ne ap
a
Sp
ni us
m
st
lg
ew a
te we
al
an
St
st
ng
en
S
te
t
d
y
er a
U
ni
U
Figure 2.14 Total Factor Productivity Growth (Average annual growth, 1992–2009,
percent)
Source: Organisation for Economic Co-operation and Development; and IMF staff estimates.
In the medium term, further labor market improvements would temporarily

sustain a higher potential growth rate. The downward trend in the unemploy-
ment rate that started around 2005, interrupted only briefly by the crisis, may
reflect ongoing dividends from the Hartz IV labor market reforms. If so, the
continued transition to a lower structural unemployment rate could temporarily
support potential growth above its long-term rate of 1.3 percent.16 In addition,
higher labor market participation rates and increased immigration could help ease
the impact of demographic pressures and further support employment growth
(Figure 2.14).
However, a longer-lasting increase in the growth potential can only be
achieved through higher TFP growth or faster capital accumulation. Germany’s
TFP growth lags that of many of its peers (see the discussion in section B). While
the United States experienced annual TFP growth of about 1.2 percent annually
during 1992–2009, German productivity expanded by only 0.4 percent a year
(0.9 percent according to OECD data). (Figure 2.15) Sectoral data suggest that
the productivity shortfall reflects lags in investment in information and commu-
nication technology (ICT) capital and related innovations, especially in private
services (see Chapter 3, by Helene Poirson, in this volume). Higher investment
rates could boost both capital accumulation and the adoption and development
of new technologies.17
16
See also Schindler (2012) for an argument that the Hartz reforms (which lowered social transfer
payments and deregulated temporary employment) had a long-lasting effect on job creation that is
still being felt. In particular, in that view, the secular downward trend since 2005 represents the tran-
sition to a lower steady-state unemployment rate.
17
High-skilled immigration, in addition to expanding the labor supply, may also contribute to TFP
growth. See West’s (2011) case for revamping the U.S. immigration system.

120
USA UK Germany Japan Euro Area
115
110
105
100
95
90
85
80
2000 2002 2004 2006 2008 2010 2012 2014 2016
Figure 2.15 Real Per Capita Potential GDP (2007=100)

The importance of productivity improvements is especially pertinent in a

long-term context. Given Germany’s declining population, although its potential
GDP is set to rise more strongly than elsewhere in per-capita terms, standard
growth theory suggests that long-run growth in living standards is driven by pro-
ductivity growth. Thus, policies that support TFP to maintain the medium-term
improvement in living standards are also crucial in the long term.
CONCLUSION
Germany has mastered the crisis well, but long-term challenges remain.
Reflecting the nature of the shock and the structure of its economy, Germany
has emerged from the crisis remarkably unblemished. However, it is set to
return to its previous trajectory of only moderate growth. Raising that growth
rate will require policy measures on many fronts, including higher labor-force
participation, higher investment rates, and—especially—stronger productivity
growth.
More recent developments in Germany’s growth recovery also pose some
downside risks to the view taken here. The medium-term growth prospects have
fallen short of most observers’ expectations, inducing downward revisions of
many analysts’ growth projections, including those by the IMF. The absence of a
permanent loss in the level of potential output depended on above-average poten-
tial growth in the near term, to compensate for the (mild) potential growth
slowdown during the crisis. To the extent that lower-than-expected growth also
reduces potential growth, potential output might not fully recover to its precrisis
trend. Such downside risks underscore the need for further reforms to accelerate
long-term potential growth in Germany.

Schindler 51
REFERENCES
Baghli, Mustapha, Christophe Cahn, and Jean-Pierre Villetelle, 2006, “Estimating Potential
Output with a Production Function for France, Germany and Italy,” Banque de France
Working Paper No. 146 (Paris: Banque de France).
Benes, Jaromir, Kevin Clinton, Roberto Garcia-Saltos, Marianna Johnson, Douglas Laxton,
Petar Manchev, and Troy Matheson, 2010, “Estimating Potential Output with a Multivariate
Filter,” IMF Working Paper No. 10/285 (Washington, DC: International Monetary Fund).
Billmeier, Andreas, 2004, “Ghostbusting: Which Output Gap Measure Really Matters?,” IMF
Working Paper No. 04/146 (Washington, DC: International Monetary Fund).
Bosworth, Barry, and Susan M. Collins, 2003, “The Empirics of Growth: An Update”
(Washington, DC: Brookings Institution).
Cahn, Christophe, and Arthur Saint-Guilhem, 2007, “Potential Output Growth in Several
Industrialised Countries: A Comparison,” ECB Working Paper No. 828 (Frankfurt am Main:
European Central Bank).
De Masi, Paula, 1997, “IMF Estimates of Potential Output: Theory and Practice,” IMF
Working Paper No. 97/177 (Washington, DC: International Monetary Fund).
Deutsche Bank Research, 2011, “Outlook 2011: German Growth Remains Robust,” Germany:
Current Issues, February 14, 2011, downloaded from http://www.dbresearch.com.
El-Shagi, Makram, 2011, “Did the Crisis Affect Potential Output?,” Applied Economics Letters,
Vol. 18, pp. 735−38.
Furceri, Davide, and Annabelle Mourougane, 2009, “The Effect of Financial Crises on Potential
Output: New Empirical Evidence from OECD Countries,” OECD Economics Department
Working Paper No. 699 (Paris: Organisation for Economic Co-operation and Development).
Gordon, Robert J., 2008, “The Slowest Potential Output Growth in U.S. History: Measurement
and Interpretation,” Paper prepared for presentation at the CSIP Symposium, “The Outlook
for Future Productivity Growth” (San Francisco: Federal Reserve Bank of San Francisco).
Hodrick, Robert J., and Prescott, Edward C., 1981, “Postwar U. S. Business Cycles: An
Empirical Investigation.” Discussion Paper No. 451 (Minneapolis: University of Minnesota).
Horn, Gustav, Camille Logeay and Silke Tober, 2007, “Estimating Germany’s Potential
Output,” IMK Working Paper No. 2/2007 (Washington, DC: International Monetary
Fund).
Ljung, Lennart, 1999, System Identification: Theory for the User (Princeton, New Jersey: Prentice-
Hall).
Mankiw, N. Gregory, 2002, Macroeconomics, 5th edition (New York: Worth Publishers).
Sachverständigenrat (Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen
Entwicklung), 2011, “Herausforderungen des demografischen Wandels,” Expertise im Auftrag
der Bundesregierung, May 2011.
Vitek, Francis, 2010, “Output and Unemployment Dynamics During the Great Recession: A
Panel Unobserved Components Analysis,” IMF Working Paper No. 10/185 (Washington,
DC: International Monetary Fund).
West, Darrell M., 2011, “Creating a ‘Brain Gain’ for U.S. Employers: The Role of Immigration,”
Brookings Policy Brief No. 178 (Washington, DC: The Brookings Institution).

APPENDIX
This appendix briefly summarizes the key features of the model. A more detailed
description is provided in Benes and others (2010). The model is built around
three gaps—the output gap (y), the unemployment gap (u), and the capacity
utilization gap (c)—and three identifying equations:
The inflation equation relates the level and the change of the output gap to
core inflation:
π 4t = π 4t −1 + βyt + Ω( yt − yt −1 ) + εtπ 4 .
The dynamic Okun’s law defines the relationship between the current unem-
ployment rate and the output gap. Based on Okun’s law, an unemployment
equation links the unemployment gap to the output gap:
ut = x1ut −1 + x 2 yt + εtu .
Finally, the model also relies on a capacity utilization equation, on the assump-
tion that capacity utilization contains important information that can help
improve the potential output and output gap estimates. The equation takes the
following form:
ct = k1ct −1 + k2 yt + εtc .
Given the three identifying equations, the equilibrium variables are assumed
to evolve dynamically as follows. A stochastic process including transitory (level)
shocks and more persistent shocks guides the evolution of equilibrium unemploy-
ment (U t ) (the NAIRU equation):
ω λ
U t = U t −1 + GtU − yt −1 − (U t −1 − U SS ) + εUt
100 100
Persistent shocks to the NAIRU (GtU ) follow an autoregressive process:

U
GtU = (1 − α ) GtU−1 + εGt (1)
And potential output ( Yt ) is modeled to be a function of the underlying trend

growth rate of potential output ( GtY ) and changes in the NAIRU. Specifically:
Yt = Y t −1 − θ(U t − U t −1 ) − (1 − θ)(U t −1 − U t −20 ) /19 + GtY /4 + εYt (2)
where θ is the labor share in a Cobb-Douglas production function. This specifica-

tion allows for short- and medium-term growth of potential to differ from trend
growth. Note that GtY is not constant, but follows serially correlated deviations

Schindler 53
(long waves) from the steady-state growth rate GSSY . Similar dynamic equations
are specified for equilibrium capacity utilization.
The full model is estimated by regularized maximum likelihood (Ljung,
1999), a Bayesian methodology. This method requires the user to define prior
distributions of the parameters. While this can improve the estimation procedure
by preventing parameters from wandering into nonsensical regions, the choice of
priors has also non-negligible implications for the final estimates as the data are
uninformative about some parameters. The choice of priors matters also in the
German case.
In addition to the prior distributions of parameters, the analyst has to provide
values for θ and the steady-state (long-run) unemployment rate (U SS ) and poten-
tial GDP growth rates ( GSSY ), which were set to 0.55, 6.7 percent and 1.3 percent,
respectively. While values especially for U SS and GSSY matter conceptually, as the
(endogenous) estimates converge to these (exogenously given) values in the long
term, from a practical point of view, the dynamics over the time horizon of inter-
est are relatively little affected by the choice of the steady-state values.


CHAPTER 3
German Productivity Growth:

An Industry Perspective
HÉLÈNE POIRSON
Germany had the advantage of a catch-up phase through the early 1970s, but there-
after, and especially since the mid-1990s, productivity growth has been relatively slow.
This aggregate picture masks considerable intersectoral differences. This chapter reports
that while Germany has maintained an enduring strength in its traditional manufac-
turing competencies, it has lagged in services delivery and, perhaps more importantly,
in the so-called knowledge economy—both in the production of information and com-
munication technology (ICT) goods and in the use of ICT to raise productivity in
private services provision. These “new” areas have been key engines of productivity
growth since the mid-1990s in the United States and some other advanced countries.
An uptick in German services productivity growth occurred from 2005 to 2007. This
is indicative of the scope and potential for progress, but it could have been a cyclical
phenomenon. To foster more efficient production and widespread use of ICT in ser-
vices delivery will require complementary measures: (a) further development of venture
capital and private equity markets (backed by a more efficient insolvency process);
(b) increased commercial use of intellectual property rights held by university and
research institutions; (c) removal of uncertainties regarding tax treatment; and
(d) further European integration in services provision.
INTRODUCTION
In the years after World War II, Germany increased its productivity at a fast clip,
thereby rapidly shrinking the United States’ lead in income levels. However, this
productivity catch-up was interrupted in the mid-1990s. Between 1995 and
2007, Germany’s private economy experienced annual productivity growth of 1.7
percent, slightly above the European average but lagging behind the United
States, the United Kingdom, Sweden, Austria, and Finland (Inklaar, Timmer, and
van Ark, 2008, Table 1, page 142; and Molagoda and Perez, 2011, Table V.1,
page 70).
For their constructive comments, the author wishes to thank Fabian Bornhorst, Malte Hübner, Anna
Ivanova, Ashoka Mody, Martin Schindler, and participants in the Germany in an Interconnected
World Conference at the BMF in Berlin (May 2011).
55

56 German Productivity Growth: An Industry Perspective
BOX 3.1 The Productivity Resurgence in the United States

Jorgenson, Ho, and Stiroh (2008) argue that the sources of U.S. productivity growth have
changed twice since 1995. From 1995 to 2000, productivity growth was led by the ICT-
producing sectors and investment in them. Since 2000, the sources of productivity growth
have shifted to sectors that were the most intensive users of information technology.
Triplett and Bosworth (2006) highlight the role of the services sector. They find that the
post-1995 ICT investment boom contributed both directly to higher U.S. productivity
growth in the services industries via capital deepening and indirectly via higher TFP
growth. Their results suggest that in the United States, both labor productivity in the ser-
vices sector and TFP growth rates more than doubled after 1995, and the services sector
became the source of economic growth.
In a subsequent paper, the same two authors extend the industry-based approach to
consider the post-2000 period and find that the services sector again accounts for the post-
2000 rise in U.S. productivity (Bosworth and Triplett, 2007). Both the 1995–2000 increase in
productivity growth and the more recent uptick were driven by strong investment that
increased U.S. labor productivity through capital deepening and by accelerating productiv-
ity (particularly TFP) in services.
This aggregate performance masks considerable sectoral differences—both

within Germany and in Germany’s performance relative to other industrialized
economies. While Germany’s productivity growth in manufacturing industries
was above the EU-15 average from 1995 to 2005, its productivity growth in the
information and communication technology (ICT) industries, while strong, has
been lagging that in other advanced countries (U.S, France, Netherlands, and
Sweden), and productivity in the private services sector has been weak and below
that in both the United States and the EU-15.
Within Germany, the deceleration in overall productivity growth in the pri-
vate economy—from 2.4 percent in the 1980s to 1.9 percent during 1995–2000
and dropping further to 1.2 percent in 2000–05—appears to be largely due to
the slowing growth of productivity in private services (The Conference Board,
2009). This contrasts with the experience of the United States and selected
other countries over the same period, when productivity accelerated from 1995
to 2005 on the back of ICT’s widespread and quick deployment in many sectors
of the economy, especially the traditionally less productive service sectors
(Box 3.1).1
Germany’s experience mirrors that of Europe as a whole. An industry-based
analysis applied to European countries finds that while the EU-15’s manufactur-
ing and utilities performed in line with the United States during 1995–2005,
local services—not just financial services, but more broadly distribution and busi-
ness services—accounted for the bulk of the productivity growth difference with
the United States during that period (van Ark, O’Mahony, and Timmer, 2008,
1
Jorgenson, Ho, and Stiroh (2004) first highlighted the role of the production and use of ICT in
accounting for productivity gains in the case of the United States.

Poirson 57
and Molagoda and Perez, 2011).2 Unlike in the United States, where total factor
productivity (TFP) growth in the services sector accelerated after 1995, in Europe
it declined (especially in distribution, finance, and business services). Several
studies have argued that low TFP growth in the service sectors in EU countries in
turn reflects the delay in investing in ICT assets and implementing the related
new technologies and processes (McKinsey Global Institute, 2010).
These delays have been attributed, among other factors, to the relatively less
attractive conditions in Europe for venture capital and other market-based
sources of financing for high-growth, high-risk projects (Box 3.2).3 In addition to
the availability of long-term financing, traditional explanations for Europe’s lag-
ging productivity growth also emphasize policy and institutional factors such as
strict regulations in product and labor markets.4 But these seem less relevant in
the case of Germany, which is one of the most deregulated advanced countries in
retail trade, according to OECD indicators, and where some reforms (e.g., trans-
port services deregulation) constitute an example of best practice in Europe. It is
true, however, that despite a recent improvement Germany remains more heavily
regulated in professional services than most other advanced countries.
This study applies the industry-based approach to Germany during the
1980–2007 period to help shed light on the historical sources of growth and
productivity trends. We use the best available data on cross-country comparisons
of the sources of productivity growth at the industry level from the EU KLEMS
database. This enables us to document a pick-up in labor productivity growth in
the private economy in Germany since 2005, led by higher TFP growth. This is
indicative of the scope and potential for progress. However, it remains too early
to conclude that a structural shift has taken place. The fact that TFP is measured
as a residual and the finding that the TFP growth acceleration was not accompa-
nied by a boom in ICT investment—unlike the U.S. experience in the late 1990s
and early 2000s—suggests that the recent improvement may be short-lived and
driven by cyclical rather than structural factors.
2
An argument is often made that productivity differentials, particularly in the services industries, are
biased or illusionary because of differences in data across countries. The results in Inklaar, Timmer,
and van Ark (2006), however, suggest that the productivity gap findings are robust to the use of vari-
ous productivity measurement models. A related argument is that the strong post-1995 productivity
growth in the U.S. services sector was illusionary because it was the result of an unsustainable boom
in consumer expenditure and household debt. While scale effects from increased demand may have
played a role in productivity improvements—notably for the distribution sector—the fact that the
acceleration in retail output and productivity occurred mainly during the late nineties and early
2000s, whereas the rise in household debt occurred later, from 2003 to 2007, makes it difficult to
attribute all the productivity improvements to the credit boom (van Ark, 2010).
3
Allard and Everaert (2010) argue that measures to develop capital markets further in Europe will not only
result in the establishment of more attractive conditions for venture capital but also create room for banks
to focus more on supporting smaller firms—in relatively large numbers in the euro area; these smaller
firms are at a higher risk of being constrained in financing but at the same time are key for innovation.
4
See Allard and Everaert (2010) for a discussion of the role of labor and service market reforms in
lifting euro area long-term growth.

BOX 3.2 The Slowdown in Europe’s TFP Growth

There is no shortage of attempts to explain the post-1995 weak European TFP growth
performance. Several studies have documented that Europe’s lag in adopting ICT technolo-
gies in the service sectors and shifting to a “knowledge economy” is a key factor behind
Europe’s poor TFP performance (see for example van Ark, O’Mahony, and Timmer, 2008).
Empirical research has confirmed the role of “new economy” factors, such as human
capital and ICT investments, in explaining subsequent TFP growth rates. For example,
Molagoda and Perez (2011) find that a significant impact is made by human capital levels
(proxied by the share of high skilled labor to overall labor) and ICT capital intensity (mea-
sured by the ratio of ICT capital to non-ICT capital) on TFP growth differences across indus-
tries and countries (see also Nahuys and van der Wiel, 2005, and EU ICT Task Force, 2006).
Other studies argue that policy/institutional factors (e.g., rigidities in product, labor,
and financial markets) have reduced incentives to shift rapidly to ICT and to adjust produc-
tion processes accordingly. Using micro establishment level data from the U.S. and
Germany, the results in Bartelsman and others (2010) suggest that the degree of market
experimentation by firms (i.e., the degree to which firms experiment with different ways of
conducting business) is lower in Germany compared to the United States, among both
young businesses and businesses actively changing their technology. The authors conjec-
ture that this result could be related to the financial system being more market-based in
the United States than in Europe, which possibly lowers risk aversion to project financing
and creates greater financing possibilities for entrepreneurs with small and innovative
projects.a The effect of strict employment protection legislation (EPL) is less clear-cut and
largely depends on the institutional system in which firms operate and the type of technol-
ogy used in the sector.b
a
Voss and Müller (2009) similarly find that financing aspects are a key limiting burden for young German
start-ups. Venture capital is hard to access and concentrates on ICT, medical research, medical appli-
ances, and biotech.
b
Bartelsman and others (2010) investigate the impact of EPL on ICT adoption. They find evidence that
both the share of employment and productivity levels in ICT-intensive sectors are relatively lower in
high-protection EU countries, suggesting that EPL slows the adoption of new ICT. However, they do not
investigate the direct impact of EPL on TFP growth and innovation.
Using the historical experience of the United States as a productivity leader

from 1995–2004 as a benchmark, our conclusions highlight the importance of
raising TFP growth more durably through innovation policy and greater incen-
tives for the use of ICT in the service sectors5:
• Over 1995–2004, Germany’s lower TFP growth was the single most impor-
tant factor driving German-U.S. productivity growth differences in the
private economy, contributing almost three-quarters of the productivity
growth differential.
5
The importance and cross-cutting nature of ICT is reflected in Germany’s high-tech strategy and,
more broadly, in Europe’s 2020 growth agenda, which also notes the link between ICT usage and
services’ productivity.

Poirson 59
• Germany’s lower investment in ICT assets was also important, explaining

over a third of the productivity gap with the United States during that
period.
• At the industry-level, the productivity growth differences are driven by TFP
and are particularly large for service industries, especially for distribution,
finance, and business services.
• Productivity lags in the service sectors in turn appear to reflect Germany’s
delay in shifting to a knowledge economy, as indicated by a lower share of
ICT in total research and development expenditure, lower internet penetra-
tion (relative to the United States), and lower ICT readiness scores relative
to some other advanced countries. Notably, Germany lags several other
OECD countries in some key areas of ICT infrastructure (e.g., availability
of secure servers) and financing for high-risk, high-innovation potential
projects.
The purpose of this chapter is to provide background on the question of why
Germany has not enjoyed higher productivity growth, despite several favorable
competitiveness indicators, including levels of innovation and spending on
research and development above the EU-15 average (Figure 3.1).6 It does so by
providing essential facts and placing Germany’s experience in international per-
spective. The next section provides facts on aggregate output and growth patterns
in Germany relative to the United States (considered as the productivity bench-
mark) during 1950–2009. A further section does the same for a number of
Finland
Sweden
Netherlands
Germany
Denmark
Japan
Austria
Belgium
United States
Norway
France
United Kingdom
Italy
Spain
0 100 200 300 400 500 600
Figure 3.1 Selected Countries: Patent Applications (Number of applications per

million population, 2010)
Sources: European Patent Office and Conference Board.
6
See McKinsey Global Institute (2010). Recent structural reforms to support competitiveness include
the 2008 business tax reform, the Hartz IV reforms, and deregulation in transport services.

industry-level sectors, including goods, ICT, and private services, extending ear-
lier work by van Ark, O’Mahony, and Timmer (2008) through 2007. Within the
services sector, we separately analyze the drivers of growth and German-U.S.
productivity differentials in distribution services, finance and business services,
and personal services. The section also documents Germany’s relative progress in
adopting a knowledge economy, as measured by a number of variables and busi-
ness survey indicators usually viewed as related to higher ICT investments and a
favorable environment for innovation.
GERMAN AND UNITED STATES PRODUCTIVITY:

STYLIZED FACTS
Germany’s postwar productivity catch-up with the United States was interrupted
in the mid-1990s. During the period 1950–1995, labor productivity grew at a
relatively fast clip, and Germany achieved parity with the United States by 1995.
In 1995, however, German productivity growth started lagging the United States,
and by 2009 its levels of hourly output were almost 10 percent below U.S. levels
(Figure 3.2 and Table 3.1).
During 1995–2004, the productivity gap with the United States widened
despite higher labor input in the latter country, where the productivity resurgence
in the mid-1990s was accompanied by significant job creation. Instead, the pro-
ductivity gap reflects both slower capital accumulation and slower TFP growth in
Germany. Germany’s overall slower capital accumulation contributed almost
three-quarters (74 percent) of the total productivity gap during 1995–2004. In
particular, its lower investment in ICT assets—including computing equipment,
120
GDP per hour
100
80
GDP per capita
60
40
20
0
1950 1960 1970 1980 1990 2000
Figure 3.2 Total Economy GDP per Hour Worked and GDP per Capita (Percent of
U.S. levels)
Sources: The Conference Board Total Economy Database, September 2010; Timmer, Ypma, and van Ark (2003);
and IMF staff estimates.

Poirson 61
TABLE 3.1
Levels of Labor Productivity and Factor Inputs (Percent of U.S. levels)

1950 1973 1995 2004 2007 2008 2009
a
GDP per capita 43.6 82.5 85.1 77.7 78.9 80.7 79.5
Hours worked per capita 124.8 104.4 88.3 84.3 83.7 83.8 82.7
GDP per hour workeda 34.1 70.2 100.3 94.0 95.9 95.2 90.6
Capital input per hour workedb 83.9 107.9 102.7 n.a. n.a. n.a.
Sources: The Conference Board Total Economy Database, September 2010; Timmer, Ypma, and van Ark (2003);
and IMF staff estimates.
a
Output levels are converted by GDP purchasing power parities for 2009 using the Elteto-Koves-Szulk (EKS) method.
b
Measured as gross fixed capital stock per hour worked. Entries for 1973 refer to 1980.
communication equipment, and software—was the single biggest factor explain-

ing the productivity gap during that period, contributing over half of it (0.6
percent out of an annual productivity gap of 1.1 percent with the United States).
The contribution of non-ICT capital growth and TFP growth to the productiv-
ity growth differential with the United States were also important: the former
contributed 0.3 percent (22 percent of total) and the latter 0.2 percent (15 per-
cent of total) to the productivity gap. Lower growth in labor skills in Germany
relative to the United States explained the remainder (0.1 percent, or about 10
percent of the total).
When focusing on developments over time in Germany and the United States,
a deceleration in TFP growth explains the bulk of Germany’s weak performance
since the mid-1990s.7 German labor productivity growth slowed by 1 percentage
point between the 1990–1995 period and the 1995–2004 period, mainly reflect-
ing a reduction in TFP growth by 0.6 percentage points between the two periods
(Table 3.2). In other words, slower TFP growth accounts for 60 percent of the
deceleration in annual labor productivity growth during 1995–2004, with lower
investment and (to a much lesser extent) slower growth in labor quality explain-
ing the rest.8 Investment in ICT assets in Germany increased only moderately
between 1995–2004 and 1990–1995, not enough to offset the decline in TFP
and investment in non-ICT assets. In contrast, higher TFP growth and invest-
ment—especially in ICT assets—contributed in almost equal parts to the U.S.
revival in the mid-1990s. Specifically, the 1 percentage point increase in U.S.
labor productivity growth between 1995–2004 and 1990–1995 reflects a 0.5
percent increase in the contribution of capital accumulation (the bulk of which is
from investment in ICT assets), accompanied by a 0.4 percent acceleration in
TFP growth. This simultaneous acceleration in ICT investments and TFP has
been linked to the emergence of a so-called “knowledge economy” in the United
States and other advanced countries during the mid-1990s, as discussed in
7
TFP is computed as a residual, thus it also includes measurement errors and the effects from unmea-
sured outputs and inputs, such as research and development and other intangible improvements,
including organizational improvements.
8
Lower investment in non-ICT assets and labor quality contributed 37 percent and 10 percent,
respectively, to the declining trend in productivity growth between the two periods.

TABLE 3.2
Contributions to Growth of GDP

(Annual average growth rates, in percentage pointsa)
Germany United States
1990–1995 1995–2004 2004–2007 1990–1995 1995–2004 2004–2007
1 GDP (2)+(3)+(4)+(7) 2.2 1.4 2.1 2.5 3.3 2.5
Contributions from
2 Hours worked –0.4 –0.2 0.3 0.8 0.7 1.7
3 Labor quality 0.2 0.1 –0.1 0.2 0.2 0.3
4 Capital stock (6)+(7) 1.0 0.7 0.8 1.0 1.5 0.9
5 ICT capital 0.3 0.4 0.3 0.6 1.0 0.4
6 Non-ICT capital 0.7 0.3 0.5 0.4 0.6 0.5
7 TFP 1.4 0.7 1.2 0.5 0.9 –0.5
Memo item:
Labor productivity 2.6 1.6 1.8 1.7 2.7 0.8
growth
Source: The Conference Board Total Economy Database, September 2010; and IMF staff estimates.
a
Based on the difference in the log of the levels of each variable.
Jorgenson, Ho, and Stiroh (2004), Triplett and Bosworth (2006), Bosworth and
Triplett (2007), and more recently Jorgenson, Ho, and Stiroh (2008).
In 2005, a productivity catch-up resumed, mainly reflecting a U.S. slowdown.
Germany’s annual labor productivity growth accelerated only moderately (by 0.2
percent) in 2004–2007 relative to 1995–2004, as a pick-up in employment offset
higher TFP growth (by 0.5 percent) and a higher contribution of non-ICT capi-
tal investment (by 0.2 percent). However, since TFP is measured as a residual, the
recent turnaround could be largely due to unmeasured cyclical factors—including
higher capacity utilization immediately precrisis in Germany. Moreover, unlike in
the United States in the mid-1990s, the recent productivity acceleration in
Germany was not accompanied by higher investment in ICT assets, which also
suggests that cyclical factors might have been at play rather than a structural shift
to a more “knowledge-driven” economy.
The results discussed so far apply to the total economy, including both public
and private services. When public services—including health, education, and
other public services—are excluded, the productivity growth gaps between
Germany and the United States that emerged in the mid-1990s are magnified and
TFP, rather than capital accumulation, explains the bulk of the gap.9 Germany’s
labor productivity in the private economy grew at broadly the same rate during
1995–2004 as the total economy (including public services) grew, namely at 1.6
percent (Table 3.3). The acceleration in U.S. productivity growth therefore becomes
even more striking when focusing only on the private economy: productivity
9
Other excluded services are public administration and defense. Following van Ark, O’Mahony, and
Timmer (2008), we also exclude real estate (ISIC 70), because output in this industry mostly reflects
imputed housing rents rather than sales of firms.

Poirson 63
growth in the private economy there rose by 3.1 percent annually over that peri-
od, compared to 2.7 percent for the total economy. The U.S. productivity lead is
thus especially pronounced in the private economy. Specifically, we find that:
• The annual productivity gap with the United States during 1995–2004 for
only the private economy is 1.5 percent, compared to 1.1 percent for the
total economy (including public services).
• Since 2005, the results continue to show the resumption of a productivity
catch-up when only the private economy is considered. During 2004–
2007, the German resurgence is more pronounced when public services are
excluded, and the U.S. slowdown is less extreme. Both trends suggest that a
catch-up process has resumed more recently, although as noted above it is
too early to conclude that the overall lag in German productivity growth has
reversed, given the importance of cyclical factors over this relatively short
period and the lack of a pick-up in ICT investments.
• TFP growth drives the differences between the two countries’ private-
economy productivity growth rates during 1995–2004, contributing over
two-thirds (72 percent) of the productivity gap (compared to 15 percent
for the total economy, including public services). The effect of slower
investment in ICT capital on Germany’s private economy is also an impor-
tant factor, accounting for more than a third (35 percent) of the slower
labor productivity growth in Germany relative to the United States over
that period (compared to more than half when the total economy is con-
sidered). The contribution of differences in the pace of labor skill growth
increases marginally (to 12 percent of total) when only the private econo-
my is considered.10
• When focusing on developments over time in the two countries, a U.S.
slowdown, rather than significantly higher productivity growth in Germany,
continues to account for most of the recent turnaround since 2005. Within
Germany’s private economy, the pick-up in TFP growth (by 1.2 percent)
since 2005 is more pronounced than for the total economy including public
services (by 0.5 percent). Similar to the result for the total economy, the
contribution of ICT capital accumulation to productivity growth in the
private economy fails to accelerate in 2004–2007, unlike the U.S. experi-
ence of the mid-1990s, suggesting that recent developments may reflect
10
The overall contribution of human capital would be underestimated in a growth-accounting frame-
work if human capital mainly influences labor productivity growth through its impact on TFP
growth. Higher education, in particular, arguably has a supportive role in fostering technological
improvements and enabling a fast adjustment to new technologies. Using a sample of 13 EU countries
plus the U.S., Molagoda and Perez (2011) confirm empirically the significant role of human capital
in explaining TFP differences across countries through both its direct impact on innovation by the
productivity leader and indirectly by increasing the size of knowledge spillovers. The largest impact of
human capital is found for countries at or close to the productivity frontier, possibly because innova-
tion is a relatively more skill-intensive activity than imitation. See also Vandenbussche, Aghion, and
Meghir (2006).

TABLE 3.3
Contributions to Growth of Real Output in the Market Economy (Annual average

growth rates, percentage points)
1980–1995 1995–2004 2004–2007 1980–1995 1995–2004 2004–2007
1 GDP (2)+(3) 1.9 1.1 2.4 3.3 3.8 2.8
2 Hours worked –0.5 –0.6 0.5 1.3 0.7 1.4
3 Labor productivity 2.4 1.6 1.9 2.0 3.1 1.4
(4)+(5)+(8)
Contributions from
4 Labor composition 0.2 0.1 –0.2 0.2 0.3 0.1
5 Capital stock per 1.3 1.1 0.6 1.0 1.4 0.6
hour (6)+(7)
6 ICT capital per 0.3 0.5 0.4 0.7 1.0 0.5
hour
7 Non-ICT capital per 1.0 0.6 0.2 0.3 0.4 0.1
hour
8 TFP 0.8 0.4 1.6 0.8 1.4 0.6
Labor productivity 1.4 1.1 1.7 1.7 2.8 1.2

contribution from
the knowledge
economy
(4)+(6)+(8)
Sources: EU Klems database, November 2009 release; and IMF staff estimates.
Note: ICT: information and communications technology; TFP: total factor productivity. Numbers may not sum exactly due
to rounding.
temporary cyclical factors rather than the emergence of a knowledge econo-

my typically associated with both higher investment in ICT assets and
higher TFP growth.
The results above are broadly consistent with existing empirical evidence sug-
gesting that slow increases in ICT investments and TFP growth were the two most
important contributors to the aggregate productivity gap with the United States in
the mid-1990s. According to Molagoda and Perez (2011), these two factors account
for 42 percent and 33 percent, respectively, of the German-U.S. labor productivity
differential in the private economy over the 1995–2007 precrisis period.11 Based on
their results, similar findings would be obtained using the United Kingdom or
Sweden as productivity leader benchmarks instead of the United States.
AN INDUSTRY PERSPECTIVE
This section shifts from the aggregate perspective of the previous section to a
sector-level (more disaggregated) perspective, allowing us to document the contri-
butions of each sector to aggregate labor productivity growth and the key sources
of productivity growth at the sector and industry level. Based on industry-level
11
Molagoda and Perez (2011) do not provide the breakdown over 1995–2004 and 2004–07, only the
full sample average results.

Poirson 65
200
180
160
140
120
100
80
60
40
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Figure 3.3 Value Added in the Services Sector (Gross value added, volume indices,
1995=100)
Sources: EU Klems database, November 2009 release; IMF staff estimates.
800
700
600
500
400
300
200
100
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Figure 3.4 ICT Capital Services (Volume indices, 1995=100)

Sources: EU KLEMS database, November 2009 release; IMF staff estimates.
measures of output, inputs, and TFP from the EU KLEMS database, the results
show that productivity differences are strong across industries too. In the case of
the German-U.S. differential in productivity growth, we find that private services
and, to a lesser extent, ICT production are the main sectors accounting for the
aggregate productivity gaps in the private economy (Figures 3.3 and 3.4).12
Private services (including wholesale and retail trade, hotels and restaurants,
transport services, and financial and business services) also explain the bulk of
12
ICT production includes production of electrical machinery and telecommunication services.

BOX 3.3 The Rising Importance of Service Sectors

Both Germany and the United States have experienced a major shift of production
and employment from manufacturing and other goods-producing industries (such as
agriculture and mining) toward services. Over the period 1980–2007, the share of hours
worked in manufacturing declined by more than 30 percent in Germany and was almost
halved in the United States. Private services—including trade and transportation services,
hotels and restaurants, and business and financial services—now account for 60 percent of
private employment in Germany (compared to over two-thirds in the United States). In the
United States, the number of hours worked is now nearly five times larger than in market
services than in manufacturing. Even in Germany, where manufacturing plays an important
role (accounting for 28 percent of total private output), the number of hours worked in
market services is almost three times greater than that for manufacturing.
This shift has important potential implications for productivity growth. Historically,
innovation and technical change in manufacturing have been the central source of produc-
tivity growth. With the emergence of the knowledge economy in the mid-1990s, the center
of gravity of productivity improvements may have shifted to service industries. The experi-
ence of the United States in the mid-1990s bears out this hypothesis. The U.S. revival
reflected the rising growth contributions of ICT productivity and investment, especially in
the distribution (trade and transportation) and other private services sectors. Due to the
rising importance of the service sectors, durable productivity gains in Germany will need
to extend to these industries in order to have a lasting impact on both real incomes and
potential growth.
Germany’s long-term declining trend in productivity growth since the mid-

1990s, and the reverse trend in the United States over the same period (Box 3.3,
Table 3.4, and Figure 3.5). We also find that productivity gaps in the private
services industries largely reflect slower investment in ICT assets and the atten-
dant slower TFP growth.
By contrast, productivity in the goods production sectors (including agricul-
ture, mining, and manufacturing other than electrical machinery, utilities, and
construction) has consistently been higher in Germany than in the United States.
This principally reflects the traditional German strength in manufacturing, a
TABLE 3.4
Major Sector Contribution to Average Annual Labor Productivity Growth in the

Market Economy (Annual average growth rates, percentage points)
1980–1995 1995–2004 2004–2007 1980–1995 1995–2004 2004–2007
1 Market economy 2.4 1.6 1.9 2.0 3.1 1.4
(2)+(3)+(4)+(5)
2 ICT production 0.3 0.5 0.5 0.4 0.9 0.7
3 Goods production 1.1 1.1 0.6 0.8 0.5 –0.1
4 Market services 0.9 0.2 0.9 0.8 1.9 0.9
5 Reallocation 0.0 –0.1 –0.2 –0.1 –0.2 –0.2
Source: EU KLEMS database, November 2009 release and IMF staff estimates.
Notes: ICT: information and communications technology. “Reallocation” refers to labor productivity effects of reallocation
of labor between sectors. ICT production includes manufacturing of electrical machinery and post and telecommuni-
cations services. Goods production includes agriculture, mining, manufacturing (excluding electrical machinery), con-
struction, and utilities. Market services include distribution services; financial and business services, excluding real
estate; and personal services. Numbers may not sum exactly due to rounding.

Poirson 67
Germany's private sector fell behind in the mid-nineties. Although productivity in the goods sector remained
strong. . .
4.5 Private Economy: Productivity Per Hour Worked 4.0 Goods Production: Productivity Per Hour Worked
4.0 (Five-Year Average Annual Percent Change) (Five-Year Average Annual Percent Change)
3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5 1.5
1.0 1.0
Germany Germany
0.5 United States 0.5 United States
0.0 0.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
. . .it lagged in information and communication
technologies (ICT). . . . . .and it was especially slow in the services sector.
14 ICT Production: Productivity Per Hour Worked 4.0 Private Services: Productivity Per Hour Worked
(Five-Year Average Annual Percent Change) 3.5 (Five-Year Average Annual Percent Change)
12
3.0
10
2.5
8
2.0
6
1.5
4 1.0
2 Germany 0.5 Germany
United States United States
0 0.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Total factor productivity (TFP) led the US revival since . . .while German TFP lagged until just before the crisis.
1995. . .
United States: Private Economy Productivity Growth Germany: Private Economy Productivity Growth
3.5 Decomposition (Five-Year Average Contribution, 3.5 Decomposition (Five-Year Average Contribution,
in Percent) in Percent)
3.0 3.0
2.5 2.5
2.0 2.0
1.5 Factor Intensity 1.5

TFP Factor Intensity
1.0 1.0
0.5 0.5 TFP
0.0 0.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Figure 3.5 Germany: Productivity Trends in the Private Economy, 1985–2007

Sources: EU KLEMS database; and IMF staff estimates.
strength that makes Germany a formidable exporter of a wide range of precision

manufactured products. Productivity growth in the ICT production sectors
(including production of electrical machinery and telecommunication services)
has been rising in line with worldwide trends but has lagged the United States
since the mid-1980s (Figure 3.5).
Within the services sector, German-U.S. productivity differentials are concen-
trated in a handful of industries. Productivity gaps during 1995–2004 were
especially large in distribution services (including trade and transportation) and
in financial and business services. The distribution sector contributed a third of
the overall annual productivity gap of 3 percent during 1995–2004. In finance
and business services, the gap was even bigger, at almost 2 percent (nearly two-
thirds of the total). In both cases, productivity growth differences reflect to a large

TABLE 3.5
Contributions of Sectors to Average Annual Labor Productivity Growth in

Market Services (Percentage points)
1980–1995 1995–2004 2004–2007 1980–1995 1995–2004 2004–2007
Market services labor 2.1 0.3 1.7 1.6 3.3 1.6
productivity
Distribution services 1.0 0.9 1.0 1.1 1.9 0.7

contribution
from factor intensity 0.4 0.3 0.2 0.4 0.6 0.3
growth
from TFP growth 0.6 0.6 0.7 0.7 1.3 0.4
Finance and Business 0.6 –0.7 0.4 0.0 1.2 0.2

services contribution
growth
from TFP growth –0.8 –2.2 –0.2 –1.0 0.0 –0.1
Personal services 0.1 –0.2 0.1 0.2 0.1 0.3

contribution
growth
from TFP growth –0.2 –0.2 0.1 0.1 0.1 0.3
Contribution from 0.4 0.3 0.2 0.3 0.0 0.3

labor reallocation
Sources: EU KLEMS database, November 2009 release; and IMF staff estimates.
Note: Factor intensity relates to the total contribution from changes in labor composition and in capital deepening of
information and communications technology (ICT) and non-ICT assets. The reallocation effect refers to the impact of
changes in the distribution of labor input between industries on labor productivity growth in market services.
Numbers may not add up due to rounding. TFP: total factor productivity.
extent differences in TFP growth at the sectoral level (i.e., efficiency of input use)
rather than differences in factor intensity growth (i.e., growth in both human and
physical capital inputs).
The closure of the gap vis-à-vis the United States between 2005 and 2007
mainly reflected slower productivity growth in the United States’ distribution
and financial and business services and improved performance in Germany’s
financial and business services. In Germany, the turnaround in financial and
business services reflects higher TFP growth rather than larger contributions of
capital accumulation and labor quality. However, international experience sug-
gests that sustaining this trend will require concurrent improvements in TFP and
investment—especially in ICT assets—since both are drivers of innovation
effects on services productivity.
The continuing productivity gaps in the services sector reflect in part
Germany’s lag, by advanced country standards, in the use of ICT. Compared to
some other advanced economies, Germany lags in research and use of ICT. This
is evidenced by the low share of ICT in total research and development spending,
compared to the average in OECD countries, and by the relatively low extent of

Poirson 69
70
Germany United States OECD total
60
50
40
30
20
10
0
2000 2001 2002 2003 2004 2005 2006 2007
Figure 3.6 Internet Subscribers (Percent of population)

business and government internet use. The latter in turn seems caused by several
infrastructure and financing factors, including:
• a relatively low number of secure internet servers;
• low public investment in advanced technologies compared to some other
OECD countries; and
• a comparatively low willingness of the financial system to provide financing
for high-risk, innovative projects (Box 3.4).
Internet penetration in Germany (measured by the number of subscribers as a
share of total population) is in line with the average for OECD countries, but it
is lower than in the United States (Figure 3.6).
A limited initial public offering (IPO) market and tax obstacles appear to be
contributing to the limited development of German private equity and venture
capital markets and thus to the limited availability of risk financing. Difficulty in
achieving successful exits, lack of entrepreneurial talent, and unfavorable tax
policies (including tax obstacles to cross-border investments and double taxation)
are the main unfavorable climate factors for venture capital in Germany, accord-
ing to a 2010 survey of 516 firms in nine countries: 72 percent of respondents
cited lack of entrepreneurial talent and tax policies as the main obstacles, and 67
percent considered exit difficulties the main issue. Eliminating tax obstacles to
cross-border investments and double taxation would require coordinated action
at the EU level to remove these and other regulatory barriers (e.g., separate regis-
tration requirements), thus allowing even smaller funds to invest EU-wide more
efficiently, develop specialized sectoral expertise, and reap economies of scale.13
13
While there is a consensus among the member states on promoting mutual recognition of national
frameworks, no significant measures have yet been taken that would make fundraising and investing
across borders easier (European Commission Enterprise and Industry Directorate General, 2009).

BOX 3.4 Productivity Growth in the Information Age

International experience suggests that innovation and productivity growth in ser-
vices are closely related to the wider use of information and communication technol-
ogy (ICT). In the U.S. private services sector since 1995, high levels of investment in ICT
have been followed by rapid productivity growth. Other high-performing economies, such
as Sweden, Finland, and the U.K. also have relatively high ICT uptake; in addition, the high-
productivity countries are characterized by a relatively high level of human capital
employed in the services sector (Molagoda and Perez, 2011).
Germany lags some advanced countries both in the use of ICT and in human capi-
tal in the services sector. Government usage of ICT and the number of secure servers are
in the mid- to lower-range. The ratio of high-skilled labor employed in the services indus-
tries in 2007 is below 20 percent, compared to almost 50 percent for the U.S. and more than
40 percent for Finland (Molagoda and Perez, 2011). In the group of advanced nations,
Germany’s ICT research and development share in total research and development also
falls in the mid- to lower-range. While public policy to support ICT development and use
remains controversial, the evidence suggests that ICT development and use can be fos-
tered through innovation policies, including promoting the availability of risk capital and
increasing the commercial use of intellectual property rights held by universities and
research institutions. A common European market for services would also generate econo-
mies of scale and raise incentives to invest in new technologies.
The share of investment and research in information The number of secure servers is low relative
technologies is relatively small in Germany. to peers.
70 6.0
ICT R&D expenditure as a share of total R&D, 2007 KOR
USA
60 (Percent) 5.5 SWECAN CHE
NLD
ICT Usage (index 1–7)
50 DEU FIN UK DNK

5.0 FRA JPN
40 AUS
BEL AUT NOR
30 4.5
ESP
20 PRT
4.0
ITA
10
3.5
0 GRC
a
D
d
en
y
s
es
re
an
an
3.0
nd
EC
ed
at
Ko
nl
m
rla
St
0 500 1000 1500

Sw
Fi
er
he
d
G
te
et
Secure internet servers per milllion population, 2008

ni
N
U
Public procurement of high-tech products is High-risk financing is less available than in

low by advanced-economy standards. other OECD countries.
6.0 6.0
CHE KOR
SWEUSA
KOR
CHE USA
SWE
5.5 5.5 CAN NLD
UK UK
DEU NLD CAN DNK DEU DNK
JPN FIN
5.0 JPN FRA
NOR FIN 5.0 FRA NOR
AUT AUS
AUT AUS BEL BEL
4.5 4.5
ESP ESP
4.0 PRT 4.0 PRT
ITA
3.5 3.5
GRC GRC
3.0 3.0
2.5 3.0 3.5 4.0 4.5 5.0 2.5 3.0 3.5 4.0 4.5 5.0
Government procurement of advanced Venture Capital Availability (survey index 1–7)
technology products (survey index 1–7)
Figure 3.4.1 Research and Use of Information and Communication Technology

Sources: The Global Information Technology Report, 2009–10; and Organisation for Economic Cooperation and
Development.

Poirson 71
The lack of exit opportunities in Germany reflects the small share of global IPO
listings in Deutsche Boerse.14 Reasons for a limited IPO market in Germany
compared to other key financial centers seem related to market liquidity: a shal-
lower pool of equity capital compared to the United States, the United Kingdom,
or the countries associated with the Euronext exchange, and a narrower investor
base compared to the United States or the UK. It is these factors that limit the
IPO market, rather than cost factors such as listing requirements and underwrit-
ing fees, where Germany appears very competitive (Oxera, 2006).
Another reason for Germany’s delay in adopting the Internet economy and
constraining factors for innovation is deficiency in the insolvency law, which
results in relatively less creditor-friendly legislation than in the United Kingdom
and thus less willingness of banks to lend to high-risk projects. Specifically,
German banks face costlier and lengthier proceedings relative to the United
Kingdom and thus potentially higher legislation-induced credit risk (Schmieder
and Schmieder, 2011). In response, they demand relatively more credit risk miti-
gation than U.K. and U.S. banks do, but still recover less than do U.K. banks.
Banks’ lower willingness to lend to risky projects in turn could hinder entrepre-
neurship and risk-taking. To be on par with U.K. banks, Schmieder and
Schmieder (2011) calculate that formal bankruptcy proceedings in Germany
would have to be shortened by about one half.
Relatively limited use of public procurement to provide sustained ICT
demand in Germany, as compared to other advanced countries such as Korea,
Sweden, and the United States, may be another factor explaining the compara-
tively low investment in new, high-risk technologies. The premise is that there are
positive externalities in the use of ICT caused, for example, by network effects or
complementary investments, such as organizational change, that go unmeasured,
and large fixed costs from the required infrastructure investments (servers, infra-
structure software, storage).15 Business models for ICT companies or services
companies that make heavy use of ICT are thus reliant on scale to be profitable.
A transparent procurement process that enables greater usage based on open
standards can create synergies.
Greater European integration in services provision would also help raise
investment in new, high-risk technologies, It would generate economies of scale
and raise incentives to invest in and provide risk financing for innovative applica-
tions of ICT in services. Obstacles to an integrated European market for online
and off-line services include a variety of compliance and regulatory issues,
14
The number of IPOs expected in Germany in 2011 is 20, compared to a backlog of 150 deals in
the U.S at end-February; Deutsche Boerse lagged other IPO markets in China, London, New York,
Tokyo, Mumbai, Australia, and Korea in 2010, both in number of deals and funds raised (Ernst &
Young, 2011).
15
See, for example, Stiroh (2002) and McKinsey Global Institute (2010). While the potential offered
and challenges posed in using public procurement as an instrument for innovation have been largely
ignored or downplayed, a number of empirical studies conclude that over long time periods, state
procurement triggered greater innovation impulses in more areas than did research and development
subsidies (see Edler and Georghiou, 2007, for a review of the evidence).

including country-specific consumer-protection laws, VAT rules, electronic

waste regulations, varying copyright rules, and postal systems. Moreover, the
need to tailor products to each national market requires maintaining region-
specific teams and translating every item, website, and online application, in
several different languages. Finally, price-comparison websites, which make
online shopping attractive in the United States, are relatively few in Europe,
where existing sites remain national.16 While these obstacles can be overcome,17
they result in higher costs of doing business for services firms that attempt to
operate across borders, and they further add to barriers to entry for smaller, start-
up firms that do not have the administrative and personnel resources to cope
with different national regulations.
Closing the productivity gap with the United States in private services could
raise TFP growth, and thus potential growth, by up to 0.6 percentage points
annually. The overall impact on potential growth could be higher if the TFP
increase is associated with higher investment in new technologies, as was the case
in the United States in the mid-1990s. Shifting adoption patterns for new IT
services and products, such as cloud computing (forecast to grow at more than
five times the rate of traditional IT products), suggest that the share of these
growing markets, currently heavily concentrated in the United States at 70.2
percent, is likely to decline in the United States to 51.4 percent by 2014, while
the share of Western Europe and Asia/Pacific, excluding Japan, is set to grow
rapidly (IDC, 2010). Countries that plan for this shift by creating a favorable
market environment, in terms of availability of risk financing and significant
additional investment in broadband and complementary infrastructure, are likely
to benefit disproportionately from this catch-up effect.18 EU regulations that
hinder the development of new IT service industries, such as EU laws that restrict
the movement of data and access to databases across borders, may also need to be
revisited, for example to allow storage of data by companies based in the EU with
vendors based outside the region.
CONCLUSION
International experience suggests that ICT applications in traditionally low-tech
industries such as the retail and wholesale sectors lead to technology and innova-
tion effects, which in turn raise TFP growth. While large and internationally
16
See The Economist, October 28, 2010.
17
Successful internet start-ups, such as Berlin-based Wooga, illustrate the scope for exploiting the
synergies of a European user market.
18
Much of the available empirical research refers to the impact of the Internet or the “digital economy”
rather than ICT infrastructure. A recent study using data for the 48 U.S. states over 2003–05 suggests
that for every 1 percentage point increase in broadband penetration in a particular area, employment
growth is estimated to increase 0.2–0.3 percentage points per year (Crandall, Litan, and Lehr, 2007).
The study also finds that state output is positively associated with broadband use, although the impact
is not statistically significant.

Poirson 73
connected German companies are perceived to be at the forefront of innovation

and usage of new technologies, overall ICT uptake and the prioritization of ICT
in national growth strategy are both low in Germany relative to some other
advanced countries.
In this paper we argue that policy measures are needed to raise the low annual
TFP growth rate of only 0.5 percent during the last decade (see Chapter 2). While
the more recent pick-up in productivity growth in Germany since 2005 is
encouraging, the improvement could be largely cyclical, since it has not been
accompanied by a concomitant rise in ICT investments. The experience of other
fast-growing advanced countries suggests that to ensure a sustained rise in pro-
ductivity and TFP growth in the private economy and to close the productivity
gaps in the service sectors, Germany needs to encourage more widespread usage
of ICT and human capital as well as investment and innovation, particularly in
the private services sector (i.e., outside Germany’s traditional strengths). The
required measures to raise incentives to invest in higher-risk, higher-growth sec-
tors include:
1. further development of venture capital and private equity markets (backed
by a more efficient insolvency process);
2. increased commercial use of intellectual property rights held by universities
and research institutions;
3. removal of uncertainties regarding tax treatment; and
4. further European integration in services provision.
Strong supply-side policies alone—including improvements of insolvency
law system and the financing environment—are important to kick-start innova-
tion and encourage risk-taking, but they may not be sufficient to sustainably
raise incentives to invest in new technologies. Some have argued that ICT
uptake is also importantly shaped by the availability of a large enough market
due to the presence of network effects and large fixed costs to IT infrastructure
investments.
In Germany’s case, there may be scope for greater but transparent public pro-
curement of high-tech products to support overall incentives for innovation and
the development of new ICT applications. Greater harmonization of rules and
regulations to foster greater European integration in services provision could help
raise competition among service providers and thus lower prices and increase
incentives for ICT investments and ICT usage, in a more efficient way than tar-
geted subsidies. A common European market for services would also enable the
realization of economies of scale, with expected positive effects on TFP growth
and investment incentives.
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APPENDIX
TABLE 3A.1
Germany and the United States: Average Annual Growth Rates

of GDP, GDP per Capita, and GDP per Hour Worked, 1950–2009
(Percent)
Average annual growth in
GDP GDP per capita GDP per hour worked
1950–1973
Germany 6.0 5.3 5.8
US 3.9 2.5 2.6
1973–1995
Germany 2.1 1.8 2.8
US 2.9 1.7 1.2
1980–1995
Germany 2.1 1.8 2.8
US 3.0 1.9 1.4
1995–2004
Germany 1.4 1.3 1.7
US 3.4 2.3 2.4
2004–2007
Germany 2.1 2.1 1.7
US 2.6 1.6 1.0
2008
Germany 1.3 1.3 0.1
US 0.0 –0.9 0.8
2009
Germany –4.9 –4.9 –2.4
US –2.6 –3.5 2.5
Sources: The Conference Board Total Economy Database, September 2010; and IMF staff estimates.
Note: Germany’s pre-1988 population is estimated as the sum of West Germany and East Germany.
Relative levels are based on Elteto-Koves-Szulc (EKS) purchasing power parities for GDP for 2009.

CHAPTER 4
What Does the Crisis Tell Us about

the German Labor Market?
MARTIN SCHINDLER
Germany’s employment fell only marginally during the crisis, despite a sharp drop in
output and in contrast to historical employment patterns over the business cycle. This
paper offers new perspectives on the apparent “puzzle” of the German labor market
response. Labor market developments during the crisis are consistent with a view that
Germany experienced mainly a temporary demand shock, necessitating relatively little
sectoral reallocation and with employers therefore adjusting hours of work while
retaining workers. The labor market dynamics also provide evidence that past reforms,
including especially the Hartz reforms during the early 2000s, enabled the labor mar-
ket to react in a way that previously had not been possible to the same extent. These
reforms facilitated a shift from adjustment in the number of individuals employed to
adjustments in hours. Thus, while the employment decline was smaller than expected
based on past dynamics, the reduction in hours worked was more in line with the drop
in output. And lastly, the moderate employment decline during the crisis reflected the
longer-term structural changes in the labor market. The upward momentum in
employment stemming from the earlier reforms held back the adverse crisis impact.
INTRODUCTION
The German labor market has gone through a remarkable transformation over
the past two decades. From being labeled the “sick man of Europe” as unemploy-
ment rates steadily went up during the 1990s, and even reached double-digit
territory during the mid-2000s, to references to the “German labor market mir-
acle” during the recent financial crisis when unemployment, after a brief rise at
its onset, continued the downward trend that had started around 2005. This
transformation is particularly striking in comparative perspective: Germany was
one of the European countries that motivated Ljungqvist and Sargent’s (1998)
study of how and why the U.S. labor market performed so much better, espe-
cially in turbulent times. Now, economists are puzzling over why the German
The author has benefitted from comments and suggestions by Ashoka Mody, Helène Poirson, Fabian
Bornhorst and participants at the Germany in an Interconnected World conference at the Ministry of
Finance in Berlin (May 2011), especially the paper’s discussant, Werner Eichhorst. Susan Becker
provided excellent research assistance.
77

78 What Does the Crisis Tell Us about the German Labor Market?
labor market has proven to be so much more resilient than the U.S. market, even
worrying about a jobless recovery there while German unemployment continues
to decline.
This chapter aims to provide new perspectives on the recent labor market
dynamics and to understand how “miraculous” the crisis performance actually
was. It also aims to answer the question of what the crisis can tell us about the
German labor market, and in particular whether the recent experience reflects
something more fundamental. The analysis suggests that, broadly speaking, the
labor market response has been benign, but less so than meets the eye, and that
the German labor market does indeed appear to be structurally different from
what it was even a decade ago. The chapter proceeds by providing some general
background on longer-term and more recent developments, discussing a number
of factors that help to better understand the recent labor dynamics. The appendix
provides details on the labor market simulations reported here.
BACKGROUND
Germany has long been labeled the “sick man” of Europe, owing in large part to
its ailing and sluggish labor market with its high and increasing unemployment
(e.g., The Economist, 1999). Indeed, starting from an unemployment rate of less
than one percent in 1970, German unemployment has almost continuously
trended upwards, interrupted only by brief cyclical declines in unemployment,
such as those during 1976–1980, 1985–1990, 1997–2001, and the most recent
decline since 2005 (with only a moderate uptick in 2009). In each of those cases,
the decline in unemployment was paralleled by a growth recovery in output
(Figure 4.1).
12
10
4
West Germany Unified Germany
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Figure 4.1 Germany: Unemployment Rate (National definition and International

Labour Organization, percent)

Schindler 79
France Italy
Japan United Kingdom
15
United States Germany
12
−3
−6
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Figure 4.2 Unemployment in Advanced Economies (ILO definition, percent)
Source: International Labour Organization (ILO).
However, the cyclical upswings in GDP were not sufficient to turn around the
secular increase in unemployment. With the exception of the most recent (ongo-
ing) episode, each trough in unemployment was higher than the previous one.
Thus, from nearly zero unemployment in the early 1970s, German unemploy-
ment peaked in 2005 at over 11 percent. Notably, the deterioration in labor
market outcomes was somewhat unique to Germany (Figure 4.2). Along with
Japan, Germany had one of the lowest unemployment rates among the large
advanced economies in the 1970s, substantially lower than in the United States,
where unemployment was on the order of 6 percent at that time. However, while
U.S. unemployment peaked at nearly 10 percent in 1982 and declined thereafter,
German unemployment continued to rise. By the early 2000s, Germany had one
of the highest unemployment rates among its peers.
The long upward trend that began as early as the 1970s suggests that Germany’s
labor market problems were not specific to the structural challenges posted by
German unification in 1990. A broad consensus has emerged on the main under-
lying causes. Siebert (2003) views the secular step-wise increase in unemployment
as the result of weak job creation, in turn caused by the German institutional
design for wage formation, which at times has led to binding negotiated wage
increases and insufficient wage differentiation; and as the result of a high reserva-
tion wage, resulting from high unemployment and social welfare benefits.1
1
This notion of “binding wage increases” is based on the observed decline in the “wage drift” (the
difference between actual and negotiated wage increases), especially during the 1990s (Siebert, 2003,
p. 8).

With its combination of high unemployment and welfare benefits, rigid wage
determination mechanisms, and high firing costs, Germany was typical of what
many authors saw as the main differences between European and U.S. labor mar-
ket models (Siebert, 1997; Ljungqvist and Sargent, 1998). In addition, Prescott
(2004) and Rogerson (2010) cite high taxation that restricts the labor supply. In
this comparison, U.S. labor market flexibility is seen as the result of low unem-
ployment benefits, low firings costs, and low labor taxation, leading to a more
dynamic labor market that can more easily adjust to economic shocks.
The exploding cost of unemployment along with public pressure to reduce the
high levels of unemployment eventually triggered the largest social policy reform
in post-war Germany (Wunsch, 2005; see also Box 4.2). This reform agenda
limited the duration and level of unemployment benefits and aimed to improve
job creation. As argued in this chapter, these reforms led to a labor market per-
formance in Germany during the recent financial crisis that was quite different
from its historical performance as well as from that in other economies.
RECENT DEVELOPMENTS
German employment, measured as the number of employed individuals, has
performed remarkably during the crisis. Employment decreased only by a mod-
erate 0.6 percent from peak (2008:Q4) to trough (2009:Q4). By contrast, the
cumulative peak-to-trough decline in real GDP (2008:Q1–2009:Q1) reached
over 6.6 percent. The change in employment is one of the smallest among
advanced economies, even compared with those that experienced smaller GDP
declines. A comparison with the United States is particularly telling: despite a
smaller decline in real GDP, U.S. employment was about 6 percent lower at the
trough, a larger decline than that in output (Figure 4.3). These differences were
reflected also in terms of recovery—by end-2010, the United States had nearly
recovered its precrisis level of GDP, but still remained about 4 percent below its
pre-crisis employment level. Conversely, in Germany employment has moved
back to precrisis levels quickly, but with output remaining more sluggish
(Figure 4.4).
Germany’s experience stands out not only in cross-country comparison, but
also from the perspective of its historical business cycle dynamics. Despite the
unique nature of the financial crisis—both in terms of magnitude and in terms
of its global reach—most countries’ labor markets responded in a fashion consis-
tent with historical dynamics. Germany was among only a small group of coun-
tries whose labor markets responded so strikingly differently. Figure 4.5 shows
actual versus predicted unemployment patterns, based on the cross-country
analysis in the 2010 World Economic Outlook (IMF, 2010, ch. 3). Most countries
experienced increases in unemployment either close to their predicted values or,
in many cases, substantially larger. By contrast, the increase in unemployment in
Germany fell substantially short of its predicted value, unique among all countries
in the sample.

Schindler 81
18 Real GDP Total employment

16
14
12
10
8
6
4
2
0
l
an
d
an
d
p an ece Italy any om nds tria ain tes nce ga ada and
l l re d la s Sp t a ra rtu l
Ire F in Ja G
m g
er Kin her A u S F Po an zer
G d t d C i t
Ne ite Sw
n ite Un
U
Figure 4.3 Peak-to-Trough Declines in Output and Employment (Percentage points)
Note: Calculated as the percent-difference between peak and trough during 2007:Q1–2010:Q3.
101
Germany
100
Sweden
99 United Kingdom
98 France
Japan Denmark
97
Employment
96 Finland USA
95
94
93
92
91 GIPS
90
90 91 92 93 94 95 96 97 98 99 100 101
Real GDP
Figure 4.4 Recovery to Pre-Crisis Levels (2010:Q4, 2008:Q2 = 100)

Note: GIPS: Greece, Italy, Portugal, and Spain.
An alternative version of Okun’s law can provide additional insights into the
German labor market dynamics (Box 4.1). The past pattern between employment
and growth would have predicted a much larger employment decline than
observed, given the output loss, on the order of more than one percent (Figure
4.6). In contrast to employment levels, total hours worked declined substantially,
by a cumulative 4.4 percent between their pre-crisis peak in 2008:Q2 and their
trough in 2009:Q2. When re-estimating a modified Okun’s relationship between
economic growth and total hours worked, the peak-to-trough decline implied by

8.0
7.0 Actual change Predicted change
6.0
5.0
4.0
3.0
2.0
1.0
0.0
−1.0
No ny
itz aly
Ja y
n
the nd
Be nds
Po ium
Ne Fra al
e
Sw and
Gr en
Au ce
De tria
Ca ark
ite Fin a
ing d
m
Ire A
Sp d
ain
a
pa
nc
d
d K lan
lan
US
g
do
a
rw
ee
Ne erla
ed
na
It
rtu
s
nm
rm
rla
lg
al
Ze
Ge
Sw
Un
Figure 4.5 Actual versus Predicted Change in Unemployment (Percentage points)
Source: IMF, World Economic Outlook (WEO).
Note: Based on figure 3.8 in IMF (2010). The predicted changes in unemployment are based on Okun’s law
specifications that include additional control variables, including measures of financial, housing and equity
market stress.
40.4 Actual employment Predicted
40.2
40.0
39.8
39.6
39.4
20 Q1
20 Q2
20 Q3
20 Q4
20 Q1
20 Q2
20 Q3
20 Q4
20 Q1
20 Q2
20 Q3
3
:Q
:Q
:Q
:Q
:
:
07
07
07
07
08
08
08
08
09
09
09
09
09
10
10
20
20
20
20
Figure 4.6 Germany: Employment During the Crisis (Millions)

Note: The predicted path is based on a regression of total employment on contemporaneous real GDP growth
during 1991:Q1–2008:Q1. The estimated coefficient is used to predict employment from 2008:Q2 onwards.
this modification is about 3.9 percent (Figure 4.7). Interpreted in this sense, the
labor market response has been less out of line with historical patterns than the
employment dynamics suggest, at least during the first stage of the crisis (i.e.,
from onset to trough). Notably, however, the dynamics in hours and (to a small-
er extent) employment were more positive than predicted during the second,
recovery stage. This is consistent with a continuation of the longer-term down-
ward trend in unemployment. As argued below, that trend would require

Schindler 83
BOX 4.1 Okun’s Law

Unemployment typically increases when economic growth slows down. Okun (1962) first
documented this casual observation, which became known as “Okun’s law,” by postulating
various equations that formalized this relationship, including a gap version, which relates
the output gap to the deviation of actual unemployment from its natural rate (see also Abel
and Bernanke, 2005), and the more commonly used changes version, which relates output
growth to changes in the unemployment rate, e.g.:
'Y/Y = α + β'u
where Y is real GDP and u is the unemployment rate. (Different versions of Okun’s law have
been estimated in a large literature focusing on the relationship between unemployment
and output. See, e.g., Knotek, 2007, and the references therein.) The coefficient β (“Okun’s
coefficient”) can be interpreted as the (semi-)elasticity of output growth with respect to
percentage changes in the unemployment rate. Okun (1962) estimated a value of β | 31/3
for the United States during 1947–1960, while later studies have typically found lower val-
ues on the order of 2.
While Okun’s law has received much empirical support, different versions of it are
appropriate in different contexts. In particular, in this paper an alternative version is esti-
mated, namely, the relationship between changes in total employment and real GDP
growth, as well as a second specification that considers the relationship between changes
in total hours worked and real GDP growth.
These specifications are preferable for a number of reasons. First, the particular interest
here is on the distinction between adjustment on the external margin—individuals being
hired or laid off—and adjustment on the internal margin—changes in hours worked by
each worker. The distinction between these two margins turns out to be important in
understanding recent labor market dynamics in Germany, but it cannot be made using the
traditional specification of Okun’s law that is focused on unemployment.
Secondly, and more broadly, employment is arguably the more preferable object of
interest, since the unemployment rate may change over the business cycle, not only due to
flows between employment and unemployment, but also because of flows into and out of
the labor force. Thus, employment is likely to be a more direct measure of economic well-
being than unemployment. That said, the broader result in this paper, that Germany’s his-
torical Okun’s law did not hold during the current crisis, is a finding that is not unique to any
specification. See, e.g., Figure 4.1 in this chapter and Chapter 3 in IMF (2010).
employers to “overshoot” in the hours/employment recovery, relative to the pre-

dicted dynamics, in order to resume the prior downward trend.
The dynamics of employment and hours worked during the crisis suggest that
German firms may have switched to new adjustment patterns. Historically,
employment and total hours typically moved together at shorter frequencies,
while hours per worker remained fairly stable around a secular downward trend
(Figure 4.8). That is, traditionally, the employment response to short-term fluc-
tuations has largely been on the extensive margin (employment) and less on the
intensive margin (hours per worker).
In contrast, during this crisis, the adjustment has mainly been on the intensive
margin, that is, in hours worked, both during the period of the sharp output fall
and during the initial recovery (implying that hours per worker and total hours

14.5 Actual hours Predicted

14.4
14.3
14.2
14.1
14.0
13.9
13.8
13.7
13.6
13.5
20 Q1
20 Q2
20 Q3
20 Q4
20 Q1
20 Q2
20 Q3
20 Q4
20 Q1
20 Q2
20 Q3
20 Q4
20 Q1
20 Q2
3
:Q
:
:
07
07
07
07
08
08
08
08
09
09
09
09
10
10
10
20
Figure 4.7 Germany: Hours Worked during the Crisis

Note: The predicted path is based on a regression of total hours worked (on contemporaneous real GDP
growth) during 1991:Q1–2008:Q1. The estimated coefficient is used to predict thours from 2008:Q2 onwards.
400 15.5
Hours worked per worker, left axis
390 Total hours worked (in billions), right axis
380 15
370
14.5
360
350
14
340
330 13.5
320
310 13
1991:Q1
1992:Q1
1993:Q1
1994:Q1
1995:Q1
1996:Q1
1997:Q1
1998:Q1
1999:Q1
2000:Q1
2001:Q1
2002:Q1
2003:Q1
2004:Q1
2005:Q1
2006:Q1
2007:Q1
2008:Q1
2009:Q1
2010:Q1
Figure 4.8 Germany: Hours Worked

Sources: Federal Statistical Office; and Deutsche Bundesbank.
moved in sync).2 This crucial change in labor dynamics reflected a number of

factors, outlined in what follows. The many factors include increased flexibility in
hourly adjustments, the temporary nature of the shock (together with the fact
that it is less costly to increase hours per worker after a crisis rather than to re-hire
workers), and lastly, emerging signs of a shortage of skilled workers.
2
More recently, the continued labor market recovery appears to have started to shift back to the
extensive margin, with the increase in total hours worked driven, once again, by employment gains.

Schindler 85
UNDERSTANDING GERMAN LABOR MARKET

DYNAMICS
To understand Germany’s labor market dynamics, it is useful to view labor mar-
ket outcomes as a function of institutions, policies, and shocks. Changes in each
of these values, along with the interactions between them, shape how labor
markets evolve during a crisis. The following discussion brings together a variety
of possible factors behind the observed labor market response in each of these
categories.
Hartz IV Reforms: Secular Trends

Over the past decade, Germany has undertaken a variety of reforms and policy
measures that have significantly altered its labor market institutions. A key pack-
age has been the so-called Hartz IV reforms, which took effect in 2005 and
contained a number of features (Box 3.2). The reforms streamlined and reduced
the generosity of social transfers, including benefits associated with unemploy-
ment insurance (UI) and welfare payments, and also deregulated temporary
employment. A key effect was to lower unemployed individuals’ reservation wages
and thus increase the flows from unemployment into employment.
The reforms came after a cyclical acceleration of the longer-term trend increase
in unemployment—starting from around 5 percent around the time of German
unification, the unemployment rate rose to a peak of over 11 percent in 2005.
Although GDP growth had the ability to lower unemployment at shorter (cycli-
cal) frequencies, the structural increase dominated (Figures 4.9 and 4.10). Near
zero real output growth during 2001 through 2003 then provided an additional
“boost” to unemployment and helped create the political economy that laid the
groundwork for the Hartz reforms to take place.
Model simulations suggest that the Hartz reforms, especially those in stage IV,
contributed strongly to reducing structural unemployment. Analyzing and assess-
ing the payoffs from a single reform episode is empirically difficult, as the
reform’s impact cannot easily be disentangled from the contributions of simulta-
neous changes in other factors. In such cases, a theoretical framework can provide
guidance on the isolated impact of reforms, since it allows one to construct a
counterfactual prediction of how the unemployment dynamics would have
evolved post-reform, holding other factors constant. In the context of labor mar-
ket reforms and their impact on employment and unemployment, the search
framework is ideally suited for this task.
Labor search models center on the flows that occur between unemployment
and employment and the various factors that may affect these flows.3 In particu-
lar, simple search models involve variables regarding the payoff from working (in
particular, the wage) as well as the payoff from being unemployed (the monetary
3
More complex models may include also the flows from outside the labor force into employment or
unemployment, and vice versa. For tractability, the model considered here abstracts from these.

10.0 Real GDP (Percent change over 4 quarters 3.0

ago), left axis
8.0
Unemployment rate (ILO, percentage point
2.0
6.0 change over 4 quarters ago), right axis
4.0
1.0
2.0
0.0 0.0
−2.0
−1.0
−4.0
−6.0
−2.0
−8.0
−10.0 −3.0
1991:Q1
1992:Q1
1993:Q1
1994:Q1
1995:Q1
1996:Q1
1997:Q1
1998:Q1
1999:Q1
2000:Q1
2001:Q1
2002:Q1
2003:Q1
2004:Q1
2005:Q1
2006:Q1
2007:Q1
2008:Q1
2009:Q1
2010:Q1
Figure 4.9 Germany: Cyclical Changes in Output and Unemployment
Real GDP (Seasonally and work day adjusted,

115.0 2000 = 100), left axis 12.0
Unemployment rate (ILO, percent), right axis
110.0
10.0
105.0
100.0 8.0
95.0 6.0
90.0
4.0
85.0
80.0 2.0
1991:Q1
1992:Q1
1993:Q1
1994:Q1
1995:Q1
1996:Q1
1997:Q1
1998:Q1
1999:Q1
2000:Q1
2001:Q1
2002:Q1
2003:Q1
2004:Q1
2005:Q1
2006:Q1
2007:Q1
2008:Q1
2009:Q1
2010:Q1
Figure 4.10 Secular Trends in Output and Unemployment

and nonmonetary value derived from being unemployed). These factors directly
impact the extent to which an unemployed individual will actively search, as well
as which job opportunities might be taken up. Another important factor for labor
market outcomes is the matching efficiency, that is, the ease with which firms
encounter the right candidates and unemployed individuals seeking work find the

Schindler 87
14
Unemployment rate (actual)
13 Simulated unemployment (USS = 5.25 percent)
Simulated unemployment (USS = 6.0 percent)
12
Simulated unemployment (USS = 7.0 percent)
11 Simulated unemployment (USS = 8.1 percent (historical average))
10
5
2000:Q1
2000:Q3
2001:Q1
2001:Q3
2002:Q1
2002:Q3
2003:Q1
2003:Q3
2004:Q1
2004:Q3
2005:Q1
2005:Q3
2006:Q1
2006:Q3
2007:Q1
2007:Q3
2008:Q1
2008:Q3
2009:Q1
2009:Q3
2010:Q1
2010:Q3
Figure 4.11 Actual and Simulated Unemployment (Percent)
Note: Hypothetical paths are model-based transition paths under the assumption that the Hartz IV reforms
lowered the structural (steady-state) unemployment rate (USS) to various levels. See text for details.
right jobs. The appendix outlines a reduced-form version of a search model, with
a focus on the implied transition dynamics.4
Model simulations suggest that the decline in unemployment observed since
2005 is likely to continue. From an average of about 8.1 percent during 1991–
2005 and a peak of 10.6 percent in 2005, the unemployment rate subsequently
started a downward trend that was interrupted only briefly at the height of the
financial crisis. Most recently, the unemployment rate, at just under 6 percent in
2011:Q2, has reached a level not seen in nearly two decades. The model suggests
that an increase in the rate at which workers encounter the right jobs can explain
much of the precrisis trend in the unemployment rate.
More specifically, the model as described by equation (1) in the appendix
contains two key parameters: the rate at which unemployed individuals find
work, α, and the rate at which workers lose employment, δ. This equation
describes the unemployment dynamics, given that current unemployment is equal
to last period’s unemployment minus the share of unemployment that has found
employment plus the share of the employed that has lost employment.5 Different
parameterizations of the equation imply different structural (steady-state) unem-
ployment rates. To the extent that the Hartz reforms raised the job-finding rate,
these reforms imply a lower steady-state unemployment rate (Figure 4.11).
4
An important feature of this reduced-form model is that one can write down an explicit search-
model which, for the right set of parameters, can rationalize the reduced form model used here.
5
As previously mentioned, these simplifying assumptions include ignoring movements into and out
of the labor force, as well as any heterogeneity in the workforce, whereby different worker groups may
have potentially different job finding/separation rates. Another important assumption is that of con-
stant parameters over time (with the exception of discrete changes at the time of a shock).

Starting from the pre-Hartz IV unemployment rate of about 10½ percent, and
assigning various parameter values to the post-reform value of α, equation (1) can
also be used to trace out the simulated unemployment transitions to a hypo-
thetical new steady-state (Figure 4.9).6 From the peak in 2005 through the onset
of the crisis, the simulated path based on a 5.25 percent long-term unemploy-
ment rate gives an almost perfect fit with the post-2005 data. In this view, the
crisis temporarily halted the trend decline, but employment quickly recovered
and is likely to continue its downward trend.7 The simulations based on a
5.25 percent long-term rate imply that the job-finding rate would be about 50
percent higher than prior to Hartz IV, an implication that is broadly supported
by other research (Lam, 2011).
The interpretation of the post-2005 path as a transition to a lower structural
unemployment rate also affects the interpretation of the observed labor market
response. If the downward trend since 2005 is indeed a transition to a new and
lower steady-state unemployment rate, rather than a low-frequency cyclical
variation around the previous unemployment rate of more than 8 percent, then
the unemployment dynamics during the crisis are best assessed relative to the
counterfactual transition path rather than relative to precrisis levels of unemploy-
ment. Thus, compared to what unemployment might have been in the absence
of the crisis, unemployment at its crisis peak in 2009:Q3 had increased by over
one percentage point relative to the counterfactual—this is more than twice the
change calculated as the difference between the precrisis level of 7.2 percent and
the crisis peak of 7.6 percent. In this reading, then, the German labor market
response has not been quite as mild as typically understood.8
Hourly Flexibility Measures

Some reforms, prior to and during the crisis, were targeted at hourly flexibility.
The most prominent such measure included extensions to the German short-time
scheme (Kurzarbeit), which subsidized workers and firms to reduce hours worked.
This measure was taken up extensively by workers and firms. However, it was
only a second or third step for many firms. In years prior, employers and unions
had agreed on a number of measures that facilitated reductions in the work week
(with commensurate income reductions) and also helped firms to smooth hours
per worker over time through work-time accounts (Arbeitszeitkonten) (Box 4.2).
Many workers had accumulated large surpluses in their work-time accounts (i.e.,
worked more than their regular work weeks), and thus firms had substantial buf-
fers to adjust labor input by exhausting these measures before turning to short-
time subsidies (see Sachverständigenrat, 2009).
6
See the appendix for details on the construction of the hypothetical paths.
7
However, the simulations are suggestive that unemployment may have shifted to a different trend
line.
8
As a corollary, employment growth could also have been stronger absent the crisis, suggesting that
the above- noted mild employment response may underestimate the true damage from the crisis.

Schindler 89
BOX 4.2 Recent Changes in German Labor Market Institutions

Recent reforms in the German labor market were mainly in two broad areas: (i) the Hartz
reforms, which, broadly speaking, facilitated movements from unemployment to employ-
ment, and (ii) measures to increase hourly flexibility, facilitating firms’ adjustment of labor
input without necessarily changing the number of employees. This box outlines some of
the key features of the various reforms.
i. The Hartz reforms were a sequence of reform packages aimed at implementing the
2002 proposals by the committee on “Modern Services in the Labor Market.”a Their
overall intent was to facilitate the flow from unemployment to employment, both by
lowering benefits during unemployment (Hartz IV) and by adding measures to improve
intermediation (Hartz I through III). More specifically:
– Key aims of the first installments, the Hartz I and II reforms (both effective January
2003) were to increase and facilitate temporary employment (e.g., through personnel
service agencies) and to raise the incentives for individuals receiving social benefits to
engage in productive work (e.g., the Ich-AG and job centers).
– The Hartz III package, effective January 2004, restructured the federal labor agency.
– The last, and arguably most important, stage came with the Hartz IV measures, effec-
tive January 2005. This fourth stage shortened the eligibility for unemployment insur-
ance benefits (Arbeitslosengeld) to 18 months from the previous 24 months and set
subsequent unemployment benefits (Arbeitslosenhilfe) at the substantially lower level
of social welfare benefits (Sozialhilfe).
ii. A second set of changes in the labor market regards hourly flexibility. The following list
summarizes some of the key measures:
– In the early 2000s, an increasing number of sectors and industries, through agree-
ments between workers and employers, introduced opening clauses (Öffnungsklauseln)
that allowed them to deviate from collectively bargained work arrangements, e.g., to
reduce worktime without compensation, or to reduce pay in exchange for avoiding
layoffs.
– Firms have also increasingly taken advantage of worktime accounts (Arbeitszeitkonten).
The main feature of these is to allow firms to vary workers’ hours worked over time,
reducing the need for overtime pay and minimizing workers’ income fluctuations. The
worktime account ensures that hourly fluctuations balance out inter-temporally.
– Short-time subsidies (Kurzarbeit) by the government have been a feature of German
labor market institutions for nearly a century. They facilitate work-time reductions by
partially compensating workers for up to 67 percent of their lost income. The subsidy
was made more generous in 2008–09 through a temporarily longer maximum dura-
tion (24 months) and through increased coverage of firms’ social contributions.
a
The committee was chaired by Peter Hartz, then-member of the executive board of Volkswagen
Aktiengesellschaft in charge of human resources and personnel management.
The Nature of the Shock

Germany experienced a different shock than, for example, the United States.
While the German economy was affected strongly and real GDP declined by
more than in the United States, the shock was largely externally driven, channeled
to Germany through a decline in export demand. Given Germany’s strong export
dependence, the impact on GDP was severe, but at the same time it was short-
lived—exports recovered almost as quickly as they had deteriorated. Partly as a

result, Germany’s growth potential was also little affected. (See Chapter 2). The
nature of the shock differed substantially from that in the United States, which
suffered a more domestic and structural shock to its economy.
Interactions between Institutions, Policies and the Shock

Firms’ expectations of a temporary shock only partially explain the strong reliance
on hourly adjustment. Although the downturn has indeed proven temporary,
with a strong recovery that started in mid-2009, the cumulative loss has been
large—for example, compared to precrisis output levels, despite its robust recov-
ery Germany still lags behind the United States, while the latter has suffered a
large and persistent increase in unemployment.9
The labor market dynamics may reflect the still-high layoff costs. While the
level of employment protection legislation (EPL) has not markedly changed in
the recent past10 or during the crisis, and so cannot by itself explain the devia-
tion in Germany’s labor market response from its past behavior, it is possible
that the increased hourly flexibility has tilted firms’ cost-benefit analysis, mak-
ing reductions in hours per worker a less costly alternative to employment
reductions.11
Labor supply constraints in the form of a shortage of skilled workers may also
have contributed, but the evidence is not fully conclusive. A shortage of skilled
workers is frequently cited by firms, academics, and policy makers alike as being
at the root of firms’ labor hoarding behavior during the crisis. Consistent with
this, a duality has started to emerge in the German labor market, whereby firms
have largely relied on extensive labor adjustment among temporary workers, who
9
The notion that firms rationally responded to a temporary shock by hoarding labor does not require
the assumption of perfect foresight—e.g., if firms use some form of Bayesian updating, then the low
level of external demand at the trough of the crisis would not have been perceived as the new equilib-
rium without it persisting for a sufficiently long time.
10
Germany continues to rank high according to the OECD’s employment protection legislation
(EPL) indicators, especially on regular employment (on temporary employment, Germany was below
the OECD average in 2008, the latest available data point). Consequently, the OECD has repeatedly
called on Germany for further reform in this area (OECD, 2011). In addition, Berger and Neugart
(2012) point to an additional cost of reducing employment in the form of uncertainty over labor court
decisions. In terms of labor market implications, because EPL tends to reduce both job destruction
and job creation, the impact on the level of employment is conceptually unclear, reflected in simi-
larly ambiguous empirical findings (Garibaldi and Mauro, 2002, versus Takizawa, 2003). But there is
a broader consensus that high EPL inhibits labor market dynamism and its ability to respond to
economic shocks. See Barone (2011) and Schindler (2009) for reviews of related literatures. In addi-
tion, Boeri (1999) argues that the asymmetric type of EPL, as increasingly observed in Germany (i.e.,
regular versus temporary employment) can lead to labor market dualism.
11
That is, the same level of employment protection legislation may have a larger impact on allocations
when firms have new ways of avoiding layoff costs, as in this case through more hourly flexibility. See
Ljunqvist and Sargent (1998) for a similar reasoning on the interactions of institutions and shocks.

Schindler 91
are typically less skilled, while relying on more intensive adjustment for their
more skilled core workforce.12
However, despite much anecdotal evidence, labor market outcomes do not
fully bear out the signs of a true shortage: Brenke (2010) has noted that such a
shortage should put upward pressure on their relative wages, something that has
not been observed. Also, university enrollment rates in engineering and the natu-
ral sciences remain at a high level and have in recent years increased substantially,
suggesting that supply is relatively strong.13 While these statistics suggest that
excess demand for skilled labor in the German labor market may not be as broad-
based and severe as some may fear, there is little doubt that demographic pressures
will pose problems in the medium term.
Matching inefficiencies appear to have diminished. Even without shortages of
skilled labor, firms may opt for “labor hoarding” if they find it difficult to rehire
the workers they need in an upswing. The relationship between vacancies and
unemployment over time (the so-called Beveridge curve, first discussed by Dow
and Dicks-Mireaux, 1958) is a frequently used gauge for a country’s matching
efficiency.14 It is especially insightful in the context of search models—in such
models, labor supply (unemployed workers) and labor demand (firms’ vacant
positions) are brought together through a matching technology, or matching
function. A more efficient matching technology then implies that a given level of
vacancies translates into a lower unemployment rate than would be the case with
a less efficient matching technology. Graphically, shifts in the Beveridge curve
toward the origin suggest gains matching efficiency, while movements along the
curve are the result of equilibrium dynamics for a constant matching technology.
The plot for Germany suggests that around 2007, the matching process
started to improve, with the Beveridge curve now at a substantially lower level
(i.e., a shift toward the origin) than pre-2007 (Figure 4.12). This apparent
improvement in matching efficiency is consistent with the previously noted faster
unemployment-to-employment transition associated with the Hartz reforms,
including, importantly, the measures taken during the first two stages that facili-
tated the development of atypical employment.
All else equal, a higher matching efficiency should increase firms’ willingness
to shed labor, on the expectation that finding a good match in the future will be
relatively easy. While the shift in the Beveridge curve makes it at first sight more
difficult to understand the stable employment during the crisis, the aggregate data
hide the fact that the Hartz reforms mostly added labor supply on the lower end
of the income and skill distribution. That addition is consistent with the fact that
employment losses were larger among low-wage segments, suggesting that
12
Employment of temporary workers declined by 2 percent in Germany during 2009, compared with
an increase of 0.4 percent in total employment (IMF, 2010, Box 3.1).
13
However, enrollment rates in these fields were broadly flat during 2004–2008, suggesting that in
the coming years, graduation rates may not keep up with demand of a growing economy.
14
Vacancies and unemployment are negatively correlated, since strong hiring demand by firms (high
level of vacancies) helps reduce unemployment.

12
11
10
9
2000–07
8
7
2008–present
6
150 200 250 300 350 400 450
Figure 4.12 Beveridge Curve

Source: Deutsche Bundesbank.
Note: The Beveridge curve plots monthly unemployment rates (in percent, sa) against the monthly number of
job vacancies (in thousands, sa).
improvements in employment flexibility and matching efficiency were more pro-

nounced in those segments.
CONCLUSION
The apparent puzzle of the German labor market during the crisis can be
explained by a combination of factors. The German economy suffered a demand
shock, which firms presumably expected to eventually reverse. Hence, firms
adjusted mainly by taking advantage of options to reduce the hours worked, keep-
ing employment levels relatively high (i.e., relative to that predicted by Okun’s
law). At the same time, the German unemployment rate had been on a downward
path since about 2005, most likely reflecting the Hartz IV reforms. This also had
the effects of dampening the decline in employment and helping the employment
recovery.
While authors in the existing literature place emphasis on different factors
(Box 4.3), most agree that the likely explanation involves some combination of
hourly flexibility measures, including work-time accounts and short-time subsi-
dies, low precrisis hiring, and long-standing wage moderation. While these views
are consistent with the interpretation put forth in this paper, the emphasis here
is different: namely, in this analysis most of the credit belongs to the Hartz
reforms, which have put Germany in a position to deal well with a temporary
demand shock. This still leaves ample room for further reforms. The increased
flexibility of the lower-wage segment has introduced an uneven distribution of
employment and wage risk: more secure high-skill and high-wage employment
along with less secure low-wage work. Also, while job creation has been made
easier, rigidities still remain on the job termination side, resulting in part from

Schindler 93
BOX 4.3 The Literature on the “German Employment Miracle”

The academic literature on the German performance during the crisis is still small, unsur-
prisingly so given the proximity of events. No clear consensus has yet emerged on the key
drivers of the German performance. Burda and Hunt (2011) cite three main factors as the
reasons for the German “labor market miracle:” relatively low precrisis hiring, due to a lack
of confidence by firms in the robustness of the precrisis boom, provided a buffer during the
crisis and accounted for about a third of the missing employment decline; the secular trend
in wage moderation, which tends to raise employment, is seen as explaining 10 percent of
the employment decline that would have otherwise been expected; and work-time
accounts are seen as the third factor. Burda and Hunt do not discuss the possibility that the
low precrisis hiring and accumulation of large surpluses in the work-time accounts may
have similar sources and thus may not be truly separate explanations of the German labor
market performance. They also do not fully explain how low precrisis hiring is consistent
with the fairly strong employment gains that were made almost immediately after the ini-
tial crisis shock had worn off. Lastly, just under half of the unexplained employment
strength is explained in their analysis.
Other authors emphasize different reasons for Germany’s labor market performance.
Gartner and Merkl (2011) also emphasize precrisis wage moderation as the main source of
the crisis performance, since it had in their view induced a permanent labor supply shock.
It is not obvious, however, how a permanent shift would impact the employment dynamics
in a cyclical downturn. It is also possible that this link between wage moderation and
reduced employment losses during the crisis reverses causality—if, as argued in this chap-
ter, the Hartz reforms were the underlying reason for the expansion in employment, then
it is the “Hartz supply shock” that weakened workers’ bargaining positions and put further
moderating pressure on wages, rather than wage moderation causing employment.
Boysen-Hogrefe and Groll (2010) and Gartner and Klinger (2010), in turn, place stronger
emphasis on work-time accounts as the key source of the robust employment dynamics
during the crisis.
Fahr and Sunde (2009) and Klinger and Rothe (2010) take a view that is most closely
aligned with that in this chapter. Namely, they argue that the Hartz reforms raised the effi-
ciency of the matching function increased, consistent with Gartner and Klinger’s (2010)
observation of a continued shift in the Beveridge curve.
still-high employment protection and uncertainties related to labor court pro-

ceedings. Lastly, demographic pressures in the medium term will necessitate
broader measures, including in education and immigration, to moderate the
emergence of bottlenecks.
Policy conclusions for other countries are to be drawn cautiously. As argued in
this note, the German crisis performance reflected the type of shock, crisis poli-
cies, and initial conditions at the time of the shock. The latter, notably, reflected
reforms initiated several years prior to the crisis, which put German unemploy-
ment on a declining trend that mitigated the increase during the crisis. A country
with differences in any of these aspects may well require a different policy
response, so blindly applying measures such as the Kurzarbeit extensions could
well have adverse effects if, for example, the shock were more structural in nature.
One broader lesson, however, is that the “right” reforms are likely to eventually
pay off.

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2005–06.

APPENDIX
A simple search model framework can help in understanding the impact of the
Hartz IV reforms on unemployment. In labor markets with search frictions, tran-
sitions from unemployment to employment are not instantaneous. Ignoring
changes to the labor force, unemployment can thus be seen to evolve over time
according to:
ut + 1 = ut(1 − α) + (1 − ut) δ (1)
where ut is unemployment at time t and α,δ are the probabilities (hazard rates) of
exiting unemployment and employment, respectively. This equation also implies
that steady-state unemployment can be expressed as
uSS = δ / (δ + α ). (2)
The Hartz IV reforms have likely lowered structural unemployment through
a higher job finding rate. The pre-Hartz IV average unemployment rate was
about 8.1 percent. Lam (2011) estimates the German job destruction rate at
about 0.5 percent. These two values imply a pre-2005 average job finding rate of
about 6.1 percent.15 Assuming δ to have remained unchanged since 2005, the
steady-state equation provides a one-to-one correspondence between estimates of
the (new) long-term steady-state and the implied (new) job finding rate α.16 The
figure in the main text plots the resulting transition paths for a variety of possible
values of the new structural unemployment rate. See also Fahr and Sunde (2009),
Klinger and Rothe (2010), and Gartner and Klinger (2011) for a similar view of
events.
15
Lam (2011) estimates job finding and destruction rates for 1970–2009 and for 1996–2009 and
finds little difference for the different time periods (for the latter period, he estimates δ = 0.6 percent).
The implied value for α corresponds to Lam’s estimate who also finds a value of also 6.1 percent dur-
ing 1970–2009.
16
For the purpose of this reduced-form exercise, we take the job arrival and destruction rates as exog-
enous. In a more general search model, both margins would be endogenous due to changes in indi-
viduals’ reservation wages. Generally speaking, a reduction in unemployment benefits would raise job
creation and lower job destruction (Pissarides, 2000)—in such models, the key channel is through
wage bargaining.

CHAPTER 5
Growth Spillover Dynamics:

From Crisis to Recovery
HÉLÈNE POIRSON AND SEBASTIAN WEBER
Can positive growth shocks from the faster-growing countries in Europe spill over to
the slower-growing countries, providing useful tailwinds to their recovery process? This
study investigates the potential relevance of growth spillovers in the context of the crisis
and the recovery process. Based on a Vector Autoregression (VAR) framework, our
analysis suggests that the United States and Japan remain the key sources of growth
spillovers in this recovery, with France also playing an important role for the European
crisis countries. Notwithstanding the current export-led cyclical upswing, Germany
generates relatively small outward spillovers compared to other systemic countries, but
it likely plays a key role in transmitting and amplifying external growth shocks to the
rest of Europe given its more direct exposure to foreign shocks compared to other
European countries. Positive spillovers from Spain were important prior to the 2008–
09 crisis, but Spain is generating negative spillovers in this recovery due to its depressed
domestic demand. Negative spillovers from the European crisis countries appear lim-
ited, consistent with their modest size.
INTRODUCTION
Can positive growth impulses from the faster-growing countries in Europe spill
over to the slower growing countries, providing useful tailwinds to their recovery
process? This analysis investigates the relevance of such potential growth spillovers
and seeks to identify the countries most likely to serve as “growth leaders.” In
particular, we examine the extent to which Germany’s current upswing may spill
over to other countries and accelerate recovery elsewhere.
A simple correlation between the lagged quarter-on-quarter output growth
rates of Germany and other euro area countries shows an increasing co-movement
between Germany and other countries, including the European crisis countries
(Greece, Ireland, and Portugal) in the last 20 years. A similar pattern can be
The authors thank Ashoka Mody for insightful comments and valuable suggestions. They also would
like to thank Céline Allard, Ansgar Belke, Rupa Duttagupta, Felix Huefner, Irina Tytell, and Francis
Vitek, participants in the Germany in an Interconnected World Economy conference (Berlin, 2011) and
in the Graduate Institute of International and Development Studies internal seminar (Geneva) for
useful discussions and comments; and Susan Becker for excellent research assistance.
97

98 Growth Spillover Dynamics: From Crisis to Recovery
observed for the correlations of the lagged growth rates of France and Italy with
the current GDP growth rate of the rest of the euro area. The correlation of the
lagged U.S. growth rate with other countries’ current GDP growth rates has also
increased markedly (Figure 5.1). While more synchronized business cycles suggest
increased growth spillovers, they do not provide a measure of the spillover effects
of individual countries. Moreover, they could also reflect the growing influence of
common factors, such as euro area monetary policy, or global factors, such as oil
price developments or financial conditions in major financial centers including
the United States and the United Kingdom.
To disentangle the independent impact of growth shocks in individual coun-
tries from the effect of common factors and measure the country-specific spillover
effects, we use a structural vector autoregression (SVAR) approach with an iden-
tification scheme similar to that proposed in Bayoumi and Swiston (2009). Using
this framework, we undertake the following analysis:
• We characterize countries by their international growth spillovers, outward
and inward. Unlike former studies, which rely on regional aggregates, we use
country-level data for a sample of 17 countries (accounting for almost 60
percent of global GDP, at market exchange rates), which includes 11 of the
euro area countries (representing 98 percent of euro area output). Focusing
on individual members rather than treating the euro area as an aggregate as
in earlier studies allows us to shed light on the country-by-country spillovers
and inter-linkages that drive growth dynamics.
• We describe the dynamics of these spillovers during the recent crisis and
recovery. This is done by applying a dynamic growth accounting calculation
to the SVAR estimation results to quantify the contribution of individual
countries to the recent decline and recovery in output growth.
• We quantify the relevance of different channels of transmission of spillovers.
We use counterfactual analysis and smaller country–by-country regressions,
which include exports as an additional variable to assess the empirical rele-
vance of various transmission channels, including trade and third-country
effects (e.g., transmission through a common trade partner).
• We analyze the determinants of the spillover size by relating outward spill-
overs to both the country’s size and the relative importance of the domestic
demand contribution to the country’s growth.
Our main findings can be summarized as follows:
• Confirming earlier results, we find evidence of significant spillover effects
from the United States to the rest of the world. Outward spillovers from
Germany are found to be surprisingly small (relative to growth impulses
emanating from other large systemic countries), and they are largely con-
fined to smaller trade partners.
• The results suggest that despite the increased correlation of Germany’s
growth rate with that of the rest of the euro area, the United States and
Japan remain the key sources of growth spillovers in this recovery, with

Poirson and Weber 99
1 Correlation(Country (t-1), EMU) 1 Correlation(Country (t-1), GIP)

United States Japan
United Kingdom Germany
0.8 France Italy 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0 0
−0.2 −0.2
1975- 1980- 1985- 1990- 1995- 2000- 2005- 2009- 1975- 1980- 1985- 1990- 1995- 2000- 2005- 2009-
1979 1984 1989 1994 1999 2004 2008 2010 1979 1984 1989 1994 1999 2004 2008 2010
Figure 5.1 Growth Correlation with EMU and GIP Countries over Time: Selected Economies
(1975–2010)
Source: OECD, IMF staff calculations.
Note: EMU: Austria, Belgium, Finland, Greece, Ireland, Netherlands, Portugal, and Spain, weighted by their respective
share in the group; GIP: Greece, Ireland, and Portugal.
France also playing an important role for the European crisis countries.
Positive spillovers from Spain were important prior to the crisis. However,
Spain is generating negative spillovers in this recovery due to its depressed
domestic demand.
• In line with earlier VAR-based evidence on channels of spillover transmission
across regions, the results of a country-by-country estimation of a smaller
SVAR model (augmented with exports) suggest that financial and other non-
trade channels explain the biggest share of cross-border growth spillovers.
However, trade effects are particularly relevant in the case of Germany.
• Taking the analysis one step further, we find that countries that generate the
largest estimated outward spillovers are the ones where growth is largely
driven by autonomous sources of domestic demand. In contrast, countries
highly sensitive to external shocks, such as Germany, tend to have a rela-
tively small independent, aggregate impact on other countries. This result,
together with the finding that third-country effects play a significant role in
the international transmission of shocks, suggests that Germany plays an
important role as a transmitter and amplifier of growth shocks originating
in other countries.
Three main caveats should be mentioned at the outset. All three provide inter-
esting avenues for future research but are beyond the scope of this paper.
• Countries outside our sample might play an important role in global spill-
overs, either as recipients or as a source of shocks. For instance, several

Eastern European countries are highly integrated with Germany and have
become an integral part of the production chain of German products. For
these countries, empirical evidence supports the idea that Germany has
played a more prominent role in recent years (see Danninger, 2008). In
recent years, China and other large emerging countries probably play an
important role as a source of shocks as well, reflecting their size and
increased trade linkages.1
• There may be other sources of growth spillovers beyond the business-cycle
fluctuations considered in this study. For example, foreign direct investment
(FDI) outflows between advanced countries and from advanced to develop-
ing countries could generate significant spillovers over time, including
through knowledge transfer and employment creation. Quantifying such
FDI-related spillovers would require a different approach, one focused on a
long-term horizon, since such effects are likely to develop only over time.
• The analysis here is backward looking and does not allow for continuous
time-varying relationships among the countries. In addition to full sample
results, we present estimation results for a more recent sub-sample (since
1993) to account for the possibility of changed responses, in line with rap-
idly increasing cross-border trade and financial linkages. The results confirm
that the potential size of cross-border growth spillovers has generally
increased, with the notable exceptions of Japan and Germany, for which we
find no evidence of higher outward spillovers on average in the recent period.
Finally, it should be noted that this analysis is descriptive. An analysis of wel-
fare implications is beyond the scope of this chapter.
The remainder of this chapter reviews the related literature on cross-country
spillovers, outlining the main empirical approaches that have been pursued and the
key findings; discusses the empirical strategies employed in this study; and high-
lights the main findings and provides estimates of individual countries’ relevance
for other countries’ growth dynamics. The potential reasons for the relevance of
particular countries as a source of spillovers are also discussed.
GROWTH LINKAGES AND SPILLOVERS:

RELATED LITERATURE
The empirical literature on growth spillovers has dealt with three interrelated
questions: What is the size of growth spillovers? Which countries or regions are
1
While data availability constrains the inclusion of China and other emerging countries in the sample,
we indirectly attempted to test this hypothesis in an earlier version of the study by including exports
to China, to developing Asia, and to the world as additional control variables. Those variables were
not statistically significant and the results remained largely unchanged, suggesting that the sample
countries already capture the bulk of relevant global demand shocks for the period under consider-
ation (1975–2010).

the main sources of growth spillovers? and, What are the main channels of trans-
mission of growth spillovers?
Existing empirical studies generally confirm the existence of spillover effects,
but the empirical evidence about the size of spillovers is inconclusive, as results
are not robust to different samples and specifications. Previous studies frequently
divide the world into regions,2 the euro area being one of them, and examine
spillovers from large advanced countries to these regions.3 The general finding of
these studies is that the United States is the main source of growth spillovers.
Relatively few studies have examined the channels through which growth shocks
are transmitted to the other regions and countries. Existing findings vary across
studies, with simulation-based results suggesting a bigger role for the trade chan-
nel—perhaps due to the difficulty of empirically modeling asset price spillovers
or confidence channels—while VAR analyses, which impose less structure on the
interlinkages, point to the relative importance of financial and other nontrade
channels.
The finding that international spillovers are relatively small under standard trans-
mission channels was first established by Helbling and others (2007). Their study
finds a limited extent of U.S. growth spillovers into other regions—excluding the
euro area and Japan—and even smaller effects of spillovers from the euro area or
Japan, when controlling for possible channels of transmission including commodity
prices (terms of trade) and financial conditions (Libor interest rate). The results
obtained are similar using three alternative approaches (simple panel regressions, a
more sophisticated dynamic analysis, and model simulations). The estimated spill-
overs are moderate in magnitude: the results from annual panel regressions for 130
countries over 1970–2005 suggest that a 1 percentage point decline in U.S. growth
is associated in the long run with an average 0.16 percent drop in growth across the
sample. The findings based on a VAR approach for 46 countries, both advanced and
developing, also suggest that U.S. growth disturbances have on average moderate
dynamic effects on growth in other regions. The simulation results in Helbling and
others (2007) also suggest that the potential spillovers from a temporary, U.S.-
specific demand shock via trade channels alone are moderate, roughly of the same
magnitude as the results from the panel and VAR analyses. However, alternative
simulations, assuming correlated disturbances across countries, generate larger spill-
over effects. The authors of the study conjecture that such a higher impact of U.S.
shocks could arise, for example, if the transmission had also involved asset price
spillovers or confidence channels.
Using a long-run (five-year average) panel regression approach for 101 coun-
tries over 1960–1999, Arora and Vamvakidis (2006) find much larger spillovers.
2
See, for example, Helbling and others (2007), Arora and Vamvakidis (2006), Bayoumi and Swiston
(2009), and Swiston (2010). For an example of similar approaches applied to the case of China spill-
overs, see Arora and Vamvakidis (2010).
3
For the latter, see Bayoumi and Swiston (2009). This study examines the extent of spillovers across
industrial regions including the U.S., the euro area, Japan, and an aggregate of small industrial coun-
tries, using VARs of growth across the four regions.

In most specifications, a roughly 1 point increase in U.S. and EU growth is asso-

ciated with, respectively, a roughly 1 point and 1⁄3 point increase in other coun-
tries’ growth (while Japan has an insignificant effect). However, the results could
capture forces beyond short-term demand and business cycle effects transmitted
via trade channels, such as technology spillovers, and are thus not directly com-
parable to those of Helbling and others (2007).
Similar to Helbling and others (2007), Bayoumi and Swiston (2009) focus on
short-run dynamics across industrial regions during 1970–2006. Their main
results suggest significant U.S. spillovers to other industrial regions, including the
eurozone, Japan, and a group of smaller advanced economies (of one-quarter to
one-half the size of the U.S. shock after two years). Spillovers from the euro area
or Japan are found to be smaller than spillovers from the United States and insig-
nificant in most cases, except for spillovers from Japan to the euro area (which are
found to be of similar size to those from the United States).
Helbling and others (2007) generally find lower spillovers from the United
States to other countries compared to Bayoumi and Swiston (2009). This is due to
two main reasons: First, Helbling and others use the London Interbank Offered
Rate (Libor) rate as a control variable. This amounts to some extent to shutting off
a potential transmission channel and thus implies a lower estimated growth spill-
over from the U.S. GDP. In fact, Bayoumi and Swiston provide estimates of this
transmission channel and show that the interest rate channel accounts for close to
50 percent of the transmission of U.S. growth shocks. Thus, once Helbling and
others’ results are adjusted by this gap, spillover effects from the United States to
other countries are closer to Bayoumi and Swiston’s estimates. Second, Helbling
and others look at responses in countries which exclude the eurozone and Japan.
As the authors themselves note, countries that have higher financial and trade link-
ages with the United States respond more strongly to growth shocks in the United
States. In fact, for Canada and Mexico they find responses to U.S. growth shocks
comparable in size to the average response found by Bayoumi and Swiston to U.S.
shocks. Thus, the sample choice appears to explain the remaining difference in the
estimated impact.
Our results are comparable to Bayoumi and Swiston (2009) when looking at
the entire sample period, but show an even higher response to U.S. GDP when
looking at the more recent episode from 1993 to 2010. This largely reflects the
higher financial integration of the United States with other countries in this
period compared to the 1975–1993 period.
To our knowledge, few studies have examined growth spillovers and linkages
within Europe. For Germany, empirical results suggest relatively small growth
spillover effects. Danninger (2008) estimates a VAR model for the growth rates
of the United States, Japan, Germany, an aggregate of other euro area members,
and an additional aggregate for the new EU member countries, for the period
1993–2007. While he finds significant spillovers from the euro area aggregate to
the new EU member states and to Germany, he finds very limited spillovers from
Germany to other countries. However, his estimation results for a more recent
sample (since 1998) suggest stronger spillovers from Germany to the euro area

and the new member countries, with 40 percent and 100 percent, respectively, of
any German growth shock transmitted after three quarters.
A related literature examines fiscal policy spillovers within Europe. Bénassy-
Quéré and Cimadomo (2006) generally find positive cross-border spillovers
from Germany, in the sense that a fiscal expansion in Germany raises GDP
abroad, at least in neighboring and smaller countries. Similarly, Beetsma,
Giuliodori, and Klaassen (2005) find that, averaged across all partner countries,
the effect on foreign GDP of a fiscal stimulus in Germany of 1 percent of GDP
is estimated to be 0.12 percent for a spending increase and 0.03 percent for a
net tax cut. In Chapter 6 of this volume, Ivanova and Weber find spillovers of
a similar order of magnitude for fiscal consolidation in Germany, France, the
United Kingdom, and the United States. The authors argue that even when
multipliers are very large, spillovers are limited, in particular from core EU
countries to peripheral countries, since trade links between the two areas are not
very strong.
Few studies have examined the transmission channels of spillovers, that is, the
major international channels through which shocks are propagated. Using model-
based simulation analysis, Helbling and others (2007) find that most of the U.S.
spillover effects are trade-related, and the effects are relatively small, roughly of
the same magnitude as identified in the panel and VAR analyses. To generate
larger effects, alternative simulations need to assume that disturbances are corre-
lated around the world. The authors posit that such correlated disturbances could
be related to increased trade and/or financial integration and could particularly
arise in times of financial crisis.
The simulation results in Bagliano and Morana (2011) also suggest a rela-
tively more important role for the trade channel as a mechanism for transmitting
U.S. economic developments to the rest of the world. Based on a large-scale open-
economy factor VAR macroeconometric model, Bagliano and Morana find no
clear-cut impact of adverse U.S. financial developments on foreign economic
activity. While increases in a U.S. credit spread index lead to an output contrac-
tion abroad, U.S. stock price dynamics do not have any relevant effect on foreign
GDP, and U.S. house price dynamics only affect the non-OECD group. Hence,
the authors of the study conclude that the trade channel appears to be the key
transmission mechanism of U.S. shocks to the rest of the world.
By contrast, Bayoumi and Swiston (2009) find that the largest estimated con-
tributions to spillovers come from financial rather than trade variables. Their
result is based on a comparison of the response of GDP growth in a basic VAR
model to that in a model augmented with a potential spillover source (either
trade, commodity prices, or financial conditions) to measure the contribution of
this source to the estimated spillovers. In particular, short-term interest rates and
financial conditions more generally (bond yields and equity prices) are found to
play an important role in the international transmission of U.S. growth shocks.
Galesi and Sgherri (2009), using a global VAR approach, also report that equity
prices are the main channel through which—in the short-run—financial shocks
are transmitted from the United States to other countries. They find that other

variables—including real credit growth, real GDP growth, and real interbank
rate—become more important over a two-year horizon.
The analysis of cross-country growth spillovers and, more generally, multicoun-
try estimations is generally hampered by dimensionality constraints. Four different
VAR-based approaches have been suggested to tackle this issue:4 Bayesian VARs,
factor model VARs, global VARs, and VARs based on regional groupings. All four
techniques also require an approach for resolving the identification issue.
• The Bayesian VAR approach tackles the problem with the use of priors
about the cross-country correlation patterns, which are subsequently updat-
ed with the data (Banbura et al., 2008, and Canova and Ciccarelli, 2006).
• Factor models, instead, collapse cross-country co-movements of several
variables into common factors that are then allowed to affect the dynamics
of the individual countries (Bénassy-Quéré and Cimadomo, 2006).
• Global VARs reduce the individual countries’ spillovers to their share in a
weighted average for the variable of interest, which then affects the individual
countries’ dynamics.5 The spillover in the global VAR therefore has a direct
interpretation, unlike the spillover in the factor VAR (Bussière, Chudik, and
Sestieri, 2009; Galesi and Sgherri, 2009; and Dees and others, 2007).
• A fourth approach focuses on a small set of countries or regions—usually
two to four—and then uses the traditional structural VAR (SVAR) approach
(Bayoumi and Swiston, 2009; and Danninger, 2008). The degrees of free-
dom are preserved by reducing the number of regressors, that is, by reducing
either the number of countries involved or the number of variables consid-
ered, or a combination of both.
Bayesian VARs and SVARs are more general than global VARs or factor VARs,
since they impose less structure on the inter-linkages. Compared to SVARs,
Bayesian VARs require making more assumptions on the data generating process
in return for more degrees of freedom, which makes the estimation feasible if the
number of regressors is high relative to the size of the available data sample. The
SVAR approach proposed by Bayoumi and Swiston (2009) requires an extensive
dataset, but has the advantage that it imposes no structure on the inter-linkages,
and thus the coefficient estimates are purely data-driven.
Our analysis takes the existing literature further in the following way:
• We confirm the finding of earlier studies, based on the assessment of spill-
overs across regions, that the United States remains the main source of
growth spillovers, using an approach that involves a larger set of 17 indi-
vidual countries.
4
Another possibility is to use model-based simulation analysis. See, for example, the analysis based on
structural estimated macro models using panel unobserved components estimation as suggested by
Vitek (2009 and 2010).
5
Cross-border trade weights are generally used to estimate the country-specific aggregate foreign vari-
able, although one study uses annual bank lending exposures over 1999–2007 (Galesi and Sgherri,
2009).

• We provide a decomposition of countries’ growth rate into the contribu-

tions from domestic and foreign components during the recent crisis and
the recovery process.
• We confirm the importance of financial transmissions channels for growth
spillovers, but find that trade channels are also relevant for several countries.
• A more general distinction made evident by the analysis in this paper is the
distinction between autonomous country demand and transmission of global
demand shocks. Our findings suggest that while spillovers vary positively with
country size, they also reflect the extent to which growth is domestically driven.
This has implications for the extent to which some economies can be consid-
ered engines of global or regional growth or, alternatively, can be considered
transmitters of growth shocks that originate elsewhere.
EMPIRICAL APPROACH
Given our focus on a univariate growth spillover framework, we follow Bayoumi
and Swiston (2009) and minimize the structure we impose on the data. The
resulting coefficient estimates thus capture all potential channels of transmission
of shocks, including both trade and financial channels (the latter of which may
be the most relevant in times of financial crises, when correlations between all
risky assets tend to rise). The main specification is based on a reduced-form VAR
estimation. Identification is obtained by weighting different orderings. The
results from the different orderings can then be summarized by focusing on the
average impulse response. This approach has the additional advantage that it
provides not only a measure of uncertainty regarding the coefficient estimates but
also a measure of uncertainty associated with the variation of responses across
different orderings. The following derivations are reduced to a minimum when
referring to the Bayoumi and Swiston (2009) approach.
Estimation Framework
The general model is given by the following reduced-form model for the growth
rate of output:
B( L ) yt = D( L )x t + et
where the vector y is given by stacking each country’s GDP growth rate ( yi,t):
yt = ( y1,t y i ,t y I ,t )
We consider the following sample of 17 countries: Austria, Belgium, Canada,

Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Portugal, Spain,
Sweden, Switzerland, United Kingdom, and United States. The model is estimated on
quarterly real PPP-adjusted GDP data, from 1975:Q1 to 2010:Q3, from the OECD
Economic Outlook database. The control vector x includes two dummy variables for

the oil shocks in 1979 and in 1990, respectively, and a constant term. When discuss-
ing the results we refer to the baseline regression as the regression which includes
additionally a crisis dummy that takes the value 1 from 2008:Q4–2009:Q1, to reflect
estimates of “normal times,” while the framework without the crisis dummy also
reflects the relationship across growth rates in crisis times.6
Identification is obtained using the Choleski ordering of the countries in the
sample, which provides the structural errors and coefficients:
A(l ) = A(0)−1 B(l ) F (l ) = A (0) D (l )
−1
εt = A(0)−1 et
For the ordering, we distinguish three sets of countries according to their share
in the total sample size, measured in USD PPP-adjusted GDP: Countries that
surpass the 8 percent threshold are considered large countries and can be a leading
country (U.S., Japan, and Germany). Countries that contribute less than 4 per-
cent to the total output are considered small economies (Canada, Netherlands,
Belgium, Sweden, Austria, Switzerland, Greece, Portugal, Ireland, and Finland).
These latter countries are ordered last in the order of their size. Since we focus on
shocks from the major countries to other nations, the ordering for the group of
the remaining smaller countries does not affect the results. The intermediate
group of countries comprises the medium-size countries (United Kingdom,
France, Italy, and Spain). While they are never ordered first, they are generally
ordered before the small countries.
We arrange the orderings roughly according to the respective country’s relative
size. The orderings assign a probability of 50 percent to the United States, being
the lead country (in line with Bayoumi and Swiston, 2009), that is, the country
that is not contemporaneously affected by other countries, and respectively a 25
percent probability to the United States to be ordered second or third. Japan and
Germany are treated symmetrically throughout (although Japan is somewhat
larger than Germany). Germany and Japan both have a chance of being ordered
first, second, or third of 25 percent and a 12.5 percent probability of being
ordered fourth or fifth. The United Kingdom, France, and Italy are also treated
symmetrically, given their comparable average size. Each of these three countries
has a probability of being ordered second or third of 81/3 percent, of being
ordered fourth or sixth of 25 percent, and of being ordered fifth or seventh of
162/3 percent. Spain has a probability of being ordered fifth or sixth of 25 percent
and of being ordered seventh of 50 percent. This size-based procedure results in
48 different orderings, the details of which are provided in the Appendix.
6
Alternative control variables, including the oil and non-oil commodity price indices, U.S. and
German short-term and long-term interest rates, U.S. investment grade and high-yield credit spreads,
German corporate bond spreads, U.S. and German real equity prices, world trade, and Asia trade,
were also included as a robustness check in an earlier version of the analysis. However, none of these
control variables except the U.S. credit spreads and, to a lesser extent, U.S. real equity prices was
significant, and their inclusion left the results unchanged. The impact of the U.S. credit spread, how-
ever, becomes insignificant when included in addition to the 2008–09 crisis dummy, suggesting that
this variable is essentially a proxy for the global financial crisis.

The computation of the standard errors and the ordering uncertainty follow
Bayoumi and Swiston (2009).
Dynamic Growth Contribution

The dynamic contribution is computed by applying to each ordering the follow-
ing algorithm:
Step 1: Determine the structural errors at each point in time using the
Cholesky decomposition.
εˆ t = Aˆ (0)−1 eˆt ∀t ∈T
Step 2: Compute the moving average (MA) representation of the entire history
of each country’s growth rate.
T
yT = ∑ Mˆ (t )εT −t
t =0
Step 3: Create an identity matrix of dimension N and combine the MA repre-

sentation and the structural errors to derive the contribution of the respective
country’s shocks to the quarterly growth rate of GDP of the country under con-
sideration.7
t
Cˆt = ∑ Mˆ (t )I εˆ t −t
t =0
Step 4: Apply the relevant compounding rule to compute the annualized con-
tribution.8
While the ordering of the small countries matters in theory for this exercise,
in practice the ordering of these countries is of minor importance for the decom-
position of the growth contribution, since growth dynamics are dominated by the
larger economies.
A similar calculation applies to the constant term, which allows decomposing
the long-run growth rate into the contributions from the individual countries in
the sample.
Transmission Channels
To gain a better understanding of the transmission channels of the shocks, we
employ a twofold strategy. The first approach uses a counterfactual analysis. We
maintain the estimation framework as outlined above, but contrast the results to
a scenario under which only the direct impact of the shock in country i is allowed

7
Note that yt = Cˆti where i is a column vector of ones, with dimension N in the absence of any
exogenous controls.
8
The rule will depend on whether the dependent variable and the shock are a level variable or a
growth rate.

to affect country j and all spillovers through third countries are prevented. This
provides us with information about the relevance of inter-linkages across coun-
tries for the transmission of shocks. In a second approach, we estimate country-
wise VARs, in which we include real exports as an explanatory variable to test for
the importance of the trade channel.
Counterfactual Analysis
In the counterfactual analysis, we constrain the structural coefficients, which are
associated with third-country effects, to equal zero. Thus, if we are interested in
looking at the direct spillover from country i’s growth shocks to country k’s
growth rate, we set all structural coefficients corresponding to the impact of coun-
try j’s growth shocks on country k equal to zero:9
α kj (l ) = 0
for all l = 0,…,L and all j ≠ i and j ≠ k, where α are the structural coefficients.
Impulse responses are then recalculated under the counterfactual assumptions.
Country-by-Country Regressions
To arrive at a parsimonious specification, we assume the sensitivity to specific
countries to be homogenous within a region and the difference in the slopes
within a group to be random. The United States, Japan, Canada, Sweden,
Switzerland and the United Kingdom comprise the non-European Monetary
Union (non-EMU, or RoW) group, and the rest of the countries constitute the
EMU group. For each country we then run the following regression:
A( L ) yt = et
where the vector y is given by: yt = ( yiRoW

,t yiEMU
,t EXPi ,t yi ,t ) and Yi ,EMU
t is
the growth rate of the output of the EMU area ( Yi ,EMU
t = ∑Yt k ) where k runs
k ≠i
over all EMU members except for country i (when it is an EMU country) and
is the growth rate of the output of the non-EMU group ( Yi ,t = ∑Yt )
RoW j
Yi ,RoW
t
j ≠i
where j runs over all non EMU members except for country i (when it is not an
EMU country).10 While throughout this exercise we keep the ordering as above,
we also allow in a robustness test for different orderings.11 This approach has the
9
This is likely to underestimate the relevance of the third-country effects since it is still possible that
third countries can have a positive feedback to country i and via this to country k. In practice these
are very small.
10
For all EMU members, the RoW shock is identical, while for all RoW members the EMU shock is
identical.
11
In particular, we look at the average response to an EMU and a non-EMU shock ordering
once Yi ,RoW
t
and once Yi ,EMU
t
first. This leaves the point estimates mostly unchanged. Allowing addi-
tionally for the following ordering Yt = ( EXPi ,t Yi ,t Yi ,RoW
t Yi ,EMU
t ) affects the point estimates, but
not the relative magnitude across countries, leaving the interpretations unchanged.

advantage that it provides a more convenient framework to distill the importance of

the trade channel as a transmission channel and reduces the problem of ordering to a
simpler choice. By grouping countries and using the group’s growth rate, we implicitly
allow for an increasing weight of a country as it grows bigger relative to other countries.
To see this, consider the coefficient on the growth rate of the non-EMU variable:
⎛ ∑ Yt j ⎞
⎜ ⎟ = α(0)
I
Yi ,t −1 ⎛ Yi ,t −1 ⎞
∑
j ≠k
α(0) ykRoW = α(0) ⎜ − 1⎟ ⎜ − 1⎟
⎜⎝ ∑ i ≠ k ∑ Y j ,t −1 ⎝ Yi ,t −1
,t j
Yt −1 ⎟ ⎠
j ≠k ⎠ j ≠k
The right-hand version of the coefficient may be conveniently rewritten in the

following form:
I
Yi ,t −1
∑α (0) yi ,t α i ,t (0) = α(0)
∑Y j ,t −1
i ,t
i ≠k
j ≠k
Thus, this model and the baseline estimation are identical under the assump-
tion that α i ,t (l ) = α i ,t −t (l ) = α i (l ) for all l = 1,.., L and all t = 1,..,T for this
model and all α ki (l ) = α k (l ) + vki with E (v ) = 0 and E (vv ) = σ v I in the baseline
model and the extension that the real exports of country k are included as an
additional variable.12
RESULTS
This section provides an overview of the key transmission channels (trade vs. finan-
cial linkages) to help interpret the results, followed by a discussion of the main
results derived from the estimation framework. The first set of results focuses on the
potential impact of spillovers from a one percent growth shock in selected countries
on other European countries. The second set of results presents the actual impact
of selected countries on all other countries in the run-up to, during, and in the
recovery from the recent financial crisis by combining the country-specific shocks
with the impulse response functions. A third and fourth set of results, respectively,
point to the relevance of the different transmission mechanisms of growth shocks
and of different potential determinants of spillover size.
Cross-Border Linkages
To interpret our results on the growth linkages, it is helpful to understand some
key facts about the relative exposures of countries in the sample to the largest
economies and regions. The most obvious channel is trade linkages: a rise in tra-
ding partners’ growth leads to an increase in their demand for imports, which
12
Unsurprisingly, this turns out not to hold, and the aggregation bias causes responses to be more
pronounced (Imbs and others, 2005). Results are discussed in more detail in the respective section.

TABLE 5.1
Exports to Selected Countries and Regions, 2010 (Percent of GDP)

With With
With With Euro United With United With With Rest of
Germany Area1 States Kingdom Japan China World
Austria 12.7 9.3 1.4 1.2 0.3 0.9 13.6
Belgium 16.5 37.0 4.6 6.2 0.8 1.4 20.1
Canada 0.2 0.8 18.4 1.0 0.6 0.8 2.8
Finland 2.9 6.4 2.0 1.4 0.5 1.4 14.0
France 3.2 6.5 1.0 1.3 0.3 0.5 6.8
Germany ... 15.7 2.0 2.4 0.4 1.8 14.2
Greece 0.8 2.2 0.3 0.4 0.0 0.1 3.2
Ireland 4.5 18.2 12.1 8.9 1.1 1.0 9.2
Italy 2.8 6.6 1.2 1.2 0.3 0.5 8.8
Japan 0.4 0.8 2.2 0.3 ... 2.7 7.8
Netherlands 18.8 26.2 2.7 5.6 0.5 0.9 17.7
Portugal 2.8 10.9 0.7 1.2 0.1 0.1 5.4
Spain 1.8 7.9 0.6 1.1 0.1 0.2 5.4
Sweden 3.5 9.9 2.1 2.6 0.4 1.0 13.5
Switzerland 7.2 10.9 3.8 2.2 1.2 1.4 10.6
United Kingdom 1.9 6.5 1.9 ... 0.2 0.4 5.8
United States 0.3 0.9 ... 0.3 0.4 0.6 6.1
Source: Direction of Trade Statistics (DOTS); IMF, World Economic Outlook; and IMF staff calculations.
1
Excluding Germany.
then contributes directly to an increase in the net exports of the home country
(Table 5.1). With growing financial integration and cross-border ownership of
assets, growth spillover effects may also be transmitted through financial linkages
(Table 5.2). Both trade and financial exposures highlight the importance of intra-
euro area transmission channels. For most European countries in our sample, the
euro area as a whole is by far the biggest export market and accounts for the larg-
est single banking sector exposure. The United States is also a key source of
financial spillover risk for European countries. Within the euro area, it is note-
worthy that for most countries (except the smaller trading partners), trade expo-
sures to Germany are relatively smaller than trade exposures to the rest of the euro
area as a whole, reflecting Germany’s relatively limited demand for imports from
other European advanced countries. Several European countries, however, have
large financial exposures to Germany.
Trade exposures follow a strong regional pattern. In particular, they suggest a
limited relevance of Asia for the sample countries (although growing in impor-
tance in the case of China). More specifically, we find that:
• Trade links within Europe are important, as is evident in Table 5.1. The euro
area is the largest export market for member countries in the sample, except
Greece. For the Netherlands and Belgium, exports to the euro area account
for about half of GDP, with a sizeable share (30 to 40 percent) directed to
Germany alone.13 Even for Ireland, which has close trade ties with the
13
This holds also true when controlling for re-exports.

TABLE 5.2
Banking Exposures to Selected Countries and Regions, 2010 (Percent of GDP)1

With With
European Of which: With With Rest
With Developed with Euro United With With United of
Germany Countries2 Area3 States Japan China Kingdom World
Austria 14.1 37.0 ... 4.7 0.4 0.5 5.4 67.1
Belgium 4.1 41.2 ... 8.1 0.2 0.3 8.5 22.0
Canada 1.0 4.3 ... 30.6 0.4 0.3 5.5 10.2
Finland 1.0 6.7 ... 0.2 0.0 0.0 1.0 1.3
France 11.0 54.0 49.4 21.5 6.0 0.8 12.4 23.7
Germany ... 41.2 37.8 15.7 1.7 0.5 14.4 16.6
Greece 1.8 7.1 ... 1.5 0.0 0.0 5.5 30.3
Ireland 21.7 67.2 ... 41.7 5.9 ... 91.0 31.5
Italy 12.9 15.2 14.1 2.1 ... 0.2 2.2 11.7
Japan 3.0 7.1 5.9 24.8 ... 0.7 2.9 5.4
Netherlands 22.0 57.6 ... 32.2 2.1 1.5 16.5 40.9
Portugal 2.0 31.7 ... 3.7 0.0 0.1 3.6 22.4
Spain 3.1 15.8 14.4 3.2 0.1 0.5 14.1 42.8
Sweden 16.3 94.3 ... 9.9 0.1 0.5 8.8 24.1
Switzerland 24.5 53.0 47.6 132.6 15.8 2.7 36.7 56.2
United 8.0 42.5 38.4 48.6 6.5 3.7 ... 62.2
Kingdom
United States 1.6 5.1 4.1 ... 5.1 0.5 4.7 4.4
Source: Bank for International Settlements; IMF, World Economic Outlook; and IMF staff calculations.
1
International bank claims of domestically-owned banks, consolidated - ultimate risk basis.
2
Excluding Germany and the UK.
3
Excluding Germany.
United States, the share of exports going to the euro area exceeds that going
to the United States.
• The euro area is also the largest importer for the United Kingdom and
Switzerland, and the second largest for the United States. However, it is only
the fourth export destination for Japan, which relies more on U.S., Chinese,
and other regional markets.
• Despite its size and reflecting a relatively closed economy, the United States
is generally not the major trading partner for European countries.
• Trade exposures to Japan are even more limited. Trade exposures to China
are also limited (except in the case of Japan), although the growing impor-
tance of China is underscored by the fact that China has now overtaken
Japan in its importance as importer for all sample countries (except Ireland).
• Similar to the United States and Japan, Germany’s relevance as an importer
is relatively limited—including for other eurozone countries. While
Germany is the second largest export destination for Austria and the
Netherlands, it is only at best the third largest export exposure for the other
European countries. These countries export relatively more either to the
non-German euro area as a whole or to the rest of the world (excluding the

euro area, the United States, the United Kingdom, China, and Japan). In
the case of non-euro area countries, exports to Germany account for less
than 0.5 percent of GDP.
Financial linkages single out the United States and Europe, in the aggregate,
as main sources of global spillover risks, while Germany’s importance is mostly
regional. Overall, financial exposures—proxied by bilateral bank lending expo-
sures on an ultimate risk basis—follow a broadly similar regional pattern as trade
exposures, illustrating the relative importance of intra-European linkages:
• For European countries, exposure to European developed countries is the
single largest source of spillover risks, amounting to 30 percent of GDP or
more (except in Finland and Greece).14 For the United States, exposure to
Europe also ranks as the first source of risks; however, relative to GDP many
European countries (including Switzerland, the United Kingdom, France,
Germany, and the Netherlands) have much larger exposures to the United
States than the United States does to Europe.
• Within Europe, some countries have high exposures to Germany of 10
percent of GDP or more (France, Austria, Switzerland, Netherlands,
Ireland, Sweden). By contrast, non-European countries (United States,
Canada, and Japan) have banking exposures to Germany at or below 3 per-
cent of GDP, well below their level of exposures to the United Kingdom in
the case of the United States and Canada.
• For Canada and Japan, financial linkages highlight the key role of the
United States as a source of spillover risks, with European exposure the
second largest source of risk.
• Exposures to Japan are at or below 6 percent of GDP for all countries
(except Switzerland), and exposures to China are below 1 percent of GDP
in most cases (except the United Kingdom, the Netherlands, and
Switzerland).
Country-Specific Outward and Inward Growth Spillovers

We illustrate the potential cross-border spillovers by calculating the maximum
weighted cumulative impulse response of the other countries to a one percent
growth shock in the originating country. Detailed impulse responses of single
countries are shown in the Appendix.
Outward Growth Spillovers

The baseline regression results (full sample, including a dummy for the 2008–09
crisis) suggest that the United States remains the largest source of spillovers to all
countries in the sample. By contrast, Germany plays a minor role for the sample
14
In all cases, except for Greece, Spain, Austria, and the U.K., which also have significant exposures to the
rest of the world (excluding the U.S., Japan, and Europe) and Switzerland (which has the largest single
exposure to the U.S.), European developed countries are the single largest source of banking exposures.

in aggregate, although some smaller European countries are strongly affected by

German growth. The United Kingdom and Japan fall between the two, as do
France, Italy, and Spain. Since the regressions include a crisis dummy, this first set
of results can be interpreted as the “normal” response outside times of crisis.
Regression results for an alternative specification, excluding the crisis dummy,
show much higher outward spillover effects from all regions, supporting the view
that nonstandard transmission channels are at play during times of crisis. Such
channels could include, for example, correlated downturns in asset prices and/or
confidence effects, which amplify the effect of a given growth shock over and above
the standard transmission of shocks through trade and/or lending channels. While
spillovers from all the large countries are found to increase during times of crisis,
the increase is especially pronounced during the recent period for the United
States, the United Kingdom, and the non-German euro area. This could reflect the
fact that the 2008–09 crisis was triggered by the housing correction in the United
States and the United Kingdom, which later affected other countries, like Spain,
where the real estate market was similarly overheated. In contrast, Germany was
not an independent source of shocks during the recent financial crisis.
Estimates for the more recent subsample (1993:Q1–2010:Q3) do not suggest
an increasingly important role of Germany for spillovers to other countries. By
contrast, we find evidence of Italy’s and the United States’ increased importance
for spillovers to other countries in recent years (Figure 5.2).
Looking at disaggregated results within Europe, Germany’s role in generating
outward spillovers appears limited despite the economy’s large size, in part reflect-
ing Germany’s own dependence on growth in the rest of the eurozone (as dis-
cussed in the next section). Germany is particularly sensitive to growth shocks in
the other three large euro area countries (France, Italy, and Spain) and in Japan,
while the United Kingdom is less relevant. France is sensitive to Spain and, to a
lesser extent, to Italy, and is much less sensitive to growth shocks in Germany
than Germany is to growth shocks in France. Italy’s growth reacts relatively simi-
larly to growth shocks in the other three large euro area countries, the United
States, and Japan, but shows little sensitivity to the United Kingdom in normal
times. Spain’s growth is potentially strongly affected by growth shocks in the
United Kingdom and in France (possibly due to Spanish banks’ relatively large
exposures to the United Kingdom) and to a lower extent by growth shocks in
Italy. Germany and Japan generate only minor outward growth spillovers to
Spain, reflecting limited trade and financial linkages.
In particular, there is little support for the view that euro area peripheral coun-
tries could benefit strongly from Germany’s ongoing recovery. The results suggest
that positive growth shocks in France and Italy generate larger spillover effects to
the European periphery. The impact of Germany and other large countries on
Greece, Ireland, and Portugal (GIP) can be summarized as follows:
• Germany plays a less prominent role for the GIP than France and, to a
lesser extent, than Italy. However, this result masks considerable heterogene-
ity in the responses across the GIP. Italy and France appear to have a relevant

2.50
Response by all other countries to a growth shock in...
1993Q1:2010Q3 Excluding crisis dummy

2.00 1993Q1:2010Q3
1975Q1:2010Q3
1.50
1.00
0.50
0.00
United States Japan Germany United Kingdom Rest of EAb GIP
2.50
Response of the GIP to a growth shock in...

2.00
1993Q1:2010Q3
1975Q1:2010Q3
1.50
1.00
0.50
0.00
United States Japan Germany United Kingdom France Italy
−0.50
Figure 5.2 Cumulative Peak Impulse Response after 10 Quarters to a 1 Percent Growth
Shock (In percent)a
a
GDP-weighted average response of other countries.
b
Excluding Germany.
influence on Ireland and Portugal. This is much less the case for Germany.
However, Germany tends to have a higher impact on Greece than Italy does,
but it still has less impact on Greece than France does.
• The United States has much more of an impact on Ireland than on the other
GIP countries, consistent with results in Kanda (2008) and the close trade
and financial linkages between the two countries. The United States also has

a more pronounced impact on Greece and Portugal in the context of the

financial crisis and the more recent episode.
• Japan and the United Kingdom play a relatively minor role for the GIP,
although the United Kingdom’s impact during the crisis was more pro-
nounced.
Finally, the results suggest that potential negative growth spillovers from the
GIP to other countries are limited, although a broadening of the crisis to larger
eurozone countries would have significant real implications. The impact of Greece,
Portugal, and Ireland as a group on other countries appears relatively small, con-
sistent with their modest size. A shock to Spain’s growth, however, has potentially
a much larger impact, particularly on other European countries (see Appendix).
Inward Growth Spillovers

Turning to the sensitivity of the four large euro area members to inward spillovers,
the results underline Germany’s high sensitivity to external shocks. A first set of
estimates from the small-country VARs shows that Germany responds to a
growth shock in EMU countries more strongly than any of the other large EMU
countries and exhibits the second largest response (after Italy) to growth shocks
in non-EMU countries (Figure 5.3). Thus, Germany’s growth is more sensitive to
foreign shocks than is that of other large EMU countries, especially to shocks
originating within the EMU. This is consistent with Germany’s large trade and
banking exposures to the rest of Europe. The result that Germany is highly sensi-
tive to foreign shocks also supports the view that Germany is less of a source of
2 0.7
After 1 year After 10 quarters Large model
1.8
0.6
1.6
1.4 0.5
1.2
0.4
1
0.3
0.8
0.6 0.2
0.4
0.1
0.2
0 0.0
Germany Italy France Spain Germany Italy France Spain
EMU shock Non-EMU shock
Figure 5.3 Sensitivity to a 1 Percent Growth Shock in the Large European Countriesa
Source: IMF Staff estimates.
a
Right axis = weighted impact on growth in percentage points in response to shock under the large model;
left axis = impact on growth in percentage points in response to shock under the small model.

independent spillovers and more of a conduit for U.S. and other external shocks
to the rest of Europe. A second set of estimates from the main baseline estimation
(i.e., large model)15 yields the same rank ordering of sensitivity to external shocks
as the smaller country-specific VARs.16
Regression results for the more recent period (since 1993, based on the large
model) show that inward spillovers from the United States to the four large EMU
member states have increased, while the United Kingdom and Japan have become
less relevant (Figure 5.4). In the baseline estimation, in normal times a 1 percent
growth shock in the United States tends to increase output growth within 10 quar-
ters by about 0.3 percent in Germany, 0.4 percent in Italy and France, and 0.1
percent in Spain. These values increase to 0.4 percent in Germany and Spain, 0.5
percent in France, and 0.6 percent in Italy when not controlling for the effect of
crisis times. The respective values more than double for Germany and Spain, in the
more recent episode (estimation for 1993:Q1–2010:Q3 including a crisis dummy),
as both become more sensitive to the United States than France and Italy.
The increased sensitivity to the United States is in line with the increased cor-
relation of the EMU countries’ GDP growth with the lagged GDP growth of the
United States (Figure 5.1). This reflects rising financial linkages, which have
become more important, particularly in the latter half of the sample period. It is
consistent with similar findings by Helbling and others (2007), who find spill-
overs to be increasing in financial and trade linkages and significantly higher
spillovers from the United States to other countries in the 1987–2006 period as
compared to the entire 1970–2006 period. Since our sample includes years that
mark the peak of financial linkages (2007 and 2008), we find even higher effects.
Within the EMU, inward spillovers from Germany, Italy, and France to the
other large EMU members are relatively stable across the two sample periods and
are robust to the inclusion of the crisis dummy (i.e., likely to persist even outside
of crisis times) (Figure 5.4). Specifically, we find that:
• Germany’s effect on the other three large euro area countries ranges at the
lower end for Spain and France, causing output there to rise by 0.1–0.2
percent, although Italy’s growth rate rises by around 0.4 percent in response
to a 1 percent growth shock in Germany.
• France affects Italy and Germany roughly by the same order of magnitude,
yielding an increase in growth by 0.4 percent in normal times and above 0.5
percent in crisis times. The effect on Spain is only marginally higher.
• A 1 percent growth shock in Italy causes German and French growth to
increase by 0.4 percent and Spanish growth by 0.2 percent in the baseline
15
While estimates from the smaller model are directly obtained for “EMU” and “Non-EMU” shocks,
the corresponding values from the baseline VAR (large model) is obtained by weighting the responses
to the single countries’ shocks which constitute the EMU and the non-EMU group in the country-
specific VARs.
16
However, it should be noted that the small country-specific VARs overestimate the impact, due to
the aggregation bias which tends to increase the persistence of the shocks and thus overestimate the
response.

2.50 Inward Spillovers to Germany from Selected 2.50 Inward Spillovers to France from Selected
Large Countries Large Countries
2.00 2.00
1993Q1:2010Q3 Excl. crisis dummy 1993Q1:2010Q3 Excl. crisis dummy
1993Q1:2010Q3 1993Q1:2010Q3
1.50 1975Q1:2010Q3 1.50 1975Q1:2010Q3
1.00 1.00
0.50 0.50
0.00 0.00
USA JPN DEU GBR FRA ITA ESP USA JPN DEU GBR FRA ITA ESP
−0.50 −0.50
2.50 Inward Spillovers to Italy from Selected 2.50 Inward Spillovers to Spain from Selected Large
Large Countries Countries
2.00 2.00
1993Q1:2010Q3 1993Q1:2010Q3
1.50 1975Q1:2010Q3 1.50 1975Q1:2010Q3
1.00 1.00
0.50 0.50
0.00 0.00
USA JPN DEU GBR FRA ITA ESP USA JPN DEU GBR FRA ITA ESP
−0.50 −0.50
Figure 5.4. Inward Spillovers to the Four Large Euro Area Countries 1993–2010 and 1975–2010
estimation. The effect increases by an additional 0.2 percent for Germany

and France and 0.3 percent for Spain in crisis times. In the more recent
period, Spain’s sensitivity to Italy’s growth shocks has increased to a higher
level than its sensitivity to growth shocks in Germany or France.
• Spain has been an important source of growth shocks for other large euro
area countries. Under the baseline regression for the full sample, a 1 percent
shock to Spain’s growth increases GDP growth in Germany by 0.7 percent,
in France by 0.5 percent, and in Italy by 0.3 percent. This position is reaf-
firmed in the regression for the more recent episode, which shows a general
increase in the importance of Spain’s growth spillovers. In particular, posi-
tive spillovers from Spain have become more important for France and Italy

TABLE 5.3
Long-Run Growth Spillover (1975:Q1–2010:Q3)

Percent spillover from:
Average
USA JPN DEU GBR FRA ITA ESP CAN Others growth
USA 0.4 0.0 –0.2 –0.1 –0.1 0.3 0.1 0.0 3.0
JPN 0.5 –0.1 –0.1 0.0 –0.1 0.5 0.1 0.0 2.2
DEU 0.7 0.6 –0.1 0.1 –0.2 0.6 0.1 0.0 1.5
UK 1.5 0.3 0.0 0.1 –0.1 0.7 0.2 0.0 2.1
FRA 0.8 0.4 –0.1 –0.1 –0.1 0.5 0.2 0.0 1.9
Percent spillover to:
ITA 0.9 0.6 –0.2 –0.2 0.1 0.4 0.2 0.0 1.5
ESP 0.7 0.3 0.0 –0.3 0.1 –0.1 0.2 0.1 2.1
CAN 2.1 0.3 0.0 –0.2 –0.2 –0.1 0.4 0.0 2.7
NLD 1.3 0.3 –0.2 –0.2 0.0 –0.1 0.6 0.2 1.9
BEL 0.7 0.4 –0.1 –0.1 0.1 –0.2 0.5 0.2 –0.1 1.6
SWE 1.4 0.2 0.1 –0.4 0.1 –0.2 0.6 0.2 0.0 2.1
AUT 0.5 0.2 –0.2 –0.1 0.2 –0.1 0.5 0.1 –0.5 1.3
CHE 0.8 0.4 0.0 –0.2 0.2 –0.3 0.5 0.1 –0.1 1.4
GRC 0.8 0.1 –0.3 –0.1 0.3 –0.1 0.8 0.1 –0.3 1.7
POR 0.2 0.5 –0.2 –0.1 0.4 –0.2 0.9 0.2 –0.7 1.7
FIN 1.6 0.4 0.2 0.3 0.3 –0.2 0.7 0.4 0.5 2.8
IRL 2.3 0.1 –0.1 0.2 0.2 –0.2 1.1 0.4 –0.7 3.6
Note: USA: United States; JPN: Japan; DEU: Germany; GBR: United Kingdom; FRA: France; ITA: Italy; ESP: Spain; CAN: Canada.
in recent years, consistent with the increase in trade and financial integra-
tion following EMU and euro adoption as well as with a domestic demand
and property boom in Spain, both partly fuelled by unsustainable increases
in corporate and household indebtedness.17
Domestic and Foreign Growth Contributions in Crisis

and Recovery
While the impulse responses measure the potential impact of growth spillovers
across countries, they do not provide insight into the actual effect of idiosyn-
cratic growth shocks originating in one country on other countries over time. The
latter reflects both the size of the impulse response and the country-specific
growth shock in the originating country. We investigate this question using a
decomposition of the individual countries’ growth rates into the contribution
from other countries over time. The results are summarized in Table 5.3, which
provides estimates of the G7 individual countries plus Spain’s contribution to the
other countries’ growth in the long run (i.e., in the absence of idiosyncratic
shocks), and in the next series of graphs (Figure 5.5), which show the evolution
17
While the subsequent deflation of the property bubble and private sector deleveraging has resulted
in negative dynamic contributions of Spain to other countries’ growth during the 2008–09 global
recession, we find that on average, over the long run, Spain has been one of the major sources of
positive growth spillovers to other countries, especially in Europe (see section D). However, the poten-
tial positive impact of Spain in future episodes could be lower than suggested by historical results if
the unwinding of Spain’s imbalances is protracted and durably undermines Spain’s growth prospects.

20 20 20
−10
−8
−6
−4
−2
0
2
4
6
8
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0
2
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8
20
–10
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2
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05 05
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0
2
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8
05 05
:Q :Q
: 20 1 20 1 20 :Q1
20 Q1 05 05
05 05 :Q
: :Q
: 20 Q3 20 3 20 3
20 Q3 06 06 06
06 :Q :Q :
: 1
ITA
1 20 20 Q1
own
20
CAN
20 Q1 06 06
06 06 :Q :Q
: :Q 3 20 3
20 Q3 20 3 20
07
07
07 07
: : :
: 20 Q1 20 Q1 20 Q1
20 Q1 07 07 07
07 :Q :Q :Q
: 3 3
JPN
3 20 20
GBR
20
Italy
20 Q3 08 08
Austria
08 08 : :Q
Germany
: : 1
Long-run
20 Q1 20 Q1 20
20 Q1 08 08
08 08 :Q :Q
United States
:Q :Q 3 3
20 3 20 3 20
09
20
09
09 09 : :
: : 20 Q1 20 Q1
20 Q1 20 Q1 09 09
09 09 : :
FRA
ESP
: : 20 Q3
others
20 Q3 20 Q3
20 Q3 10 10
10 10 :Q :Q
: :Q 1 20 1
20 Q1 20 1 20
10
10 10 10
:Q :Q :Q
:Q
3 3 3
3
USA
DEU
20 20
20
20
–10
–8
–6
–4
–2
0
2
4
6
−15
−10
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0
5
10
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0
2
4
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8
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0
2
4
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8
05 05
05
: 05
Growth rate
:Q
20 Q1 20 :Q1
1
20 20 :Q1
05 05 05 05
: :Q :Q
20 Q3 20 :Q3 20 3 20 3
06 06 06 06
: : : :Q
20 Q1 20 Q1 20 Q1 20 1
06 06 06 06
: :Q :Q :Q
20 Q3 20 3 20 3 20 3
07 07 07 07
: : :
Figure 5.5 Growth Contribution in Crisis and Recovery (Percent)

20 Q1 20 Q1 : 20 Q1
20 Q1
07 07 07 07
: :Q :Q :Q
20 Q3 20 3 20 3 20 3
France
08 08 08 08
: :Q Finland :Q :Q
Netherlands
20 Q1 20 1 20 1 20 1
Japan
08 08 08 08
: :Q :Q :Q
20 Q3 20 3 20 3 20 3
09 09 09 09
: : : :
20 Q1 20 Q1 20 Q1 20 Q1
09 09 09 09
:Q : : :
20 3 20 Q3 20 Q3 20 Q3
10 10 10 10
: :Q :Q :Q
1 1

20 Q1 20 20 1 20
10 10 10 10
:Q :Q :Q :Q
3 3 3
Poirson and Weber
3
119
20 20
120
0
2
4
6
8
-8
-6
-4
-2
–10
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2
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2
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2
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20 20 20
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0
2
4
6
8
05 05 05 05 05
:Q :Q :Q : :
20 1 20 1 20 1 20 Q1 20 Q1
05 05 05 05 05
:Q :Q : :
States.
20 3 20 3 :Q
06 06 20 3 20 Q3 20 Q3
Figure 5.5
06 06 06
:Q :Q :Q : :
20 1 20 1 20 1 20 Q1 20 Q1
06 06 06 06 06
:Q :Q :Q : :
20 3 20 3 20 3 20 Q3 20 Q3
07 07 07 07 07
:Q :Q :Q : :
20 1 20 1 20 1 20 Q1 20 Q1
07 07 07 07 07
:Q :Q :Q : :
20 3 20 3 3 20 Q3 20 Q3

20
(continued)
08 08 08 08 08
Greece
:Q : :
Portugal
:Q :Q
1 1
Spain
20 20 1
Sweden
20 20 Q1 20 Q1
08 08 08 08 08
:Q :Q :Q : :
United Kingdom
20 3 20 3 20 3 20 Q3 20 Q3
09 09 09 09 09
:Q :Q :Q :Q :
20 1 20 1 20 1 20 1 20 Q1
09 09 09 09 09
:Q :Q :Q : :
20 3 20 3 20 3 20 Q3 20 Q3
10 10 10 10 10
:Q :Q :Q : :
20 1 20 1 20 1 20 Q1 20 Q1
10 10 10 10 10
:Q :Q :Q :Q :Q
3 3 3 3 3
20 20 20
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:Q :Q : :
1
Growth Spillover Dynamics: From Crisis to Recovery
20 20 1 20 Q1 20 Q1
05 05 05 05
:Q :Q : :Q
20 3 20 3 20 Q3 20 3
06 06 06 06
:Q :Q : :
20 1 20 1 20 Q1 20 Q1
06 06 06 06
:Q :Q : :
20 3 20 3 20 Q3 20 Q3
07 07 07
ITA
:Q 07 : :
own
JPN
CAN
GBR
20 1 :Q 20 Q1 20 Q1
07 20 1 07 07
07 : :
Long-run
:Q :Q
20 3 20 3 20 Q3 20 Q3
08 08 08
Ireland
:Q 08 : :
20 1 :Q 20 Q1 20 Q1
20 1 Belgium
Canada
08 08 08 08
:Q :Q :Q
Switzerland
20 3 :Q 20 3 20 3
09 20 3 09 09
09 : :
FRA
ESP
:Q
USA
DEU
1 :Q
others
20 20 1 20 Q1 20 Q1
09 09 09
:Q 09
:Q : :
20 3 20 Q3 20 Q3
Growth rate
10 20 3 10 10
:Q 10
:Q : :
20 1 1
20 Q1 20 Q1

10 20 10 10
:Q 10 :Q :Q
3 :Q 3 3
3
Note: CAN: Canada; DEU: Germany; ESP: Spain; FRA: France; ITA: Italy; JPN: Japan; GBR: United Kingdom; USA: United
of the growth rate from 2005:Q1 to 2010:Q3 for all countries in the sample,
splitting a country’s growth rate into its own contribution (light grey bar), the
cyclical contribution stemming from each G7 member and Spain, and the long-
run growth rate (dark grey bar). The height of the individual bars represents the
overall contribution at each moment in time.
We first examine the long-term impact of each country on the other countries
in the sample. The long-run decomposition in Table 5.3 shows that the United
States has been the largest positive contributor to long-term growth in other
countries. The United States matters particularly for the Anglo-Saxon countries
and the smaller Northern European countries. Long-run spillovers from Japan
and Spain have also been positive and relatively important, with Spain more
relevant for European countries. Canada and France provide relatively minor
long-run growth support to other countries, although spillovers from France are
particularly relevant for the GIP. By contrast, long-run external growth spillovers
from Germany are close to zero, and the United Kingdom and Italy’s long-run
spillovers have been small and negative. In the case of Italy, this reflects rela-
tively weak GDP growth over the period (similar to Germany), while the result
for the United Kingdom could reflect the United Kingdom’s dependence on
U.S. prospects.
The dynamic contribution analysis—focusing on the recent period, including
the global financial crisis—highlights for all countries the dominant contribution
of external growth shocks and the relatively low contribution of domestic shocks
to overall GDP growth. This is particularly true for the smaller open economies
such as the Netherlands, Austria, Belgium, and Finland. Even for the United
States, the results suggest that synchronized downturns in Japan and the European
advanced countries contributed to amplify the depth of the U.S. recession in
2008–09. The finding that external spillovers have been large and significant in
the recent period may be regarded as supporting the appropriateness of the
model, since it implies that the model captures most of the likely sources of
global growth spillovers and thus generates a limited idiosyncratic error compo-
nent, which in turn implies a relatively high explanatory power.18
Turning to a finer analysis of growth contributions pre-, during, and post-
crisis, the main findings are as follows:
• The boom period before the crisis is reflected in the significant domestic
contribution to each country’s GDP growth, which cannot be accounted for
completely by growth fluctuations in other countries. In terms of outward
spillovers, the United States and Spain have been major sources of positive
growth support in the precrisis period, with the United States mattering
most for Canada, the United Kingdom, and Ireland. France played an
important role for some countries in the run-up to the crisis, notably the
southern peripheral countries, as well as Belgium, Austria, and Finland.
18
The average (adjusted) R-squared value of the reduced form equations for the baseline model is
around 0.6 (0.4). Including the crisis dummy implies an increase by 0.04 in explanatory power in
both cases.

Germany initially weighed negatively on most countries’ growth, but in the

latter half of the precrisis period contributed positively, in particular to GDP
growth in the Netherlands, Italy, Greece and Austria—although at lower
levels than was the case for the contributions from the United States, Spain,
Italy, or France. Italy and the United Kingdom have contributed negatively
to growth in other European countries in the years preceding the crisis.
• During the crisis, large negative domestic contributions to growth are
observed in Italy, the United States, Japan, Sweden, Ireland, the United
Kingdom, and since the first quarter of 2010 in Greece. Japan has generated
negative spillovers for virtually all countries in the sample, reducing German
output growth by over 1.5 percentage points, Italian growth by 1.4 percent-
age points, and U.S. growth by 1.2 percentage points. The effect on other
countries has been less strong. Similarly, the U.S. shock has affected growth
in almost all countries in 2009, with the strongest effect on Anglo-Saxon
countries—Canada and Ireland (−2 percent) and the United Kingdom
(−1.5 percent)—but also significant effects on European economies led by
the Netherlands (−1 percent). Italy also had a strong negative spillover effect
during the crisis on several European countries, most severe for Switzerland
but also significant for growth in the peripheral countries. Germany’s nega-
tive external spillovers have dragged down growth primarily in neighboring
countries, with the strongest impact on the Netherlands. The United
Kingdom has primarily been relevant for Finland, Sweden, Spain, and
Ireland, dragging down GDP growth in these countries especially toward
the later part of the crisis.
• The recovery, in turn, is led by the United States and Japan, which account for
most of the countries’ positive external support to growth in 2010 (through the
third quarter).19 This is supported by additional positive domestic growth
momentum in Germany, France, Canada, Switzerland, and Sweden. By con-
trast, the recovery has been hampered by continued negative domestic growth
contributions in Italy, Spain, and Ireland, and by falling dynamic support from
domestic demand in the Netherlands, Greece, and Portugal.
Both the analysis of growth contributions and the impulse response functions
yield broadly similar conclusions. However, the former provides a more nuanced
description of the spillovers by quantifying how growth contributions change
over time in terms of their magnitude and the relevance of individual countries.
It also confirms the role of the United States and Japan as important sources of
spillovers on a global scale, while Spain is primarily relevant for Europe. France,
Italy and Germany are also relevant on a European-wide scale, although their
impact appears to be regionally concentrated, focused on the smaller neighbors in
the case of Germany and concentrated on southern European countries in the
19
While the cyclical contributions of U.S. and Japan growth dynamics on other countries are gener-
ally small, both countries provide the bulk of the long-run growth rate support.

case of France and Italy. The United Kingdom in turn appears mostly relevant for
the northern European economies and for Spain.
CHANNELS OF GROWTH SPILLOVER TRANSMISSION

The pattern of spillovers identified in the previous two sections hinges on the
relevance of regional linkages, consistent with the regional dimension of cross-
border linkages highlighted in Section B. This section attempts to quantify the
importance of trade as a transmission mechanism for growth spillovers, based on
country VARs that include real exports as an additional variable. We also seek to
shed light on the shock transmission mechanisms underlying the outsized impact
of the United States and Japan on advanced European countries by presenting
empirical evidence on the size of third-country transmission effects based on
counterfactual analysis. While financial channels are not directly analyzed in this
study, both the finding that third-country effects tend to be larger during times
of financial distress and the finding that trade effects play only a limited role in
the international transmission of shocks to European countries suggest that an
analysis of financial channels would be a fruitful avenue for future research.20
Third-Country Transmission
In a first approach, we analyze the extent to which third-country effects are relevant
for the transmission of shocks. In particular, we identify the countries most directly
affected by global shocks versus those primarily affected by shocks through third-
country effects and that therefore tend to be affected only with a lag. Further, if third-
country effects are important, countries less relevant as a source of shocks may still
play a central role as transmitter and amplifier of shocks to other countries, through
either trade or financial linkages, and therefore they matter on a systemic level.
The relevance of third-country effects is calculated as the fraction of the inward
spillover from a shock in a given country that is transmitted through other coun-
tries after one year. The lower this indicator of third-country effects, the more
directly sensitive the country is to the impact of a given external shock. Conversely,
the higher the indicator, the more likely it is that the country will only respond
after a lag, since the entire spillover effect needs more time to trickle down through
trade or financial channels. Since the measure of third-country transmission is only
meaningful in cases where a significant impact is observed, we calculated third-
country effects only for such constellations.
20
In an earlier version of the paper, we attempted to test for the relevance of financial transmission
channels by following the approach of Bayoumi and Swiston (2009), i.e. by including global financial
variables (such as the U.S. equity prices, interest rates, and U.S. and German credit spreads) as addi-
tional control variables. The U.S. credit spread was found to be the most significant variable, with an
impact similar to that of including the crisis dummy (i.e. reducing estimated outward spillovers from
the U.S. and other large countries); however, the spread variable had not statistically significant effect
once the crisis dummy is also included, suggesting that this channel of transmission is only relevant
during times of crisis.

Germany stands out as a country that tends to respond swiftly and directly to
shocks to growth in the United States or Japan. For France, Italy, and the small core
euro area members, similar shocks are channeled to a larger extent through third
countries before they impact growth in the home economy. The relatively high
values of the third-country indicator for the non-German euro area suggest that
inter-linkages between euro area countries are highly relevant in the transmission of
shocks to Europe from outside the euro area. Combined with the relative directness
with which Germany reacts to shocks in the United States and Japan, this finding
suggests that Germany acts as an important transmitter and amplifier of shocks
originating outside the euro area to other euro area members (Figure 5.6).
When looking at the relevance of third-country effects for intra-European
shocks, the regional patterns are again noticeable. Growth shocks from Italy and
Spain affect Dutch growth primarily through third countries, while growth
shocks from Germany affect Dutch growth mostly directly and hardly at all
through third countries. Switzerland’s growth is directly affected by growth
shocks in Italy, and Belgium’s growth is most directly affected by French growth
shocks. Austrian growth is most directly affected by France and Germany, less
directly by Italy, and least by Spain. Italy’s growth is most directly affected by
Germany followed by France and then Spain (Figure 5.7).
Interestingly, Germany’s impact on Greece and Portugal appears to be less
direct than the impact of France and Italy on these two countries, which is com-
parable to the impact of Spain on Portugal. This confirms the relevance of France
and Italy for the southern peripheral countries. Finally, it is worth noting that in
120
United States
Japan
Average over United States and Japan
100
80
60
40
20
0
Germany France Italy Netherlands, Belgium,
Austria, and Finland
Figure 5.6 Relative Importance of Third-Country Effects for Inward Spillovers to

Selected European Countries from the United States and Japana
a
Based on the regression incling no crisis dummy. Incling the dummy causes all value to drop slightly.
Netherlands, Belgium, Austria, and Finland refers to the GDP PPP weighted average response. PPP: pur-
chasing power parity.

100 From Italy to...

90 No crisis
80
70 Crisis
60
50
40
30
20
10
0
GRC CHE FRA SWE PRT DEU NLD BEL AUT ESP
100 From France to...
90
No crisis
80
70 Crisis
60
50
40
30
20
10
0
DEU SWE BEL GRC PRT AUT CHE ITA FIN ESP IRL
100 From Germany to...
90 No crisis
80
Crisis
70
60
50
40
30
20
10
0
NLD AUT ITA GRC FIN PRT FRA BEL
100 From Spain to...
90 No crisis
80 Crisis
70
60
50
40
30
20
10
0
FRA IRL CHE GRC DEU SWE PRT BEL NLD AUT ITA
Figure 5.7 Relative Importance of Third-Country Effects for Spillovers from the Four Large
European Countries to Selected European Countries
Note: AUT: Austria; BEL: Belgium; CHE: Switzerland; DEU: Germany; ESP: Spain; FIN: Finland; FRA: France;
GRC: Greece; IRL: Ireland; ITA: Italy; NLD: Netherlands; PRT: Portugal; SWE: Sweden.
crisis times, third-country effects appear to play a larger role, confirming earlier
results on the importance of confidence and asset-price spillover effects during
times of financial distress.21
21
Although the VAR modeling framework does not allow testing directly for asymmetry in the pattern
of spillovers, the importance of third-country effects during times of financial distress could explain
why negative spillovers originating during a crisis tend to be empirically larger than either positive or
negative spillovers outside of crisis times: unlike “normal” spillovers, “crisis” spillovers tend to be
amplified to a greater extent by confidence and asset price effects.

An important caveat to the counterfactual analysis should be noted. It is sub-

ject to the Lucas (1976) critique in the sense that the deep parameters underlying
the reduced-form estimates are likely to be different under the counterfactual
scenario. However, several authors have argued that the change in the deep
parameters may be too small to have a major implication for the reduced-form
estimates of the VAR in the context of various policy changes.22 Nevertheless, this
problem may be somewhat reflected in certain estimates of the relevance of third-
country effects in our simulations, such as in the rather low role of third-country
effects for the transmission of Italian shocks to Sweden.
Trade Channel Transmission
The second counterfactual analysis is based on the small-country VAR specification,
which reduces the variables of interest to four variables. The estimation is repeated
for each country in the sample, in the case of both EMU and non-EMU shocks.
The results shown for the four largest countries in the euro area highlight in
all cases the dominance of non-trade channels, especially for shocks originating
within the EMU.
The finding that trade is relatively less important as a transmission mechanism
for inward spillovers is somewhat surprising, given the high degree of trade links
within the EMU. This result, however, is consistent with the increased relevance
of monetary and credit channels and other links that are crucial within a mone-
tary union but not between two currency blocks.23
Compared to other large EMU members, Germany exhibits the highest reli-
ance on trade effects for inward growth spillovers, with a share of growth spill-
overs from non-EMU countries’ shocks due to trade of close to 40 percent. The
respective value for France is around 30 percent, for Spain 15 percent, and for
Italy only 10 percent. A similar pattern emerges for EMU shocks, although
France appears to rely on trade effects proportionally more than Germany for
EMU shocks. However, France’s overall sensitivity to shocks in the EMU is far
below the sensitivity of Germany (Figure 5.8).
Not surprisingly, trade accounts for around 50 percent of the spillovers for the
small open economies such as Belgium, Sweden, Austria, and Ireland in the case
of non-EMU shocks. For EMU shocks, the respective values for Austria and
Belgium drop by about 20 percentage points and for Sweden by about 40 per-
centage points, though for Ireland there is only a minor drop of 5 percentage
points. It therefore remains the case for smaller economies in Europe that trade
effects are more relevant for non-EMU shocks than for EMU shocks.
Determinants of Spillover Size
This section analyzes the extent to which the size of outward spillovers originating
in a given country is related to the economy’s size (measured by PPP-adjusted
22
See for instance Rudebusch (2005) for the case of monetary policy.
23
See Vitek (2010) for model simulation-based evidence of a strong transmission of supply shocks via
non-trade channels in a monetary union.

1.8 In response to an EMU shock 1.6 In response to a non-EMU shock

1.6 1.4
Trade channel Trade channel
1.4 Non-trade channel Non-trade channel
1.2
1.2
1
1
0.8
0.8
0.6
0.6
0.4 0.4
0.2 0.2
0 0
Germany Italy France Spain Germany Italy France Spain
Figure 5.8 Relative Importance of Trade Channel for Inward Spillovers for Large EMU Members
Note: EMU: Austria, Belgium, Finland, Greece, Ireland, Netherlands, Portugal, and Spain.
GDP) and to the existence of autonomous domestic drivers of growth. While size
is a natural a priori determinant of spillovers, we also conjecture that countries
that are relatively more sensitive to external shocks are more likely to receive large
inward spillovers but less likely to generate large outward spillovers; by contrast,
countries that rely more on domestic drivers of growth are more likely to generate
large outward spillovers.
To identify the presence of autonomous sources of domestic demand growth,
we look at two dimensions: (i) the average contribution of trade to GDP, and (ii)
the co-movement of GDP growth and net exports. The former gives us an indi-
cation of the relevance of the external sector for overall GDP growth. The latter
helps us to understand whether GDP growth and net exports move in tandem
or whether net exports and GDP growth move in opposite directions. In the
latter case, a country is a potential spillover risk (positive or negative) for other
countries, since its growth relies to a greater extent on autonomous domestic
demand fluctuations, while in the former the country is more likely to import
spillovers through trade and other links, and possibly re-export them to others
by serving as a third-country transmitter rather than acting as an independent
engine of growth.
Countries that exhibit a positive average net contribution of trade to GDP
include Japan, Germany, Netherlands, Belgium, Sweden, Austria, Switzerland,
Finland, and Ireland; those that do not include the United States, the United
Kingdom, France, Italy, Spain, Canada, Greece, and Portugal (Table 5.4).24 In
terms of relevance of external demand for overall GDP growth, Germany is the
leading country, followed by Ireland, Switzerland, Japan, Austria, Sweden,
Finland, Belgium and the Netherlands. In the last decade, exports have become
the major engine of growth for Japan, Austria, and particularly for Germany.
Regarding the co-movement of external demand and GDP growth, the coun-
tercyclical pattern of domestic and external contribution to growth indicates the
24
Note that this concept is not identical to whether a country is a net exporter or net importer, since
it refers to the change in the net trade position rather than the level.

greatest spillover risk is in the case of the United Kingdom, the United States,
Canada, Spain, Portugal, and Greece (Table 5.5). These countries have a high
negative correlation between the contribution of domestic and external demand
and a high positive correlation between domestic demand and GDP. This represents
TABLE 5.4
Contribution of Domestic and External Demand to GDP Growth (1996:Q1–2010:Q3)a

Due to External demand
Average GDP in percent of GDP
growth rate Domestic demand External demand growth
United States 2.6 2.8 –0.2 –7.3
Japan 0.7 0.5 0.2 49.0
Germany 1.2 0.7 0.4 59.8
United Kingdom 2.2 2.5 –0.2 –8.9
France 1.7 2.0 –0.3 –12.9
Italy 0.9 1.2 –0.3 –22.4
Spain 2.9 3.4 –0.5 –14.1
Canada 2.6 3.2 –0.5 –16.6
Netherlands 2.3 2.1 0.2 11.6
Belgium 1.9 1.6 0.2 13.8
Sweden 2.5 2.1 0.4 21.2
Austria 2.1 1.5 0.6 37.5
Switzerland 1.6 1.1 0.5 49.3
Greece 2.8 2.9 –0.1 –3.8
Portugal 1.8 2.3 –0.5 –20.9
Finland 2.9 2.6 0.4 15.8
Ireland 4.3 2.8 1.6 57.9
Sources: Eurostat; national authorities; and IMF staff calculations.
a
Due to rounding and statistical discrepancies, values do not necessarily add up.
TABLE 5.5
Correlation of Contributions with GDP Growth (1996:Q1–2010:Q3)

Correlation Between
Domestic and external External and GDP Domestic and GDP
United States –0.9 –0.8 1.0
Japan 0.3 0.6 0.9
Germany 0.0 0.7 0.7
United Kingdom –0.8 –0.6 1.0
France –0.4 –0.1 0.9
Italy 0.1 0.4 0.9
Spain –0.9 –0.8 1.0
Canada –0.6 0.1 0.7
Netherlands –0.2 0.1 1.0
Belgium 0.0 0.4 0.9
Sweden 0.1 0.5 0.9
Austria 0.5 0.8 0.9
Switzerland 0.1 0.8 0.6
Greece –0.9 –0.6 0.9
Portugal –0.8 –0.6 0.9
Finland 0.4 0.7 0.9
Ireland –0.5 –0.3 1.0
Source: Eurostat; national authorities; and IMF staff calculations.

a pattern under which high domestic demand drives growth and worsens the
net trade position due to increased domestic demand.
Germany, Japan, Austria, and Finland illustrate the opposite, export-driven
growth pattern (Table 5.5). These countries exhibit a positive correlation between
the external contribution to growth and GDP and a positive correlation between
the domestic contribution and the external contribution to GDP. Higher external
demand accelerates growth, which in turn stimulates domestic consumption and
investment. For the Netherlands, Sweden, France, and Belgium, the patterns
appear less pronounced according to these indicators.
Plotting the correlation between external contribution to growth and GDP
against the weighted outward spillovers from the main (baseline) regression, we
find that the link between the presence of domestic drivers of growth and the
relevance of a country as a source of growth spillovers to other countries is con-
firmed.25 While we also find evidence of a positive relationship between a coun-
try’s size and the estimated outward spillover, the presence of clear outliers such
as Canada and Spain (larger spillovers than predicted by size alone), or Germany
(smaller spillovers than expected based on size) suggest that size alone fails to
explain spillover risk (Figure 5.9).
0.60 External Contribution to Growth and Size of Growth 0.6 Economic Size and Size of Growth
Growth spillover, 1975:Q1–2010:Q3, percent
Growth spillover, 1975:Q1–2010:Q3, percent
Spillovers Spillovers
0.50 0.5
Canada Canada
0.40 USA 0.4 USA
Spain Spain
0.30 0.3
Italy Italy
0.20 UK Japan 0.2 UK Japan

Belgium
France Belgium France
Sweden Sweden Germany
0.10 Germany 0.1
Switzerland
Switzerland Austria
R² = 0.494 Netherlands Austria Netherlands R² = 0.3315
0.00 0
−1.00 −0.50 0.00 0.50 2.2 2.7 3.2 3.7 4.2
Correlation between external contribution and growth Economic Country Size, log (GDP, PPP US dollar)
Figure 5.9 Correlation of Outward Spillovers, Size and Export-Driven Growth, Selected
Countries
25
The relationship also holds when excluding the crisis dummy. Regressing the size of the outward
spillover on a constant, the log size of the country, and the correlation between GDP growth and the
external contribution to growth yields a positive significant effect for the former and a negative sig-
nificant effect for the latter. Increasing the size of the country by 10 percent increases the outward
spillover by 0.1 percentage points, and reducing the correlation of external demand and GDP growth
from +0.5 to −0.5 increases the size of outward spillovers by 0.14 percentage points. The smallest four
counties are excluded from the graph. While Finland confirms the pattern, Greece, Portugal and
Ireland are too small to generate significant growth spillovers.

CONCLUSION
The divergent growth recovery paths in Europe in the aftermath of the 2008–09
financial crisis have brought the question of growth spillovers again to the fore-
front, since spillovers from faster growing countries could provide positive growth
impetus to the slower growing countries, whose recovery is hampered by domes-
tic demand constraints. Furthermore, against the background of renewed sover-
eign debt concerns in the euro area, negative growth shocks originating in the
crisis countries could spill over to other countries through trade linkages or
extensive cross-border asset ownership.
Our empirical analysis suggests that growth spillovers can indeed explain a
significant fraction of the variation in output growth for some euro area members,
in particular the small open economies. In terms of spillover origins, we find that
the United States remains the key source of growth spillovers in this recovery.
Despite the increased correlation of Germany’s GDP growth with several other
countries’ GDP growth, its spillover impact remains primarily confined to its
smaller neighbors, while France and Italy are more relevant for the southern
peripheral countries. Both Japan and Spain also appear to be significant sources
of potential growth spillover risk to European countries, although the positive
spillover impact of Spain in future episodes could be much smaller than indicated
by our results if domestic demand growth is persistently hampered by the ongo-
ing unwinding of longstanding imbalances. To some extent, a similar caveat
applies to the U.S. results in light of uncertainties surrounding the sustainability
of the current U.S. recovery.
Our analysis of transmission channels suggests that trade channels matter rela-
tively less than financial and other non-trade channels. Trade effects seem to mat-
ter relatively more for Germany’s inward spillovers, compared to other large euro
area countries, reflecting Germany’s relatively high trade exposures. For all euro
area members, we find that growth shocks from outside the EMU are more likely
than those originating within the EMU to be transmitted through trade; those
originating within the EMU appear to be predominantly transmitted through
monetary and financial linkages. We fail to find an increasingly important role for
Germany as an independent source of growth shocks in the euro area in recent
years, which reflects the country’s relatively high sensitivity to external shocks.
Finally, the results suggest that growth spillover risks from the European crisis
countries to the rest of Europe remain limited, although stronger effects could be
expected if the debt crisis were to spread to larger countries, such as Spain.
Our results are consistent with the premise that for countries to be an impor-
tant source of growth spillovers, their growth should rely to a greater extent on
autonomous domestic sources. Germany fails to meet these criteria, since it is
more sensitive to growth shocks in other countries than other large advanced
countries and its GDP growth tends to closely follow the performance of its
external sector. However, consistent with the view that Germany’s imports are
very sensitive to demand for German exports (due to the high import content
of German exports), our results suggest that Germany may be acting as an

important “third country” or transmitter of shocks, since it is more directly

affected by external growth shocks than other large euro area countries and third-
country effects are found to account for much of the transmission of external
shocks to the other euro area members.
While our results appear to be robust across variations of the sample and carry
over to estimates restricted to the more recent period, some caveats remain. First,
we cannot infer much about the role that the sample countries might play for other
countries, which are not included in the sample. Second, the analysis is backward
looking and does not allow for time-varying relationships between the countries.
And third, our approach does not allow us to uncover the particular source or
nature of the country-specific shock, masking potential variations stemming from
supply as opposed to demand shocks which stand behind the growth shocks. All
three caveats provide an interesting avenue for future research. Another worthwhile
avenue for future research would be to explore the financial transmission channels
that likely underlie the finding that both spillover estimates and third-country
effects tend to become larger for most countries during periods of financial distress.
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APPENDIX
TABLE 5A.1
Size-Based Ordering of Spillovers between Countries

(From left to right, in order of independence from other regions1)
DEU JPN USA FRA GBR ESP ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU JPN USA FRA ITA ESP GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU JPN USA GBR FRA ESP ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU JPN USA GBR ITA ESP FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU JPN USA ITA FRA ESP GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU JPN USA ITA GBR ESP FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA JPN DEU GBR ESP ITA FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA JPN DEU ITA ESP GBR FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA JPN DEU FRA ESP ITA GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA JPN DEU GBR ESP FRA ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA JPN DEU ITA ESP FRA GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA JPN DEU FRA ESP GBR ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN DEU USA FRA GBR ESP ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN DEU USA FRA ITA ESP GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN DEU USA GBR FRA ESP ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN DEU USA GBR ITA ESP FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN DEU USA ITA FRA ESP GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN DEU USA ITA GBR ESP FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA DEU JPN GBR ESP ITA FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA DEU JPN ITA ESP FRA GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA DEU JPN FRA ESP ITA GBR CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA DEU JPN GBR ESP FRA ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA DEU JPN ITA ESP GBR FRA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA DEU JPN FRA ESP GBR ITA CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN USA FRA DEU ITA GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN USA FRA DEU GBR ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN USA ITA DEU GBR FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN USA ITA DEU FRA GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN USA GBR DEU ITA FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
JPN USA GBR DEU FRA ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU USA FRA JPN ITA GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU USA FRA JPN GBR ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU USA ITA JPN GBR FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU USA ITA JPN FRA GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU USA GBR JPN ITA FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
DEU USA GBR JPN FRA ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA FRA DEU GBR JPN ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA FRA DEU ITA JPN GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA FRA JPN GBR DEU ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA FRA JPN ITA DEU GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA GBR DEU FRA JPN ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA GBR DEU ITA JPN FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA GBR JPN FRA DEU ITA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA GBR JPN ITA DEU FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA ITA DEU FRA JPN GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA ITA DEU GBR JPN FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA ITA JPN FRA DEU GBR ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
USA ITA JPN GBR DEU FRA ESP CAN NLD BEL SWE AUT CHE GRC PRT FIN IRL
Note: AUT: Austria; BEL: Belgium; CHE: Switzerland; DEU: Germany; ESP: Spain; FIN: Finland; FRA: France; GBR: United
Kingdom; GRC: Greece; IRL: Ireland; ITA: Italy; NLD: Netherlands; PRT: Portugal; SWE: Sweden.
1
Each line corresponds to a different country ordering.

134
1.6 1.6
DEU FRA 1.8 USA
1.1 1.1
1.3
0.6 0.6 0.8
0.1 0.1 0.3
– 0.4 – 0.4 – 0.2

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
ITA ESP JPN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 – 0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
NLD BEL GBR
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 – 0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Figure 5A.1 Response to a 1 Percent Growth Shock in the United States (Percent)

1.6 1.6 1.6 CAN
AUT GRC
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
PRT FIN SWE
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6
IRL CHE
1.1 1.1 IRF
Counterfactual IRF
0.6 0.6
Ordering uncertainty
0.1 0.1 Parameter uncertainty
– 0.4 – 0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Poirson and Weber

Figure 5A.1 (continued)
Note: IRF: impulse response function. AUT: Austria; BEL: Belgium; CAN: Canada; CHE: Switzerland; DEU: Germany; ESP: Spain; FIN: Finland; FRA: France; GBR: United Kingdom; GRC: Greece; IRL: Ireland; ITA: Italy;
JPN: Japan; NLD: Netherlands; PRT: Portugal; SWE: Sweden; USA: United States.
135
136
1.6 1.6
DEU FRA 1.8 USA
1.1 1.1
1.3
0.6 0.6 0.8
0.1 0.1 0.3
– 0.4 – 0.4 –0.2

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
ITA ESP JPN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
NLD BEL GBR
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Figure 5A.2 Response to a 1 Percent Growth Shock in Japan (Percent)

1.6 1.6 1.6
AUT GRC CAN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 – 0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
PRT FIN SWE
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 – 0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6
IRL CHE
1.1 1.1 IRF
Counterfactual IRF
0.6 0.6
– 0.4 – 0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Poirson and Weber

137
138
1.6 1.6
DEU FRA 1.8 USA
1.1 1.1
1.3
0.6 0.6 0.8
0.1 0.1 0.3
– 0.4 – 0.4 –0.2

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
ITA ESP JPN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
NLD BEL GBR
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Figure 5A.3 Response to a 1 Percent Growth Shock in the United Kingdom (Percent)

1.6 1.6 1.6
AUT GRC CAN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
PRT FIN SWE
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6
IRL CHE
1.1 1.1 IRF
Counterfactual IRF
0.6 0.6
– 0.4 – 0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Poirson and Weber

Source: IMF staff calculations.
139
140
1.6 1.6
DEU FRA 1.8 USA
1.1 1.1
1.3
0.6 0.6 0.8
0.1 0.1 0.3
– 0.4 –0.4 –0.2

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
ITA ESP JPN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
–0.4 –0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
NLD BEL GBR
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
–0.4 –0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Figure 5A.4 Response to a 1 Percent Growth Shock in Germany (Percent)

1.6 1.6 1.6
AUT GRC CAN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
PRT FIN SWE
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6
IRL CHE
1.1 1.1 IRF
0.6 0.6 Counterfactual IRF
0.1 0.1
Parameter uncertainty
– 0.4 – 0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Poirson and Weber

141
142
1.6 1.6
DEU FRA 1.8 USA
1.1 1.1
1.3
0.6 0.6 0.8
0.1 0.1 0.3
– 0.4 – 0.4 –0.2

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
ITA ESP JPN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
NLD BEL GBR
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Figure 5A.5 Response to a 1 Percent Growth Shock in France (Percent)

1.6 AUT 1.6 1.6
GRC CAN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 PRT 1.6 1.6
FIN SWE
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6
IRL CHE
1.1 1.1 IRF
Counterfactual IRF
0.6 0.6
– 0.4 – 0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Poirson and Weber

143
144
1.6 1.6
DEU FRA 1.8 USA
1.1 1.1
1.3
0.6 0.6 0.8
0.1 0.1 0.3
– 0.4 – 0.4 –0.2

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
ITA ESP JPN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
NLD BEL GBR
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Figure 5A.6 Response to a 1 Percent Growth Shock in Italy (Percent)

1.6 1.6 1.6
AUT GRC CAN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
PRT FIN SWE
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6
IRL CHE
1.1 1.1 IRF
Counterfactual IRF
0.6 0.6
– 0.4 – 0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Poirson and Weber

145
146
1.6 1.6
DEU FRA 1.8 USA
1.1 1.1
1.3
0.6 0.6 0.8
0.1 0.1 0.3
– 0.4 – 0.4 –0.2

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 2.1 ESP 1.6
ITA JPN
1.1 1.6 1.1
1.1
0.6 0.6
0.6
0.1 0.1
0.1
– 0.4 – 0.4 –0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
NLD BEL GBR
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
– 0.4 – 0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Figure 5A.7 Response to a 1 Percent Growth Shock in Spain (Percent)

1.6 1.6 1.6
AUT GRC CAN
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
–0.4 –0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6 1.6
PRT FIN SWE
1.1 1.1 1.1
0.6 0.6 0.6
0.1 0.1 0.1
–0.4 –0.4 –0.4

1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
1.6 1.6
IRL CHE
1.1 1.1
IRF
0.6 0.6 Counterfactual IRF
0.1 0.1
Parameter uncertainty
–0.4 –0.4
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Poirson and Weber

147

CHAPTER 6
Do Fiscal Spillovers Matter?

ANNA IVANOVA AND SEBASTIAN WEBER
This chapter assesses the impact of fiscal spillovers on growth in the context of a coor-
dinated exit from crisis management policies. We find that despite potentially sizeable
domestic effects from consolidation, aggregate negative spillovers to other countries are
likely to be contained in 2011–12 unless fiscal multipliers and/or imports elasticities
are very large. However, small and open European economies will be substantially
affected. In contrast, the coordinated exit from fiscal stimulus will have a limited
direct effect on European peripheral countries, since they are relatively closed, with the
notable exception of Ireland.
INTRODUCTION
Under normal circumstances, when business cycles and fiscal policies are unsyn-
chronized, changes in domestic fiscal stances are unlikely to have a significant
global impact because the reduction in domestic demand can be partly offset by
the increase in net exports, as documented, for example, in the 2010 World
Economic Outlook (IMF, 2010). However, the current situation is not normal.
Countries went through a global 2008–09 financial crisis and in response have
implemented synchronized fiscal stimuli, which have left substantial amounts of
public debt that now need to be reduced. For many governments, fiscal consoli-
dation has thus become a major objective, and since 2011 these governments have
embarked on ambitious fiscal consolidation plans. This implies that many coun-
tries will consolidate at the same time.
Does the ongoing synchronized fiscal consolidation have the potential to lead
to significant spillover effects? In other words, will fiscal actions in one country
convey to economic activity in other countries? Some would argue that such a risk
exists. Several considerations favor such a view: Exchange rates cannot adjust if
many countries consolidate simultaneously. Additionally, a large number of coun-
tries undertaking consolidation are in the eurozone, where the real exchange rates
can adjust only slowly anyway. Hence, the offsetting effect of adjustments in net
exports may not be feasible. Moreover, empirical evidence suggests that fiscal
The authors would like to thank Ashoka Mody for detailed suggestions and insightful comments, and
Daniel Leigh and Vladimir Klyuev for helpful discussions. They also would like to thank Emre Alper,
Bas Bakker, Xavier Debrun, Peter Doyle, Lorenzo Figliuoli, Kevin Fletcher, Doug Laxton, Ester Perez
Ruiz, Francis Vitek, and Erik de Vrijer for useful comments.
149

150 Do Fiscal Spillovers Matter?
multipliers are likely to be higher at the time of financial stress and when interest
rates are close to the zero bound (Blanchard and others, 2009; Christiano
Eichenbaum, and Rebelo, 2009; IMF, 2010; Auerbach and Gorodnichenko,
2010; Corsetti et al. 2010b). Both aspects have thus the potential to magnify
spillover effects from fiscal consolidation.
We use a simple analytical framework to evaluate the relevance of fiscal spill-
over effects through trade channels based on estimates of fiscal multipliers and
import elasticities obtained in other studies. The methodology is applied to a
sample of 20 countries covering more than 70 percent of world GDP.1 The
approach accounts for carry-over effects from previous years’ fiscal positions and
allows differentiating between revenue and expenditure measures. The baseline
estimates of multipliers obtained in the literature are based on the premise that
monetary policy is accommodative. To reflect the current environment, in which
exchange rate adjustments to “soften the blow” may not be feasible, we perform
a series of robustness checks with higher multipliers and a range of import elas-
ticities. We also assess the sensitivity of the results to various measures of the fiscal
stance.
The results do imply that the domestic contractionary effects of fiscal consoli-
dation could be sizable. However, aggregate spillovers of these contractionary
impulses to other countries are likely to be contained in 2011–12 unless fiscal
multipliers and/or imports elasticities are significantly larger than seems reason-
able now. However, the effect will be different across countries. Small and open
European economies, including Ireland, Belgium, Austria and the Netherlands
will be substantially affected. European peripheral countries other than Ireland
will face limited direct impacts, because they are relatively closed. Ireland would
benefit from a more relaxed pace of fiscal consolidation elsewhere, but such sup-
port would be meaningful only if it were coordinated across the major economies,
including the United States and the United Kingdom. In contrast, a reduced
consolidation effort by Germany alone would have a limited impact on the
European periphery.
Our analysis consists of two parts. First, we estimate the impact of a uniform
shock (1 percent of GDP reduction in expenditure) in 20 major economies to
gauge the relative strength of the impact on growth across countries. Second, we
estimate the growth impact based on the projected fiscal position in these econo-
mies in 2011–12, which also reflects the size of the expected fiscal change for each
country under the current plans. In both cases, we quantify the potential effect of
fiscal consolidation on output growth and the trade balance and calculate the
contribution of spillovers from other countries’ consolidation plans to the respec-
tive changes.
The approach only quantifies the direct demand impact and does not
reflect credibility or other non-demand-driven effects (to the extent that they
1
The full list of countries includes Austria, Belgium, Brazil, China, France, Germany, Greece, India,
Ireland, Italy, Japan, Korea, Netherlands, Portugal, Russia, Spain, Sweden, Switzerland, United
Kingdom, and United States.

Ivanova and Weber 151
are not embedded in the underlying multiplier estimates). Moreover, the

approach focuses on a short-term impact (two years) and may not fully capture
the effects of exchange rate and price adjustments on growth and the trade
balance, which are also likely to reduce the spillovers in the longer term.
Hence, the results can be viewed as upper-bound estimates of fiscal spillovers
from consolidation, since the other effects would reduce the negative impact
on growth.
The remainder of the chapter briefly discusses the findings of the related
literature on fiscal multipliers and spillover effects; derives the analytical frame-
work; presents the simulation results and discusses the global effects of spillovers;
and provides concluding policy implications.
LITERATURE
The literature on economic spillovers across borders has grown in recent years.
However, there are only a few quantitative studies measuring the growth impact
of fiscal spillovers, that is, the impact of domestic fiscal changes on growth in
other countries. This is not surprising, since aggregate fiscal spillovers are negli-
gible when the fiscal cycles of countries are independent from each other, because
the sum of fiscal changes in the rest of the world is likely to be small as consolida-
tion and expansion in different countries offset each other.
But in the event of a global downturn, fiscal spending tends to become syn-
chronized as countries step up spending to bolster output during the recession.
For example, in the aftermath of the financial crisis of 2008–09, governments
simultaneously implemented fiscal stimulus packages, while now there is a global
tendency to reduce fiscal deficits.
Estimates of growth spillovers in the context of crises and synchronized fiscal
consolidation are scarce. Thus, our understanding of the international growth
impact of fiscal changes derives from studies that focus on the domestic effect of
fiscal consolidation. Since the size of the domestic effect of fiscal consolidation on
growth is rather important for evaluating the potential for cross-country spillover
effects, we also review the literature on the domestic effects of fiscal policy. We
focus on studies that investigate the difference in the effects on growth between
times of crises and ‘normal’ times.
In reviewing the literature, we reach two main conclusions. First, the existing
estimates of fiscal spillovers suggest that they are limited, although spillovers from
the United States may be relevant. In most cases, however, the analysis of spill-
overs is based on the effect of an individual country while keeping fiscal policy in
other countries unchanged. Hence, the effect of coordinated consolidation may
not be fully captured. Furthermore, the estimates of growth spillovers are based
on ‘normal times’ and simulation results often rely on forward-looking agent
models; both favor the finding that the impact of fiscal changes on growth is low.
Second, while estimates of the impact of fiscal multipliers from domestic policy
action in a single country on its own growth vary widely, the evidence suggests

that the multipliers are likely to be on the higher side in the current environment.
In particular, interest rates are close to the zero bound and cannot fall much fur-
ther to crowd in investment. Also, the shares of liquidity-constrained households
and firms are likely to be high in the aftermath of the financial crisis.
Some recent studies investigate the spillover effects of fiscal policy.2 Beetsma,
Giuliodori, and Klaassen (2006) find that the average effect of a fiscal stimulus of
1 percent of GDP in Germany is an increase of 0.23 percent in foreign GDP for
a spending increase and 0.06 percent for a net tax cut, within two years.3
Spillovers from France are found to be lower but still non-negligible. The authors
employ a two-step procedure. In the first step, they use a standard panel vector
autoregression (VAR) approach to identify fiscal shocks. In the second step, a
panel bilateral trade model is estimated to obtain the effects of changes in domes-
tic output on foreign exports. Merging the responses from the two blocks allows
them to compute the overall effect of the fiscal impulses on bilateral exports and
thereby on the output of other countries. However, their estimates do not repre-
sent the full extent of the spillovers, since they do not account for further feed-
back effects among the economies.4
Bénassy-Quéré and Cimadomo (2006) find positive cross-border spillovers
from Germany, at least in neighboring and smaller countries. The authors find
tax multipliers to be larger than spending multipliers and the effect of tax shocks
on output to be more persistent.5 They estimate a factor-augmented VAR model,
appending the GDP and the real exchange rate of one country at a time to the
German model. Their focus is on the seven biggest European Union (EU) mem-
ber countries. Germany is assumed to be contemporaneously unaffected by the
foreign variables, while German shocks can affect the country under analysis. The
estimation procedure constrains the analysis to direct effects from Germany to the
respective country while not accounting for multi-country spillovers and poten-
tial feedback loops.
Some authors have employed multi-country macro models to simulate the
extent of spillovers from fiscal policies. For instance, Gros and Hobza (2001)
provide an overview of results from four major macroeconomic models on the
2
Another study which looks at fiscal spillovers is Canova and Pappa (2007). However, the authors
focus on the effect of regional expenditure and revenue shocks on the price differentials, and not
growth, in monetary unions using the example of the U.S. states as well as nine EMU member coun-
tries. Since the authors run separate BVARs for each unit and construct average responses from these
estimates, they also cannot account explicitly for spillovers across regions.
3
German fiscal expansion has a particularly strong effect on its small neighbors. An increase in public
spending (a decrease in net taxes) by 1 percent of GDP in Germany leads to a more than 0.4 percent
(0.1 percent) normalized increase in the GDP of Austria, Belgium, Luxemburg, and the Netherlands
after two years.
4
The authors thus argue that the effects should be regarded as lower bounds and that further research
is needed on the feedback between all countries.
5
The authors find that German tax shocks have a beneficial impact on foreign GDP. However, this
effect seems to be limited to neighboring countries. Cross-border spillovers from fiscal spending
shocks are found to be low and rarely significant, except for a few countries (Belgium, Austria, and
the Netherlands).

cross-country spillover effects of fiscal policy, focusing on the effect of a govern-

ment spending shock of 1 percent of GDP in Germany.6 Effects are found to be
relatively small. The effects are generally positive for small open economies, which
trade extensively with Germany, ranging around 0.02 percent of baseline GDP
(Austria, Belgium, and the Netherlands). However, they tend to be negative for
the bigger countries and the small countries with few trade links with Germany,
ranging around −0.05 percent of baseline GDP (France, Italy, Spain, Greece, and
Portugal). Cwik and Wieland (2009) use five different empirical macroeconomic
models to evaluate the impact of fiscal stimulus in the financial crisis.7 Spillover
effects from German expansion during the crisis are found to increase GDP in
France by 0.04 percent after one year, while the effect is found to be negative for
Italy with −0.001 percent. The authors explain the negative effect by the fact that
the direct-demand effects are overwhelmed by the indirect effect of a euro appre-
ciation.8 The OECD (2009) provides some aggregate spillover results for the
United States, Japan, the Euro area, and other OECD countries. Spillovers are
lowest to the United States and to the euro area as a whole, but they are sizeable
to other OECD countries in 2009 and even more so in 2010, mainly due to U.S.
fiscal expansion. The 2011 World Economic Outlook demonstrates potentially
large spillovers from a coordinated fiscal consolidation to a small open economy
like Canada (IMF, 2010).
In the single-country context, estimates of fiscal multipliers vary substantially
across various studies and across countries.9 Blanchard and Perotti (2002) find
that, consistent with theory, an increase in government spending in the United
States boosts output, while an increase in taxes reduces output. They do not find
a significantly lower impact of taxes compared to spending in terms of cumulative
multipliers, but the tax shocks appear to be less persistent. Multipliers are close to
one. Spending shocks tend to have a negative effect on investment, while con-
sumption tends to rise. Romer and Romer (2010), in contrast, find much stron-
ger effects of tax changes for the United States. Their results, however, are not
strictly comparable, since in Romer and Romer (2010) fiscal shocks are not based
6
The impact on German GDP in the first year amounts to a change of 0.4 to 1.2 percent. The origi-
nal paper includes results from four models including MULTIMOD (IMF), NiGEM (NIESR),
QUEST (EC), and Marmotte (CEPII). We excluded results from the latter for the discussion here,
since it is based on a multi-country framework that assumes full flexibility of output prices and
rational forward-looking agents.
7
The four models based on the New-Keynesian approach do not support a textbook Keynesian mul-
tiplier effect. The reason is the forward-looking behavior of households and firms. They anticipate
higher tax burdens and higher interest rates in the future and therefore reduce consumption and
investment. Only the ECB’s area-wide model, which largely ignores forward-looking behavior, is
found to generate government spending multipliers that are significantly above one.
8
It should be noted that the results are based on a G7 country model and on the assumption of no
fiscal change in the other countries. Thus, positive spillovers from third country effects are likely to
be underestimated (due to the country sample) and negative repercussions from the appreciation of
the euro overestimated (due to the country sample and the absence of a fiscal expansion in the other
countries).
9
For a summary of literature on multipliers see Schindler, Spilimbergo, and Symansky (2009).

on the standard estimation framework but derived from a narrative approach. An

exogenous tax increase of one percent of GDP lowers real GDP, typically by over
1.5 percent after one year and by 2.5 percent after two years. Investment falls
sharply in response to exogenous tax increases. Using the change in the cyclically
adjusted revenues yields a smaller impact of about 0.5 percent after one year and
1.3 percent after two years. The 2010 World Economic Outlook, which uses a
similar narrative approach to construct the measure of fiscal policy in a sample of
advanced countries, concludes that expansionary effects of consolidation are
unusual in the short run, with an estimated average reduction in GDP of about
½ percentage point after two years from a 1 percent of GDP fiscal contraction.
Several recent studies have focused on the effects of fiscal policy during the
financial crisis. This literature argues that during the recent financial crisis, spill-
over effects were prone to be particularly high, since conditions were relatively
favorable (Blanchard and others, 2009; IMF, 2010): interest rates were very low,
inflation pressure was low, and investment had collapsed. With interest rates often
at the zero lower bound, crowding out was minimized (Christiano, Eichenbaum,
and Rebelo, 2009). Almunia and others (2009) employ the experience of the
Great Depression to estimate fiscal multipliers at the time when the banking
system is dysfunctional and monetary policy is constrained by the zero bound.
They employ a VAR technique, instrumental variables, and qualitative evidence
for a panel of 27 countries in the period 1925–1939, and they find large fiscal
multipliers; for example, for expenditure they find a multiplier of 2.5 on impact
and 1.2 after one year.
Auerbach and Gorodnichenko (2010) find a stark contrast between multipli-
ers in recessions and expansions.10 Estimates for spending multipliers in recession
are about 2–2.5 times higher than estimated multipliers when not accounting for
different stages in the business cycle. Shocks also appear to be of a much more
permanent nature during recessions, as opposed to expansions. Tagkalakis (2008)
finds that liquidity constraints can explain these asymmetric effects of fiscal poli-
cy on output over the business cycle. In recessions, liquidity constraints are bind-
ing for a wider range of firms and households, which makes the fiscal policy more
effective by stimulating consumption spending through either tax cuts or govern-
ment spending.
Similarly, Corsetti, Meier, and Müller (2010b), analyzing a panel of countries,
find that multipliers for government spending shocks are much higher in times
of crises, causing output to increase twofold relative to the spending increase. The
authors use a two-step procedure, first identifying country-specific spending
shocks and then using a panel approach to regress spending shocks interacted
with country characteristics. The confidence bands, however, are very wide, sug-
gesting caution in interpreting these results.
10
On the other hand, the OECD (2009) argues that multipliers may be lower in the current crises,
about 0.5 percent, due to households’ higher propensity to save.

While the recent literature provides some results on the impact of fiscal
spillovers on growth, the analysis is generally conducted in an “all else being
equal” manner, that is, it looks at the direct effect of a single country’s fiscal
policy on others without taking into account indirect second-round effects
through trading partners, which could amplify the impact. We contribute to
the literature by accounting for these second-round effects. Moreover, unlike
earlier studies, we study not only the potential spillover effects but also the
spillovers that are implied by the announced global fiscal consolidation plans
for 2011–12.
FRAMEWORK
Fiscal Spillover Framework
The spillover framework is based on a representation of the national accounts and
behavioral assumptions for government spending, taxes, consumption, invest-
ment, exports, and imports. Starting from the national accounting identity, we
know that:
Yt , j = C t , j + I t , j + Gt , j + X t , j − M t , j (1.1)
Where Yt , j is the real output, I t , j is real investment, Gt , j is the real government
spending, X t , j is real exports and M t , j is real imports of country j in time t
denominated in a common currency. The single elements of output are respec-
tively given by:11
(
Ct , j = C 0 + c1 Yt , j − Tt , j ) M t , j = μ jYt , j
I
I t , j = I 0 + d1Yt , j − d 2rt , j X t , j = ∑ ω ij μ iYt ,i (1.2)
i≠ j
i =1
μ i is the marginal propensity to import of a trading partner i,12 Yt,i is the output
of a trading partner i, and ωij is the weight of imports from country j in total
imports of country i. Substituting the definitions (1.2) in (1.1) yields
I
Yt , j = ext , j + m jGt , j − m j c1Tt , j + m j ∑ ωij μ iYt ,i (1.3)
i≠ j
i =1
11
The model does not account for potential crowding-out effects. Allowing consumption and invest-
ment to react to fiscal changes (beyond the output effect) potentially reduces the contractionary effect
of fiscal consolidation. While this is clearly a simplifying assumption, it is not unreasonable in the
current economic environment.
12
In the calculations, the marginal propensity to import μi was computed as the ratio of imports to
GDP multiplied by the imports elasticity for each country.

( )
−1
Where ext , j = C 0 + I 0 − d 2rt , j and m j = 1 − c1 − d1 + μ j is the expenditure
multiplier, which is also the multiplier for exports. Taking the first difference and
dividing by real output in t-1 yields the contribution of the fiscal change to out-
put growth:
ΔYt , j ⎡ ΔGt , j ⎤ ⎡ ΔTt , j ⎤ I
ΔYi Yt −1,i
= mj ⎢ ⎥ − m j c1 ⎢ ⎥ + m j ∑ ωij μi (1.4)
Yt −1, j ⎣⎢ Yt −1, j ⎦⎥ ⎣⎢ Yt −1, j ⎦⎥ i≠ j Yt −1,i Yt −1, j
i =1
Converting expenditure and revenue ratios into nominal terms with respect to
GDP we have:13
⎡ ΔGtN, j Pj ,t −1 ⎤ ⎡ ΔTt ,Nj Pj ,t −1 ⎤ I

Yi ,Nt −1
y j ,t = m j ⎢ N ⎥ − m j c1 ⎢ N ⎥ + m j ∑ ω ij μ i yi N (1.5)
⎣⎢ Y j ,t −1 Pj ,t ⎦⎥ ⎣⎢ Y j ,t −1 Pj ,t ⎦⎥ i =1
i≠ j
Y j ,t −1
Where Pj ,t is the price level at time t, which is measured by the GDP deflator.
Consistent with empirical findings, we allow the fiscal measures to incorporate
a current period as well as a lagged period effect from fiscal measures imple-
mented in the previous period:
⎡ ΔGtN, j Pj ,t −1 ⎤
⎥ = m j g j ,t + m j g j ,t −1
G ,1 G ,2
mj ⎢ N
Y P
⎣⎢ j ,t −1 j ,t ⎦⎥
⎡ ΔTt ,Nj Pj ,t −1 ⎤
⎥ = m j t j ,t + m j t j ,t −1
T ,1 T ,2
m j c1 ⎢ N (1.6)
Y P
⎣⎢ j ,t −1 j ,t ⎦⎥
Equation (1.5) is a system of I linear equations that can be written in matrix

notation and solved for the change in expenditures and revenues according to:
Yt = W ⎡⎣ A1Gt − A2Tt ⎤⎦ (1.7)
Where W = ( I − B )−1 is an I-by-I identity matrix, B is an I-by-I matrix, Y is an

I-by-1 vector of real GDP growth rates, A1 and A2 are diagonal I-by-I matrices,
and Gt and T are I-by-1 vectors. It is possible to derive country i’s contribution
to country j’s GDP growth by evaluating:
yt , ji = w ji ⎡⎣ a1ji g ti − a2ji tt i ⎤⎦
(1.8)
* * N*
Yt −1,i qijYt −1,i sij Pt −1,i Yt −* 1,i sijYt −1,i Yt −N1,i
13
Note that we used the following transformation: = = = N = N
Yt −1, j Yt −1, j Pt −1, j Yt −1, j Yt −1, j Yt −1, j
where qij and sij are respectively the real and the nominal exchange rate between country i and country
j and stars denote values in foreign currency. The nominal exchange rate is assumed to be stable across
the period of analysis.

We can use the definitions in (1.2) to derive the implicit change in the real
trade balance that is caused by the change in fiscal spending. To do so, we first
compute the real change in exports and imports relative to real GDP in t-1:
ΔX t , j I
ΔYt ,i Yt −1,i
= ∑ ω ij μ i ΔM t , j ΔYt , j
Yt −1, j i≠ j Yt −1,i Yt −1, j = μj (1.9)
i =1 Yt −1, j Yt −1, j
Converting into nominal terms with respect to GDP and subtracting gives the
real change in the trade balance relative to GDP in t-1:
( )
X jN,t Pj ,t −1 / Pj ,t − X jN,t −1
−
( )
M jN,t Pj ,t −1 / Pj ,t − M jN,t −1
N N
Y j ,t −1 Y j ,t −1
(1.10)
I
YN
= ∑ ωij μi i N,t −1 yt ,i − μ j yt , j
i≠ j Y j ,t −1
i =1
Measures of Fiscal Stance

An important question in identifying the growth impacts of fiscal changes is the
choice of the measure of fiscal stance. In theory, the multiplier is defined with
respect to the change in real fiscal variables; in particular, it provides an answer to
the question, By how many units does the output change if the fiscal variable (say,
expenditure) changes by one unit, keeping other things constant? In practice,
however, policymakers often use the measure of fiscal policy changes in relation
to GDP or potential GDP, which facilitates comparison across countries. In addi-
tion, a measure of cyclically adjusted fiscal changes is often employed to separate
the impact of discretionary fiscal policy on output. While the latter allows one to
make a clear link between fiscal changes and growth, since it can be viewed as
largely exogenous to output changes, it misses an important component of auto-
matic stabilizers, which contribute to output dynamics.
To assess the robustness of our results, we employ three different measures of
fiscal stance:
• Changes in cyclically adjusted revenues/expenditures in percent of GDP,
using Girouard and André (2005) estimates of elasticities and European
Comission (EC) approach for calculating cyclical adjustment;14
• Changes in headline revenue/expenditure in percent of GDP; and
• Changes in headline revenue/expenditure in real terms.
All three measures have their advantages and disadvantages and capture different
aspects of fiscal policy. Cyclically adjusted measures attempt to capture discretionary
fiscal action. However, they might not provide an accurate picture when historical
14
We compared the estimates of fiscal changes based on cyclically adjusted revenue/expenditure in per-
cent of GDP with those in percent of potential GDP and found the differences to be small. We chose
to report the results for the measure scaled by GDP to facilitate comparison with the headline measure.

elasticities of revenues/expenditures do not correctly capture automatic stabilizers,

for example in countries where asset prices play an important role (e.g., the United
Kingdom) or where there might have been structural changes (e.g., the German
labor market, where developments have recently decoupled from developments in
the output gap). Estimation of potential output is also inherently difficult.
The measure of fiscal balance based on revenue/expenditure in percent of
GDP is a commonly used indicator that captures not only discretionary policy
but also automatic stabilizers. While it does not require additional assumptions
on the output gap and elasticities, it is endogenous in the sense that it is itself
affected by developments in the GDP. Resolving the issue of endogeneity, how-
ever, is rather difficult and is beyond the scope of this study.
Moreover, the fact that the denominator—be it actual GDP or potential
GDP—is changing implies that any measure in ratios is bound to reflect those
changes, which may be distortive in terms of measuring fiscal contribution to
growth. The following example demonstrates this for government spending: The
change in expenditure in real terms, which is relevant for computing fiscal con-
tribution to growth (see formula (1.4)), can be written as
Gtr − Gtr−1
ΔG real =
Yt r−1
where Gtr is real fiscal spending at time t and Yt r−1 is real output at time t-1. Then
the change in expenditure in ratios to GDP or potential GDP can be written as
Gtr Pt Gtr−1Pt −1 Gtr
ΔG ratios = − = ΔG real
− g r
Yt r Pt Yt r−1Pt −1 Yt r Yt
where gYtr is a real GDP or potential GDP growth at time t. Therefore, provided
that the growth in GDP or potential GDP is non-zero, the differences can be
substantial for revenue/expenditure subcomponents, since the ratio of expendi-
ture/revenue to GDP is typically large. The differences for the overall balance,
however, will be small, since the differences for revenue and expenditure largely
offset each other.
While the theoretical definition of multiplier is based on a concept of real
change in revenue/expenditure, the empirical estimates of fiscal multipliers are
sometimes geared towards the measure based on ratios to GDP or potential GDP.
Therefore, none of the measures mentioned above is perfect, and the three mea-
sures capture different aspects of fiscal policy, so all three can be useful in assessing
the impact on growth.
SIMULATION RESULTS
For practical reasons we limit our discussion to 20 countries, with a focus on
European countries but a fair representation of major international actors. More
precisely, our exercise includes all nations with a ratio of domestic output to world
output above 2 percent. Given our particular interest in the euro area countries,

we also include in the sample a range of euro area members and their relevant
trading partners. The final sample includes the following 20 countries:15
Austria Germany Japan† Spain
Belgium Greece Korea† Sweden
Brazil† India† Netherlands Switzerland‡
China†‡ Ireland Portugal United Kingdom†‡
France Italy Russia† United States†‡
The sample represents more than 70 percent of world GDP and covers on aver-
age two-thirds of a country’s imports and of its exports. For the euro area members
in the sample, the values are roughly three-quarters for imports and exports.
The OECD (2009) reports revenue and spending multipliers for current peri-
ods and lagged effects for subcomponents of revenues and expenditures for a wide
sample of countries. We draw on these multipliers for specific tax and revenue
T ,1
policies to compute the respective values for the current-period revenue ( m j )
G ,1 T ,2
and expenditure ( m j ) as well as the lagged effect revenue ( m j ) and expendi-
G ,2
ture ( m j ) multiplier.16 We use each country’s share of specific revenue compo-
nents to compute an overall revenue multiplier and similarly an overall spending
multiplier. In some cases, the resulting average multipliers are adjusted in line
with country-specific estimates provided by IMF country desks.
Import elasticities are taken from Kee, Nicita, and Olarreaga (2008). The
marginal propensity to import ( μ i ) is then computed by multiplying the elastic-
ity with the respective imports-to-GDP ratio in 2009. An overview of the multi-
pliers and import elasticities is provided in Table 6A.1.
The fiscal measures are based on the IMF’s April 2011 World Economic
Outlook data. The simulation framework implies that the differences in the
impact of fiscal consolidation are a combination of the following elements:
• The country-specific revenue and expenditure multipliers
• The composition of the consolidation (revenue versus expenditure measures), and
• The trade links between countries (and thus these countries’ characteristics
for sub-points 1 to 2) and their propensity to import when income changes.
We will refer to variations in the above in the respective robustness checks.
Uniform Fiscal Shock
Baseline Multipliers and Import Elasticities
We first demonstrate an impact of a 1 percent of GDP shock to expenditures to
gauge the relative size of spillovers between countries under the baseline assumption
15
Countries marked by † account for more than 2 percent of world output, and countries marked
with ‡ are major trading partners for one or more of the euro member countries. We excluded Canada
and Mexico in favor of several smaller euro zone members. Both Mexico and Canada have negligible
effects on the European countries but are very much subject to U.S. shocks.
16
More precisely we employ the country-specific multipliers labeled “high multipliers” by the OECD (2009).
The term “high” in this context refers to the fact that the OECD’s “reference” multiplier employed in its study
is “judgmentally scaled down, by more for tax cuts than for government spending,” since the current eco-
nomic circumstances are “more likely to reduce multipliers.” Thus we use effectively the original series.

on multipliers and import elasticities. The baseline multipliers average at 0.5 for
revenue and 0.8 for expenditure after two years across the sample of 20 countries.
Consequently, the baseline multipliers are relatively high. The import elasticities
average at 1.15.
To clarify the mechanics and the intuition behind the reported results, we
present the calculation of the first-round spillover effects from a 1 percent decline
in government spending in Germany to the peripheral European countries after
one year in Table 6.1.
The first-round effect of the fiscal consolidation in Germany on growth in
Portugal can be approximated as follows. German imports from Portugal com-
prise only 0.7 percent of total German imports,17 while Germany’s marginal
propensity to import out of income is 0.5 (imports share in GDP times imports
elasticity). Therefore, out of every additional euro of income Germany will
import only 0.35 cents from Portugal, and the opposite is true for income
reduction. Since fiscal spending in Germany has a multiplier of only about 0.4
after one year, a one percent of GDP decline in fiscal spending in Germany will
reduce German GDP due to domestic consolidation by only about 0.4 percent
after one year, which would result in a decline of about 10 billion euros. As a
result, Germany will import 0.03 billion euros less from Portugal, and
Portuguese exports will decline by this amount. However, this does not trans-
late to the equivalent amount of income loss for Portugal since, for example,
some of this reduction will be compensated by lower imports. Since exports
have the same multiplier as expenditures (see equation (1.3)), which is about
0.5 for Portugal, the actual income loss for Portugal would only be about 0.015
billion euros, which corresponds to about 0.009 percent reduction in
Portuguese GDP in the first year (German GDP is 15 times larger than
Portuguese GDP).
This calculation, however, does not incorporate second-round effects, since a
reduction in German GDP will result in lower growth in other common trading
partners of Germany and Portugal. Taking into account these second-round
effects will result in a slightly greater reduction in GDP growth in Portugal,
namely 0.011 percent. The impact on Ireland is somewhat greater but on Greece
it is almost negligible.18
Consequently, the impact of Germany’s fiscal policy on the peripheral coun-
tries is likely to be rather small. As we demonstrate below, even very high multi-
pliers result in only a moderate impact from Germany alone.
The matrix of results of a coordinated 1 percent decline in fiscal spending
across all 20 countries is reported in Table 6A.2 in the Appendix. The table
17
In fact, the share is even smaller; the results in the table were rescaled by the total over the sample
of 20 countries to sum up to 1.
18
It should be noted that the calculation results are based on the pattern of trade in goods. Greece,
however, has a substantial share of trade in services, hence the estimates are biased downward.
Nonetheless, the impact is likely to be very small; even assuming that trade in services is about 50
percent of total trade in Greece and, hence, by roughly doubling the results would yield very small
spillovers from Germany.

TABLE 6.1
An Example of a Simple Calculation of a Spillover Effect from Germany to the Peripheral European Countries, Baseline Multipliers
Total Spillover
Effect on
First-Round Effect on Growth after
First-Round Effect on German GDP First-Round Effect on Peripheral Exports Peripheral GDP One Year
The solution
Share of given by (1.8),
country’s Ratio of Export First round reflects
imports in German German German multiplier spillover effect indirect effects
Expenditure Expenditure total German imports marginal output to First-round effect of the on growth through other
shock in multiplier First-round effect German imports share in propensity country’s on peripheral peripheral after one year countries
Germany in Germany on German GDP imports elasticity GDP to import output exports country (percent) (percent)
ΔGtN,i Pi ,t −1 ⎡ ΔG N P ⎤ Mt −1,i Mt −1,i Yi N,t −1 ΔX t , j Yi N,t −1 ΔX t , j

Peripheral y i = mi ⎢ N t ,i i ,t −1 ⎥ μi = εi = ω ij μ i y i mj
Yi N,t −1 Pi ,t mi ⎣ Yi ,t −1 Pi ,t ⎦ ω ij εi Yt −1,i Yt −1,i YjN,t −1 Yt −1, j YjN,t −1 mj Yt −1, j y t , ji
Country
Greece –1.000 0.410 –0.410 0.004 1.140 0.422 0.481 10.975 –0.008 0.555 –0.004 –0.005
Ireland –1.000 0.410 –0.410 0.013 1.140 0.422 0.481 16.124 –0.042 0.395 –0.017 –0.024
Portugal –1.000 0.410 –0.410 0.007 1.140 0.422 0.481 14.604 –0.021 0.453 –0.009 –0.011
Source: IMF, World Economic Outlook database, and Direction of Trade Statistics; and IMF staff estimates.

reports the growth impact (percent deviation from the baseline of no fiscal
change) after two years. Countries where the fiscal shock originates are reported
in columns, while recipient countries of the growth impact are in rows. Hence,
the diagonal elements of this matrix show the growth impact of the country’s
domestic fiscal policy while the off-diagonal elements show the spillovers—the
impact on country’s growth due to the fiscal changes in other countries. The total
at the end of the row, therefore, is the total growth impact on a particular country
reported in this row from the coordinated fiscal consolidation. The PPP-weighted
average at the bottom of the table can be interpreted as an individual country’s
impact on the whole group of 20 countries—a proxy of the impact on world
growth. The PPP-weighted average, however, includes both the impact on global
growth from the changes in domestic growth of a country and through the spill-
overs from this country to other countries weighted by the PPP GDP of each
country.
The results indicate that the overall impact of a 1 percent of GDP coordinated
fiscal consolidation is sizeable, reducing growth in the 20 countries on average by
about 0.9 percent after two years (PPP-weighted basis), largely due to the impact
on growth from domestic consolidation, with only about 15 percent being
accounted for by spillovers from one country to another. The largest contribu-
tions to the PPP-weighted average growth decline come from the United States
and China (close to 0.2 percent) reflecting their large weight in the world econo-
my, followed by Japan and India (close to 0.1 percent) with Germany, France,
Brazil, Italy and Russia contributing close to 0.05 percent while United Kingdom,
Spain, and Korea contributing about 0.03 percent each.
Total inward fiscal spillovers to most countries are limited, not exceeding 0.3
percentage points over two years and averaging at 0.1 on PPP-weighted basis and
0.2 on simple average basis. However, spillovers to Ireland, Belgium, Austria, the
Netherlands and Korea are more substantial, close to ½ percentage points over
two years. (Figure 6.1) In the case of Ireland, the largest single-country contribu-
tion comes from the United States (Table 6A.2). For Austria and the Netherlands,
spillovers from Germany are particularly pronounced, while for Belgium spill-
overs from Germany and France are equally important. In Korea, spillovers from
China play an important role. However, individual country spillovers to other
individual countries are rather small, not exceeding 0.16 percentage points over
two years.
Higher Multipliers and Import Elasticities

There are several arguments why multipliers in the current economic environ-
ment are likely to be higher than under the usual circumstances (see Corsetti,
Meier, and Müller, 2010b; Auerbach and Gorodnichenko, 2010, and IMF,
2010). To reflect such a possibility, we analyze the extent to which a multiplier
level of one standard deviation above the respective baseline value for expenditure
multiplier changes the growth impact and, in particular, spillovers. This implies
that expenditure multipliers are about 25 percent above their baseline values and

0
–0.1
–0.2
–0.3
–0.4
–0.5
–0.6
–0.7
–0.8
Simple average PPP–weighted average
–0.9
–1
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Figure 6.1 Inward Fiscal Spillovers (Impact on real GDP from a 1 percent of GDP
reduction in fiscal spending in other countries, baseline multipliers, cumulative after two
years, percent)
the resulting multiplier close to 1. In principle, higher multipliers could be caused

by a higher propensity to consume or a lower propensity to import (see explana-
tion to equation 1.3 above). If multipliers are higher due to higher marginal
propensity to consume, with unchanged marginal propensity to import, then
spillovers would be higher since they would raise the impact on domestic
demand. The impact on spillovers from higher multipliers due to lower propen-
sity to import is ambiguous, since lower propensity to import would contribute
to lowering spillovers while higher multipliers would tend to increase them. We
analyze the impact of higher multipliers under the assumption that it is a result
of higher propensity to consume to give spillovers a higher chance to play out. It
should be noted that the resulting average high multiplier (close to 1 after two
years) is consistent with the estimates obtained under constrained monetary
policy in the 2010 World Economic Outlook (IMF, 2010).
There is also evidence that import elastitices vary over the cycle, with higher
elasticities during the downturn (e.g. Leibovici and Waugh, 2011). We therefore
also perform a robustness check with higher import elasticities while leaving
unchanged the baseline assumption on expenditure multipliers. We assume that
in this scenario, higher import elasticities were combined with higher marginal
propensities to consume such that the opposing effects of these changes lead to
unchanged expenditure multipliers. Higher import elasticities are calculated as
baseline elasticities plus five standard deviations, resulting in an average elasticity
of 1.64, that is, about 40 percent higher than the baseline elasticities (Table 6.2).

164
TABLE 6.2

Impact of a 1 Percent of GDP Reduction in Fiscal Spending on Growth After Two Years (Percent)
Baseline Expenditure Multipliers and Higher Imports
Baseline Multipliers and Imports Elasticitiesa Higher Multipliers and Baseline Imports Elasticitiesa Elasticitiesa
Inward Inward Inward
From: Total Domestic spillovers Total Domestic spillovers Total Domestic spillovers
To:
Austria –1.5 –1.1 –0.4 –2.0 –1.3 –0.7 –1.8 –1.1 –0.7
Belgium –1.3 –0.7 –0.5 –1.8 –0.9 –0.9 –1.6 –0.8 –0.8
Brazil –0.9 –0.8 –0.1 –1.1 –1.0 –0.1 –0.9 –0.8 –0.1
China –1.0 –0.8 –0.2 –1.4 –1.0 –0.3 –1.1 –0.8 –0.3
France –1.3 –1.1 –0.2 –1.7 –1.3 –0.4 –1.5 –1.1 –0.4
Germany –1.0 –0.8 –0.2 –1.4 –1.0 –0.4 –1.2 –0.8 –0.3
Greece –0.9 –0.8 0.0 –1.1 –1.0 –0.1 –0.9 –0.8 –0.1
India –0.9 –0.8 –0.1 –1.1 –1.0 –0.1 –0.9 –0.8 –0.1
Ireland –1.3 –0.8 –0.5 –1.9 –1.0 –0.9 –1.6 –0.8 –0.8
Italy –1.2 –1.0 –0.2 –1.4 –1.2 –0.3 –1.3 –1.0 –0.3
Japan –0.9 –0.8 –0.1 –1.1 –1.0 –0.1 –0.9 –0.8 –0.1
Korea, Republic of –1.2 –0.8 –0.3 –1.6 –1.0 –0.5 –1.3 –0.8 –0.5
Netherlands –1.1 –0.8 –0.4 –1.6 –1.0 –0.7 –1.4 –0.8 –0.6
Portugal –1.0 –0.8 –0.2 –1.3 –1.0 –0.3 –1.1 –0.8 –0.3
Russian Federation –1.0 –0.8 –0.2 –1.3 –1.0 –0.3 –1.1 –0.8 –0.2
Spain –1.2 –1.0 –0.2 –1.5 –1.2 –0.3 –1.3 –1.0 –0.3
Sweden –0.9 –0.7 –0.1 –1.2 –0.9 –0.2 –1.0 –0.7 –0.2
Switzerland –1.0 –0.7 –0.3 –1.4 –0.9 –0.5 –1.1 –0.7 –0.4
United Kingdom –0.8 –0.7 –0.1 –1.1 –0.8 –0.2 –0.8 –0.7 –0.2
United States –0.6 –0.6 0.0 –0.8 –0.8 –0.1 –0.7 –0.6 –0.1
PPP-weighted average –0.9 –0.8 –0.1 –1.2 –1.0 –0.2 –1.0 –0.8 –0.2
Simple Average –1.0 –0.8 –0.2 –1.4 –1.0 –0.4 –1.2 –0.8 –0.3
Source: World Economic Outlook database, and Direction of Trade Statistics; and IMF staff estimates.
a
See Table 5.1 for the assumptions on multipliers and imports elasticities under the baseline and using higher values. In the case when imports elasticities were increased, expenditure multipliers were assumed to
remain unchanged from the baseline as marginal propensity to consume is assumed to compensate the decline in multipliers due to higher imports elasticity.

0
–0.1
–0.2
–0.3
–0.4
–0.5
–0.6
–0.7
–0.8
–0.9
–1
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reduction in fiscal spending in other countries, higher multipliers, cumulative after two
years, percent)
Sources: IMF, World Economic Outlook database, and Direction of Trade Statistics; and IMF staff estimates.
Results reported in the table above suggest that the average growth impact
increases with higher multipliers. However, what is more striking is the non-lin-
earity with which this affects the impact through spillovers. While multipliers are
increased by only about 25 percent, the overall impact of fiscal consolidation on
output growth is increased by more than 30 percent. This is primarily due to a
more than 60 percent increase of spillovers from other countries’ consolidation
efforts, while the domestic effect increased proportionally to the average increase
in multipliers. In PPP-average terms, the increase implies a reduction of GDP
growth due to spillovers by only 0.2 percentage points, while a simple average is
now close to 0.4 percentage points. However, for some countries, spillovers now
account for a sizable fraction of growth reduction, with the largest spillovers close
to 1 percentage point for Ireland and Belgium (Figure 6.2).
Import elasticities also have a magnifying effect on spillovers, although the
effect is less pronounced. Import elasticities that are higher on average by 40
percent lead to an increase in spillovers by over 50 percent, while the domestic
impact remains virtually unchanged. As a result, the overall growth impact
increases by about 10 percent compared to the baseline, since the share of spill-
overs remains relatively small (just over 20 percent on the PPP-average basis of
the overall growth impact). After two years, the average spillovers on a PPP basis
are close to 0.2 and on a simple-average basis are over 0.3 percentage points. The
list of countries substantially affected by spillovers remains unchanged
(Figure 6.3).

0
–0.1
–0.2
–0.3
–0.4
–0.5
–0.6
–0.7
–0.8
–0.9 Simple average PPP–weighted average
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reduction in fiscal spending in other countries, higher imports elasticities, cumulative after
two years, percent)
These results suggest that, on average, the size of spillovers remains limited
under alternative assumptions on multipliers and import elasticities, with the
exception of small open economies, where the effects can be substantial.
However, even for those countries where spillovers can be substantial, the
impact of fiscal changes in a single trading partner remains contained, not
exceeding ¼ percentage point over two years. German fiscal policy, in particu-
lar, has limited implications for growth in the European periphery. Very high
multipliers would have to operate for Germany to exhibit a relatively modest
impact on these countries. For example, with expenditure multipliers equal to
the baseline plus four standard deviations (an average expenditure multiplier of
1.6 after two years), after two years a one percent of GDP fiscal expenditure
stimulus in Germany would raise the GDP growth in Ireland by only 0.3 per-
centage points, in Portugal by 0.1 percentage points, and in Greece with virtu-
ally no effect on growth. Similarly, fiscal policy changes in Germany alone have
only a small impact on the trade balance of the peripheral countries and are thus
unlikely to contribute to the reduction in the peripheral countries’ imbalances
(Figure 6.4).
Actual Consolidation Plans

We now turn to the growth impact of the actual fiscal plans in the years 2011 and
2012. To assess the robustness of our conclusions, we employ all three measures
previously discussed.

Percent deviation of output level from the 0.9

Germany
0.8
France
0.7 United States
baseline after 2 years
0.6
0.5
0.4
0.3
0.2
0.1
0
Ireland Greece Portugal
Figure 6.4 Fiscal spillovers to Greece, Ireland, and Portugal

Sources: IMF, World Economic Outlook database, and Direction of Trade Statistics; and IMF staff
estimates.
Note: Government spending shock is 1 percent of GDP increase in spending. The simulation assumes
large domestic fiscal multipliers on government spending averaging at 1.6 for Germany, USA and
France.
Cyclically Adjusted Fiscal Measure (Percent of Potential GDP)

Fiscal consolidation started in 2011 and is forecast to intensify in 2012. The aver-
age adjustment to the cyclically adjusted balance is 0.3 percent of GDP in 2011
and 1.4 percent in 2012. The average adjustment is biased toward expenditure
reductions (Table 6.3).
The overall growth impact of fiscal consolidation is moderate in 2011 (0.2
percentage points) but more notable in 2012 (0.7 percentage points). This reflects
not only the fact that the fiscal plans include a larger degree of consolidation in
2012, in particular in the United States, but also the fact that the impact in 2011
is somewhat cushioned by a lagged effect from 2010, when the fiscal stance was
still expansionary on average. The cross-country variation in the growth impact
reflects the respective countries’ extent of consolidation and the varying size of the
spillovers from other countries (Table 6.4).
There are hardly any aggregate spillovers from consolidation in 2011, and the
small aggregate spillovers in 2012 largely reflect spillovers to small open econo-
mies. Of the cumulative average decline in GDP in 2011 and 2012 (by about 1
percent on a PPP-weighted basis), only about 15 percent may be attributable to
spillovers from one country to another, with the effect on GDP decline of only
about 0.1 percentage points. The spillovers are somewhat bigger on a simple-
average basis (0.2 percentage points), reflecting the fact that spillovers to larger
countries tend to be smaller.
While aggregate fiscal spillovers are limited, for small open economies such as
Ireland, Belgium, Netherlands, and Austria, spillovers can be substantial, largely
in 2012. Ireland, in particular, could substantially benefit from a coordinated

168
TABLE 6.3

Changes in Cyclically Adjusted Fiscal Aggregates
Fiscal measure = cyclically-adjusted revenue/expenditure (Fiscal change in percent of GDP)
2010 2011 2012
Countrya Revenue Expenditure Overall balance Revenue Expenditure Overall balance Revenue Expenditure Overall balance
Austria –1.1 0.1 –1.2 0.1 –0.7 0.8 0.0 –0.3 0.2
Belgium –0.1 –1.0 0.9 0.5 –0.2 0.7 –0.4 0.0 –0.4
Brazil 1.3 1.8 –0.6 –1.8 –1.2 –0.6 0.1 0.0 0.0
China 0.0 0.0 0.0 0.6 –0.5 1.1 0.8 0.1 0.7
France 0.3 0.7 –0.4 0.7 –0.8 1.5 0.0 –0.8 0.9
Germany –3.0 –1.1 –1.9 –0.5 –1.0 0.5 –0.4 –1.0 0.6
Greece 3.5 –3.8 7.4 3.8 0.3 3.5 –0.1 –0.9 0.8
India –0.4 –0.6 0.3 0.2 –0.3 0.6 1.1 0.2 0.9
Ireland 0.8 0.3 0.5 0.6 –0.6 1.2 0.4 –0.9 1.3
Italy –0.8 –0.6 –0.2 –0.6 –1.2 0.6 –0.5 –1.0 0.5
Japan –0.7 –0.2 –0.6 0.3 0.3 0.0 0.5 –0.2 0.7
Korea, Republic of –1.2 –2.4 1.2 –0.3 –0.6 0.3 0.3 –0.1 0.4
Netherlands –1.3 –0.9 –0.4 0.5 –0.9 1.4 0.3 –0.3 0.7
Portugal 2.2 0.5 1.6 0.7 –1.8 2.6 1.1 –0.1 1.2
Russian Federation –1.3 –1.5 0.3 0.1 –0.1 0.1 –0.5 –1.0 0.5
Spain 2.0 –0.2 2.2 0.4 –2.2 2.6 –0.2 –0.4 0.2
Sweden –2.3 1.0 –3.3 –0.6 0.0 –0.6 0.2 –0.7 1.0
Switzerland –1.4 0.0 –1.3 0.4 –0.1 0.5 0.1 –0.7 0.8
United Kingdom –0.9 –0.2 –0.7 0.6 –1.6 2.2 0.3 –1.7 2.0
United States –0.6 0.1 –0.7 –0.3 0.4 –0.8 1.4 –1.9 3.3
PPP weighted average –0.5 –0.2 –0.3 0.0 –0.3 0.3 0.6 –0.8 1.4
Simple average –0.3 –0.4 0.2 0.3 –0.6 0.9 0.2 –0.6 0.8
Sources: IMF, World Economic Outlook, April 2011; and IMF staff estimates.
a
Financial sector support recorded above-the-line was excluded for Ireland (2.5 percent of GDP in 2009 and 5.3 percent of GDP in 2010) and the US (2.4 percent of GDP in 2009, 0.2 percent of GDP in 2010 and 2011,
and 0.1 percent of GDP in 2012). Financial sector support is not expected to have a significant impact on demand. For Russia only non-oil revenues are assumed to have an impact on growth.

TABLE 6.4
The Impact of Changes in Cyclically Adjusted Aggregates on Growth

Fiscal Contribution to Growth
Fiscal measure = cyclically-adjusted revenue/expenditure (fiscal change in percent of GDP)
(In percentage points)
2010 2011 2012
Total Of which: Total Of which: Total Of which:
growth growth growth
Countrya impact Domestic effect Spillover effect impact Domestic effect Spillover effect impact Domestic effect Spillover effect
Austria 0.9 0.5 0.3 0.0 0.0 0.0 –0.8 –0.5 –0.3
Belgium 1.3 0.8 0.5 –0.6 –0.5 –0.1 –0.6 –0.2 –0.5
Brazil 0.9 0.8 0.1 –0.1 –0.1 0.0 0.0 0.0 –0.1
France 1.7 1.5 0.2 –0.5 –0.4 –0.1 –1.2 –1.0 –0.2
Germany 0.9 0.7 0.2 0.4 0.5 –0.1 –0.6 –0.5 –0.2
Greece –1.7 –1.7 0.0 –2.4 –2.4 0.0 –1.2 –1.2 0.0
Ireland 1.6 1.1 0.5 –0.5 –0.4 –0.1 –1.4 –0.8 –0.6
Italy 0.7 0.6 0.2 –0.8 –0.7 0.0 –1.0 –0.8 –0.2
India 0.3 0.2 0.1 –0.3 –0.3 0.0 –0.3 –0.3 –0.1
Netherlands 1.9 1.6 0.3 –0.5 –0.5 –0.1 –0.9 –0.6 –0.3
Portugal 1.8 1.7 0.2 –1.5 –1.4 –0.1 –1.3 –1.2 –0.2
Spain 1.4 1.3 0.1 –2.0 –1.9 –0.1 –1.3 –1.1 –0.2
Korea, Republic of –0.5 –0.8 0.3 –0.7 –0.7 –0.1 –0.5 –0.2 –0.2
Russian Federation 0.8 0.6 0.2 –0.2 –0.2 0.0 –0.6 –0.5 –0.1
Sweden 1.0 0.8 0.1 1.1 1.2 0.0 –0.2 –0.1 –0.1
Switzerland 0.7 0.5 0.2 0.2 0.3 0.0 –0.6 –0.4 –0.2
Ivanova and Weber

China, P.R. of 0.9 0.7 0.2 –0.4 –0.4 0.0 –0.6 –0.4 –0.2
Japan 1.8 1.7 0.0 0.2 0.2 0.0 –0.3 –0.3 –0.1
United Kingdom 1.2 1.1 0.1 –0.7 –0.7 0.0 –1.3 –1.2 –0.1
United States 0.7 0.7 0.0 0.3 0.3 0.0 –0.9 –0.9 0.0
PPP weighted average 0.9 0.8 0.1 –0.2 –0.1 0.0 –0.7 –0.6 –0.1
Simple average 0.9 0.7 0.2 –0.4 –0.4 0.0 –0.8 –0.6 –0.2
169
a
Financial sector support recorded above-the-line was excluded for the calculation of growth impact for Ireland (2.5 percent of GDP in 2009 and 5.3 percent of GDP in 2010) and the US (2.4 percent of GDP in 2009,
0.2 percent of GDP in 2010 and 2011, and 0.1 percent of GDP in 2012). Financial sector support is not expected to have a significant impact on demand. For Russia only non-oil revenues are assumed to have
an impact on growth.
0
–0.1
–0.2
–0.3
–0.4
–0.5
–0.6
–0.7
–0.8
Simple average PPP-weighted average
–0.9
–1
d
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ium
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Fr
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Figure 6.5 Inward Fiscal Spillovers (Impact on real GDP from cyclically adjusted fiscal
changes in other countries, cumulative 2011–2012, percent)
fiscal relaxation, although this would require contributions from the major
economies, including the United States and the United Kingdom, both countries
where such relaxation is not in the cards (Figure 6.5).
The decomposition of spillovers by country (Table 6A.3) reveals the rela-
tively large impact on PPP-weighted average from the United States and China
followed by the United Kingdom, Spain, France, and Italy. This reflects both the
size of the country and the actual amount of consolidation. For instance, while
a uniform fiscal shock would result in a larger impact from Germany than the
United Kingdom (Table 6A.2), Germany’s consolidation plans are much more
moderate than the United Kingdom’s consolidation plans, resulting in a rela-
tively larger impact from the United Kingdom under the actual consolidation
plans.
For some countries, the overall growth effect masks the various forces that are
at work. This is evident once the effect is decomposed into the effects from cur-
rent period consolidation and the carry-over effects from the last period’s fiscal
change. For instance, in the case of the Netherlands and Belgium, the spillovers
in 2011 are negative from the current period consolidation, but there are also
small positive spillovers from the previous year’s mostly expansionary fiscal
change in relevant trading partner countries, reducing the overall negative effect
from spillovers in 2011. However, for countries that are large and not very
open (e.g., the United States), spillovers tend to be negligible in both periods
(Table 6.5).

TABLE 6.5
Fiscal Contribution to Growtha (Percentage points)

2011 2012
Of which: Of which:
Change in the fiscal Total growth Change in the fiscal Total growth
balance impact Domestic effect Spillover effect balance impact Domestic effect Spillover effect
Germany 0.5 0.4 0.5 –0.1 0.6 –0.6 –0.5 –0.2
of which:
- current year –0.3 –0.2 –0.1 –0.4 –0.2 –0.1
- carry over prev. year 0.7 0.7 0.0 –0.3 –0.2 –0.1
Netherlands 1.4 –0.5 –0.5 –0.1 0.7 –0.9 –0.6 –0.3

of which:
- current year –0.5 –0.4 –0.2 –0.3 –0.1 –0.2
- carry over prev. year 0.0 –0.1 0.1 –0.6 –0.5 –0.1
Belgium 0.7 –0.6 –0.5 –0.1 –0.4 –0.6 –0.2 –0.5

of which:
- current year –0.4 –0.2 –0.2 –0.2 0.1 –0.3
- carry over prev. year –0.2 –0.4 0.1 –0.4 –0.2 –0.2
Portugal 2.6 –1.5 –1.4 –0.1 1.2 –1.3 –1.2 –0.2

of which:
- current year –1.1 –1.0 –0.1 –0.4 –0.3 –0.1
- carry over prev. year –0.3 –0.3 0.0 –1.0 –0.9 –0.1
Ivanova and Weber

PPP weighted average 0.3 –0.2 –0.1 –0.1 1.4 –0.7 –0.6 –0.1
Simple average 0.9 –0.4 –0.3 –0.1 0.8 –0.8 –0.6 –0.2
a
0.2 percent of GDP in 2010 and 2011, and 0.1 percent of GDP in 2012). Financial sector support is not expected to have a significant impact on demand. For Russia only non-oil revenues are assumed to have an
impact on growth.
171
Headline Fiscal Measure (Percent of GDP)

We now turn to a headline measure of fiscal changes that incorporates not only
the impact of discretionary fiscal policy but also that of automatic stabilizers.
While this measure is likely to overstate the impact on fiscal changes due to the
feedback effect to automatic stabilizers from changes in the GDP, it could be
viewed as an upper bound, which together with the impact estimated based on
the cyclically adjusted balance provides an estimate of the possible range of fiscal
changes on growth.
The change in the overall balance in percent of GDP is higher than that mea-
sured by the cyclically adjusted balance (0.6 percent of GDP in 2011 and 1.6
percent of GDP in 2012), largely due to the contribution from automatic stabiliz-
ers as the output gaps are closing. Automatic stabilizers also explain the
differences for 2010. This is particularly the case for Germany, where the esti-
mated impact on growth in 2010 using the headline measure almost doubled
(Figure 6.6 and Table 6.6).
These fiscal changes can be expected to reduce GDP growth in 2011 and 2012
cumulatively by about 1¼ percentage points. Again, the domestic effect of con-
solidation dominates, contributing 80 percent to the growth contraction, with
spillovers from one country to another contributing the remaining 20 percent. A
large variation across countries remains. The domestic effect from fiscal changes
will be substantial in Greece, Spain, Portugal, and the United Kingdom, exceed-
ing 2 percentage points over the two years. The domestic impact of fiscal chang-
es on growth in Sweden, Switzerland, and Brazil can be expected to be rather
small, less than ½ percentage point. The German domestic drag on growth over
2.5
Domestic
2.0 Spillover
Total
1.5
1.0
0.5
0.0
– 0.5
–1.0
–1.5
2010 2011 2012
Figure 6.6 Germany: Growth Contribution of Domestic Fiscal Changes and Spillover from
Fiscal Changes in Other Countries, 2010–2012 (Percentage points)

TABLE 6.6
Changes in Headline Fiscal Aggregates

Fiscal measure = health revenue/expenditure
(Fiscal change in percent of GDP)
2010 2011 2012
a
Country Revenue Expenditure Overall balance Revenue Expenditure Overall balance Revenue Expenditure Overall balance
Austria –0.9 0.1 –1.0 0.3 –0.7 1.0 0.1 –0.3 0.4
Belgium 0.2 –1.0 1.3 0.6 –0.2 0.8 –0.2 0.0 –0.1
Brazil 2.4 1.8 0.5 –1.8 –1.2 –0.6 0.0 0.0 –0.1
China 0.0 0.0 0.0 0.5 –0.5 1.0 0.7 0.1 0.6
France 0.5 0.7 –0.2 0.9 –0.8 1.7 0.3 –0.8 1.1
Germany –1.9 –1.4 –0.5 –0.2 –1.0 0.9 –0.2 –1.0 0.8
Greece 2.0 –3.8 5.8 2.6 0.4 2.3 0.0 –0.9 0.9
India –0.2 –0.6 0.4 0.3 –0.3 0.6 1.1 0.2 0.9
Ireland 0.6 0.3 0.3 0.7 –0.6 1.4 0.7 –0.9 1.7
Italy –0.5 –0.7 0.2 –0.4 –1.2 0.8 –0.2 –1.0 0.8
Japan 0.5 –0.2 0.7 0.6 0.2 0.3 0.8 –0.3 1.1
Korea, Republic of –0.6 –2.4 1.9 –0.1 –0.6 0.5 0.2 –0.1 0.3
Netherlands –0.9 –0.4 –0.6 0.8 –0.9 1.7 0.5 –0.3 0.8
Portugal 2.4 0.5 1.9 –0.1 –1.8 1.7 0.6 0.0 0.6
Russian Federation –0.7 –1.5 0.8 0.6 –0.1 0.7 –0.2 –1.0 0.8
Spain 1.7 –0.2 1.9 0.5 –2.2 2.7 0.1 –0.4 0.5
Sweden –0.7 0.7 –1.4 0.5 –0.2 0.7 0.8 –0.8 1.6
Switzerland –1.1 –0.1 –1.0 0.3 –0.1 0.5 0.1 –0.7 0.8
Ivanova and Weber

United Kingdom –0.4 –0.3 –0.2 0.7 –1.6 2.3 0.4 –1.7 2.1
United States –0.1 0.0 –0.2 0.2 0.4 –0.2 1.6 –1.9 3.6
PPP weighted average 0.0 –0.2 0.2 0.3 –0.4 0.6 0.8 –0.8 1.6
Simple average 0.1 –0.4 0.5 0.4 –0.7 1.0 0.4 –0.6 1.0
Source: IMF, World Economic Outlook, April 2011; and IMF staff estimates.
a
Financial sector support recorded above-the-line was excluded for Ireland (2.5 percent of GDP in 2009 and 5.3 percent of GDP in 2010) and the US (2.4 percent of GDP in 2009, 0.2 percent of GDP in 2010 and
173
2011, and 0.1 percent of GDP in 2012). Financial sector support is not expected to have a significant impact on demand. For Russia only non-oil revenues are assumed to have an impact on growth.

these two years will be noticeable—expected to reach 1 percentage point, with

another ¼ percentage point subtracted from growth due to the spillovers from
abroad.19 Most of this effect will be felt in 2012, since in 2011 the lagged effect
of the fiscal stimulus from 2010 was still lingering. The impact on 2011 growth
was muted due to the strong positive carry-over effects from the last period’s
expansion. This observation is true for the countries on average—consolidation
will have a stronger “bite” in 2012—though for some countries (e.g. the United
States) it also reflects a larger fiscal adjustment in 2012 (Table 6.7).
For most countries, spillovers to growth from fiscal policy in other countries
remain limited when using headline balance as a fiscal measure (below ½ percent-
age points over the next two years, Table 6A.4), though the average has slightly
increased. As with the cyclically adjusted measure, Ireland, Belgium, Austria, and
the Netherlands stand out (Figure 6.7). As in the case of the cyclically adjusted
measure, German influence is primarily with respect to its direct neighbors:
Austria, Belgium, the Netherlands and Switzerland. The United States is gener-
ally exerting a greater influence on other countries, and the United States and
China provide the largest contribution to the average (Figure 6.7).
To summarize, using the change in the headline ratio rather than the change in
the cyclical adjusted ratio does not substantially alter the main conclusions. While
the growth impact is larger in this case, the cross-border spillovers remain limited
in 2011 and 2012 with the exception of small and open European economies.
Real Fiscal Changes

The last measure of fiscal stance that we are employing is the change in real rev-
enues and expenditures. As discussed above, this is the measure that is most
consistent with the theoretical concept of the fiscal multiplier, but it is not com-
monly employed by the policymakers and, more importantly, the estimates of
fiscal multipliers obtained in the literature are often not based on this definition.
Consequently, although we present estimates based on the real fiscal changes
comparison, the results should be interpreted with caution.
First, note that as explained previously, as long as real GDP growth between
the two periods is non-zero the two measures of fiscal stance will differ, and since
revenue/expenditure-to-GDP ratios are rather large numbers (e.g., expenditure is
close to 40 percent on average in the sample of 20 countries), with even a moder-
ate real GDP growth of 2.5 percent (simple average in the sample for 2011) the
difference can be as large as 1 percent of GDP for revenue/expenditure measures.
For the overall balance, however, the differences are likely to be small, since the
overall balance is a relatively smaller number.
19
Given the recent divergence in the developments in the labor market in Germany and the output
gap, possibly, reflecting structural changes in the labor market, the commonly used cyclically adjusted
measure with elasticities estimated from historical data and the output gap is likely to understate the
true degree of discretionary policy intervention. While for comparability we used a common cyclical
adjustment method for all countries, we believe that for Germany the headline measure better cap-
tures changes in the underlying fiscal position.

TABLE 6.7
The Impact of Changes in Headline Fiscal Aggregates on Growth

Fiscal measure = headline revenue/expenditure (Fiscal change in percent of GDP)
2010 2011 2012
Total growth Of which: Total growth Of which: Total growth Of which:
Austria 1.9 1.4 0.5 –0.4 –0.2 –0.2 –1.0 –0.6 –0.4
Belgium 2.0 1.3 0.7 –0.9 –0.7 –0.3 –0.8 –0.3 –0.5
Brazil 1.0 0.9 0.1 –0.3 –0.3 0.0 0.0 0.1 –0.1
China, People’s Republic of 1.0 0.7 0.3 –0.5 –0.4 –0.1 –0.6 –0.4 –0.2
France 2.0 1.7 0.3 –0.7 –0.5 –0.1 –1.3 –1.1 –0.2
Germany 1.7 1.4 0.3 –0.3 –0.2 –0.1 –0.9 –0.7 –0.2
Greece –1.1 –1.1 0.1 –1.8 –1.8 0.0 –1.0 –0.9 –0.1
India 0.4 0.3 0.1 –0.4 –0.4 0.0 –0.3 –0.3 –0.1
Ireland 2.5 1.9 0.6 –0.6 –0.4 –0.2 –1.6 –0.9 –0.6
Italy 1.0 0.8 0.2 –0.9 –0.8 –0.1 –1.1 –0.9 –0.2
Japan 2.2 2.2 0.1 –0.4 –0.4 0.0 –0.6 –0.5 –0.1
Korea, Republic of –0.4 –0.8 0.4 –1.0 –0.8 –0.1 –0.5 –0.2 –0.3
Netherlands 2.7 2.2 0.5 –0.6 –0.4 –0.2 –1.1 –0.7 –0.4
Portugal 2.2 1.9 0.2 –1.4 –1.2 –0.1 –1.0 –0.8 –0.2
Russian Federation 1.3 1.0 0.2 –0.5 –0.4 –0.1 –0.8 –0.6 –0.1
Spain 2.1 1.9 0.2 –2.0 –1.9 –0.1 –1.4 –1.3 –0.2
Sweden 1.8 1.6 0.2 0.2 0.3 –0.1 –0.8 –0.7 –0.1
Ivanova and Weber

Switzerland 1.2 0.8 0.3 0.1 0.2 –0.1 –0.7 –0.4 –0.2
United Kingdom 1.4 1.3 0.2 –0.9 –0.8 0.0 –1.4 –1.3 –0.1
United States 0.8 0.8 0.0 0.1 0.1 0.0 –1.1 –1.0 0.0
PPP weighted average 1.2 1.0 0.2 –0.4 –0.3 –0.1 –0.8 –0.7 –0.1
Simple average 1.4 1.1 0.3 –0.7 –0.5 –0.1 –0.9 –0.7 –0.2
175
a
0
–0.1
–0.2
–0.3
–0.4
–0.5
–0.6
–0.7
–0.8
–0.9
–1
d
ina
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ia
nd
y
s
Sw ance
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ce
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Fr
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Be
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Fe
ite
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Un
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rea
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ssi
Ko
Ru
Figure 6.7 Inward Fiscal Spillovers (Impact on real GDP from headlined fiscal changes in
other countries, cumulative 2011–2012, percent)
With that in mind, the results presented below are not surprising. (Table 6.8)
The changes in the overall balance using the real measure based on the CPI20 are
rather close to those obtained by using the ratios to GDP. The composition of
changes, however, is quite different. In particular, while the measure in ratios sug-
gests that consolidation in 2011 and 2012, on average, includes both revenue and
expenditure contributions, the measures based on real changes suggests that in
real terms expenditures are in fact projected to increase, so consolidation is
mainly revenue-based.
Since the multiplier on revenue is lower than that on expenditure, this leads
to a substantially smaller estimated negative impact on growth, with the contribu-
tion to growth remaining positive, on average, in 2011, partly due to the lagged
effect from 2010. However, for some countries (e.g., Greece) where growth is
projected to remain in the negative territory in 2011, fiscal impulse measured by
the real change implies a larger consolidation on the expenditure side, so the
growth impact is more negative compared to the measure in ratio to GDP
(Table 6.9). (See Table 6A.5 for detailed country-by-country estimates).
The spillovers are also correspondingly much smaller on average than in the
case of the fiscal measure in ratios. While the list of top countries affected by the
spillovers (Ireland, Belgium, Netherlands, and Austria) is unchanged, the magni-
tude of spillovers in 2011–12 has declined substantially, and for Korea spillovers
have turned positive. However, the milder negative impact on growth should be
interpreted with caution, since the empirical estimates of multipliers obtained
20
We use CPI rather than the GDP deflator because the majority of fiscal changes work through either
private consumption decisions or government consumption. The results are not substantially different
if we employ the GDP deflator.

TABLE 6.8
Changes in Real Fiscal Aggregates

Fiscal measure = headline revenue/expenditure
(fiscal change in real terms)
2010 2011 2012
a
Country Revenue Expenditure Overall balance Revenue Expenditure Overall balance Revenue Expenditure Overall balance
Austria 0.1 1.1 –1.1 1.1 0.1 1.0 0.9 0.6 0.3
Belgium 1.1 –0.1 1.2 1.1 0.3 0.8 0.8 1.0 –0.2
Brazil 6.0 5.7 0.3 –0.3 0.4 –0.7 1.4 1.6 –0.2
China 2.3 2.7 –0.4 2.6 1.8 0.8 2.8 2.3 0.5
France 0.8 1.0 –0.2 1.5 –0.1 1.6 1.2 0.1 1.1
Germany –0.1 0.5 –0.6 0.7 –0.2 0.8 0.5 –0.2 0.8
Greece –0.3 –6.6 6.4 1.0 –1.6 2.6 0.4 –0.5 0.9
India 0.7 0.8 –0.1 1.8 1.9 –0.1 2.6 2.4 0.2
Ireland 0.5 0.1 0.4 1.3 0.1 1.2 1.5 0.0 1.5
Italy –0.1 –0.3 0.2 –0.1 –0.8 0.7 0.3 –0.4 0.7
Japan 1.3 0.9 0.5 0.8 0.5 0.3 1.2 0.2 1.0
Korea, Republic of 0.9 –1.1 2.0 0.9 0.3 0.6 1.3 0.9 0.5
Netherlands 0.1 0.8 –0.7 1.2 –0.4 1.7 1.0 0.2 0.8
Portugal 3.0 1.2 1.8 –1.2 –3.1 1.9 0.4 –0.2 0.6
Russian Federation 1.6 1.9 –0.4 2.6 2.9 –0.3 1.1 0.9 0.2
Spain 1.3 –0.7 2.0 0.3 –2.4 2.7 0.7 0.2 0.4
Sweden 1.8 3.3 –1.5 2.5 1.8 0.7 2.6 1.0 1.6
Switzerland –0.3 0.7 –1.0 1.1 0.6 0.5 0.7 –0.1 0.8
Ivanova and Weber

United Kingdom 0.0 0.3 –0.3 1.2 –0.9 2.1 1.5 –0.4 2.0
United States 0.5 0.9 –0.4 1.0 1.4 –0.5 2.5 –0.9 3.4
PPP weighted average 1.2 1.3 –0.1 1.3 1.0 0.4 1.9 0.6 1.4
Simple average 1.1 0.7 0.4 1.1 0.1 0.9 1.3 0.4 0.8
a
Financial sector support recorded above-the-line was excluded for Ireland (2.5 percent of GDP in 2009 and 5.3 percent of GDP in 2010) and the US (2.4 percent of GDP in 2009, 0.2 percent of GDP in 2010 and
177
2011, and 0.1 percent of GDP in 2012). Financial sector support is not expected to have a significant impact on demand. For Russia only non-oil revenues are assumed to have an impact on growth.

178
TABLE 6.9
The Impact of Changes in Real Fiscal Aggregates on Growth


Fiscal measure = headline revenue/expenditure (fiscal change in real terms)
2010 2011 2012
Total growth Of which: Total growth Of which: Total growth Of which:
Austria 2.5 2.0 0.5 0.3 0.3 0.0 –0.4 –0.2 –0.2
Belgium 2.1 1.5 0.7 –0.5 –0.4 0.0 –0.3 0.0 –0.3
Brazil 2.4 2.3 0.1 0.6 0.6 0.0 0.7 0.7 0.0
China 2.2 1.8 0.3 0.7 0.7 0.0 0.5 0.6 –0.1
France 1.9 1.6 0.3 –0.1 0.0 0.0 –0.5 –0.3 –0.1
Germany 1.8 1.5 0.3 –0.1 –0.1 0.0 –0.7 –0.6 –0.1
Greece –2.3 –2.3 0.1 –2.8 –2.8 0.0 –1.0 –1.0 0.0
India 0.9 0.7 0.1 0.7 0.7 0.0 0.8 0.9 0.0
Ireland 1.4 0.7 0.7 –0.3 –0.3 0.0 –0.9 –0.5 –0.4
Italy 0.8 0.5 0.2 –0.6 –0.5 0.0 –0.7 –0.6 –0.1
Japan 2.3 2.2 0.1 –0.2 –0.2 0.0 –0.4 –0.4 0.0
Korea, Republic of 0.2 –0.4 0.6 –0.3 –0.5 0.2 0.1 0.1 0.0
Netherlands 2.4 1.9 0.5 0.0 0.1 –0.1 –0.6 –0.4 –0.2
Portugal 2.3 2.0 0.2 –1.5 –1.4 –0.1 –1.2 –1.1 –0.1
Russian Federation 2.0 1.7 0.3 1.2 1.2 0.0 0.4 0.5 –0.1
Spain 1.6 1.4 0.2 –2.1 –2.1 0.0 –1.1 –1.1 –0.1
Sweden 2.1 1.9 0.2 0.9 0.9 0.0 –0.2 –0.2 –0.1
Switzerland 1.3 1.0 0.4 0.4 0.4 0.0 –0.3 –0.2 –0.1
United Kingdom 1.2 1.1 0.2 –0.6 –0.6 0.0 –1.0 –1.0 –0.1
United States 1.0 0.9 0.0 0.5 0.5 0.0 –0.7 –0.7 0.0
PPP weighted average 1.6 1.4 0.2 0.3 0.3 0.0 –0.2 –0.1 –0.1
Simple average 1.5 1.2 0.3 –0.2 –0.2 0.0 –0.4 –0.3 –0.1
a

0.2
0.1
–0.1
–0.2
–0.3
–0.4
Simple average PPP-weighted average
–0.5
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Figure 6.8 Inward Fiscal Spillovers (Impact on real GDP from headline real fiscal changes
in other countries, cumulative 2011–2012, percent)
from the literature may not correspond to this fiscal measure and the effects may
be underestimated (Figure 6.8).
To summarize, using real changes rather than the change in the ratio of the
fiscal position implies that the growth contribution of consolidation is generally
less negative, due to the fact that consolidation is no longer dominated by expen-
diture reductions but rather by revenue increases. While the net change in the
fiscal balance is mostly unaffected, the combination of higher revenue adjustment
and lower multipliers for revenue causes the contribution of fiscal changes to
GDP growth to fall. Consequently, using the real fiscal change as the relevant
fiscal measure leads to an even less important role of cross-country spillovers.
Higher Multipliers and Higher Import Elasticities

To evaluate the robustness of our results, we calculate growth impact under
higher multipliers and higher import elasticities. Higher revenue and expenditure
multipliers with unchanged import elasticity were calculated by assuming that
higher multipliers are a result of the higher marginal propensity to consume. This
is consistent with the proposition that higher multipliers after a financial crisis
may reflect a higher share of liquidity-constrained households and firms.
However, it implies a steeper rise in revenue multipliers, which are more sensitive
to the changes in the marginal propensity to consume. Correspondingly, we
raised revenue multipliers by 1.5 times the standard deviation of revenue multi-
pliers across the sample of 20 countries, while expenditure multipliers were raised
by one standard deviation of expenditure multipliers across the sample. This
resulted in an average revenue multiplier of about 0.7 (almost 50 percent higher
than in the baseline) and expenditure multipliers of about 1 (about 25 percent
higher than in the baseline).

Raising import elasticities is a more complex experiment, since higher import

elasticities would reduce marginal propensities to import and, therefore, would
reduce the size of fiscal multipliers. To evaluate the maximum impact on spillovers,
we have assumed that expenditure multipliers remain unchanged compared to the
baseline, which implies that the marginal propensity to consume has increased
enough to compensate for the reduction in expenditure multipliers due to higher
import elasticities. However, given the more elastic response of revenue multipliers
to changes in the marginal propensity to consume, they would have to increase
compared to the baseline. Therefore, we raised revenue multipliers by 0.5 times the
standard deviation of revenue multipliers in the sample, which resulted in an aver-
age revenue multiplier of about 0.5 (about 15 percent higher than in the baseline).
The results of these robustness checks for all three measures of fiscal position
are summarized in Figures 6.9a and 6.9b. They suggest that our main conclusions
on spillovers hold under the alternative assumptions. In particular, although fiscal
consolidation across the world may have a substantial impact on domestic
growth, fiscal spillovers from one country to another will play a limited role in
absolute terms—the aggregate spillovers not exceeding 0.3 percentage points over
the two years (2011 and 2012) on a PPP-average basis and 0.5 percentage points
on a simple-average basis. Fiscal spillovers will also play a limited role in relation
to impact on domestic growth. However, small open economies, such as Ireland,
Belgium, Austria, and the Netherlands, can be substantially affected. The effect
of domestic fiscal policy on growth, however, varies substantially, depending on
the choice of fiscal measure, the size of fiscal multipliers, and imports elasticities,
but in most cases a substantial reduction in growth would be in the cards.
It is also worth mentioning that while we simulated the impact under rela-
tively large import elasticities, the assumption here was that the process of nor-
malizing world trade after the collapse during the 2008–09 financial crisis will
continue in 2011–12. Hence, the import elasticities assumed are not as high as
those observed during the collapse of world trade in the course of the recent
financial crisis. Extreme import elasticities could lead to larger fiscal spillovers if
combined with an increase in the marginal propensity to consume. Therefore, if
the downward spiral in world trade were to reoccur, the rationale for a coordi-
nated fiscal relaxation would be strengthened.
Alternative Scenarios
The Growth Impact of More Consolidation
Continued market pressure and rising concerns about debt levels could lead gov-
ernments to consolidate beyond the currently announced level in the forthcom-
ing two years. We thus simulate the results for a scenario in which some countries
in the euro zone (Eur I) reduce spending by an additional 0.5 percent of GDP in
2011 and 2012 or, alternatively, manage to increase structural revenues by an
additional 0.5 percent of GDP in the two years.
Under the baseline multiplier scenario, spillovers are hardly affected, in par-
ticular if tax revenues increase in selected European countries. But even in the case

0.4
Domestic Spillover
0.2
0
–0.2
–0.4
–0.6
–0.8
–1
–1.2
–1.4
–1.6
–1.8
Baseline Higher Higher Baseline Higher Higher Baseline Higher Higher
parameters multipliers imports parameters multipliers imports parameters multipliers imports
elasticities elasticities elasticities
Cyclically Headline Headline
adjusted measure measure
measure (ratios) (real)
Figure 6.9a Cumulative Domestic Growth Impact and Fiscal Spillovers in 2011–2012
Under a Range of Fiscal Multipliers and Imports Elasticities and Using Various Measures of
Fiscal Changes (PPP-weighted average)
0.7
Domestic Spillover
0.2
–0.3
–0.8
–1.3
–1.8
–2.3
Baseline Higher Higher Baseline Higher Higher Baseline Higher Higher
parameters multipliers imports parameters multipliers imports parameters multipliers imports
elasticities elasticities elasticities
Cyclically- Headline Headline
adjusted measure measure
measure (ratios) (real)
Figure 6.9b Cumulative Domestic Growth Impact and Fiscal Spillovers in 2011–2012
Under a Range of Fiscal Multipliers and Imports Elasticities and Using Various Measures of
Fiscal Changes (Simple average)

of additional expenditure cuts, spillovers are limited, not exceeding an additional

growth reduction of 0.1 percentage points.
Assuming higher multiplier values causes the effect to be slightly magnified, in
particular for the small open economies. However, even in this case, growth spill-
overs do not increase by more than an additional 0.2 percentage points in any of
the exercises. Thus, greater consolidation in countries with no fiscal space (Eur II)
appears to lead to only limited growth spillovers beyond their border, although
such consolidation is likely to put an additional drag on growth in those countries
themselves (Table 6.10).
The Growth Impact of Coordinated Fiscal Relaxation

If spillovers were sufficiently large, a coordinated fiscal effort could alleviate the
negative impact of strong fiscal consolidation on GDP growth through positive
spillovers. To simulate the effect of such a policy, we compare the baseline speci-
fication to a specification in which (i) Germany reduces its expenditures by 0.5
percent of GDP less in 2011 and 2012; or (ii) an extended set of European coun-
tries (Austria, Germany, Netherlands, and Switzerland) reduce their expenditures
by 0.5 percent of GDP more in 2011 and 2012.
In the baseline multiplier case under the scenario that Germany slows the
reduction in spending by 0.5 percent of GDP, GDP growth in other countries is
hardly affected in 2012 through lowered negative spillover. In the high multiplier
scenario, the spillovers are also little affected; they are limited to an additional 0.1
percentage point higher growth rate in selected economies. Left alone to
Germany, it would require an increase in fiscal spending of about 2.5 percent of
GDP in 2011 and 2012 to move the growth rate in Ireland by 0.5 percentage
points. Such a scenario, however, does not take into account a possible negative
credibility effect of the German fiscal leadership in Europe as well as a narrower
space left for the ECB’s interest policy maneuver.
In a scenario in which Austria, the Netherlands, and Switzerland increase their
fiscal spending by 0.5 percent of GDP, effects change little under the baseline
assumption for the multipliers. Also, once the higher set of multipliers is applied,
effects are contained to an increase by 0.1 percentage point, with the exception of
the Netherlands, which grows by an additional 0.2 percentage point more due to
the lower consolidation in Austria, Germany, and Switzerland. Only under sig-
nificantly higher multipliers or import elasticities will the effect from less con-
solidation translate into visible growth effects in other countries.
The Impact on Trade Balances

We can also use the framework to evaluate the extent to which trade imbalances
(measured by the change in the real trade balance relative to the GDP in the
previous period) can be addressed by a coordination of demand management.
More precisely, we can determine by how much Germany’s trade balance would
deteriorate in comparison with the baseline if Germany were to consolidate by
0.5 percent less, and to what extent this would alter the trade balance of other

TABLE 6.10.
Total Growth Spillovers from Fiscal Consolidation, 2012a

Fiscal measure = cyclical adjusted revenue/expenditure, change in percent of previous year GDP
Baseline multiplier High multiplier
More consolidation Less consolidation More consolidation Less consolidation
German German
Baseline Eur I cntry (G)a Eur I cntry (T)a stimulus Eur II cntrya Baseline Eur I cntry (G)a Eur I cntry (T)a stimulus Eur II cntrya
Austria –0.3 –0.4 –0.4 –0.3 –0.2 –0.5 –0.6 –0.6 –0.4 –0.4
Belgium –0.5 –0.6 –0.5 –0.4 –0.4 –0.8 –1.0 –0.9 –0.7 –0.7
Brazil –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1
China, P.R. of –0.2 –0.2 –0.2 –0.2 –0.2 –0.3 –0.3 –0.3 –0.3 –0.3
France –0.2 –0.2 –0.2 –0.2 –0.2 –0.3 –0.4 –0.3 –0.3 –0.3
Germany –0.2 –0.2 –0.2 –0.2 –0.2 –0.3 –0.4 –0.4 –0.3 –0.3
Greece 0.0 –0.1 0.0 0.0 0.0 –0.1 –0.1 –0.1 –0.1 –0.1
India –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1
Ireland –0.6 –0.6 –0.6 –0.5 –0.5 –1.0 –1.1 –1.0 –0.9 –0.9
Italy –0.2 –0.2 –0.2 –0.1 –0.1 –0.3 –0.3 –0.3 –0.2 –0.2
Japan –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1 –0.1
Korea, Republic of –0.2 –0.3 –0.2 –0.2 –0.2 –0.4 –0.4 –0.4 –0.4 –0.4
Netherlands –0.3 –0.4 –0.3 –0.2 –0.2 –0.6 –0.7 –0.6 –0.5 –0.4
Portugal –0.2 –0.2 –0.2 –0.1 –0.1 –0.3 –0.3 –0.3 –0.2 –0.2
Russian Federation –0.1 –0.1 –0.1 –0.1 –0.1 –0.2 –0.2 –0.2 –0.2 –0.2
Spain –0.2 –0.2 –0.2 –0.1 –0.1 –0.2 –0.3 –0.3 –0.2 –0.2
Ivanova and Weber

Sweden –0.1 –0.1 –0.1 –0.1 –0.1 –0.2 –0.2 –0.2 –0.2 –0.2
Switzerland –0.2 –0.2 –0.2 –0.2 –0.2 –0.3 –0.4 –0.4 –0.3 –0.3
United Kingdom –0.1 –0.1 –0.1 –0.1 –0.1 –0.2 –0.2 –0.2 –0.2 –0.2
United States 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
PPP weighted average –0.1 –0.1 –0.1 –0.1 –0.1 –0.2 –0.2 –0.2 –0.2 –0.2
Simple average –0.2 –0.2 –0.2 –0.2 –0.2 –0.3 –0.4 –0.3 –0.3 –0.3
183
a
Less consolidation is an increase in expenditures by 0.5 percent of GDP in 2011 and 2012, while more consolidation is either a reduction in expenditures (G) or an increase in revenues (T) by 0.5 percent of GDP in
2011 and 2012. “Eur I” includes Belgium, France, Italy, Ireland, Greece, and Portugal. “Eur II” includes Austria, Germany, Netherlands, and Switzerland.

countries. We provide an additional simulation in which surplus countries

(defined as countries that had a current account surplus in the years 2008–10)
increase their spending by 0.5 percent of GDP in comparison with the baseline
(Tables 6.11 and 6.12).
If consolidation proceeds as predicted according to the WEO estimates, the
cumulative effect on the trade balance in 2012 will broadly contribute to a rebal-
ancing. Several surplus countries, including Germany Belgium, Sweden,
Switzerland, Russia, Korea, China, and Japan, are likely to experience a deteriora-
tion of the trade balance due to the fiscal changes, while deficit countries includ-
ing, Greece, Portugal, Spain, the United Kingdom, and the United States are
likely to experience an improvement in the trade balance. However, Ireland is
likely to experience no strong change in the trade balance. Overall, the magni-
tudes are moderate, and the trade balances of relatively closed economies, such as
Greece, Portugal and Spain, are primarily driven by domestic consolidation
rather than by spillovers, while the contrary is true for open economies such as
Belgium.
It turns out that the cumulative change in the trade balance in the peripheral
countries, implied by the scenario under which only Germany consolidates less,
is with the exception of Ireland no different from zero. Even when we simulate a
wider policy coordination effort encompassing other surplus countries, the
TABLE 6.11
Change in the Real Trade Balance in 20 Selected Countries, 2010–2012

Fiscal measure = cyclical adjusted revenue/expenditure, change in percent of previous year GDP
Of which:
Change trade balance Own effect Spillovers
Austria 0.0 0.3 –0.3
Belgium –0.6 0.6 –1.1
Brazil –0.1 0.0 –0.1
China –0.1 0.2 –0.3
France 0.2 0.5 –0.3
Germany –0.6 0.0 –0.6
Greece 1.1 1.2 –0.1
Ireland 0.0 1.0 –1.1
Italy 0.2 0.5 –0.3
India 0.1 0.2 –0.1
Japan –0.2 0.0 –0.2
Korea, Republic of 0.1 0.5 –0.4
Netherlands 0.0 0.8 –0.8
Portugal 0.6 1.1 –0.5
Russian Federation 0.0 0.2 –0.2
Spain 0.7 1.0 –0.3
Sweden –0.9 –0.5 –0.4
Switzerland –0.5 0.1 –0.5
United Kingdom 0.5 0.7 –0.2
United States 0.1 0.1 –0.1

TABLE 6.12
Change in the Real Trade Balance Due to Fiscal Consolidation in 20 Selected Countries (2010–2012)a
Fiscal measure = cyclical adjusted revenue/expenditure, change in percent of GDP
Baseline multiplier High multiplier
Difference to baseline Difference to baseline
Baseline German stimulus Selected surplus country Baseline German stimulus Selected surplus country
Austria 0.0 0.1 –0.3 0.0 0.1 –0.4
Belgium –0.6 0.2 0.3 –0.5 0.2 0.4
Brazil –0.1 0.0 0.1 –0.2 0.0 0.1
China, People’s Republic of –0.1 0.0 –0.1 –0.1 0.0 –0.1
France 0.2 0.0 0.1 0.3 0.0 0.1
Germany –0.6 –0.3 –0.1 –0.7 –0.4 –0.2
Greece 1.1 0.0 0.0 1.6 0.0 0.0
India 0.1 0.0 0.0 0.1 0.0 0.1
Ireland 0.0 0.1 0.2 0.3 0.1 0.2
Italy 0.2 0.0 0.1 0.2 0.0 0.1
Japan –0.2 0.0 0.0 –0.2 0.0 –0.1
Korea, Republic of 0.1 0.0 –0.2 0.1 0.0 –0.2
Netherlands 0.0 0.2 –0.1 0.1 0.2 –0.2
Russian Federation 0.0 0.0 –0.1 0.0 0.0 –0.1
Portugal 0.6 0.0 0.1 0.8 0.0 0.1
Spain 0.7 0.0 0.1 0.9 0.0 0.1
Sweden –0.9 0.0 –0.1 –1.1 0.1 –0.2
Ivanova and Weber

Switzerland –0.5 0.1 0.0 –0.6 0.1 –0.1
United Kingdom 0.5 0.0 0.1 0.6 0.0 0.1
United States 0.1 0.0 0.0 0.1 0.0 0.0
PPP weighted average 0.0 0.0 0.0 0.0 0.0 0.0

Simple average 0.0 0.0 0.0 0.1 0.0 0.0
a
The assumption for the scenarios is an increase in government spending by 0.5 percent in 2011 and 2012. The sample of surplus countries is given by Austria, China, Korea, Japan, Germany,
185
Netherlands, Russia, Sweden, and Switzerland.

impact on the peripheral countries remains contained to an improvement of

0.1–0.2 percentage points. Only Belgium is likely to experience an improvement
in the trade balance by close to ½ percentage point.
The reason for the low impact is that most of the correction in the trade bal-
ance is brought about by domestic policies, since none of the peripheral countries
is highly interlinked in trade terms with the core countries that have surpluses.
Additionally, the absence of an impetus from the United States or the United
Kingdom in this scenario explains the low impact on Ireland.
CONCLUSION
In a world of unsynchronized fiscal spending patterns across countries and nor-
mal interest rate levels, spillovers from fiscal policies across countries are likely to
be limited. However, since 2009 the fiscal patterns across most developed coun-
tries have been largely synchronized. While the magnitude varies, in most coun-
tries the fiscal expansion of 2009 and 2010 is set to be followed by fiscal consoli-
dation in 2011, 2012, and beyond. At the same time, the interest rates remain
low, while the output gaps have not closed yet in many advanced economies. In
such an economic environment, fiscal multipliers are likely to be above the usual
levels, and a synchronized and significant swing in fiscal policy from expansion to
consolidation is likely to magnify the role of spillovers from fiscal policy across
countries.
We find that even in this setting, aggregate negative spillovers to other coun-
tries are likely to be contained in 2011–12. Despite potentially sizeable domestic
effects from consolidation, we find that the cumulative impact on GDP over the
two years (2011 and 2012) is not likely to exceed 0.3 percentage points on a PPP-
weighted basis and ½ percentage points on simple-average basis under the various
assumptions on fiscal multipliers and import elasticities. While the absolute size
of spillovers varies depending on the measure of fiscal stance, size of multipliers,
and imports elasticities, average spillovers are invariably small compared to the
size of the impact of domestic fiscal policy.
Nevertheless, the average masks differences across countries. For small and
open European economies such as Belgium, Netherlands, and Austria, spillovers
are important. In contrast, the coordinated exit from fiscal stimulus will have a
limited direct effect on European peripheral countries, since they are relatively
closed, with the notable exception of Ireland. While the latter could benefit from
external support, such support would require contributions from the major
economies, including the United States and the United Kingdom—both coun-
tries where fiscal relaxation is not currently in the cards. Changes in the German
fiscal plan alone would have a very limited impact on the European periphery.
Under the baseline scenario, projected fiscal change for 2011 and 2012 will
help reduce external imbalances. However, the effects over these two years are
likely to be relatively small. While a stronger fiscal expansion in surplus countries
could reduce the respective countries’ surpluses, the “leakages” tend not to go to

the peripheral countries. Therefore, most of the correction in the peripheral coun-
tries’ trade balances will have to be brought about by domestic consolidation in
these countries.
Consequently, the bad news is that the countries in need cannot rely much on
other countries’ fiscal policies to stimulate their growth in the short run. The
good news, however, is that ambitious consolidation plans in the European
peripheral countries will have only limited repercussions for much of the rest of
the world.
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APPENDIX
TABLE 6A.1
Assumptions on Fiscal Multipliers and Elasticities by Country, Baseline Multipliers (Higher values in, baseline multipliers brackets)
Revenue multiplier Expenditure multiplier Elasticities
Current year Previous year Current year Previous year Import elasticity Revenue Expenditure
Austria 0.2 (0.29) 0.6 (0.82) 0.7 (0.82) 1.1 (1.29) 1.08 (1.57) 0.90 –0.07
Belgium 0.18 (0.27) 0.48 (0.69) 0.35 (0.47) 0.74 (0.93) 1.05 (1.54) 0.99 –0.13
Brazil 0.22 (0.31) 0.42 (0.64) 0.56 (0.67) 0.82 (1.01) 1.34 (1.83) 0.77 –0.16
China 0.22 (0.31) 0.42 (0.64) 0.56 (0.67) 0.82 (1.01) 1.13 (1.62) 1.00 0.00
France 0.2 (0.29) 0.3 (0.52) 0.7 (0.82) 1.1 (1.29) 1.14 (1.63) 0.88 –0.10
Germany 0.35 (0.44) 0.74 (0.95) 0.4 (0.51) 0.8 (1) 1.14 (1.63) 0.94 –0.24
Greece 0.22 (0.31) 0.42 (0.64) 0.56 (0.67) 0.82 (1.01) 1.12 (1.61) 0.77 –0.16
India 0.22 (0.31) 0.42 (0.64) 0.56 (0.67) 0.82 (1.01) 1.33 (1.82) 1.14 –0.03
Ireland 0.2 (0.29) 0.4 (0.62) 0.4 (0.51) 0.8 (1) 1.07 (1.56) 0.90 –0.10
Italy 0.16 (0.24) 0.32 (0.54) 0.58 (0.69) 0.96 (1.15) 1.14 (1.63) 0.89 –0.23
Japan 0.35 (0.44) 0.74 (0.95) 0.4 (0.51) 0.8 (1) 1.37 (1.86) 1.00 –0.05
Korea, Republic of 0.22 (0.31) 0.42 (0.64) 0.56 (0.67) 0.82 (1.01) 1.1 (1.59) 0.99 –0.13
Netherlands 0.1 (0.18) 0.28 (0.49) 0.34 (0.46) 0.76 (0.95) 1.07 (1.56) 1.16 –0.03
Portugal 0.23 (0.31) 0.49 (0.7) 0.45 (0.57) 0.84 (1.03) 1.09 (1.58) 1.15 –0.04
Russian Federation 0.22 (0.31) 0.42 (0.64) 0.56 (0.67) 0.82 (1.01) 1.12 (1.61) 1.00 0.00
Ivanova and Weber

Spain 0.23 (0.31) 0.45 (0.67) 0.6 (0.72) 1 (1.19) 1.14 (1.63) 1.06 –0.07
Sweden 0.18 (0.27) 0.48 (0.69) 0.35 (0.47) 0.74 (0.93) 1.11 (1.6) 0.94 –0.19
Switzerland 0.18 (0.27) 0.48 (0.69) 0.35 (0.47) 0.74 (0.93) 1.1 (1.59) 0.99 –0.13
United Kingdom 0.25 (0.34) 0.4 (0.62) 0.4 (0.52) 0.65 (0.84) 1.13 (1.62) 1.10 –0.05
United States 0.2 (0.29) 0.3 (0.52) 0.4 (0.52) 0.6 (0.79) 1.3 (1.79) 1.10 –0.09
Average 0.22 (0.3) 0.45 (0.66) 0.49 (0.6) 0.83 (1.02) 1.15 (1.64) 0.98 –0.10
Sources: Organisation for Economic Cooperation and Development (2010); Kee, Nicita and Olarreaga (2008); and IMF staff calculations.
189
TABLE 6A.2
Impact of a 1 Percent of GDP Reduction in Fiscal Spending on Growth After Two Years,
Baseline Multipliers (Percent)
From: Austria Belgium Brazil China France Germany Greece India Ireland Italy Japan
To:
Austria –1.10 –0.01 –0.01 –0.02 –0.03 –0.16 0.00 –0.01 0.00 –0.05 –0.01
Belgium –0.01 –0.75 0.00 –0.02 –0.12 –0.12 0.00 –0.02 0.00 –0.04 –0.01
Brazil 0.00 0.00 –0.82 –0.02 0.00 –0.01 0.00 0.00 0.00 0.00 –0.01
China 0.00 0.00 –0.01 –0.82 –0.01 –0.01 0.00 –0.01 0.00 –0.01 –0.04
France 0.00 –0.01 0.00 –0.01 –1.11 –0.05 0.00 –0.01 0.00 –0.03 –0.01
Germany –0.02 –0.01 0.00 –0.02 –0.03 –0.81 0.00 –0.01 0.00 –0.02 –0.01
Greece 0.00 0.00 0.00 0.00 0.00 –0.01 –0.82 0.00 0.00 –0.01 0.00
India 0.00 0.00 0.00 –0.01 0.00 –0.01 0.00 –0.82 0.00 0.00 –0.01
Ireland 0.00 –0.04 –0.01 –0.02 –0.04 –0.05 0.00 –0.01 –0.81 –0.03 –0.04
Italy –0.01 0.00 0.00 –0.01 –0.03 –0.03 0.00 –0.01 0.00 –0.97 –0.01
Japan 0.00 0.00 0.00 –0.02 0.00 0.00 0.00 0.00 0.00 0.00 –0.81
Korea, 0.00 0.00 –0.01 –0.14 –0.01 –0.01 0.00 –0.02 0.00 –0.01 –0.05
Republic of
Netherlands –0.01 –0.03 0.00 –0.01 –0.05 –0.11 0.00 –0.01 –0.01 –0.03 –0.01
Portugal 0.00 0.00 0.00 0.00 –0.03 –0.02 0.00 0.00 0.00 –0.01 0.00
Russian 0.00 0.00 0.00 –0.02 –0.01 –0.03 0.00 –0.01 0.00 –0.02 –0.01
Federation
Spain 0.00 0.00 0.00 –0.01 –0.04 –0.03 0.00 0.00 0.00 –0.02 –0.01
Sweden 0.00 –0.01 0.00 –0.01 –0.01 –0.03 0.00 –0.01 0.00 –0.01 –0.01
Switzerland –0.01 0.00 –0.01 –0.02 –0.03 –0.06 0.00 –0.03 0.00 –0.02 –0.02
United 0.00 0.00 0.00 –0.01 –0.01 –0.02 0.00 0.00 –0.01 –0.01 –0.01
Kingdom
United States 0.00 0.00 0.00 –0.01 0.00 0.00 0.00 0.00 0.00 0.00 –0.01
PPP –0.01 –0.01 –0.04 –0.18 –0.05 –0.06 0.00 –0.07 0.00 –0.04 –0.08
weighted
average

TABLE 6A.2 (continued)
Impact of a 1 Percent of GDP Reduction in Fiscal Spending on Growth After Two Years,
Baseline Multipliers (Percent)
Korea,
Republic Russian United United Inward
of Netherlands Portugal Federation Spain Sweden Switzerland Kingdom States Total Spillovers
–0.01 –0.01 0.00 –0.01 –0.01 –0.01 –0.02 –0.02 –0.04 –1.53 –0.43
0.00 –0.04 0.00 –0.01 –0.02 –0.01 –0.01 –0.03 –0.04 –1.26 –0.51
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.02 –0.89 –0.07
–0.01 –0.01 0.00 –0.01 0.00 0.00 0.00 –0.01 –0.07 –1.03 –0.21
0.00 –0.01 0.00 –0.01 –0.02 0.00 –0.01 –0.02 –0.03 –1.34 –0.23
–0.01 –0.01 0.00 –0.01 –0.01 –0.01 –0.01 –0.01 –0.03 –1.04 –0.22
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.86 –0.05
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.02 –0.90 –0.08
–0.01 –0.02 0.00 –0.01 –0.03 –0.01 –0.01 –0.06 –0.14 –1.33 –0.52
0.00 –0.01 0.00 –0.01 –0.01 0.00 –0.01 –0.01 –0.02 –1.15 –0.18
–0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.02 –0.88 –0.08
–0.82 0.00 0.00 –0.01 0.00 0.00 0.00 –0.01 –0.07 –1.17 –0.34
0.00 –0.76 0.00 –0.01 –0.02 –0.01 –0.01 –0.03 –0.03 –1.13 –0.37
0.00 –0.01 –0.84 0.00 –0.05 0.00 0.00 –0.01 –0.01 –1.01 –0.16
–0.01 –0.01 0.00 –0.82 –0.01 0.00 0.00 –0.01 –0.02 –0.98 –0.16
0.00 –0.01 –0.01 0.00 –1.00 0.00 0.00 –0.01 –0.01 –1.17 –0.17
0.00 –0.01 0.00 –0.01 –0.01 –0.74 0.00 –0.01 –0.02 –0.88 –0.14
0.00 0.00 0.00 –0.01 –0.01 0.00 –0.74 –0.01 –0.03 –1.00 –0.26
0.00 –0.01 0.00 0.00 –0.01 0.00 0.00 –0.65 –0.02 –0.77 –0.12
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.60 –0.63 –0.03
–0.03 –0.02 0.00 –0.04 –0.03 –0.01 –0.01 –0.03 –0.20 –0.91 –0.14

TABLE 6A.3
Cumulative Growth Impact of Actual Consolidation in 2011–2012, Cyclically-Adjusted Fiscal

Measure, Baseline Multipliers (Percent)
To:
Austria –0.52 –0.01 0.00 –0.02 –0.04 0.00 –0.02 –0.01 0.00 –0.08 0.00
Belgium 0.00 –0.69 0.00 –0.02 –0.15 0.00 –0.02 –0.01 –0.01 –0.06 0.00
Brazil 0.00 0.00 –0.01 –0.02 0.00 0.00 0.00 0.00 0.00 0.00 0.00
China 0.00 0.00 0.00 –0.79 –0.01 0.00 0.00 –0.01 0.00 –0.01 0.00
France 0.00 –0.01 0.00 –0.01 –1.41 0.00 –0.01 0.00 0.00 –0.04 0.00
Germany –0.01 –0.01 0.00 –0.02 –0.04 0.03 –0.01 0.00 0.00 –0.04 0.00
Greece 0.00 0.00 0.00 0.00 –0.01 0.00 –3.54 0.00 0.00 –0.02 0.00
India 0.00 0.00 0.00 –0.01 0.00 0.00 0.00 –0.58 0.00 –0.01 0.00
Ireland 0.00 –0.04 0.00 –0.02 –0.06 0.00 –0.01 0.00 –1.20 –0.04 0.00
Italy 0.00 0.00 0.00 –0.01 –0.04 0.00 –0.02 0.00 0.00 –1.56 0.00
Japan 0.00 0.00 0.00 –0.02 0.00 0.00 0.00 0.00 0.00 0.00 –0.02
Korea, Republic of 0.00 0.00 0.00 –0.13 –0.01 0.00 –0.02 –0.01 0.00 –0.01 0.00
Netherlands 0.00 –0.03 0.00 –0.01 –0.06 0.00 –0.02 0.00 –0.01 –0.05 0.00
Portugal 0.00 0.00 0.00 0.00 –0.03 0.00 0.00 0.00 0.00 –0.02 0.00
Russian Federation 0.00 0.00 0.00 –0.02 –0.02 0.00 0.00 0.00 0.00 –0.02 0.00
Spain 0.00 0.00 0.00 –0.01 –0.05 0.00 –0.01 0.00 0.00 –0.03 0.00
Sweden 0.00 0.00 0.00 –0.01 –0.02 0.00 0.00 0.00 0.00 –0.01 0.00
Switzerland –0.01 0.00 0.00 –0.01 –0.03 0.00 –0.01 –0.02 0.00 –0.04 0.00
United Kingdom 0.00 0.00 0.00 –0.01 –0.02 0.00 0.00 0.00 –0.02 –0.01 0.00
United States 0.00 0.00 0.00 –0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00
PPP weighted 0.00 –0.01 0.00 –0.17 –0.07 0.00 0.00 –0.05 –0.01 –0.06 0.00
average

Cumulative Growth Impact of Actual Consolidation in 2011–2012, Cyclically-Adjusted Fiscal

Korea,
Republic Russian United United
of Netherlands Portugal Federation Spain Sweden Switzerland Kingdom States Total Domestic Spillovers
–0.01 –0.01 –0.01 –0.01 –0.04 0.01 0.00 –0.05 –0.04 –0.85 –0.52 –0.34
0.00 –0.06 –0.01 –0.01 –0.07 0.01 0.00 –0.11 –0.04 –1.25 –0.69 –0.57
0.00 0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 –0.02 –0.09 –0.01 –0.07
–0.02 –0.01 0.00 –0.01 –0.01 0.00 0.00 –0.02 –0.07 –0.97 –0.79 –0.18
0.00 –0.01 –0.01 –0.01 –0.07 0.01 0.00 –0.05 –0.03 –1.67 –1.41 –0.27
–0.01 –0.02 –0.01 –0.01 –0.04 0.01 0.00 –0.04 –0.03 –0.24 0.03 –0.27
0.00 0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 –0.01 –3.59 –3.54 –0.05
0.00 0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 –0.02 –0.66 –0.58 –0.08
–0.01 –0.03 –0.01 –0.01 –0.09 0.01 0.00 –0.20 –0.15 –1.85 –1.20 –0.66
0.00 –0.01 –0.01 –0.01 –0.04 0.00 0.00 –0.03 –0.02 –1.76 –1.56 –0.20
–0.01 0.00 0.00 0.00 0.00 0.00 0.00 –0.01 –0.02 –0.10 –0.02 –0.08
–0.87 –0.01 0.00 –0.01 –0.01 0.00 0.00 –0.02 –0.07 –1.16 –0.87 –0.30
0.00 –1.10 –0.01 –0.01 –0.06 0.01 0.00 –0.09 –0.03 –1.46 –1.10 –0.36
0.00 –0.01 –2.53 0.00 –0.16 0.00 0.00 –0.03 –0.01 –2.81 –2.53 –0.27
–0.01 –0.02 0.00 –0.66 –0.02 0.01 0.00 –0.02 –0.02 –0.80 –0.66 –0.14
0.00 –0.01 –0.04 0.00 –3.09 0.00 0.00 –0.04 –0.01 –3.30 –3.09 –0.21
0.00 –0.01 0.00 0.00 –0.02 1.05 0.00 –0.04 –0.02 0.90 1.05 –0.15
0.00 –0.01 0.00 0.00 –0.03 0.00 –0.15 –0.03 –0.03 –0.38 –0.15 –0.23
0.00 –0.01 0.00 0.00 –0.02 0.00 0.00 –1.95 –0.02 –2.07 –1.95 –0.12
0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.01 –0.59 –0.62 –0.59 –0.03
–0.03 –0.02 –0.01 –0.03 –0.09 0.01 0.00 –0.10 –0.19 –0.86 –0.73 –0.13

TABLE 6A.4
Cumulative Growth Impact of Actual Consolidation in 2011–2012, Headline Fiscal

Measure in Ratios, Baseline Multipliers (Percent)
Korea,
Republic
From: Austria Belgium Brazil China France Germany Greece India Ireland Italy Japan of
To:
Austria –0.82 –0.01 0.00 –0.02 –0.05 –0.18 –0.01 –0.01 0.00 –0.09 –0.02 –0.01
Belgium –0.01 –0.92 0.00 –0.02 –0.17 –0.13 –0.01 –0.01 –0.01 –0.07 –0.01 –0.01
Brazil 0.00 0.00 –0.23 –0.02 0.00 –0.01 0.00 0.00 0.00 0.00 –0.01 0.00
China 0.00 0.00 0.00 –0.74 –0.01 –0.02 0.00 –0.01 0.00 –0.01 –0.05 –0.02
France 0.00 –0.02 0.00 –0.01 –1.58 –0.05 –0.01 0.00 0.00 –0.05 –0.01 –0.01
Germany –0.01 –0.01 0.00 –0.02 –0.05 –0.90 –0.01 –0.01 0.00 –0.04 –0.01 –0.01
Greece 0.00 0.00 0.00 0.00 –0.01 –0.01 –2.71 0.00 0.00 –0.02 0.00 0.00
India 0.00 0.00 0.00 –0.01 –0.01 –0.01 0.00 –0.62 0.00 –0.01 –0.01 –0.01
Ireland 0.00 –0.05 0.00 –0.02 –0.07 –0.06 –0.01 0.00 –1.31 –0.05 –0.04 –0.01
Italy 0.00 –0.01 0.00 –0.01 –0.04 –0.04 –0.01 0.00 0.00 –1.73 –0.01 0.00
Japan 0.00 0.00 0.00 –0.02 0.00 0.00 0.00 0.00 0.00 0.00 –0.89 –0.01
Korea, 0.00 0.00 0.00 –0.13 –0.01 –0.02 –0.01 –0.01 0.00 –0.01 –0.06 –1.07
Republic of
Netherlands –0.01 –0.04 0.00 –0.01 –0.07 –0.13 –0.01 0.00 –0.01 –0.05 –0.01 –0.01
Portugal 0.00 0.00 0.00 0.00 –0.04 –0.03 0.00 0.00 0.00 –0.02 0.00 0.00
Russian 0.00 0.00 0.00 –0.02 –0.02 –0.03 0.00 0.00 0.00 –0.03 –0.01 –0.01
Federation
Spain 0.00 –0.01 0.00 –0.01 –0.06 –0.03 –0.01 0.00 0.00 –0.04 –0.01 0.00
Sweden 0.00 –0.01 0.00 –0.01 –0.02 –0.03 0.00 0.00 0.00 –0.02 –0.01 0.00
Switzerland –0.01 0.00 0.00 –0.01 –0.04 –0.06 –0.01 –0.02 0.00 –0.04 –0.02 –0.01
United 0.00 –0.01 0.00 0.00 –0.02 –0.02 0.00 0.00 –0.02 –0.01 –0.01 0.00
Kingdom
United States 0.00 0.00 0.00 –0.01 0.00 0.00 0.00 0.00 0.00 0.00 –0.01 0.00
PPP –0.01 –0.01 –0.01 –0.16 –0.08 –0.07 0.00 –0.05 –0.01 –0.07 –0.09 –0.04
weighted
average

Cumulative Growth Impact of Actual Consolidation in 2011–2012, Headline Fiscal

Measure in Ratios, Baseline Multipliers (Percent)
Russian United United Inward

Netherlands Portugal Federation Spain Sweden Switzerland Kingdom States Total Domestic Spillovers
–0.01 –0.01 –0.02 –0.04 0.00 –0.01 –0.05 –0.06 –1.4 –0.8 –0.59
–0.06 –0.01 –0.01 –0.08 –0.01 0.00 –0.11 –0.06 –1.7 –0.9 –0.79
0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 –0.02 –0.3 –0.2 –0.10
–0.01 0.00 –0.01 –0.01 0.00 0.00 –0.02 –0.11 –1.0 –0.7 –0.29
–0.01 –0.01 –0.01 –0.07 0.00 0.00 –0.05 –0.04 –2.0 –1.6 –0.37
–0.02 0.00 –0.01 –0.04 0.00 0.00 –0.05 –0.04 –1.2 –0.9 –0.33
0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 –0.01 –2.8 –2.7 –0.08
0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 –0.03 –0.7 –0.6 –0.11
–0.02 –0.01 –0.01 –0.09 0.00 0.00 –0.21 –0.22 –2.2 –1.3 –0.88
–0.01 0.00 –0.01 –0.05 0.00 0.00 –0.03 –0.04 –2.0 –1.7 –0.28
0.00 0.00 0.00 0.00 0.00 0.00 –0.01 –0.03 –1.0 –0.9 –0.10
–0.01 0.00 –0.01 –0.01 0.00 0.00 –0.02 –0.10 –1.5 –1.1 –0.40
–1.08 –0.01 –0.01 –0.06 –0.01 0.00 –0.09 –0.04 –1.6 –1.1 –0.57
–0.01 –2.02 0.00 –0.17 0.00 0.00 –0.03 –0.02 –2.4 –2.0 –0.33
–0.01 0.00 –1.06 –0.02 0.00 0.00 –0.02 –0.03 –1.3 –1.1 –0.21
–0.01 –0.03 –0.01 –3.17 0.00 0.00 –0.04 –0.02 –3.4 –3.2 –0.26
–0.01 0.00 –0.01 –0.02 –0.38 0.00 –0.04 –0.03 –0.6 –0.4 –0.21
–0.01 0.00 –0.01 –0.03 0.00 –0.24 –0.03 –0.05 –0.6 –0.2 –0.35
–0.01 0.00 0.00 –0.02 0.00 0.00 –2.10 –0.04 –2.3 –2.1 –0.17
0.00 0.00 0.00 0.00 0.00 0.00 –0.01 –0.91 –1.0 –0.9 –0.04
–0.02 –0.01 –0.05 –0.10 0.00 0.00 –0.11 –0.30 –1.19 –1.0 –0.19

TABLE 6A.5
Cumulative Growth Impact of Actual Consolidation in 2011–2012, Headline Real Fiscal

To:
Austria 0.12 0.00 0.01 0.04 –0.01 –0.13 –0.02 0.02 0.00 –0.06 –0.01
Belgium 0.00 –0.43 0.01 0.03 –0.04 –0.10 –0.02 0.04 0.00 –0.04 –0.01
Brazil 0.00 0.00 1.28 0.03 0.00 0.00 0.00 0.01 0.00 0.00 –0.01
China 0.00 0.00 0.01 1.28 0.00 –0.01 0.00 0.02 0.00 –0.01 –0.03
France 0.00 –0.01 0.01 0.02 –0.35 –0.04 –0.01 0.01 0.00 –0.03 –0.01
Germany 0.00 0.00 0.01 0.03 –0.01 –0.65 –0.01 0.01 0.00 –0.03 –0.01
Greece 0.00 0.00 0.00 0.00 0.00 –0.01 –3.81 0.00 0.00 –0.01 0.00
India 0.00 0.00 0.01 0.02 0.00 0.00 0.00 1.57 0.00 0.00 –0.01
Ireland 0.00 –0.02 0.01 0.03 –0.02 –0.04 –0.01 0.01 –0.75 –0.03 –0.03
Italy 0.00 0.00 0.01 0.02 –0.01 –0.03 –0.02 0.01 0.00 –1.13 –0.01
Japan 0.00 0.00 0.00 0.04 0.00 0.00 0.00 0.01 0.00 0.00 –0.64
Korea, Republic of 0.00 0.00 0.02 0.22 0.00 –0.01 –0.02 0.04 0.00 –0.01 –0.04
Netherlands 0.00 –0.02 0.00 0.02 –0.02 –0.09 –0.02 0.01 –0.01 –0.03 –0.01
Portugal 0.00 0.00 0.01 0.01 –0.01 –0.02 0.00 0.00 0.00 –0.01 0.00
Russian Federation 0.00 0.00 0.00 0.03 0.00 –0.02 –0.01 0.01 0.00 –0.02 –0.01
Spain 0.00 0.00 0.01 0.01 –0.01 –0.02 –0.01 0.01 0.00 –0.02 0.00
Sweden 0.00 0.00 0.01 0.02 0.00 –0.02 0.00 0.01 0.00 –0.01 –0.01
Switzerland 0.00 0.00 0.01 0.02 –0.01 –0.04 –0.01 0.06 0.00 –0.03 –0.01
United Kingdom 0.00 0.00 0.00 0.01 0.00 –0.01 0.00 0.01 –0.01 –0.01 0.00
United States 0.00 0.00 0.00 0.01 0.00 0.00 0.00 0.00 0.00 0.00 –0.01
PPP weighted 0.00 0.00 0.06 0.28 –0.02 –0.05 0.00 0.14 0.00 –0.05 –0.06
average

Cumulative Growth Impact of Actual Consolidation in 2011–2012, Headline Real Fiscal

Korea,
Republic Russian United United Inward
of Netherlands Portugal Federation Spain Sweden Switzerland Kingdom States Total Spillovers
0.00 –0.01 –0.01 0.03 –0.04 0.01 0.00 –0.04 –0.01 –0.1 –0.23
0.00 –0.02 –0.01 0.02 –0.08 0.01 0.00 –0.08 –0.01 –0.7 –0.32
0.00 0.00 0.00 0.01 –0.01 0.00 0.00 –0.01 0.00 1.3 0.01
–0.01 0.00 0.00 0.02 –0.01 0.00 0.00 –0.02 –0.02 1.2 –0.07
0.00 0.00 –0.01 0.01 –0.07 0.00 0.00 –0.04 –0.01 –0.5 –0.18
0.00 –0.01 –0.01 0.02 –0.04 0.01 0.00 –0.03 –0.01 –0.7 –0.08
0.00 0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 0.00 –3.8 –0.03
0.00 0.00 0.00 0.00 –0.01 0.00 0.00 –0.01 –0.01 1.6 –0.01
0.00 –0.01 –0.01 0.01 –0.09 0.01 0.00 –0.16 –0.05 –1.1 –0.40
0.00 0.00 –0.01 0.02 –0.05 0.00 0.00 –0.03 –0.01 –1.2 –0.10
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.01 –0.6 0.03
–0.35 0.00 0.00 0.02 –0.01 0.00 0.00 –0.01 –0.02 –0.2 0.17
0.00 –0.38 –0.01 0.01 –0.06 0.01 0.00 –0.07 –0.01 –0.7 –0.28
0.00 0.00 –2.50 0.00 –0.17 0.00 0.00 –0.02 0.00 –2.7 –0.22
0.00 0.00 0.00 1.73 –0.02 0.00 0.00 –0.01 0.00 1.7 –0.05
0.00 0.00 –0.04 0.01 –3.16 0.00 0.00 –0.03 0.00 –3.3 –0.12
0.00 0.00 0.00 0.01 –0.02 0.73 0.00 –0.03 0.00 0.7 –0.06
0.00 0.00 0.00 0.01 –0.03 0.00 0.13 –0.02 –0.01 0.1 –0.07
0.00 0.00 0.00 0.01 –0.02 0.00 0.00 –1.57 –0.01 –1.6 –0.06
0.00 0.00 0.00 0.00 0.00 0.00 0.00 –0.01 –0.17 –0.2 –0.00
–0.01 –0.01 –0.01 0.08 –0.10 0.01 0.00 –0.08 –0.05 0.1 –0.04


CHAPTER 7
Current Account Imbalances:

Can Structural Policies Make
a Difference?
ANNA IVANOVA
The discussion of global and regional imbalances has put the spotlight on a possible
link between current accounts and structural policies. Drawing on standard empirical
current account models, the paper finds that the commonly recommended structural
factors cannot explain the widening of imbalances prior to the 2008–09 crisis. That
said, structural factors do help explain some part of long-standing cross-country differ-
ences in the current account levels. In particular, countries with stricter credit market
regulation, higher taxes on businesses, lower minimum wage (in particular, in slow-
growing economies), and generous unemployment benefits tend to have higher current
account balances than others.
INTRODUCTION
Although the relationship between global current account imbalances and the
financial crisis of 2008–09 is far from obvious, concern remains that such imbal-
ances are a continuing source of global instability and a threat to a sustainable
recovery (Blanchard and Milesi-Ferretti 2009). The seriousness with which the
imbalances are viewed is reflected in the far-reaching actions that have been pro-
posed to limit them, including a suggestion for imposing quantitative targets on
the current account balances.1 Underlying these proposals is the premise that
some sizeable fraction of both the surpluses and the deficits represents
The author is grateful for invaluable support and guidance from Ashoka Mody. She also thanks Fabian
Bornhorst for allowing her to use some of his analysis. The chapter has benefited from the insightful
comments by participants at several workshops at the Germany in an Interconnected World Economy
conference organized by the Federal Ministry of Finance of Germany, with particular thanks to the
discussant, Carsten-Patrick Meier; “Preventing and Correcting Macro Economic Imbalances in the
Euro Area” co-organized by the Central Bank of the Netherlands and the IMF; and the IMF internal
group on macroeconomic imbalances in Europe. Special thanks also go to Akito Matsumoto for help-
ful discussions. Susan Becker provided valuable research assistance.
1
See, for example, the proposal by U.S. Treasury Secretary Timothy Geithner to the meeting of G-20
ministers in South Korea in 2010 (http://graphics8.nytimes.com/packages/pdf/10222010geithnerletter.
pdf ).
199

200 Current Account Imbalances: Can Structural Policies Make a Difference?
“distortions.” In other words, where the current account balance is the outcome
of an “optimal” allocation of resources (“good imbalance”), it is not a problem;
but the imbalances that result from policy distortions or externalities are “bad.”
Since distortions are undesirable even from the country perspective, their mitiga-
tion by policy action is twice blessed, since this also scales back the threat from
global instability.
In this paper, I empirically examine the contribution of structural factors—the
presumed locus of the distortions—to current account imbalances. While the
analysis covers an extended period, 1975–2009, I use the results to interpret
developments during the last phase of the sample period. It was in those years that
the unprecedented global expansion and exuberance were accompanied by widen-
ing imbalances. I conclude that a significant fraction of the imbalances in the
run-up to the crisis reflected the global cycle. Yet, since much policy attention has
been focused on possible structural causes and remedies, the bulk of the paper is
devoted to assessing the link between structural policies and the current account.
I apply these findings in particular to Germany, where the current account sur-
plus surged to 7.5 percent of GDP in 2007.
In practice, the specific distortions at the root of imbalances remain a matter
of some speculation, with competing explanations for the observed behavior of
the current account. For example, high current account surpluses due to low
investment may reflect a variety of factors, including lack of competition in the
financial sector, high corporate taxation, or expectations of low potential growth.
More seriously, the same package of structural policies is at times prescribed to
both surplus and deficit countries. That package often includes deregulation of
product, services, and credit markets, reduction in employment protections,
removal of rigidities in the labor market, and taxation. While these policies may
be good for many reasons, their impact on the current account is not clear a
priori. Structural policies, which may influence productivity growth and/or access
to credit, could impact both savings and investment decisions. The variety of
channels and the complex interactions between them make the issue an empirical
one, a perspective that I adopt.
For a panel of 106 advanced, emerging, and developing countries, I estimate
an equation to determine the correlates of the current account balance, using five-
year non-overlapping averages. As is standard practice, to represent the intertem-
poral consumption and investment decisions underlying the current account, I
include such control variables as income growth and level, population age struc-
ture, fiscal balance, initial net foreign asset position, and the degree of financial
integration. In line with other recent studies, I find that these standard determi-
nants of the current account did not evolve significantly during the final years of
the global exuberance and so cannot be used to explain the emergence of global
imbalances. I then add a number of variables representing structural factors.
Even more so than the standard variables, structural factors changed little over
time or changed in the same direction in both surplus and deficit countries.
Therefore, these factors can explain very little of the emergence of imbalances
prior to the crisis.

Ivanova 201
I infer from these findings that the emergence of imbalances was likely linked
to cyclical factors. Germany, in particular, was able to benefit from the global
increase in demand for technology-intensive goods, in the production of which
Germany has a comparative advantage. However, the “windfall” profits of
German firms due to their export success did not immediately translate into an
increase in domestic investment, since German firms apparently viewed the boom
as temporary, and the German growth potential remained low.
As a further consideration, I ask if structural policies, while not directly influ-
ential, may have helped shape the response of the current account to the standard
variables. The evidence presented in this paper suggests that even in their role as
absorbers or amplifiers of changes in fundamentals, structural factors account for
only a small fraction of the imbalances.
To be clear, even if they are not candidates for explaining the rise in imbal-
ances, some structural factors do have a meaningful correlation with the current
account balance and so can explain longstanding differences in the current account
balances across countries. Even these findings need to be qualified, however, as
they are often not robust across country samples and time periods, with some com-
monly recommended policies increasing and some reducing the current account
balance. With these caveats, the empirical results suggest that lower business taxa-
tion, credit market regulation,2 and unemployment benefits can reduce the current
account surplus. Consistent with earlier studies, I find that a lower minimum wage
and less strict employment protection, often recommended for making the labor
market “more flexible,” are associated with larger current account surpluses. In the
application to Germany, this would imply that the minimum wage would have to
be raised and employment protection strengthened to reduce the current account
surplus, although this may not be desirable since a higher minimum wage and
stricter employment protection might also raise unemployment. These findings’
relevance to Germany is therefore unclear. However, in some of Europe’s periph-
eral economies, reducing minimum wage and lowering employment protection
could contribute to reducing their current account deficits.
The empirical evidence therefore points to select structural measures that
would need to be tailored to particular countries, rather than a package of broad
structural policies for addressing imbalances. For Germany, these results suggest
that lower taxes on businesses, further reduction in the gross unemployment
replacement rate, and a smaller public share in the banking system3 could reduce
the surplus. Altogether, however, the impact on the German current account
surplus will likely be modest.
2
The measure of credit market regulation employed in this paper includes four components measur-
ing the degree of public ownership of the banking system, control of interest rates, percentage of
credit extended to private sector, and competition from foreign banks.
3
Germany scores well on all of the subcomponents of the index of credit market regulation except the
degree of public ownership of the banking system due to the large presence of publicly owned banks
(Landesbanken and Sparkassen).

LITERATURE REVIEW
The relationship between structural policies and the current account remains an
open one. The literature agrees that fundamentals such as income per capita,
demographics, fiscal policy, and other traditional factors are important determi-
nants of the current account. But beyond that, while several recent studies point
to imbalances in the run-up to the 2008–09 crisis as “excessive” compared to the
fundamentals, the role of structural factors in the emergence of these imbalances
remains an open question. The overall impact of the commonly recommended
package of structural policies—such as liberalization of product, services and
credit markets, reduction in employment protection, removal of other labor mar-
ket rigidities, and reduction in business taxation—remains unclear.
Chinn and Prasad (2003), Abiad, Leigh and Mody (2009), Jaumotte and
Sodsriwiboon (2010), and Lane and Milessi-Ferretti (2011) find that current
account balances are largely driven by such fundamentals as relative per-capita
income, fiscal stance, demographics, oil prices, the initial net foreign assets posi-
tion, and the degree of financial integration conditional on income level. The
studies find a positive and significant relationship between relative income per
capita and the current account, possibly capturing the fact that capital flows from
rich countries to poor countries, where there are higher growth “catching up”
opportunities. The current account balances are also found to be relatively large
where the fiscal balances are relatively large, suggesting that private sector savings
provide only a partial Ricardian offset to changes in public savings (the coefficient
is often found to be less than one).
Higher old and young dependency ratios are associated with lower current
account balances, since relatively higher dependency ratios are associated with the
lower aggregate savings. However, the expected change in the old dependency
ratio has a positive association with the current account, since countries that age
rapidly are saving more. For oil producers, the current account is positively
related to the oil balance, which captures fluctuations in the oil price. The litera-
ture also finds that the current account is positively associated with the initial net
foreign assets position. While it is somewhat counterintuitive, this finding likely
reflects the fact that the net foreign assets position is generating net investment
income, which is part of the current account. Financial integration is also found
to facilitate access to capital for poor countries; hence, poorer countries tend to
have lower current account balances at a given state of financial integration. Some
studies also find that among developing countries, the degree of trade openness is
negatively associated with the current account balance. Chinn, Eichengreen, and
Ito (2011) also find weak evidence that countries with more developed financial
markets have weaker current accounts, but their results are not robust.
While a substantial body of literature exists on the link between current
accounts and macroeconomic fundamentals, the literature on the link between
structural policies and the current account is scarce and inconclusive. Following
is a summary of the recent studies, which should allow one to view this chapter
in proper perspective.

Ivanova 203
Kennedy and Sløk (2005) conclude that current account imbalances are struc-
tural in nature because they deviate from the current accounts projected under
unchanged fiscal policies, unchanged real exchange rates, and monetary policy
aimed at closing the output gap in the medium term. They also find that cycli-
cally adjusted current accounts are correlated with the potential growth, although
this correlation is largely driven by cross-country differences. On the other hand,
they do not find a robust link between specific structural policies and the current
account in their reduced-form pooled time series and cross-country regressions,
which they conducted on a sample of 14 OECD countries. However, there is
some evidence that more open product and financial markets are associated with
weaker current accounts. The other variables under investigation included indica-
tors of labor market regulation, foreign direct investment (FDI) restrictiveness,
financial market development (stock market capitalization), and labor market
performance (trend participation rate and non-accelerating inflation rate of
unemployment, or NAIRU). Nevertheless, they encourage policymakers to
undertake structural policies because a faster growing economy will improve wel-
fare, though it may or may not reduce imbalances.
Kerdrain, Koske and Wanner (2010) estimate reduced-form regressions in a
large panel of 117 advanced, emerging, and developing countries to assess the
impact of structural policies on savings, investment, and the current account.
They conclude that structural policies may influence savings, investment, and the
current account, not only through their impact on macroeconomic conditions
such as productivity growth or public revenues and expenditures but also directly.
In particular, social spending, notably spending on health care, is associated with
lower savings rates, possibly due to lower precautionary savings, and with a lower
current account. Stricter employment protection is associated with lower savings
rates, if unemployment benefits are low, as well as higher investment rates, per-
haps due to a greater substitution of capital for labor, leading to lower current
account balances. Product market liberalization is found to temporarily boost
investment, though direct impact on the current account could not be detected.
Financial market deregulation may lower the savings rate, although only in less
developed countries, and again the direct impact on the current account could
not be detected.
While the Kerdrain, Koske and Wanner (2010) study is rather comprehensive,
their regression includes country-specific fixed effects, which may absorb some of the
cross-country variation in the current account, possibly related to the structural
variables, which do not change significantly over time. Also, some of their other
variables, such as user cost of capital and productivity growth, might reflect struc-
tural conditions. As a result, their study does not allow one to fully answer the ques-
tion of the individual impact of various structural policies on the current account.
Kerdrain, Koske, and Wanner (2010) find little evidence that structural poli-
cies affect the speed of adjustment of the current account to the equilibrium. In
contrast, Ju and Wei (2007) provide evidence that rigid labor markets reduce the
speed of adjustment of the current account to the long-run equilibrium. The lat-
ter authors use a two-step approach: first, they estimate a speed of convergence of

the current account ratio to the steady state for each country separately, using a
vector-error correction model, and second, they relate the speed of convergence
to the degree of labor market rigidity in a cross-section of countries. However,
large economies, such as the United States, Japan, and Germany, are excluded
from this analysis, because the authors suggest that the current accounts in large
economies could behave systematically differently due to the importance of not
only their domestic labor market flexibility but also foreign labor market
flexibility.
Jaumotte and Sodsriwiboon (2010) estimate pooled current account regres-
sions with traditional determinants as controls in a smaller sample of 49 advanced
and emerging economies to test for the importance of the European Monetary
Union and the potential impact of policies. They find that financial liberalization
and higher minimum wage lower the current account, while no direct link could
be detected between the level of employment protection or the level of unemploy-
ment benefits and the current account. In an econometric study covering 100
advanced, emerging, and developing countries for the period 2001–09 (annual
data), Bayoumi, Vamvakidis, and Vitek (2010) find that countries with more
(less) credit market regulation have higher (lower) current account balances while
controlling for traditional fundamentals.4
Berger and Nitsch (2010) investigate the link between employment protection
and product market regulation and the bilateral trade balances as a fraction of
total bilateral trade in a sample of 18 European countries over a long time horizon
(1948 through 2008). They find that countries with less flexible labor and product
markets exhibit systematically lower bilateral trade surpluses than others.
A recent body of literature also identifies imbalances in the period preceding
the crisis as “excessive” compared to fundamentals. These studies including
Barnes, Lawson, and Radziwill (2010), who estimate current account regression
with traditional factors in a sample of 25 OECD countries; Lane and Milessi-
Ferretti (2011), in a sample of 65 advanced and emerging economies; and Chinn,
Eichengreen, and Ito (2011), in a sample of 109 industrial and developing coun-
tries. Barnes, Lawson, and Radziwill (2010) and Chinn, Eichengreen, and Ito
(2011) find some evidence that such excesses could partly be explained by hous-
ing investment, real housing appreciation, and stock market performance.
However, large residuals remain, in particular, for the United States and China.
Lane and Milessi-Ferretti (2011) conclude that the countries with the largest
excesses before the 2008–09 crisis have experienced the largest corrections there-
after, and also find that the adjustment in deficit countries has been achieved
primarily through demand compression rather than expenditure switching.
They further conclude that the high output costs that have been associated
with the rapid current-account corrections provide support for research that
assesses whether current account deficits during good times might partly reflect
4
Bayoumi, Vamvakidis, and Vitek (2010) employ an index of credit market regulation constructed by
the Fraser Institute, which is also utilized in this paper (see Appendix for details).

Ivanova 205
distortions that fail to internalize the risk of a subsequent sudden stop. It is not
clear, however, what exactly these distortions are.
Finally, theoretical literature (see, for example, Vogel 2011) suggests that while
structural policies that mainly target supply-side weaknesses may help regain
competitiveness in economies with competitiveness problems in the short run, in
the longer run this effect is offset by the income effect as imports rise.
Consequently, the lasting long-term rebalancing of external accounts also requires
the correction of demand imbalances.
The current paper contributes to the existing empirical literature in the follow-
ing three dimensions. First, it attempts to shed some light of the role of struc-
tural policies in the emergence of imbalances in the run-up to the 2008–09
financial crisis. Second, it assesses the direct impact of a commonly recommended
package of structural policies on the current account in a large sample of
advanced, emerging, and developing countries while controlling for traditional
macroeconomic fundamentals. Third, it assesses the potential size of the current
account reduction due to these policies in Germany, which has come under a
spotlight due to its large current account surplus.
While the results in this paper support some of the earlier findings, they point
to the lack of robustness of many results in determining the level of the current
account. Moreover, the paper emphasizes the muted role of structural factors in
causing the growth of imbalances just prior to the recent crisis. For Germany, the
paper offers some policy directions for change but cautions that the quantitative
effects may be small.
BASELINE MODEL
This section introduces the results of the baseline econometric model. The base-
line model is estimated using a random effects model in a sample of 106
advanced, emerging, and developing countries. It includes traditional fundamen-
tals, which were found to be important current account determinants in the
earlier literature. As a robustness check, an Ordinary Least Squares OLS model
with cluster robust standard errors (not including fixed effects) is also estimated
and yields similar results. The current account is averaged over five-year non-
overlapping periods spanning the period of 1975–2009, since the goal is to iden-
tify the determinants of the medium term or so to speak “structural current
account.” Many of the explanatory variables enter as deviations from the PPP-
weighted sample average in a given period, which captures the fact that current
accounts are determined by the countries’ positions relative to their trading part-
ners. Data sources are described in the Appendix.
The baseline model (Table 7A.1)5 largely confirms the findings in the litera-
ture. Higher relative income per capita, fiscal balance, and initial net foreign
assets position as well as higher oil prices for oil producers are associated with the
5
Tables 7A.1 through 7A.6 may be found at the end of this chapter.

higher current account balances.6 Countries with relatively high current depen-
dency ratios have lower current account balances, as the elderly tend to draw on
savings more. However, countries with the higher expected increases in the
dependency ratio, capturing the speed of aging, are found to have higher current
account surpluses.
The regression also includes the degree of financial integration, measured by
the sum of foreign assets and liabilities in percent of GDP and the interaction of
the financial integration with the GDP per capita growth in the previous period
(column 2). The link between financial integration and the current account
works more robustly through growth than through the income level. In particu-
lar, it reduces the current account balance in the countries with higher previous-
period growth. However, high-growth countries also tend to be poorer countries,
so this finding is consistent with that in Abiad, Leigh and Mody (2009).
The model presented in this chapter does not include any crisis dummies,
unlike some of the earlier studies. The reason is that the goal is to explain the
developments in the current account with the known set of factors, including
structural policies, while the dummies could capture some of the effects without
identifying the policies and factors behind the crisis.
The relationship between the fundamentals and the current account balance
in the sample of OECD countries is somewhat different (Tables 7A.1, 7A.2,
7A.4, and 7A.5, columns 1 and 2). The relationship between the current account
and income per capita, fiscal balance, the ratio of net foreign assets to GDP, old
dependency ratio, an increase in the old dependency ratio, and the interaction of
financial integration and past growth remains broadly unchanged in the OECD
sample, although in some cases the coefficients become insignificant. In contrast,
the coefficient on the young dependency ratio becomes positive and significant.
While this result appears counterintuitive, it is consistent with the findings of
Kerdrain, Koske, and Wanner (2010) as well as Barnes, Lawson and Radziwill
(2010). It could perhaps be explained by the fact that richer OECD countries can
afford to save more for future generations, for example for education purposes.
The degree of trade openness also appears to matter more in a sample of OECD
countries; in particular, the higher the trade openness the higher is the current
account surplus, perhaps reflecting the fact that richer countries that are also more
open tend to export capital to the poorer countries.
The baseline model generates a fairly good fit, especially for advanced coun-
tries, explaining about 35 percent of the variation in the current account bal-
ances in the sample. The model explains cross-country variation better than
time-series variation, with the between R-square of 0.5 (Figures 7.1a and 7.1b).
6
Although some of the variables, e.g. financial integration, openness, and oil price, may be nonsta-
tionary, the residuals from the baseline regression estimated on annual data are found to be stationary
using an augmented Dickey-Fuller test, though they exhibit serial correlation. Therefore, the results
of the random effects model were estimated using standard errors robust for heteroscedasticity and
serial correlation.

Ivanova 207
0.3
0.2
Actual current account to GDP
0.1
– 0.1
– 0.2
– 0.3
– 0.4
– 0.5
– 0.1 – 0.05 0 0.05 0.1 0.15
Fitted Current Account to GDP
Figure 7.1a Actual and Fitted Current Account to GDP, Advanced Economies
0.3
0.2
Actual current account to GDP
0.1
– 0.1
– 0.2
– 0.3
– 0.4
– 0.5
– 0.15 – 0.1 –0.05 0 0.05 0.1
Fitted Current Account to GDP
Figure 7.1b Actual and Fitted Current Account to GDP, Other Countries
Sources: Annual Macroeconomic Database of the European Commission (AMECO); World Economic Outlook data-
base; and IMF staff estimates.
Nonetheless, the residuals from the current account regression largely mirror
the imbalances that emerged in mid-2000. The “fundamentals” therefore did not
evolve to generate the imbalances. This is the case even when accounting for the
potential impact of the financial integration and trade openness. The fact that
imbalances widened across the globe suggests that some global forces were at
work, although country-specific factors probably determined the direction of
change in the current accounts (Figures 7.2a and 7.2b).

10
China Germany
8
Japan Spain
6
United States
4
2
0
–2
–4
–6
–8
–10
1975 1980 1985 1990 1995 2000 2005
Year indicates the beginning of the 5-year period
Figure 7.2a Current Account Balance, Germany and Four Large Economies, 1975–2005
(Five-year averages, percent of GDP)
10
China Germany
8
Japan Spain
6
United States
4
2
0
–2
–4
–6
–8
– 10
1975 1980 1985 1990 1995 2000 2005
Figure 7.2b Residuals from the Baseline Model, Germany and Four Large Economies,
1975–2005 (Five-year averages, percent of GDP)
Sources: Annual Macroeconomic Database of the European Commission (AMECO); IMF, World Economic Outlook
database; and IMF staff estimates.
STRUCTURAL POLICIES AND THE CURRENT

ACCOUNT
This section introduces structural policies such as regulation, taxation, and the
level of minimum wage and unemployment benefits, and discuss the results of the
estimation when these factors are added to the baseline regression as five-year
averages.
With respect to the emergence of imbalances, two distinct possibilities emerge
regarding what role structural policies could have played. First, structural policies
on their own could have directly impacted the current accounts. For example, a
high level of business taxation may have reduced investment incentives, leading

Ivanova 209
4.5
Japan
4.0 United States
Germany
3.5
Spain
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1989 1992 1995 1998 2001 2004 2007
Figure 7.3a Employment Protection, Germany and Three Selected Countries, 1989–2007
0.6
0.5
0.4
0.3
China Japan
United States Germany
0.2
Spain
0.1
0.0
1980 1983 1986 1989 1992 1995 1998 2001 2004
Figure 7.3b Gross Unemployment Replacement Rate, Germany and Four Selected
Countries, 1980–2004
12
10
4
China Japan
2 United States Germany
Spain
0
1985 1988 1991 1994 1997 2000 2003 2006
Figure 7.3c Credit Market Regulation, Germany and Four Selected Countries, 1985–2006

2
United States Japan
1 Spain Germany
0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Figure 7.3d Regulation in Electricity/Transport/Communication, Germany and Three

Selected Countries, 1980–2007
Sources: Aleksynska and Schindler (2011); Fraser Institute; and Organisation for Economic Cooperation and
Development.
to lower investment and higher current account balances. Second, structural

policies could have shaped the response of the current account to changes in
macroeconomic fundamentals and shocks, including global shocks. But even if
structural policies did not play a major role in the emergence of imbalances in any
way, they might help explain the differences in the levels of the current accounts
across the globe. In that case, they could also be used as a tool for reducing imbal-
ances. These three possibilities are investigated below.
First, I note that many structural indictors either did not change substantially over
time, in particular during the period of the emergence of global imbalances, or if they
did, often changed in the same direction for the surplus and deficit countries (Figures
7.3a-d).7 China is the notable exception, where its credit market was substantially
deregulated in 2005 and there was a substantial increase in the ratio of minimum to
mean wages in 2002. However, given the earlier findings in the literature on the
impact of the financial liberalization and the minimum wage, one could expect both
of these changes to reduce China’s current account surplus. So it is unlikely that
structural factors on their own can explain the emergence of imbalances.
Second, I augment baseline regressions with the structural indicators that vary
over time 8 (see Table 7A.1 for the full sample and Table 7A.4 for an OECD
7
In Germany, the 2004 Hartz IV reform reduced unemployment benefits and social transfers and
increased the flexibility of temporary employment. The subcomponent of the employment protection
indicator, which measures protection of temporary employment, did decline, but the overall index
increased.
8
Some of the variables to replace the missing values were interpolated, as some of these variables are
not available on an annual basis. I also extrapolated the values of some structural variables to 2009,
since for this year many of the structural variables were not available. The index of employment pro-
tection is available only for OECD countries, but there are subcomponents of this indicator, such as
advance notice period and severance pay after nine months, available for a broader set of countries in
(Aleksynska and Schindler, 2011). I constructed an employment protection index for a broader set
using an out-of-sample forecast from the regression of the employment protection index on advance
notice period and severance pay after nine months.

Ivanova 211
sample). Generally, the results do not indicate a robust relationship between the
current account and structural policies, although in some specifications in the full
sample the coefficient on the unemployment gross replacement ratio is positive
and significant, while that on the ratio of the minimum-to-mean wage and
employment protection indicator is negative and significant. No significant asso-
ciation is found for OECD countries, although the sample there is rather small.
The positive association between the current account and the gross unemploy-
ment replacement rate could reflect the fact that generous unemployment systems
might contribute to higher unemployment rates by reducing incentives to seek
new jobs (Bassani and Duval 2006, Vandenberg 2010). In such an environment,
the unemployment rate and the probability of becoming unemployed are higher,
which could lead to higher precautionary savings by households. However, there
might be a counteracting impact as high unemployment benefits provide higher
income in the event of job loss. However, to have a negative impact on the current
account-to-GDP-ratio, this higher income would have to lead to an increase in
the marginal propensity to consume. The results suggest that the latter effect has
not been important historically.9
The negative association between the ratio of the minimum wage to the mean
wage and the current account is consistent with earlier findings and may reflect
the fact that higher minimum wage may lead to higher labor costs and, therefore,
hurt competitiveness. This, in principle, could work through both savings and
investment channels. Higher labor costs may reduce corporate profitability and
savings. However, higher labor costs may also encourage companies to substitute
capital for labor, when the latter is expensive.
Finally, higher employment protection is associated with a lower current
account, which is consistent with the findings in the literature that higher
employment protection reduces savings and increases investment. Higher
employment protection raises implicit and explicit labor costs, so the impact can
be similar to that of the minimum wage.
Not surprisingly, the residuals from the regression where three of the struc-
tural variables are included (unemployment gross replacement rate, ratio of the
minimum-to-mean wage, and employment protection index) continue to mirror
the imbalances (Figure 7A.2). Hence, structural factors on their own did not
evolve to generate the imbalances either.
While structural policies may not have contributed directly to the emergence
of imbalances, they may have helped shape the response of the current account to
macroeconomic shocks and changes in the fundamentals. In other words, struc-
tural factors might have played a role as macroeconomic shock absorbers or
amplifiers. This hypothesis is tested by analyzing the interaction of structural
factors with the more dynamic fundamentals.
9
At the time of the financial crisis, however, the impact of the reduction in unemployment benefits
may have been different from that observed historically, since the level of unemployment may be
largely a reflection of lower demand for labor rather than lower labor supply. Hence, the finding on
unemployment benefits should be interpreted in the medium-term context.

10
Japan United States
8
Germany Spain
6
4
2
0
−2
−4
−6
−8
−10
1990 1995 2000 2005
Figure 7.4 Residuals from the Model with Structural Variables, Germany and Three
Selected Countries, 1990–2005 (Five-year averages, percent of GDP)
LONG-STANDING STRUCTURAL DIFFERENCES AND

THE CURRENT ACCOUNT
The long-standing differences in the levels of structural variables on the figures
above are striking. They reflect not only policy differences but also differences in
institutional arrangements and social norms. As such, these factors could have
been important in explaining the long-standing cross-country differences in the
current accounts.
To test this hypothesis, given a rather small sample size, all structural variables
over all available years were averaged to construct a structural indicator for each
country that captures that country’s long-term structural characteristic. The
relationship between the current account and these structural variables, which
do not vary over time, are investigated, while controlling for fundamentals as
before (see Tables 7A.1 and 7A.2 for the global sample; Table 7A.4 for the
OECD sample). In most cases, structural variables enter as deviations from a
PPP GDP-weighted sample mean to capture the relative standing of a country
compared to its trading partners. This formulation essentially allows us to test
whether structural factors help explain country-specific fixed effects. The results
are summarized in Table 7.1.
The most robust result is for the ratio of the minimum-to-mean wage, which
has a negative sign and is significant in almost all specifications. The positive
impact of the unemployment gross replacement rate is also fairly robust. However,
the impact of other structural indicators is not robust across two different sam-
ples. Moreover, some commonly recommended policies would increase the cur-
rent account while others would reduce it. In particular, lower business taxation,
less credit market regulation, and lower unemployment benefits can reduce the
current account surplus. However, lower minimum wage and employment

TABLE 7.1
Impact of Selected Structural Reforms on Current Account, All Countries and OECD Countries
Advanced, Emerging, and Developing Economies OECD Sample
Impact on the current account Impact on the current account
Statistically Statistically
Direction significant Possibly strengthened by Direction significant
Structural reforms that could REDUCE the current account
balance
Deregulation of the credit market p Yes p No
Reducing taxes (profit, labor and other business taxes) and p Yes p No
simplifying procedures for tax payments
Reducing Unemployment gross replacement rate p Yes the higher initial value of the net foreign p Largely Yes
assets and lower previous period growth
Product market deregulation NA NA p No
Deregulation in retail trade NA NA p No
Structural reforms that could INCREASE the current account

balance
Deregulation of professional services NA NA n No
Reducing the ratio of minimum wage to mean wage n Yes the higher previous period growth n Yes
Reducing employment protection n Largely No n Largely Yes
Ivanova
213
protection, often recommended for making the labor market “more flexible,” are
associated with larger current account surpluses.
The two new indicators that become significant in the overall sample when
structural variables enter as averages over time are corporate income tax rate/
indicator of doing business paying taxes10 and credit market regulation (the
higher value of this index means less regulation). Countries with a long-standing
tradition of relatively high business taxes are found to have, on average, higher
current account balances. This could reflect the fact that higher corporate taxa-
tion reduces investment incentives and so may raise the current account bal-
ance.11
The credit market regulation index, which is constructed by the Fraser
Institute, includes several components, namely: the degree of public ownership of
the banking system, control of interest rates, percentage of credit extended to the
private sector, and competition from foreign banks. For example, in the case of
Germany this index indicates strict regulation largely on account of the high
public ownership of the banking system. The results suggest that stricter credit
market “regulation” raises the current account. Stricter credit market regulation
can work through both savings and investment channels. In particular, the lack
of access to credit may constrain investment. However, lack of access to credit
may also encourage household and corporate savings. Given that the index cap-
tures a broader set of components than just credit extended to the private sector,
the results could indicate that it is the broader effectiveness and efficiency of the
banking sector that affects the current account.
To be clear, though, these relationships are not evident in the OECD sample.
The indicators of the degree of regulation in product and services markets, which
are available only for OECD countries, generally are not significantly associated
with the current account. The results for the OECD sample, however, should be
interpreted with caution due to a relatively small number of observations.
Following Chinn and Ito (2007) and Abiad, Leigh, and Mody (2009), as a
robustness check two additional financial measures were included, namely the
degree of financial development measured by the ratio of private credit to GDP
and the measure of capital account openness constructed in Chinn and Ito
(2008). Unlike Chinn and Ito (2007), however, I included a measure of financial
development at the start of the period rather than the five-year period average to
mitigate the potential endogeneity problem, since financial development is mea-
sured by the ratio of private credit to GDP. Both financial development and
capital account openness were not significant when included on their own.
However, similarly to Abiad, Leigh and Mody (2009), I find that fast growing
countries (typically, these are poorer countries), which a have higher degree of
capital account openness, also have lower current account balances, which could
10
This variable captures the amount and administrative burden of paying taxes and contributions for
a medium-size company; it is a rank of a country among all countries.
11
There is evidence from firm-level data that lower corporate tax rates or higher depreciation allow-
ances are associated with higher investment (e.g., Vartia, 2008; Schwellnus and Arnold, 2008).

Ivanova 215
be interpreted as greater capital account openness helping the inflow of capital to

poorer countries.
The inclusion of these variables does not alter the conclusions for other struc-
tural variables with the exception of the credit market regulation variable, the
coefficient on which becomes insignificant. While in principle, credit market
regulation and the degree of capital account openness are conceptually different,
they appear to capture similar aspects of the availability of credit. For simplicity
of exposition, capital account openness is not included in the tables, but the result
on credit market regulation should be treated with caution in this light.
Overall, empirical evidence points to select structural measures, rather than a
broad and diffuse package of structural policies, for addressing imbalances.
Moreover, there may be a trade-off between reducing the current account imbal-
ance and achieving other policy objectives, so the choice of the policy instruments
should not be based purely on their impact on the current account.
INTERACTION OF STRUCTURAL FACTORS

AND FUNDAMENTALS
This section investigates whether long-standing structural differences may have
shaped the response of the current account to changes in fundamentals.
To this end, I augment regressions in Table 7A.112 with the interaction terms
of the structural variables averaged over time with the fundamentals. Due to a
substantial reduction in the degrees of freedom with the inclusion of the interac-
tion terms, I experimented with the groups of variables both separately and
together and chose the variables that turned out to be significant based on a set
of these regressions. The results are summarized in Table 7A.5.13
The evidence of the indirect impact of structural policies on the current
account is inconclusive, since most of the findings, with the exception of the
interaction of the minimum-to-mean ratio and the previous period growth, are
not robust across specifications. The most robust finding is that the negative
impact of the minimum-to-mean wage ratio on the current account is stronger in
countries that experience rapid income growth. This finding could be consistent
with the interpretation that a higher minimum wage increases labor cost and
reduces companies’ savings or forces them to substitute capital for labor. Higher
labor costs in the fast growing countries may provide stronger incentives for com-
panies to substitute capital for labor, leading to higher investment and a lower
current account balance. This finding also suggests that the relationship between
the minimum wage and the current account may be stronger for less developed
countries, which tend to have higher rates of growth.
12
Tables 7A.1 through 7A.6 are located in the appendix to this chapter.
13
The analysis included various interaction terms, but the table reports only a subset of the results. In
particular, no robust link between the interaction of credit market regulation/demographics and the
current account could be established, although some theoretical research (Coeurdacier, Guibaud, and
Jin, 2012) suggests that such interaction may be important.

The impact of the gross unemployment replacement rate depends on the ini-
tial net foreign assets position and the previous period’s per capita income growth.
In particular, the positive impact of the unemployment benefits on the current
account may be reduced in countries that experience rapid income growth. This
finding would be consistent with the explanation that high unemployment ben-
efits increase the rate of unemployment and the probability of becoming unem-
ployed, which in turn lead to higher precautionary savings, since such a probability
would be reduced in an environment of rapid income growth. The finding that
the positive impact of unemployment benefits on the current account is strength-
ened in countries with a high initial net-foreign-assets position is difficult to
interpret; it could be related to the fact that the net-foreign-asset position might
capture the persistence of the current account beyond the factor-income contri-
bution.
Nonetheless, the residuals from the regression with interaction terms (Table
7A.5, column 2; and Figure 7.5) track the imbalances, though they are closer to
zero than in the baseline model for all countries except Japan. So even as absorb-
ers or amplifiers of changes in the fundamentals, the commonly evoked struc-
tural policies cannot account for the emergence of imbalances. There might be
other important structural differences in the economies of the surplus and deficit
countries, not necessarily representing policy distortions, which translated global
shocks into the differing responses of the current accounts.
In addition, the emergence of imbalances coincided with the global cyclical
upswing and a rapid expansion of world trade; cyclical factors have therefore
likely played a role. The correlation of the “excess imbalances” with the housing
investment/housing real price as well as with the performance of the stock market
found in the literature provide further support to this proposition. A further
investigation into the role of structural policies and broader structural factors in
the impact of cyclical shocks on the current account may therefore be warranted.
10
8 China Japan
6 United States Germany
Spain
4
2
0
–2
–4
–6
–8
1975 1980 1985 1990 1995 2000 2005
Figure 7.5 Residuals from the Model with Structural Variables Interacted with
Fundamentals, Germany and Four Selected Countries, 1975–2005 (Five-year averages,
percent of GDP)

Ivanova 217
IMPLICATIONS FOR GERMANY

This section analyzes what the empirical findings imply for a country like
Germany, where the current account surplus reached a historical high of
7.5 percent in 2007. The improvement in the current account in Germany was
driven by an improvement in Germany’s trade balance on goods and coincided
with the expansion of global trade. Germany’s trade surplus has been consis-
tently positive over the past half-century. Its export competitiveness derives
from a comparative advantage in a large number of specialized product variet-
ies. Germany was able to hold its market share when other European countries
lost it.14 (Figures 7.6 and 7.7)
While Germany has increased both exports to and imports from Europe as part
of increased trade integration, its imports are increasingly tilted toward products
produced most cost-effectively by China.15 (Figures 7.8a and 7.8b) Thus, while
German exports have remained largely unaffected by the competition from Asia
and Eastern Europe, much of the rest of Europe was affected. European imbal-
ances therefore largely reflect the loss of competitiveness of other countries.
While German exports have been performing strongly for a good reason, it is
somewhat puzzling why imports did not catch up. A look at domestic demand
Germany’s competitive advantage arises from specialized product

varieties.
12
World market share in specialized
CHN
10 DEU
USA
product varieties
6
ITA
4 JPN FRA
NLD
KOR ESP
2 MYS IND
POL
IRL
0 GRC PRT
0 100 200 300 400 500
Number of specialized product varieties
Figure 7.6 Specialized Products Varieties and World Market Share,

Selected Countries.
Sources: See footnote 14; UN Comtrade Database; and staff estimates.
Note: Computed with Standard International Trade Classification (SITC) 4 level trade data for 2007.
14
The charts on competitiveness and imports were provided by Fabian Bornhorst as part of the joint
column on VOXEU, which can be found at http://www.voxeu.org/index.php?q=node/6873.
15
In view of East Asia’s deep and extensive industrial division of labor, China’s exports to Germany
include export value added from other countries.

Germany’s export growth is mainly due to growth in world trade, not increas-
ing market share.
500
Increased market share
World trade effect
400
300
200
100
–100
ina
d
ia
rea
d
s
y
ce
ain
ly
l
e
sia
dS n
es
ga
nd
an
lan
nc
lan
Ita
Ind
ee
tat
p
lay
Ch
Sp
rtu
Ko
rla
rm
Fra
Ja
Po
Ire
Gr
Po
Ma
the
Ge
ite
Ne
Un
Figure 7.7 Contribution of World Trade Growth and Changes in Market
Share to Export Increases, 15 Selected Countries
Sources: UN Comtrade Database; and IMF staff estimates.
Note: Increase in exports 2001–08, as percent of exports in 2001, decomposed into the effect of
world trade growth and that of increased market share. Computed with Standard International
Trade Classification (SITC) 4 level trade data.
The share of imports from China has grown rapidly from a low base.
Rest of the
World
28%
European
Union
United States 60%
9%
China
3%
Figure 7.8a Origin of German Imports, 2000

Source: UN Comtrade Database.
suggests that while all sectors contributed to increased current account surplus,
the largest contributor was German corporate sector (Figure 7.9), which did not
match a substantial increase in profits with increased investment despite the latter
being consistently low. Germany’s corporate investment remained low compared

Ivanova 219
Rest of the
World
27%
European
United States Union
3% 56%
China
14%
Figure 7.8b Growth of Germany’s Imports, by Region 2000–2009

Source: UN Comtrade Database.
German investment has been low compared to EU peers even after accounting
for outward foreign direct investment.
25 EU
Germany
23
21
19
17
15
13
11
9
1999 2001 2003 2005 2007 2009
Figure 7.9 Combined Domestic Corporate Investment (Gross) and Outward

FDI , Germany and European Union (EU), 1999–2009 (Percent of GDP)
Sources: Eurostat; and Organisation for Economic Cooperation and Development.
to European peers, even accounting for foreign direct investment (FDI) outflows.
The reluctance to invest domestically reflects long-standing low returns to invest-
ment in Germany, but pinning down particular policy distortions that could hold
back investment is difficult. One possible explanation, consistent with the find-
ings for the German labor market in the years preceding the 2008–09 crisis
(Burda and Hunt, 2011), is manufacturing employers’ lack of confidence that the
boom would last. The estimated potential growth in Germany remained
low (close to 1 percent) during those years, and the companies chose to save a

TABLE 7.2
Germany: Potential Impact of the Selected Structural Reforms on the Current

Account
Change in the current
account in percent of GDP
Credit Market Deregulation to OECD average –0.5
Reduction in taxes and simplification of tax procedures to US rank –0.3
Reduction in gross unemployment replacement ratio to OECD average –0.4
Total –1.2
substantial portion of the “windfall profits” while increasing investment only

slowly.16
Nonetheless, the results of the estimation would suggest that in application to
Germany, lower taxes on businesses, further reduction in the gross unemploy-
ment replacement rate, and a smaller public share in the banking system could
help reduce the surplus, albeit only moderately.
Despite a comprehensive reform of the corporate income tax in 2008, the
combined federal and local corporate tax rates in Germany remain above the
OECD average. German unemployment benefits also remain rather generous.
Public sector banks occupy an important place in the German system, more so
than in other advanced economies. These banks have implicit government back-
ing and low profitability. The package of measures, which includes scaling down
the public provisioning of banking services, reducing unemployment benefits in
the direction of the OECD average, and reducing and simplifying business taxes
to move Germany to the U.S. rank in the World Bank’s “Doing Business” indica-
tor could reduce the surplus by about 1.25 percent of GDP. Reduction in taxes
and unemployment benefits, however, should be undertaken in a way that does
not jeopardize long-term fiscal sustainability goals.
CONCLUSION
This chapter reported on my econometric investigation into the possible links
between the current account balance and the commonly recommended package
of structural policies, including financial regulation, tax policy, and labor market
flexibility. I find little evidence that this set of policies contributed substantially
to the emergence of global imbalances. The large imbalances likely reflected
mainly a booming world economy. Moreover, while the structural factors might
have helped shape the response of the current account to macroeconomic shocks
and fundamentals, even in their role as shock absorbers/amplifiers those factors
only partially account for the emergence of imbalances.
16
In addition, overall low private investment in the 2000s reflected a prolonged period of normaliza-
tion in housing construction following the reunification boom and restructuring in the commercial
real estate construction.

Ivanova 221
Nonetheless, structural policies do help explain long-standing cross-country

differences in the current account levels. While the results are not always robust,
there is evidence that stricter credit market regulation—encompassing the degree
of public ownership of the banking system, interest rate controls, percentage of
credit extended to the private sector, and competition from foreign banks—is
associated with a higher current account balance. Countries with higher taxes on
businesses, generous unemployment benefits, lower minimum wage, and less
strict employment protection also tend to have higher current account balances
than others. To the extent that less developed countries tend to experience higher
rates of growth, lowering the minimum wage is likely to be more effective in
reducing the current account deficits of these countries than of advanced coun-
tries. Some of the commonly proposed structural policies would reduce—while
others would increase—the current account balance. These findings point to
select structural measures tailored to the specific country circumstances, rather
than a package of broad and diffuse structural policies, for addressing imbalances.
It is also important to keep in mind that current account balance is not the only
objective of policy makers, and the design of a policy package should take other
objectives into account. For example, some of the policies that could lower the
current account may increase inequality, which could be undesirable from the
social point of view.
In relation to Germany, which experienced a large increase in the current
account surplus in mid-2000, these findings imply that the most promising ave-
nues for Germany to pursue in reducing its current account surplus through
structural policies is to lower the tax burden, liberalize the banking system to
allow greater private sector participation, and reduce unemployment benefits.
However, altogether, the impact of these structural policies on the surplus will
likely be modest, so a broader strategy for raising potential growth and raising
domestic consumption and investment in the medium term will be essential.
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Ivanova 223
APPENDIX
Data Description
The analysis included a sample of 106 advanced, emerging, and developing coun-
tries with populations exceeding one million. The OECD sample included 27
countries. The new EU member states are included starting from the year 1994
to avoid structural breaks. Most of the traditional variables determining the cur-
rent account were computed following Abiad, Leigh, and Mody (2009).
The current account as a ratio to GDP was taken from the Annual
Macroeconomic Database (AMECO) of the European Commission’s Directorate
General for Economic and Financial Affairs (http://ec.europa.eu/economy_
finance/indicators_en.htm) where available, and from the IMF’s World Economic
Outlook (WEO) database in other cases. Income per capita is real PPP GDP per
capita in 2005 constant prices with 1996 reference year from Penn World Tables
7.3 up to year 2007 (http://pwt.econ.upenn.edu). The rest of the years were
extrapolated using per capita real GDP growth from the WEO database. Fiscal
balance as a share of GDP was computed as general government net lending/
borrowing from the WEO database where available, otherwise general govern-
ment overall fiscal balance was used from the same database. Net foreign assets as
a ratio to GDP were computed as foreign assets minus foreign liabilities divided
by GDP. All the variables are from the External Wealth of Nations (1970–2007)
database, which can be downloaded from http://www.philiplane.org/EWN.html.
Financial integration was computed as the sum of foreign assets and foreign lia-
bilities divided by GDP from the same data source.
Old (young) dependency ratios were computed using the data from the World
Development Indicators (WDI) database. The old (young) dependency ratio was
defined as the ratio of the population aged above 64 (below 15) relative to the
population aged 15–64. The increase in the old dependency ratio was computed
over the five-year period (see below) to capture the underlying demographic
trend. Trade openness is calculated as the sum of exports and imports divided by
GDP; it is obtained from the Penn World Tables 7.3 database (‘openc’/100). Oil
price is taken from IMF’s WEO database.
Several macroeconomic variables (current account to GDP ratio, GDP per capita
growth, fiscal balance, oil price) were averaged over the 5-year non-overlapping
periods, namely, 1975–79, 1980–84, 1985–89, 1990–94, 1995–99, 2000–04, and
2005–09. Other variables were included as of the year preceding the beginning of
the five-year period, e.g. 2004 for the period 2005–09. Many of the variables were
also included as the deviations from the PPP-weighted sample average (growth, fiscal
balance, young and old dependency ratios) while real GDP per capita was computed
as the ratio to the U.S. real GDP per capita in a given year.
Credit market regulation is obtained from the Fraser Institute (http://www.
freetheworld.com/) and comprises an index consisting of four components, mea-
suring the degree of public ownership of the banking system, control of interest
rates, percentage of credit extended to the private sector, and competition from
foreign banks. The index ranges between zero and 10 with the higher values
implying less regulation.

The gross unemployment replacement rate is obtained from Aleksynska and

Schindler (2011) and is the average of the gross unemployment replacement rates
over two years of unemployment. The ratio of minimum wage to mean wage is taken
from the same database. Employment protection indicator for OECD countries was
obtained from the OECD database (http://www.oecd.org). For other countries,
employment protection index was constructed as an out-of sample forecast from the
regression of the OECD employment protection index on the measures of the stipu-
lated advance notice period (in months) and severance pay after nine months (in
months), which were obtained from Aleksynska and Schindler (2011).
For OECD countries, central government corporate income tax rates were
obtained from the OECD database. The corporate income tax rate comprises the
basic central government statutory (flat or top marginal) corporate income tax
rate, measured gross of a deduction if any for sub-central tax. The corporate
income tax rate for other countries was obtained from the IMF Fiscal Affairs
Corporate Income Tax rate database. The indicator of doing business paying taxes
is a country’s rank among 183 countries based on the indicator that combines
measures of the level of taxes and mandatory contributions that a medium-size
company must pay in a given year with the measures of the administrative burden
of paying taxes and contributions. The data is available at http://www.doingbusi-
ness.org/rankings. Labor tax wedge for OECD countries is a total tax wedge of the
average earner from the OECD database. It is computed as a combined central and
sub-central government income tax plus employee and employer social security
contribution taxes and expressed as a percentage of labor costs, defined as gross
wage earnings plus employer social security contributions. The tax wedge is also
adjusted for cash transfers. The indicators of product market regulation, regulation
in energy transport and communication as well as regulation in professional ser-
vices and retail trade are available only for OECD from the OECD database.
The indicators of product market regulation are a comprehensive and interna-
tionally comparable set of indicators that measure the degree to which policies
promote or inhibit competition in areas of the product market. This indicator is
available only for a subset of years, namely 1998, 2003, and 2008. When struc-
tural variables were included as time-varying, the values for available years were
assigned to the corresponding five-year periods. The OECD indicator of regula-
tion in energy, transport and communications (ETCR) summarizes regulatory
provisions in seven sectors: telecoms, electricity, gas, post, rail, air passenger
transport, and road freight. While this indicator is not as broad as that of product
market regulation, it is available as longer time-series, namely, annual data for the
period 1975–2007 with gaps for some countries. The data in available years were
attributed to the five-year periods.
The indicator of regulation in professional services covers entry and conduct
regulation in the legal, accounting, engineering, and architectural professions.
The indicator of regulation in retail trade covers barriers to entry, operational
restrictions, and price controls in retail distribution. Both of these indicators are
available for the years 1996, 2003, and 2008 and in econometric analysis the data
for available years were assigned to the corresponding five-year periods.

TABLE 7A.1
Current Account and Structural Policies: Random Effects Model with Robust Standard Errors, Structural Variables are Averages over Five Year
Periods, Total Sample
Dependent variable=current account to GDP (1) (2) (3) (4) (5) (6) (7) (8) (9)
(5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009
Log of GDP per capitaa,b 0.0247*** 0.0236*** 0.0265*** 0.0211*** 0.0176** 0.0107 0.0047 0.0107 0.0083
[4.49] [4.36] [4.33] [3.01] [2.55] [1.18] [0.47] [1.18] [1.26]
Previous period growthc,d –0.0002 0.0010 0.0012 0.0003 0.0011 0.0016 0.0020 0.0016 0.0022
[–0.25] [1.03] [1.18] [0.34] [1.09] [1.09] [1.25] [1.09] [1.41]
Fiscal balance to GDPc,d 0.3853*** 0.3782*** 0.3790*** 0.1882** 0.2325*** 0.1328 0.0219 0.1328 0.1450
[4.56] [4.42] [3.73] [2.42] [2.84] [1.13] [0.21] [1.13] [1.45]
Net foreign assets to GDPb 0.0146** 0.0197*** 0.0194*** 0.0253*** 0.0248** 0.0229** 0.0282** 0.0229** 0.0196
[2.26] [3.28] [2.62] [2.61] [2.05] [2.21] [2.15] [2.21] [1.45]
Old dependency ratiob,d –0.3226*** –0.3400*** –0.3744*** –0.3810*** –0.1273 0.0191 0.0373 0.0191 –0.2631**
[–3.73] [–3.93] [–4.15] [–3.64] [–1.29] [0.20] [0.29] [0.20] [–2.09]
Young dependency ratiob,d –0.0138 –0.0177 –0.0253 –0.0116 0.0354 0.0699** 0.0899** 0.0699** 0.0110
[–0.54] [–0.67] [–0.88] [–0.43] [1.25] [2.33] [2.08] [2.33] [0.31]
Trade opennessb –0.0080 –0.0117 –0.0079 –0.0033 0.0022 0.0046 0.0146 0.0046 0.0152
[–0.82] [–1.12] [–0.64] [–0.23] [0.25] [0.41] [1.17] [0.41] [1.19]
Increase in the old dependency ratio over 5 years 0.7330*** 0.6511** 0.6117** 0.5964** 0.2593 0.6761*** 0.8173** 0.6761*** 1.0855***
[2.91] [2.54] [2.19] [2.02] [0.96] [3.37] [2.28] [3.37] [3.35]
Contemporaneous oil price*Oil producerc 0.0005** 0.0004** 0.0005** 0.0006*** 0.0003 0.0001 0.0003* 0.0001 0.0004**
[2.29] [2.07] [2.09] [2.73] [1.42] [0.89] [1.88] [0.89] [2.10]
Financial integrationb 0.0034 0.0035* 0.0031 0.0032* 0.0004 –0.0010 0.0004 0.0009
[1.61] [1.73] [1.44] [1.71] [0.28] [–0.69] [0.28] [0.38]
Financial integration*Previous period growthe –0.0010** –0.0013*** –0.0011*** –0.0011*** –0.0003 –0.0005 –0.0003 –0.0010**
[–2.53] [–3.59] [–3.44] [–3.46] [–0.77] [–1.49] [–0.77] [–2.04]
Credit market regulationc,d –0.0025 –0.0010 –0.0018 –0.0020 –0.0017 –0.0020
[–1.45] [–0.63] [–1.04] [–1.16] [–0.88] [–1.16]
Ivanova
(continued)
225
226
Current Account Imbalances: Can Structural Policies Make a Difference?

Periods, Total Sample
(5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009
Gross replacement ratec,d,f 0.0572** 0.0421 0.0314 0.0816* 0.0314 0.0709
[2.12] [1.49] [0.89] [1.79] [0.89] [1.60]
Corporate income tax ratec,d 0.0002 0.0002 –0.0004 0.0002
[0.78] [0.40] [–0.86] [0.40]
Ratio of minimum wage to mean wagec,d –0.0169 –0.0271* –0.0169 –0.0194
[–1.31] [–1.92] [–1.31] [–1.23]
Employment protection indexc,d,g –0.0125** –0.0053
[–2.06] [–0.82]
Observations 548 548 501 371 242 153 124 153 172
Number of countries 106 106 101 77 65 48 48 48 59
Source: IMF staff estimates, see Data Description for data sources.
a
Deviation from US level in a given year.
b
At the beginning of the period, for example for a 5-year period covering 2005–2009, 2004 value was used.
c
5-year period average.
d
Deviation from a PPP GDP-weighted sample average.
e
Financial Integration is one year before the beginning of a given 5-year period; growth is the average over the previous 5-year period.
f
Gross replacement rate is the average over 2 years of unemployment.
g
For OECD countries OECD employment protection index was used. For a broader sample an index was constructed as an out-of-sample forecast from the regression of the employment protection index on
advance notice period and severance pay after 9 months. The latter two indicators are available for a large sample of advanced, emerging and developing countries (Aleksynska & Schindler, 2010).

TABLE 7A.2
Current Account and Structural Policies: Random Effects Model with Robust Standard Errors, Structural Variables are Averages over the
Whole Period, Total Sample
(5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–1994 1995–2009
Log of GDP per capitaa,b 0.0264*** 0.0205*** 0.0206*** 0.0157*** 0.0158*** 0.0187*** 0.0191*** 0.0130 0.0263***
[4.83] [3.58] [3.42] [3.01] [3.00] [3.49] [3.65] [1.50] [2.99]
Previous period growthc,d 0.0012 0.0014 0.0015 0.0016 0.0016 0.0017 0.0018 0.0009 –0.0009
[1.17] [1.31] [1.35] [1.31] [1.31] [1.45] [1.51] [0.26] [–0.35]
Fiscal balance to GDPc,d 0.3941*** 0.3123*** 0.3369*** 0.3202** 0.3201** 0.2954** 0.2925** 0.1979** 0.2683
[4.58] [2.90] [3.02] [2.39] [2.38] [2.31] [2.32] [2.23] [1.59]
Net foreign assets to GDPb 0.0211*** 0.0194** 0.0193** 0.0228** 0.0226** 0.0277*** 0.0283*** 0.0209 0.0611***
[3.34] [2.47] [2.29] [2.49] [2.40] [3.11] [3.18] [1.53] [3.33]
Old dependency ratiob,d –0.3481*** –0.3966*** –0.4024*** –0.4652*** –0.4657*** –0.4644*** –0.4671*** –0.0167 –0.4961***
[–4.07] [–4.46] [–4.39] [–4.93] [–4.92] [–4.94] [–5.00] [–0.10] [–3.39]
Young dependency ratiob,d –0.0211 –0.0193 –0.0170 –0.0236 –0.0232 –0.0191 –0.0203 0.0647* 0.1191
[–0.80] [–0.79] [–0.66] [–0.88] [–0.86] [–0.76] [–0.81] [1.69] [1.49]
Trade opennessb –0.0056 0.0032 0.0100 0.0114 0.0117 0.0080 0.0064 –0.0169 0.0155
[–0.48] [0.25] [0.81] [1.00] [1.01] [0.63] [0.52] [–1.17] [1.06]
Increase in the old dependency ratio over 5 years 0.6131** 0.6208** 0.6741** 1.0845*** 1.0905*** 0.9556*** 0.9197*** 0.6809* 1.6603***
[2.37] [2.13] [2.22] [3.13] [3.14] [2.92] [2.82] [1.90] [2.95]
Contemporaneous oil price*Oil producerc 0.0004** 0.0005** 0.0005** 0.0005** 0.0005** 0.0005** 0.0005** 0.0000 0.0004*
[2.06] [2.48] [2.38] [2.16] [2.15] [2.11] [2.08] [0.08] [1.83]
Financial integrationb 0.0034 0.0032 0.0030 0.0016 0.0015 0.0023 0.0027 0.0098 –0.0002
[1.60] [1.64] [1.54] [0.72] [0.67] [0.98] [1.14] [1.23] [–0.09]
Financial integration*Previous period growthe –0.0011*** –0.0013*** –0.0014*** –0.0013** –0.0013** –0.0013*** –0.0014*** 0.0012 –0.0006
[–2.81] [–4.10] [–4.00] [–2.37] [–2.36] [–2.63] [–2.69] [0.33] [–1.35]
Credit market regulationd,f –0.0047** –0.0081*** –0.0080*** –0.0059** –0.0059*** –0.0070*** –0.0067*** –0.0001 –0.0088
[–2.16] [–3.11] [–2.70] [–2.29] [–2.58] [–3.07] [–2.81] [–0.04] [–1.44]
Ivanova
Gross replacement rated,f,g 0.0971*** 0.0998*** 0.0929** 0.0945** 0.1130*** 0.1007** 0.0511 0.1128*
[2.73] [2.65] [2.16] [2.50] [2.80] [2.12] [1.15] [1.79]
(continued )
227
228

Current Account and Structural Policies: Random Effects Model with Robust Standard Errors, Structural Variables are Averages over the
Whole Period, Total Sample
(5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–1994 1995–2009
Corporate income tax rated,f 0.0005 0.0014** 0.0014** 0.0003 –0.0007
[0.90] [2.15] [2.53] [0.54] [–0.67]
Ratio of minimum wage to mean waged,f –0.0400** –0.0399** –0.0325* –0.0328* –0.0122 –0.0669**
[–2.42] [–2.48] [–1.89] [–1.88] [–0.69] [–1.99]
Employment protection indexd,f,h –0.0004 –0.0048
[–0.07] [–0.71]
Doing business paying taxes rankf 0.0001* 0.0001*
[1.82] [1.76]
Observations 532 426 400 323 323 349 349 114 118
Number of countries 101 78 73 60 60 65 65 43 59
Source: IMF staff estimates. See Data Description for data sources.
a
b
c
d
e
f
Structural variable are country averages over all available years in a given period.
g
h

TABLE 7A.3
Current Account and Structural Policies: OLS with Cluster Robust Standard Errors, Structural Variables are Averages over the Whole Period,
Total Sample
(5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–1994 1995–2009
Log of GDP per capitaa,b 0.0215*** 0.0149*** 0.0143** 0.0113** 0.0111** 0.0146*** 0.0153*** 0.0113 0.0202**
[4.51] [2.90] [2.58] [2.16] [2.09] [2.87] [3.07] [1.35] [2.31]
Previous period growthc,d 0.0017* 0.0016 0.0015 0.0018 0.0018 0.0020* 0.0021* 0.0009 –0.0003
[1.72] [1.48] [1.43] [1.45] [1.44] [1.72] [1.79] [0.26] [–0.12]
Fiscal balance to GDPc,d 0.3643*** 0.3084*** 0.3418*** 0.3219** 0.3222** 0.2965** 0.2910** 0.1589* 0.2666
[4.31] [3.34] [3.44] [2.62] [2.61] [2.55] [2.55] [1.80] [1.59]
Net foreign assets to GDPb 0.0339*** 0.0347*** 0.0354*** 0.0383*** 0.0386*** 0.0431*** 0.0429*** 0.0338*** 0.0661***
[5.72] [4.47] [4.26] [4.16] [4.03] [4.78] [4.74] [2.70] [3.47]
Old dependency ratiob,d –0.3061*** –0.3373*** –0.3240*** –0.4374*** –0.4378*** –0.4487*** –0.4504*** –0.0533 –0.6214***
[–3.35] [–4.19] [–3.91] [–5.12] [–5.13] [–5.22] [–5.24] [–0.31] [–4.48]
Young dependency ratiob,d –0.0204 –0.0238 –0.0216 –0.0318 –0.0313 –0.0281 –0.0294 0.0502 0.0442
[–0.76] [–1.03] [–0.88] [–1.19] [–1.17] [–1.16] [–1.21] [1.33] [0.57]
Trade opennessb –0.0061 –0.0002 0.0042 0.0057 0.0060 0.0051 0.0034 –0.0184 0.0207
[–0.54] [–0.01] [0.35] [0.48] [0.49] [0.43] [0.29] [–1.44] [1.67]
Increase in the old dependency ratio over 5 years 0.3301 0.4243 0.4938 0.8303** 0.8340** 0.7158** 0.6772* 0.4677 1.5275***
[1.16] [1.27] [1.50] [2.41] [2.41] [2.15] [1.98] [1.25] [2.71]
Contemporaneous oil price*Oil producerc 0.0005** 0.0006*** 0.0006*** 0.0005** 0.0005** 0.0005** 0.0005** 0.0002 0.0005**
[2.10] [3.29] [3.30] [2.57] [2.59] [2.41] [2.33] [0.43] [2.01]
Financial integrationb 0.0061*** 0.0047*** 0.0048*** 0.0044* 0.0043* 0.0050* 0.0054** 0.0122 0.0027
[2.95] [2.69] [2.71] [1.74] [1.68] [1.91] [2.03] [1.50] [0.78]
Financial integration*Previous period growthe –0.0016*** –0.0015*** –0.0016*** –0.0017*** –0.0017*** –0.0018*** –0.0018*** 0.0009 –0.0014**
[–4.21] [–5.29] [–5.40] [–3.05] [–3.05] [–3.57] [–3.58] [0.26] [–2.15]
Credit market regulationd,f –0.0039** –0.0069*** –0.0066** –0.0050** –0.0052** –0.0064*** –0.0061*** –0.0006 –0.0082
[–2.04] [–3.04] [–2.57] [–2.21] [–2.51] [–3.05] [–2.76] [–0.32] [–1.39]
Ivanova
Gross replacement rated,f,g 0.0789** 0.0760** 0.0768** 0.0798** 0.0955*** 0.0837* 0.0492 0.1009*
[2.46] [2.30] [2.01] [2.46] [2.81] [2.00] [1.18] [1.70]
(continued )
229
230

Current Account and Structural Policies: OLS with Cluster Robust Standard Errors, Structural Variables are Averages over the Whole Period,
Total Sample
(5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–1994 1995–2009
Corporate income tax rated,f 0.0006 0.0010* 0.0010* 0.0002 –0.0005
[1.23] [1.75] [2.00] [0.36] [–0.52]
Ratio of minimum wage to mean waged,f –0.0348** –0.0344** –0.0287* –0.0293* –0.0089 –0.0684**
[–2.30] [–2.36] [–1.80] [–1.81] [–0.53] [–2.13]
Employment protection indexd,f,h –0.0010 –0.0043
[–0.19] [–0.70]
Doing business paying taxes rankf 0.0001* 0.0001*
[1.74] [1.68]
Observations 532 426 400 323 323 349 349 114 118
R-squared 0.371 0.399 0.401 0.368 0.368 0.363 0.361 0.311 0.549
Note: OLS: ordinary least squares standard linear regression procedure.
a
b
At the beginning of the period, for example for a 5-year period covering 2005-2009, 2004 value was used.
c
d
e
f
g
h

TABLE 7A.4
Periods, OECD Sample
(1) (2) (3) (4) (5) (6) (7) (8)
Dependent variable=current account to GDP (5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009
Log of GDP per capitaa,b 0.0372** 0.0401** 0.0402** 0.0384* 0.0444** 0.0127 0.0140 0.0207
[2.05] [2.28] [2.12] [1.94] [2.29] [0.89] [0.80] [0.92]
Previous period growthc,d –0.0021 –0.0005 –0.0005 –0.0007 –0.0022 0.0006 0.0012 0.0015
[–1.09] [–0.21] [–0.27] [–0.31] [–0.97] [0.37] [0.56] [0.70]
Fiscal balance to GDPc,d 0.2813** 0.2814** 0.2796** 0.2928** 0.3608*** 0.3052* 0.1279 0.1275
[2.21] [2.16] [2.16] [2.24] [2.70] [1.66] [0.69] [0.67]
Net foreign assets to GDPb 0.0291 0.0307 0.0304 0.0348 0.0310 0.0311** 0.0530*** 0.0692***
[1.41] [1.35] [1.33] [1.50] [1.31] [2.32] [3.96] [5.90]
Old dependency ratiob,d 0.0055 –0.0562 –0.0588 –0.0376 –0.0430 0.0862 0.0525 –0.1104
[0.05] [–0.47] [–0.46] [–0.27] [–0.28] [0.66] [0.40] [–0.55]
Young dependency ratiob,d 0.1513** 0.1422** 0.1447* 0.1843*** 0.1483** 0.0994* 0.1431 0.1367
[2.14] [1.98] [1.88] [2.76] [2.33] [1.94] [1.61] [1.21]
Trade opennessb 0.0261* 0.0295** 0.0295** 0.0346*** 0.0420*** 0.0380*** 0.0527*** 0.0534***
[1.95] [2.18] [2.00] [2.71] [3.44] [2.96] [3.61] [3.36]
Increase in the old dependency ratio over 5 years 0.5264** 0.4982* 0.4958* 0.5353* 0.5232* 0.9795*** 1.5232*** 1.6074***
[1.97] [1.76] [1.76] [1.89] [1.85] [4.05] [4.00] [4.19]
Contemporaneous oil price*Oil producerc 0.0002 0.0002 0.0002 0.0001 0.0001 0.0001 0.0002 0.0001
[0.94] [0.81] [0.80] [0.34] [0.45] [0.64] [1.61] [0.53]
Financial integrationb 0.0002 0.0001 –0.0004 –0.0004 –0.0017 –0.0029** –0.0018
[0.08] [0.06] [–0.22] [–0.23] [–1.49] [–2.28] [–1.10]
Financial integration*Previous period growthe –0.0008** –0.0008** –0.0007** –0.0006 –0.0004 –0.0007** –0.0010***
[–2.07] [–1.98] [–1.97] [–1.59] [–1.35] [–2.04] [–3.81]
Credit market regulationc,d 0.0002 0.0004 –0.0027 –0.0020 0.0016 0.0014
[0.09] [0.15] [–0.73] [–0.69] [0.27] [0.20]
Ivanova
Gross replacement ratec,d,f 0.0090 –0.0043 –0.0128 0.0282 0.0384
[0.32] [–0.16] [–0.46] [0.46] [0.83]
(continued )
231
232

Periods, OECD Sample
(1) (2) (3) (4) (5) (6) (7) (8)
Dependent variable=current account to GDP (5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009
Corporate income tax ratec,d 0.0003 0.0006 0.0005 0.0001
[0.61] [0.90] [0.52] [0.07]
Ratio of minimum wage to mean wagec,d 0.0192 –0.0020 –0.0271
[0.77] [–0.09] [–1.25]
Employment protection indexc,d,g –0.0041 –0.0121
[–0.39] [–1.14]
Regulation in energy transport and communicationc,4 0.0048
[0.72]
Observations 160 160 160 148 142 97 68 66

Number of countries 27 27 27 26 26 19 19 19
a
b
c
d
e
f
g

TABLE 7A.5
Current Account and Structural Policies: Random Effects Model with Robust Standard Errors, Structural Variables are Averages over the Whole
Period, OECD Sample
Dependent variable=current (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
account to GDP (5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009
Log of GDP per capitaa,b 0.0407* 0.0302 0.0314 0.0168 0.0089 0.0185 0.0227 0.0153 0.0185 0.0133 0.0113
[1.67] [1.30] [1.33] [0.62] [0.30] [0.71] [1.16] [0.76] [0.71] [0.67] [0.65]
c,d
Previous period growth –0.0005 –0.0010 –0.0012 0.0002 0.0004 0.0002 0.0005 0.0007 0.0002 0.0007 0.0007
[–0.23] [–0.42] [–0.46] [0.08] [0.16] [0.10] [0.19] [0.31] [0.10] [0.33] [0.30]
Fiscal balance to GDPc,d 0.2807** 0.2643** 0.2612* 0.0893 0.0746 0.0795 0.1092 0.0971 0.0795 0.0717 0.0831
[2.13] [1.98] [1.94] [0.59] [0.48] [0.51] [0.72] [0.65] [0.51] [0.55] [0.59]
Net foreign assets to GDPb 0.0302 0.0330 0.0310 0.0612*** 0.0641*** 0.0666*** 0.0665*** 0.0712*** 0.0666*** 0.0728*** 0.0720***
[1.34] [1.44] [1.30] [4.42] [4.82] [5.29] [4.49] [4.57] [5.29] [5.74] [5.44]
Old dependency ratiob,d –0.0606 –0.0893 –0.0911 –0.2026* –0.2107* –0.2047* –0.3575*** –0.4064*** –0.2047* –0.3607*** –0.3429***
[–0.47] [–0.72] [–0.70] [–1.77] [–1.73] [–1.69] [–2.64] [–3.07] [–1.69] [–2.83] [–3.62]
Young dependency ratiob,d 0.1438** 0.1384** 0.1435** 0.0557 0.0612* 0.0719** 0.0503* 0.0389 0.0719** 0.0465* 0.0491*
[1.96] [2.08] [2.08] [1.41] [1.96] [2.14] [1.87] [1.45] [2.14] [1.80] [1.69]
Trade opennessb 0.0299** 0.0321** 0.0321** 0.0373*** 0.0377*** 0.0378*** 0.0385*** 0.0323*** 0.0378*** 0.0360*** 0.0388***
[2.10] [2.38] [2.29] [2.88] [3.11] [2.89] [3.55] [3.36] [2.89] [3.61] [3.41]
Expected increase in the old 0.4963* 0.4769* 0.4774 0.7237** 0.7191* 0.7086* 1.0304** 0.9610** 0.7086* 0.9749** 0.9351**
dependency ratio
[1.75] [1.65] [1.64] [2.00] [1.89] [1.94] [2.22] [2.14] [1.94] [2.09] [2.07]
Contemporaneous oil price*Oil 0.0002 0.0002 0.0001 0.0001 0.0001 0.0000 0.0002 0.0002 0.0000 0.0002 0.0001
producerc
[0.81] [0.78] [0.78] [0.66] [0.53] [0.25] [0.94] [1.08] [0.25] [0.99] [0.65]
Financial integrationb 0.0001 –0.0001 –0.0002 –0.0014 –0.0017 –0.0018 –0.0015 –0.0015 –0.0018 –0.0015 –0.0014
[0.06] [–0.03] [–0.11] [–0.99] [–1.41] [–1.42] [–1.03] [–1.07] [–1.42] [–1.21] [–1.06]
Financial integration*Previous –0.0008* –0.0007* –0.0006 –0.0009*** –0.0009*** –0.0010*** –0.0012*** –0.0013*** –0.0010*** –0.0012*** –0.0011***
period growthe
[–1.88] [–1.84] [–1.55] [–3.05] [–3.28] [–3.57] [–2.94] [–2.97] [–3.57] [–3.21] [–2.72]
Credit market regulationd,f –0.0001 0.0006 0.0013 –0.0003 –0.0039 –0.0032 –0.0011 –0.0012 –0.0032 –0.0044 –0.0031
Ivanova
[–0.02] [0.10] [0.20] [–0.06] [–0.67] [–0.44] [–0.16] [–0.22] [–0.44] [–1.03] [–0.72]
Gross replacement rated,f,7 0.0367 0.0360 0.0226 0.0804* 0.0821** 0.0785* 0.0808** 0.0821** 0.0823** 0.0777*
[0.81] [0.79] [0.58] [1.95] [2.00] [1.87] [2.01] [2.00] [2.27] [1.82]
Corporate income tax rated,f –0.0004 0.0011 0.0012 0.0006 0.0008 0.0011 0.0011
[–0.63] [0.99] [1.18] [0.81] [1.24] [1.41] [1.38]
233
©International Monetary Fund. Not for Redistribution (continued )
234

Current Account and Structural Policies: Random Effects Model with Robust Standard Errors, Structural Variables are Averages over the Whole
Period, OECD Sample
Dependent variable=current (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
account to GDP (5-year average) 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009 1975–2009
Ratio of minimum wage to mean –0.0386*** –0.0468*** –0.0483*** –0.0649*** –0.0658*** –0.0483*** –0.0507*** –0.0511***
waged,f
[–3.00] [–3.42] [–2.96] [–3.99] [–4.70] [–2.96] [–3.83] [–4.15]
Employment protection indexd,f,h –0.0121* –0.0123 –0.0126** –0.0150** –0.0123 –0.0134** –0.0134**
[–1.72] [–1.48] [–2.06] [–2.43] [–1.48] [–2.02] [–2.04]
Doing business paying taxes rankf 0.0000 0.0000
[0.26] [0.26]
Labor tax wedged,f 0.0007 0.0006 0.0007 0.0006
[1.15] [0.97] [1.40] [1.41]
Regulation in professional servicesd,f –0.0058 –0.0041 –0.0029
[–1.08] [–0.67] [–0.55]
Regulation in retail traded,f 0.0020 0.0029 0.0021
[0.41] [0.64] [0.50]
d,f
Product market regulation 0.0139
[0.83]
Regulation in energy transport 0.0097
and communicationd,f
[1.43]
Observations 160 157 157 115 115 115 115 115 115 115 115
Number of countries 27 26 26 19 19 19 19 19 19 19 19
a
b
c
d
e
f
g
h
For OECD countries OECD employment protection index was used. For a broader sample an index was constructed as an out-of-sample forecast from the regression of the employment protection index on advance
notice period and severance pay after 9 months. The latter two indicators are available for a large sample of advanced, emerging and developing countries (Aleksynska & Schindler, 2010).

TABLE 7A.6
Current Account and Structural Policies (interaction with fundamentals): Random Effects Model with Robust Standard Errors, Structural
Variables are Averages over the Whole Period, Total Sample
(1) (2) (3) (4) (5)
Dependent variable=current account to GDP (5-year average) 1975–2009 1975–2010 1975–2009 1975–1994 1995–2009
Log of GDP per capitaa,b 0.0130** 0.0169*** 0.0134*** 0.0111 0.0200**
[2.53] [3.17] [2.74] [1.45] [2.07]
Previous period growthc,d 0.0011 0.0011 0.0016 0.0012 –0.0037
[0.60] [0.96] [1.24] [0.49] [–1.60]
Fiscal balance to GDPc,d 0.3104** 0.3107** 0.2846** 0.1732* 0.2735*
[2.43] [2.17] [2.55] [1.81] [1.69]
Net foreign assets to GDPb 0.0237** 0.0293** 0.0424*** 0.0268** 0.0769***
[2.41] [2.26] [5.44] [2.19] [5.03]
Old dependency ratiob,d –0.4416*** –0.4878*** –0.4353*** –0.0229 –0.4896***
[–4.86] [–5.33] [–5.21] [–0.14] [–3.48]
Young dependency ratiob,d –0.0238 –0.0133 –0.0265 0.0463 0.0566
[–0.89] [–0.50] [–1.04] [1.22] [0.80]
Trade opennessb 0.0083 0.0078 0.0050 –0.0171 0.0102
[0.73] [0.75] [0.45] [–1.00] [0.51]
Increase in the old dependency ratio over 5 years 1.0614*** 1.0954*** 1.0508*** 0.8079** 1.5315**
[3.16] [2.98] [3.29] [2.37] [2.48]
Contemporaneous oil price*Oil producerc 0.0005** 0.0004* 0.0005** –0.0002 0.0004*
[2.26] [1.84] [2.39] [–0.63] [1.69]
Financial integrationb 0.0020 0.0048 0.0018 0.0099 –0.0020
[0.90] [1.12] [0.96] [1.16] [–1.14]
Financial integration*Previous period growthe –0.0013** –0.0007 –0.0014*** 0.0001 –0.0001
[–2.16] [–1.37] [–3.35] [0.03] [–0.21]
Credit market regulationd,f –0.0053** –0.0110*** –0.0059*** –0.0008 –0.0105***
[–2.34] [–2.58] [–3.11] [–0.34] [–2.79]
Ivanova
Gross replacement rated,f,g 0.0843** 0.1608*** 0.1275*** 0.0385 0.1962***
[2.38] [3.12] [4.41] [0.81] [3.91]
Corporate income tax rated,f 0.0015*** 0.0011* 0.0011** 0.0003 –0.0004
[2.81] [1.72] [2.10] [0.39] [–0.53]
235
(continued )
236
Current Account and Structural Policies (interaction with fundamentals): Random Effects Model with Robust Standard Errors, Structural
Variables are Averages over the Whole Period, Total Sample

(1) (2) (3) (4) (5)
Dependent variable=current account to GDP (5-year average) 1975–2009 1975–2010 1975–2009 1975–1994 1995–2009
Ratio of minimum wage to mean waged,f –0.0495*** –0.0462*** –0.0460*** –0.0388** –0.0565**
[–3.37] [–2.66] [–3.43] [–2.07] [–1.98]
Employment protection indexd,f,h –0.0004 –0.0089 –0.0027 0.0018 –0.0002
[–0.07] [–1.32] [–0.62] [0.30] [–0.03]
Crerdit Market Regulation*Previous period growthc,d,f –0.0002
[–0.30]
Gross replacement rate*Previous period growthc,d,f,g –0.0145 –0.0166** –0.0115 –0.0257**
[–1.43] [–2.17] [–1.21] [–2.05]
c,d,f
Corporate income tax rate*Previous period growth 0.0003 0.0004** 0.0001 0.0003
[1.26] [1.96] [0.57] [0.72]
Ratio of minimum wage to mean wage*Previous period growthc,d,f –0.0119** –0.0110** –0.0136*** –0.0199**
[–2.26] [–2.24] [–2.75] [–2.01]
Employment protection index*Previous period growthc,d,f,h –0.0003
[–0.19]
Ratio of minimum wage to mean wage*Financial integrationb,d,f 0.0130
[1.30]
Gross replacement rate*Trade opennessb,d,f,g
Gross replacement rate*Net foreign assets to GDPb,d,f,g 0.2037*** 0.0632 0.2415**

[4.66] [0.86] [2.44]
Observations 323 323 323 116 118

Number of countries 60 60 60 44 59
a
b
Fundamentals are included as of the beginning of the period, for example for a 5-year period covering 2005–2009, 2004 value was used.
c
Fundamentals are included as 5-year period averages.
d
e
f
g
h

TABLE 7A.7
Structural Indicators: Germany in Comparison

Latest
available United OECD
year Statesa France Spain Japan Germany Average
Credit Market Regulationa 2008 7.7 9.2 9.3 8.9 8.2 9.0
Combined Corporate Income Tax Rateb 2009 39 34 30 40 30 26
Average Labor Tax Wedge (single earner w/o children at 100 percent of average wage) 2009 29 49 38 29 51 36
Doing business rank on paying taxes 2009 54 55 86 115 80 NA
Unemployment Gross Replacement Ratec 2008 55 66 61 54 60 56
Product Market regulation 2008 0.8 1.5 1.0 1.1 1.3 1.4
Regulation in Professional Services 2008 1.1 2.1 2.1 1.5 2.9 2.0
Regulation in Retail Trade 2008 2.6 3.1 2.7 2.4 2.4 2.4
Regulation in Energy Transport and Communication 2007 1.8 2.2 1.6 2.2 1.1 2.1
Employment Protection Regulation 2008 0.2 2.5 2.5 1.9 3.0 2.2
Ratio of Minimum Wage to Mean Waged 2005 0.3 0.5 0.2 0.4 0.0 0.3
Sources: Fraser Institute; Organisation for Economic Co-operation and Development (OECD); Business Indicators; and Aleksynska and Schindler (2011). See Data Description for more detailed information.
a
Higher value means less regulated. For the United States the index declined from 8.9 to 7.7 between 2007 and 2008.
b
The regression included federal corporate income tax rate, which was available for a wide set of countries. The table presents combined corporate income tax rate, including sub-central tax rates, which provides a
better assessment of the actual tax burden on corporations.
c
The regression included a two-year average unemployment gross replacement ratio, which was available for a wide set of countries but the series ended in 2005. The table presents unemployment net
replacement ratio for a single person, no children, at 100 percent of average wage, which is available for OECD countries up to 2008.
d
While Germany has no minimum wage in most sectors except for construction workers, electrical workers and some others, the de facto floor may be higher as wages are set by collective bargaining
agreements and enforceable by law.
Ivanova
237
EU and Germany: Corporate Savings EU and Germany: Corporate Investment

(Net, percent of GDP) (Net, percent of GDP)
5 5
European Union European Union
4 Germany Germany
4
3
3
2
2
1
1
0
−1 0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
EU and Germany: Household Savings EU and Germany: Household Investment
8.0 4
European Union European Union
7.5
7.0 Germany Germany
3
6.5
6.0
5.5 2
5.0
4.5
1
4.0
3.5
3.0 0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
EU and Germany: Government Savings EU and Germany: Government Investment

2 1.2
European Union
1 Germany European Union
0.8 Germany
0
−1
0.4
−2
−3
0.0
−4
−5 −0.4
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Figure 7A.1 Germany and EU: Savings and Investment by Sector, 1999–2009
Source: Eurostat.

CHAPTER 8
Discussion
Comment on Chapters 2 and 3
MALTE HÜBNER
Martin Schindler’s chapter (Chapter 2) addresses a highly relevant topic. Two

years ago, the German Council of Economic Experts (GCEE), along with
many others, was very concerned that the crisis could have an adverse impact
on long-term growth. The concern was that financing costs would rise and
remain high over a sustained period, slowing down growth and increasing long-
term unemployment. Another concern was that rushed policy responses could
harm potential growth (GCEE, 2009). It is therefore reassuring to read Martin
Schindler with two years of development behind us. He finds that potential
output in Germany has remained almost unaffected by the financial crisis.
This, he concludes, is the consequence of the specific nature of the shock that
Germany faced: a temporary drop in external demand. I fully agree with this
analysis.
Before taking a closer look at Schindler’s results, it is important to note, as he
does, that potential output can be measured by a variety of methods, each with
its strengths and weaknesses. He is rightly concerned about univariate approach-
es, which can mislead, especially in times of drastic change. However, it is impor-
tant to assess the robustness of findings from any particular approach. This is
what I do here. To check the plausibility of the results, I am going to compare his
results with the GCEE’s estimations, which I carried out with a production func-
tion approach (GCEE, 2011).
For the period from 2005 to 2011, the GCEE’s production function approach
leads to results very similar to Schindler’s. There are small differences between
both estimates, but they are natural, given that the results have been obtained
with different methods (Figure 8.1a). But importantly, there is little indication of
a decline in potential growth relative to the precrisis average.
For the medium term, Schindler is a little bit more optimistic than the
GCEE. It is interesting to briefly consider why this is the case. Consider the
decomposition of the GCEE’s potential growth projection (Figure 8.1b). The
GCEE expects a negative contribution to potential growth from the labor
force from 2014 onwards, with the dampening of the labor contribution due
Malte Hübner is an economist at the German Council of Economic Experts.
239

240 Discussion
3.0
IMF estimate GCEE estimate
2.0
1.0
0.0
2004 2006 2008 2010 2012 2014 2016
−1.0
Figure 8.1a Potential Growth (In percent)
3.0
Hours worked Capital stock Total factor productivity
2.0
1.0
0.0
2003 2005 2007 2009 2011 2013 2015
−1.0
Figure 8.1b Contributions to Growth (GCEE estimates, 2010, percent)

Sources: German Council of Economic Experts (GCEE); and IMF staff calculations.
to ageing and shrinking of the population already evident in prior years. This
estimate already relies on fairly optimistic assumptions, for instance that
unemployment can decrease further without causing an acceleration in infla-
tion and that net migration inflows will add 200,000 persons per year to the
workforce. The slightly higher potential growth rates in Schindler’s estimate
are thus most likely caused by other determinants of potential output, such as
faster capital accumulation or a rise in total factor productivity growth. Both
developments are plausible. For instance, it is conceivable that Germans are

Discussion 241
beginning to channel savings, which previously fueled housing price bubbles

in the European periphery, into domestic investments, thus increasing the pace
of capital accumulation.
The GCEE’s findings also reinforce Schindler’s conclusion that medium-term
growth prospects for Germany are moderate at best, despite the stability of poten-
tial output during the crisis. Should total factor productivity continue to grow at
the average rate of the last decade, potential growth in the medium-term may
only range from 0.8 to 1.2 percentage points per year (GCEE, 2011). It is there-
fore important to bring the issue of productivity growth back on the agenda.
Chapter 3 in this volume, by Helene Poirson, does exactly this.
Poirson shows that productivity growth in Germany declined relative to the
United States between 1995 and 2004, reflecting faster capital accumulation and
more rapid TFP growth in the United States. The period of strong TFP growth
in the United States was correlated with high levels of investment in ICT, where-
as slow TFP growth in Germany coincided with relatively modest investment in
ICT, suggesting that lack of ICT investment caused the meager productivity
performance in Germany.
However, there is always the problem of separating correlation from causa-
tion. Possibly, firms in the United States were more productive in the first
place, and more productive firms simply invested more in ICT. Moreover, since
2005, there was a resurgence in productivity growth in Germany’s market sec-
tor without a corresponding increase in ICT investment, as Poirson discusses.
Of course, TFP growth after 2005 might have been driven by cyclical factors,
but overall, the developments after 2005 suggest a cautious interpretation of
the data.
The reference to the link between ICT adoption and productivity growth
reflects state-of-the-art thinking about the reasons for the poor productivity per-
formance in Europe as compared with the United States. Putting aside the issue
of how firmly this link is established, Poirson makes some important suggestions
about how to foster ICT adoption in Germany. I see this as the main innovation
in Poirson’s approach.
I find the proposal to foster ICT adoption by public procurement most inter-
esting. However, I am skeptical. The link between government procurement of
ICT and ICT adoption in the private sector does not strike me as firmly estab-
lished. I do agree, however, that public demand might generate economies of scale
that would foster ICT adoption in the private sector.
There is always the question of why the market on its own should not be able
to adopt technologies that are produced with economies of scale. My main con-
cern with using public procurement to foster ICT adoption is that it may invite
ICT producers to rent-seeking activities. The government might be persuaded to
procure ICT products by claiming that this might benefit ICT adoption in the
private sector. For this reason, I would be careful about setting objectives other
than enhancing public sector productivity when deciding on the level of public
sector investment in ICT.

242 Discussion
Improving Germany’s education would be an alternative way to foster ICT

adoption. A substantial literature provides evidence that high-skilled workers facili-
tate ICT adoption (see Doms et al. 1997 for an analysis at the macro level and
Arvanitis, 2005; Bresnahan, Brynjolfsson, and Hitt, 2002; Fabiani, Schivardi, and
Trento, 2005 for the firm-level). Currently, demographic trends are beginning to
cause the German workforce to shrink. This process will accelerate once the baby-
boomers reach retirement age. Even if improving educational outcomes in Germany
failed to foster ICT adoption, this strategy would help to offset part of the impact
of a declining workforce on potential growth by raising labor productivity.
Comment on Chapter 4
WERNER EICHHORST
MAIN ARGUMENTS
Martin Schindler provides a consistent analysis of the German employment
response to the 2008–09 global economic crisis. He demonstrates that the moder-
ate impact of the crisis on the German labor market can be explained by the
propitious nature of existing institutions, discretionary action, and the type of
external shock experienced. He refers to five main explanatory elements:
• First, prior labor market reforms adopted in the early to mid-2000s, in
particular the Hartz package, contributed to reducing unemployment in
Germany both with respect to measured open unemployment and struc-
tural unemployment. One can therefore argue that the institutional envi-
ronment of the German labor market has become more employment-
friendly during the past decade. Schindler infers that the Hartz IV reform
has been the most crucial factor, since it merged unemployment assistance
with social assistance and reinforced activation policies for the long-term
unemployed so that the likelihood of the unemployed (re)entering the labor
market increased as incentives to take up paid work were boosted.
• Second, automatic stabilizers helped stabilize employment at the core of the
German labor market, namely in export-oriented manufacturing (Eichhorst
et al. 2010; Möller, 2010). German manufacturers were most heavily hit by
the crisis, which affected them mainly through a trade shock, with foreign
orders declining steeply in late 2008 and early 2009. However, work-time
adjustments meant that they were able to protect their skilled workforce
without having to resort to major redundancies. On the one hand, work-
time accounts, which had run into surplus due to the full utilization of
Werner Eichhorst is Deputy Director of Labor Policy at IZA, Bonn.

Discussion 243
production capacities during the boom phase between 2007 and 2008,
facilitated a phase of shorter actual weekly working hours. On the other
hand, employers were able to rely on the long-established short-time work
allowance, which provides workers with a partial replacement of pay losses
for hours not worked amounting to at least 60 percent of net hourly pay.
However, without further policy changes, employers would have encoun-
tered major non-wage labor costs in social security contributions to be paid
for hours not worked.
• Third, as a response to this and in order to encourage the take-up of short-
time work instead of dismissing workers, the short-time work allowance was
made more attractive in late 2008 and early 2009. On the one hand, the
maximum duration was increased from six months to 24 months on a tem-
porary basis. On the other hand, and most importantly, employers’ social
security contributions were paid by the unemployment insurance fund if
training was provided to short-time workers or if short-time work lasted for
more than six months. This considerably lowered employers’ costs of using
short-time work.
• Fourth, German manufacturing employers acted very cautiously during the
crisis. Past experience had taught them that dismissing skilled workers dur-
ing a temporary downturn can lead to severe skill shortages when demand
recovers. This is particularly true in situations of imminent demographic
change, which result in smaller cohorts of young workers entering the labor
market. In fact, there is evidence that those sectors where firms had experi-
enced difficulties in recruiting before the crisis were most affected by the
crisis, and employers were most reluctant to dismiss workers at short notice
(Möller, 2010).
• Fifth, and finally, the existing institutional repertoire tallied well with the
character of the shock that hit Germany. It was possible to cope with a
temporary external shock, which predominantly affected manufacturing,
through strong reliance on work-time flexibility in the form of working-
time accounts and subsidized short-time work. Had the shock not been so
temporary—and had it then spread into other sectors—unemployment
would probably have risen more dramatically.
SOME QUALIFYING FACTORS

In general, the arguments put forward by Schindler are essentially consistent with
the consensual interpretation of Germany’s most recent ‘employment miracle.’
However, some qualifications are necessary. First, the effect of the Hartz IV
reform on the German unemployment rate is highly plausible, and in fact there
is some evidence in favor of this. Nonetheless, empirical research has not been
totally conclusive on this issue, since it is very difficult to determine the effect of
Hartz IV in the context of a number of simultaneous labor market changes, in
particular a far-reaching liberalization of nonstandard employment, lifting most

244 Discussion
TABLE 8.1
The German Labor Market from 2008–2011

2011
(medium IAB
2008 2009 2010 scenario)
Real GDP, percent 1 –4.7 3.6 2.4
Hours worked, percent 1.2 –3.1 2.9 1.7
- Full-time 1 –4 2.8 1.7
- Part-time 2.6 1.2 3.4 1.8
Total employment, percent 1.4 –0.1 0.5 0.9
Total employment, 1,000 40,216 40,171 40,438 40,841
Employees covered by social insurance, percent 2.1 0 1.2 1.6
Unemployment, 1,000 3,268 3,414 3,238 2,927
Unemployment rate, percent 7.8 8.1 7.7 7
Source: Fuchs et al., 2011.
restrictions on the use of temporary agency work. So it seems more appropriate

to attribute the downward trend in unemployment to the full Hartz package, the
related ‘Agenda 2010’ reforms, and the parallel growth of sectors with highly flex-
ible wages in the absence of collective agreements or binding minimum wages.
Second, the moderate upward deviation from the stable downward trend of
the unemployment rate experienced during the crisis does not put into question
the general structural improvement of the German labor market due to institu-
tional change. More than other countries, Germany succeeded in avoiding a
massive increase in unemployment and was able to return to the downward path
of unemployment in 2010. In fact, the German labor market turned out to be
more resilient than expected by most observers. As Table 8.1 shows, the recession
did not result in significant unemployment and, moreover, it was not followed by
jobless growth but by robust job creation.
A CLOSER LOOK AT THE GERMAN LABOR MARKET

When analyzing the German labor market in more depth, one can see that it was
characterized not only by stable unemployment during the crisis but also by stable
and growing total employment. Taking a sectoral perspective (Table 8.2), there
were in fact some marginal employment losses in manufacturing. However,
robust job creation in most other sectors led to stable employment figures even in
2009 and continued growth in 2010. In particular, the private services sector
(especially transport and hospitality) and public employment (e.g., education,
health and social services) continued to grow during 2009 and 2010. However,
the strong expansion of business services was partly driven by a massive increase
in agency work contracts—a sector where significant job cuts had been imple-
mented in the first phase of the crisis. Therefore, the general picture of stable
overall employment and a resilient labor market tends to hide important differ-
ences in sectoral employment dynamics.

Discussion 245
TABLE 8.2
Sectoral Employment Patterns

Percentage change
Sector (Employment in thousands) Feb-09 Feb-10 Feb-11 2009–2011
Mining, Energy, Water 546 544 544 –0.4
Total Manufacturing 6,490 6,237 6,331 –2.5
Construction 1,493 1,489 1,544 3.4
Wholesale and Retail Trade, Repairs 4,044 4,002 4,073 0.7
Transport and Logistics 1,399 1,378 1,428 2.1
Hotels and Restaurants 779 788 809 3.9
Information and Communication 834 826 842 1
Finance and Insurance 1,007 1,005 1,003 –0.4
Business Services 3,361 3,415 3,707 10.3
Of which: Temporary Work 533 560 738 38.5
Public Administration, Social Security 1,684 1,706 1,704 1.2
Education 1,067 1,105 1,100 3.1
Health and Social Services 3,339 3,464 3,574 7
Other Services, Private Households 1,070 1,082 1,073 0.3
Total 27,307 27,230 27,929 2.3
Sources: Bundesagentur für Arbeit; and author’s calculations
In fact, differential growth in some sectors and occupations contributes to an

ever more prominent dualization of the German labor market (Eichhorst and
Marx, 2011). This also applies to manufacturing, where internal flexibility was not
the only channel of adjustment and external flexibility was equally important.
While working-time accounts and subsidized short-time work stabilized the core
workforce, there were significant job losses at the margin, in particular among less
skilled blue-collar workers carrying out routine operative tasks. After the Hartz
reforms, which had deregulated temporary agency work and established collec-
tively agreed wages below those of direct employees of manufacturers, many labor-
ers and machine operators were employed as agency workers. They were made
redundant at the outset of the crisis (and rehired later on when demand picked up
again), thereby taking a disproportionate share of employment risks. A similar
phenomenon was observed with respect to fixed-term contracts in manufacturing.
Between 2008 and 2009, a large share of these contracts were neither renewed nor
transformed into permanent jobs (Hohendanner, 2010). In fact, due to this pat-
tern, manufacturing companies now have smaller core workforces than in the past.
This part of the labor force shows growing average tenure as long-term employ-
ment is emphasized — but at the same time there is a larger marginal segment of
routine jobs where skills shortages do not seem to matter (Figures 8.2 and 8.3).
SUMMARY AND POLICY CONCLUSIONS

Germany seems to have found a solution to short-term fluctuations in demand.
This solution is not perfect, but it proved to be quite effective during the recent
economic crisis, since the existing institutional repertoire was suited to the tempo-
rary, export- and manufacturing-centered nature of the crisis and required only
minor adjustment. Furthermore, the German labor market benefited not only

246 Discussion
1,600,000
Stock, East
Stock, West
1,400,000 Notifications
1,200,000 2009: About 4 percent of all

employees, 11 percent in
1,000,000 manufacturing, 20 percent in car
making, about 350,000 FTE
800,000 (would be 1 PP
unemployment rate)
600,000
400,000
200,000
0
Jan. 08
Feb. 08
March 08
Apr. 08
May 08
June 08
July 08
Aug. 08
Sept. 08
Oct. 08
Nov. 08
Dec. 08
Jan. 09
Feb. 09
March 09
Apr. 09
May 09
June 09
July 09
Aug. 09
Sept. 09
Oct. 09
Nov. 09
Dec. 09
Jan. 10
Feb. 10
March 10
Apr. 10
May 10
June 10
July 10
Aug. 10
Sep. 10
Oct. 10
Nov.10
Dec. 10
Figure 8.2 Short Time Work in Germany
Source: Bundesagentur fuer Arbeit.
Note: FTE: full time equivalents; PP: percentage point
Employment loss and recovery of

900,000 about 250,000 agency workers
Actual values
800,000
Six month moving average
700,000 (Actual values)
600,000
500,000
400,000
300,000
200,000
100,000
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Figure 8.3 Temporary Agency Work in Germany

Sources: Bundesagentur fuer Arbeit; and author calculations.
from fairly stable employment in manufacturing but also from robust employment
growth in the private and public service sectors. This ongoing sectoral shift implies
a growing variety of job types and a wider dispersion of working conditions and
wages across occupations. Policymakers face a new set of challenges, which are
probably harder to tackle than mere fine-tuning of existing policy schemes.
From a policy perspective, the German experience demonstrates two themes.
On the one hand, automatic stabilizers are important for promoting internal flex-
ibility as a (limited) alternative to external flexibility, that is, dismissals. Flexible
work-time agreements and publicly subsidized short-time work schemes can help
avoid major job losses in the skilled core workforce if, and only if, economic

Discussion 247
shocks are temporary. On the other hand, the German case is also characterized
by a specific function of the second tier of employment, consisting of fixed-term
contracts and temporary agency work, which helps buffer the core against major
short-term adjustment of the number of jobs. Nevertheless, the more volatile
forms of employment at the margin of the labor market create new challenges
regarding employment stability and promotion as well as social protection. This
calls for the recalibration of employment protection and unemployment benefits,
in particular better coverage by unemployment insurance.
FELIX HÜFNER
Hélène Poirson and Sebastian Weber’s chapter is important in the German con-
text from an analytical as well as policy perspective. Analytically, it challenges the
conventional wisdom that German growth is an important driver of other coun-
tries’ (especially European) economies, by showing that growth spillovers from
Germany, despite the size of the German economy, are actually smaller than those
originating in other large economies. This obviously bears an important policy
message, namely that increased fiscal spending in Germany is less effective in
stimulating growth abroad than is often assumed. This point was underlined in
Chapter 6. At a time of increasing divergences in Europe, these findings are an
important contribution to the debate.
The study presented in Chapter 5 estimates a VAR for 14 European countries
plus Canada, Japan and the United States. One of its key findings is that the
German economy is more sensitive to external shocks than are other countries:
the sensitivity is particularly notable to shocks originating in the United States
and Asia. In contrast, outward spillovers from Germany to other countries are
estimated to be less than half the size of spillovers of other large economies.
However, the spillovers from Germany to some smaller euro area countries that
have tight trade links, such as Austria and the Netherlands, are large, not least
because these smaller countries are integrated into the supply chains of German
companies. Among the larger economies, spillovers are significant only to Italy.
Importantly, however, spillovers to the peripheral countries like Greece, Ireland,
and Portugal are much smaller than, for example, spillovers to these countries
emanating from France. Overall, the finding is that Germany acts as a conduit of
international shocks to other countries, rather than being an independent source
of spillovers. In line with these results is the fact that identified third-country
effects matter less for Germany than for other countries in the sample, showing
that Germany is more directly affected by foreign shocks.
Felix Hüfner was senior economist on the Germany desk in the OECD Economics Department at
the time of writing. The views expressed are those of the author and do not necessarily reflect those
of the OECD or its member countries.

248 Discussion
An innovative feature of the paper is the analysis of the time-variation of spill-

over effects by splitting the sample and testing for a differing impact during the
financial crisis of 2008–09. Spillovers from Germany are found to have been
broadly stable during the period from 1993 to 2010 compared with the full sample
that starts in 1975. This is a surprising result given the increase in trade integration,
not least in Europe, and the increase in FDI-driven supply chain links during the
past two decades. Shock transmission is generally found to increase during the
2008–09 crisis period for most countries, although this is less the case for Germany.
ACCOUNTING FOR GDP SIZE DIFFERENCES

AND OPENNESS
When interpreting the estimated responses, it needs to be kept in mind that the
impulses are not adjusted for GDP size. Thus, a one-percent growth shock origi-
nating from the United States is more likely to have a growth effect on other
countries than a one-percent shock from Germany. Indeed, the authors report in a
chart showing GDP size with outward spillovers that both are correlated. Adjusting
the spillover estimates for the size-difference throughout the paper would make the
German results even more outstanding, since even without such an adjustment the
estimation results show a larger effect for shocks emanating from countries smaller
than Germany, such as the United Kingdom or France. At the same time, this last
result might partly reflect the sample composition, which lacks some eastern
European countries with which Germany has tight supply-chain links.
INTERPRETATION OF THE CRISIS DUMMY

The VAR specifications include a dummy for 2008:Q4 and 2009:Q1, aiming to
gauge any amplification effects in crisis times. Estimation results including the
dummy show much lower spillover effects—often only half of the response
yielded in estimations without the dummy—suggesting substantial amplification
effects (even though this is less the case for Germany). To the extent that such a
dummy captures, for example, spillovers of crisis in the domestic banking system
or the housing market, say in the United States or Spain, to other countries, its
size seems large. It would be interesting to identify in more detail what is driving
the crisis amplification result; one factor worth exploring is the role of the break-
down of trade financing following the insolvency of Lehman Brothers (Cheung
and Guichard, 2009). Including the crisis dummy into the authors’ framework
for identifying the trade channel could shed more light on this issue.1 Similarly,
1
In addition to including a crisis dummy, an interesting exploration would be to test whether the
importance of the trade channel has changed over time by identifying its importance for the split
sample. This would probably help to better understand the result that the trade channel is less impor-
tant for the transmission of shocks originating in the euro area relative to those coming from non-euro
area countries. At first glance, this finding is surprising, given the tight trade integration within the area.

Discussion 249
it would be interesting to have a discussion on why Germany had no higher

spillovers during the crisis, while other countries’ had a high amplification during
the crisis, and on how this finding might affect the authors’ claim that Germany
acts as a conduit for external shocks to other countries.
RECENT LACK OF DOMESTIC DEMAND IN GERMANY

When interpreting the results of the study, one has to keep in mind the particular
growth performance of Germany over most of the past decade, which was char-
acterized by a lack of domestic demand and significant growth contributions
from foreign demand. For example, real total domestic demand grew by an
annual average of just 0.75 percent since 1999, compared to an (un-weighted)
average of close to 2 percent for the G-7 countries (excluding Germany). Keeping
in mind the role of domestic demand in the size of spillovers, as identified by the
authors, the lower spillovers from Germany in the more recent period may just
reflect the particular growth composition in Germany during the period (between
1975 and 1992, annual average growth in German real total domestic demand
was equal to the un-weighted G-7 average). While the lack of domestic demand
also reflects structural factors (OECD, 2010a), many forecasters expect a cyclical
increase in domestic demand in Germany over the coming years, so spillovers
might turn out to be higher going forward.
LIMITED PICK-UP IN SPILLOVERS

At the same time, trade linkages in the euro area, at least between the large mem-
ber countries, are smaller than often presumed, limiting the upside potential for
German spillovers at least through trade. Exports to Germany account for at most
3 percent of GDP in the large euro area countries, while for the smaller, more
integrated neighbouring countries the share amounts to more than 10 percent
(Table 8.3). Therefore, even if the projected increase in domestic demand in
TABLE 8.3
Trade Linkages Between Germany and Euro Area

Countries (Percent)
Exports to Germany…
…as a share of total exports …as a share of GDP
France 13 3
Italy 11 3
Spain 8 2
Greece 4 1
Ireland 9 9
Austria 22 12
Netherlands 15 12
Slovakia 17 14
Source: Author’s calculations.

250 Discussion
0.40
0.35
Import propensity of domestic demand
0.30
0.25
0.20
0.15 Germany
0.10
0.05
0.0
0 0.2 0.4 0.6 0.8
Import propensity of exports
Figure 8.4 Estimated Import Propensities

Source: Long-run marginal import propensities as estimated in Pain, N. et al. (2005), “The New International
Trade Model,” Organisation for Economic Cooperation and Development Economics Department Working
Paper No. 440.
Germany materializes, increased imports are unlikely to exert large effects on the
other major euro area countries. This hypothesis is supported by the fact that
import propensities out of domestic demand are estimated to be relatively low in
Germany, again limiting the outward growth effects of any domestic stimulus
(Figure 8.4). However, import propensities for exports are much higher, again
supporting the chapter’s finding that Germany acts as a conduit to other countries
of changes in external demand for its goods.
OTHER CHANNELS THAT COULD BE AT WORK

The authors’ finding that the trade channel accounts for at most 30 percent of
spillovers among large euro area countries opens up the questions of which other
channels can account for the remaining part of the spillovers and whether growth
may spill over through channels that are not captured by the chosen approach (as
indicated by the increased correlation of Germany’s growth rate with that of the
rest of the euro area the authors report). Two candidates for growth transmission
within the euro area over and above the trade channel are the financial channel
and the monetary policy channel (OECD, 2010b).
One indicator for the importance of the financial channel for the transmis-
sion of shocks is the size of a country’s banking sector claims on other countries.
These claims have increased substantially over the past decade; for example,

Discussion 251
10 25
9 Germany on Spain
Percent of Spanish GDP

Percent of German GDP
8 20
Spain on Germany
7
6 15
5
4 10
3
2 5
1
0 0
1999:Q4
2000:Q2
2000:Q4
2001:Q2
2001:Q4
2002:Q2
2002:Q4
2003:Q2
2003:Q4
2004:Q2
2004:Q4
2005:Q2
2005:Q4
2006:Q2
2006:Q4
2007:Q2
2007:Q4
2008:Q2
2008:Q4
2009:Q2
2009:Q4
Figure 8.5 Consolidated Banking Claims between Germany and Spain (Percent
of GDP)
Source: Bank for International Settlements, Consolidated Banking Statistics database and Organisation for
Economic Co-operation and Development, Economic Outlook database.
claims by German banks on Spanish banks have increased from around 5 per-
cent of Spanish GDP in 2002 to close to 20 percent by 2008, while the claims
of Spanish banks on German banks have remained fairly stable in terms of
German GDP over the same period (Figure 8.5). German surplus savings,
originating not least through the lack of domestic investment, were thus partly
channelled to Spain, supporting domestic demand there, not least in the resi-
dential investment sector. It is worth noting that this channel works in both
directions, with negative spillovers from Spain affecting German growth during
and after the crisis; this may be one explanation behind the significant spillovers
from Spain to Germany (the second largest after the United States in the more
recent period) identified by the authors, notably in the more recent period and
the crisis.
The mechanics of monetary policy in the monetary union are another avenue
of growth transmission. According to this channel, slow growth in Germany dur-
ing most parts of the last decade kept monetary conditions looser than they
otherwise would have been (as monetary policy is set on the basis of data for the
euro area average). Given Germany’s weight in the euro area average, slow growth
in Germany translated via lower interest rates to higher growth elsewhere. Thus,
this channel provides an indirect growth spillover from Germany to other coun-
tries in the euro area, however with lower growth in Germany leading to higher
growth elsewhere (Figure 8.6).
The framework applied by the authors might not be able to directly capture
both the financial and the monetary policy channel, since it focuses solely on
GDP growth rates. One possible, though likely imperfect, identification would
be to include (residential) investment growth as an additional variable into the
VAR. This would allow for the identification of an ‘investment channel’

252 Discussion
1 Germany
0
−1
Interest rate gap
−2
−3
−4
−5
−6
−7
−8
0 1 2 3 4 5 6 7
Annual real GDP growth
Figure 8.6 Monetary Conditions and Real GDP Growth in the Euro Area (Average
1999–2007)
Sources: Organisation for Economic Co-operation and Development; and author’s calculations.
(in analogy to the inclusion of export growth, which the authors apply to iden-
tify the trade channel), which is the most likely way in which differences in
financial conditions are transmitted across countries.
CARSTEN-PATRICK MEIER
MOTIVATION AND FINDINGS

Anna Ivanova’s chapter looks at an important topic. Current account imbalances
are widely suspected to be related to the global financial crisis of 2008–09 as well
as to the ensuing debt crisis in Europe. Although the question is still open
whether those imbalances have to be regarded as one of their causes or rather as
one of their early symptoms, they are at the heart of the policy debate. In par-
ticular, the significant increase in Germany’s current account surplus in the aggre-
gate and vis-à-vis most of the other Euro area countries over the past decade has
renewed the interest in understanding the factors behind the current account
surge and, at the same time, to identify possible cures.
This is the starting point of the chapter, which looks at the structural—as
opposed to the cyclical—determinants of the German current account surplus
Dr. Carsten Patrick Meier is founder and Managing Director of Kiel Economics.

Discussion 253
and proposes policy measures that could help to reduce it. The basis of its policy
prescriptions is an econometric study of the current account movements of a
total of 106 advanced, emerging, and developing countries over the years from
1970 to 2009 and their likely determinants. The analysis is conducted within a
random-effects panel framework that uses five-year averages of variables in an
attempt to filter out cyclical forces. The conclusion is that while structural factors
such as taxes, labor market, and product market regulations do not play a sig-
nificant role in the emergence of large current account positions over the last
decade, they may in some cases explain part of the differences in the current
account positions of the countries in the sample. In particular, for some subsets
of countries it is found that the current account is likely to be more positive the
higher the corporate income tax rate, the stricter the credit market regulation,
and the higher the gross replacement rate. Consequently, the tentative policy
prescription of the paper for Germany is to lower the replacement rate, the cor-
porate income tax rate, and regulation of the banking sector (which in the discus-
sion is identified with reduced public ownership of banks) in order to reduce its
current account surplus.
SOME QUARRELS
The paper’s empirical findings and the policy prescriptions derived for Germany
raise questions. With respect to the empirical analysis, what strikes me most is
the lack of robustness in the findings across different country samples. To be
sure, the paper emphasizes this lack of robustness several times and concludes
that “the impact of these structural reforms on the surplus will likely be mod-
est….” Importantly, none of the three structural determinants that the policy
prescriptions for Germany are to address turn out to be significant when the
sample is restricted to the OECD countries. Evidently, there is a structural dif-
ference in the sample; the parameters of the panel model for the non-OECD
countries are significantly different from the parameters for the OECD coun-
tries. Given this difference, it is difficult to draw conclusions from the full-
sample analysis, especially for the OECD countries, to which Germany
belongs.
But even if one accepts the econometric results despite their somewhat shaky
statistical grounding, they look rather puzzling. This is especially the case for the
gross replacement rate, which turns out to have a positive sign in the regression
results. According to standard labor market theory (e. g. Layard, Nickell, and
Jackmann, 2005), a higher replacement rate—in a manner similar to a higher
minimum wage and higher unemployment protection—should increase the res-
ervation wage, thus raising overall wages and unit labor costs and leading to a loss
of price competitiveness, which should ultimately dampen exports and stimulate
imports. The sign should, therefore, be negative. While the paper presents some
economic reasoning for this counterintuitive result, the most likely explanation
is that the statistical result is driven by the high amount of collinearity of the

254 Discussion
three labor market indicators used: replacement rate, minimum wage, and
employment protection index. Indeed, countries that have high replacement
rates often also feature high employment protection and minimum wages. A
simple remedy for the empirical strategy would be to aggregate the three indica-
tors into one overall indicator of “worker protection.”
When the result with respect to the replacement rate is applied to Germany, it
becomes even more puzzling. According to the econometric finding of a positive
relationship between this indicator and the current account surplus, the signifi-
cant reduction in unemployment benefits and social assistance from 2004
onwards mentioned in the paper should have reduced Germany’s current account
surplus in the second half of the last decade. Instead, the German current account
surplus increased at an accelerated pace until the global financial crisis took hold.
This lack of dynamic correspondence in the case of Germany also applies to
the second determinant identified in the paper. While the estimated positive
association between the corporate income tax rate and the current account sur-
plus seems plausible—since, everything else being equal, higher corporation taxes
mean lower investment and thus higher capital exports—it is again tricky to find
the pattern for Germany that is suggested by the regression results. Indeed, cor-
porate income taxes were lowered substantially in 2000—two years before the
German current account surplus started to take off.
Finally, there is the conclusion that stricter banking regulation is a factor that
contributes to Germany’s current account surplus. Again, the economic rationale
that tighter credit resulting from a lack of competition in the banking sector low-
ers investment and increases the current account surplus seems plausible.
However, it is hard to see that Germany, with its 2,000 independent banks, suf-
fers from a lack of competition in the banking sector. While most of the savings
banks that make up one-third of the banks are not held by private entities but by
the local communities, they cannot simply be counted as belonging to the state
and therefore hampering competition. Indeed, in the past it has sometimes been
argued that the German banking sector is over-competitive, resulting in low mar-
gins and relatively low capitalized banks. Moreover, the banking sector has been
deregulated substantially over the past 15 years, notably with the elimination of
the public guarantee obligation for the state-owned Landesbanken enforced by
European Union law in 2005. In the case of Germany, neither the level of bank-
ing regulation nor its dynamics lend themselves readily to confirm the positive
relationship between strict banking regulation and the current account as sup-
posed by the regression results.
NEED FOR POLICY MEASURES

Given my difficulties with the three factors mentioned above, the main conclu-
sion I draw from the empirical analysis is that structural factors do not play much
of a role in the current account in most countries, at least not in the advanced
countries. In my view, current accounts are largely cyclical phenomena. The cycle

Discussion 255
driving them may have a longer duration than the conventional four to five
years—a fact that casts some doubt on the validity of taking simple five-year
averages for cyclical adjustment—but it remains a cycle. Typically, this cycle
reflects the longer-term adjustment of the economies in question to external
shocks.
The German current account is a case in point. After unification, it turned
negative as government deficits widened, investment in housing soared, and price
competiveness was eroded by sharp wage hikes. It went back into positive terri-
tory in the second half of the 1990s when investment in housing slowed down
and fiscal deficits declined. However, until 2001, the trade account was never
more than 1.5 percent of GDP, thanks partly due to the hike in consumption and
in business investment spurred by the tech-bubble, which happened to be par-
ticularly pronounced in Germany. It was only after the effects of the European
Monetary Union began to take hold that trade and current account surpluses
widened significantly. While the common monetary policy was too strict for
Germany, it was too lax for the economies at the European periphery, which were
already stimulated heavily by the decline in long-term interest rates brought about
by monetary union. As a consequence, consumption and investment boomed and
wage growth accelerated in those countries while the German economy was
dampened, leading to widening current account imbalances between the two
regions of the euro area. The comprehensive tax, social security, and labor market
reforms implemented in Germany between 2000 and 2005 enhanced this pro-
cess. Intended to stop the rise of unemployment and fiscal deficits, the reforms
not only depressed private consumption temporarily, but also lowered workers’
reservation wage and thus improved the price competitiveness of German firms,
not least vis-à-vis its competitors from the rest of the Euro area.
Today, the macroeconomic setting looks completely different. The German
economy has recovered quickly from the global financial crisis, thanks mainly to
the long-term effects of the reforms. Employment continues to rise and unem-
ployment is falling. Most other advanced countries have not come out of the
crisis as well as Germany has. In the rest of the euro area, unemployment has risen
sharply and capacity utilization is well below normal levels. However, adjustment
is already visible. Not only have European periphery countries, such as Ireland
and Spain, managed to improve their current accounts, the German trade surplus
has also declined from its peak of 8.5 percent at the end of 2007 to about 5 per-
cent at the end of 2011. On the domestic side, we now have interest rates that are
too low for the German economy while they are too high for most of the rest of
the euro area countries, a fact that is enhanced by the debt crisis. A small con-
struction boom is already building up in Germany as property prices have risen
in real terms in 2011—for the first time in a decade.
At the same time, with the unemployment rate heading for 6.5 percent in
2012, 5.5 percentage points lower than in 2005, labor shortages have become an
important concern for many firms, and wage pressure is rising. At Kiel Economics,
we expect unit labor costs to increase significantly in Germany over the coming
years while unit labor costs in the rest of the euro area are set to stagnate or even

256 Discussion
fall as a consequence of high unemployment and, possibly, labor market reforms.

Inflation is therefore set to accelerate in Germany, while it is likely to remain
moderate in the rest of the euro area. This process will eventually erode German
price competitiveness and will further reduce the German trade surplus—
completely without the help of structural policies.
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About the Contributors
Fabian Bornhorst
Fabian Bornhorst is an economist in the European Department of the
International Monetary Fund (IMF) and works on the surveillance teams for
Germany and the euro area. Previously he worked in the Fiscal Affairs and African
departments of the IMF and was an economist in the Ministry of Finance in
Namibia as a fellow of the Overseas Development Institute (ODI). He has pub-
lished papers on fiscal policy, natural resource related tax revenue, and public
investment and growth. He obtained his Ph.D. in economics from the European
University Institute (Italy) and holds master’s degrees in economics from
University College London (U.K.) and the Freie Universität Berlin (Germany).
Werner Eichhorst
Werner Eichhorst studied sociology, political science, psychology, and public
policy and administration at the universities of Tübingen and Konstanz
(Germany), where he graduated as Diplom-Verwaltungswissenschaftler in 1995.
He received his Ph.D. from the University of Konstanz in 1998. From 1999 to
2004 he was project director at the Bertelsmann Foundation, a private think tank
in Germany, where he was responsible for comparative analyses of the German
labor market and related policy areas. After working with the Institute for
Employment Research (IAB) from 2004 to 2005, he joined the Institute for the
Study of Labor (IZA) as research associate in July 2005, becoming a senior
research associate there in February 2006 and deputy director of labor policy in
April 2007. His main research area is the comparative analysis of labor market
institutions and performance as well as the political economy of labor market
reform strategies.
Malte Hübner
Malte Hübner is an economist at the German Council of Economic Experts,
where he is responsible for macroeconomic analysis and energy policy. Before
joining the staff of the Council, he conducted theoretical and empirical research
in the area of fiscal federalism. He obtained his Ph.D. in economics from the
University of Mannheim (Germany) in 2009 and holds a master’s degree in com-
puter science from the Universität des Saarlandes (Germany).
Felix Hüfner
Felix Hüfner is deputy director in the Global Macroeconomic Analysis Department
at the Institute of International Finance (IIF), where he is responsible for the IIF’s
257

258 About the Contributors
global macroeconomic forecasting work, its monthly Global Economic Monitor

publication, and its report on Capital Flows to Emerging Economies. Before coming
to the IIF in 2012, he was senior economist and head of the Germany/Slovak
Republic desk at the Organisation for Economic Co-operation and Development
(OECD). He also worked as an economist for the Bundesbank, the European
Central Bank (ECB) and the Centre for European Economic Research (ZEW)
and was a bank apprentice at Deutsche Bank. He received a B.A. from the
University of Cologne (Germany), a master’s degree in economics from the
University of Munich, and a Ph.D. from the University of Würzburg (Germany).
He passed all three levels of the CFA program.
Anna Ivanova
Anna Ivanova is a senior economist in the European Department of the IMF
and works on the surveillance team for Germany. Previously she worked as an
economist in the Fiscal Affairs, Middle East, and Central Asia departments
of the IMF and as a physicist at the Institute of Nuclear Problems in Belarus.
She has published a series of papers in the areas of fiscal policy, the role of
international financial institutions, and growth. She obtained her Ph.D. in
economics from the University of Wisconsin-Madison (USA), a master’s
degree in economic development from Vanderbilt University (USA), and a
master’s degree in nuclear physics from the Belarussian State University
(Belarus).
Christian Kastrop
Christian Kastrop is deputy director-general of the Economics Department and
director of the Public Finance, Macroeconomics, and Research Directorate of the
German Federal Ministry of Finance. He has been director of the European
Economic and Monetary Union Directorate and director of the International and
Financial and Monetary Policy Directorate. He is chairman of the OECD Senior
Budgetary Officials (SBO) Network on Performance and Results. From 2008 to
2009, he chaired the EU Economic Policy Committee (ECOFIN-EPC), of which
he was vice-chairman from 2005 to 2008. He is a lecturer at the Free University
of Berlin at the Hertie School of Governance, a policy fellow of the Cologne
Institute of Public Finance, and a State Member for Germany at BRUEGEL, a
think-tank located in Brussels. After starting his career as an assistant researcher
and lecturer in economics at the University of Cologne, he joined the Federal
Ministry of Finance in 1989, where he held various positions, including chief
press officer, director of the Press and Communication Division in the Minister’s
Office, and director of the Fiscal Policy Division. He holds a master’s degree and
a Ph.D. in economics from the University of Cologne, after studies in economics,
psychology, medieval philosophy, and methodology of science at Cologne and at
Harvard University (USA).

About the Contributors 259
Carsten-Patrick Meier
Carsten Patrick Meier is founder and managing director of Kiel Economics, a
macroeconomic and risk management consultancy. He studied economics in
Göttingen and Kiel (Germany) and obtained his Ph.D. under Prof. Dr. Juergen
B. Donges. Between 1998 and 2008 he led the research groups on the German
business cycle and, later, on risks in the banking sector at the Kiel Institute for the
World Economy. He is the author of numerous articles on the business cycle,
capital markets, and banks, as well as on economic modeling and forecasting.
Ashoka Mody
Ashoka Mody was deputy director in the IMF’s European and then Research
Department when this book was written. He is now Charles and Marie Robertson
visiting professor in International Economic Policy at Princeton University. He
worked for many years at the World Bank and has also been a visiting professor
at the University of Pennsylvania’s Wharton School (USA). His academic
research, motivated by and drawing closely on his policy responsibilities, has
recently focused on international finance and domestic political economy.
Hélène Poirson
Hélène Poirson is senior economist in the European Department at the
International Monetary Fund (IMF), where she is responsible for financial sector
surveillance for France. Previously, she worked on the surveillance teams for
France and Germany, and held positions in the Research, Asia and Pacific, and
Finance Departments. Before joining the IMF in 1999, she was economist at the
Observatoire Francais des Conjonctures Economiques (OFCE), a private think-
tank. She has published a range of policy and research papers, especially in the
areas of economic growth, exchange rate and monetary policy issues, and capital
markets issues. Her most recent research focuses on bank-level spillovers within
and from the euro area. She holds a Ph.D. in economics from DELTA, École des
Hautes Études en Sciences Sociales (France) and a MSc in mathematics from
Ecole Polytechnique (France). She is a CFA charterholder.
Martin Schindler
Martin Schindler is a senior economist at the Joint Vienna Institute (JVI), on
leave from the IMF. He is also a policy fellow at the Institute for the Study of
Labor (IZA). At the JVI, he directs and contributes to capacity building and
training activities for public sector officials in Central, Eastern and Southeastern
Europe, mostly on policies for macroeconomic management and financial stabil-
ity. At the IMF, he most recently worked on the surveillance teams for Germany
and the euro area. He has published on a range of topics in macroeconomics and

260 About the Contributors
international finance, and his work has appeared in the Journal of Monetary
Economics, the Journal of International Economics, and the Journal of International
Money and Finance, among other outlets. He holds a Diplom-Kaufmann degree
from the Universität des Saarlandes and a Ph.D. in economics from the University
of Pennsylvania (USA).
Sebastian Weber
Sebastian Weber currently works as an economist at the IMF, where he has held
positions in the European and African departments. He has written policy papers
and articles on labor markets, monetary policy, and international macro and
finance. His current research agenda focuses on the role of domestic institutions
for the transmission of shocks. He has been a consultant for the OECD and the
World Bank. He holds a Ph.D. and a master’s degree in international economics
from the Graduate Institute of International and Development Studies in Geneva
(Switzerland) and studied politics and economics at the University of Cape Town
(South Africa) and the University of Hamburg (Germany), where he obtained a
B.Sc. (Hons.) in economics.

Index
[Page numbers followed by b, f, n, or t refer to boxed text, figures, footnotes, or tables,

respectively.]
A trade patterns, 110

Access to capital Beveridge curve, 91, 92f
current account balance dynamics and, Brazil, 162, 172
199, 200, 202, 214–215
future challenges and opportunities, 10 C
initial public offerings in Germany and, 71 Canada
obstacles to technology investment in generation and transmission of spillover
Europe, 57 effects, 121, 127, 128, 129, 153
See also Credit market regulation international financial linkages, 112
Agriculture sector, projected output gaps, responses to U.S. growth shocks, 102
45f Capital account openness, 214–215
Asian economies China
future challenges for Germany’s growth, credit market deregulation, 210
2, 10 current account surpluses of 2000s, 16
Germany’s integration with, in early domestic investment patterns, 16
2000s, 13 European trade, 2, 111
global competition, 15–16, 217 generation and transmission of shocks,
See also specific Asian nation 100, 111, 162, 170, 184
Austria German exports to, 15, 22–23, 22f
fiscal consolidation spillover effects, German imports from, 217, 218f
150, 174, 176, 180, 182 as global competitor, 28
generation and transmission of wage patterns and trends, 210
spillovers, 124, 126, 127, 129, 162, Cloud computing, 72
186, 247 Collective bargaining agreements, 24, 89b
growth spillover effects, 121, 122 Consolidation, fiscal
post-World War II growth, 5 spillover effects of synchronization of,
Automatic stabilization, 21n, 157, 158, 149–150, 151, 186
172, 242, 246 See also Fiscal spillover effects on recovery
Corporate investment, 218–219, 219f
B Corporate profits, 7, 16, 218–219
Banking. See Financial sector Credit market regulation
Baseline econometric modeling, 205, current account imbalances and, 200,
206–207 201, 204, 209f, 214, 215, 221, 254
Belgium Germany’s, 201n
fiscal consolidation spillover effects, 150, measures of, 201n, 214, 223
165, 170, 174, 176, 180, 184, 186 Current account balances
generation and transmission of current literature on, 202–205
spillovers, 121, 124, 126, 127, 129, cyclical sources of current imbalances,
162, 186 16, 201, 216, 254–255
261

262 Index
data sources, 223 Hartz reforms and, 255

economic significance of, 252 post-World War II recovery, 4, 7
effect of long-standing structural spillover effects and, 25, 99, 105, 249
packages, 212–215, 225–234t U.S., 3
effect of structural factors on Domestic investment and savings
fundamental determinants of, 201, causes of low investment in Germany,
210, 211, 215, 216f, 235–237t 16, 201
findings from baseline econometric in current account balance dynamics,
modeling, 205–206 203
fundamental determinants of, 200, 202, future economic growth and, 49
206–207 Germany’s current account imbalances
Germany’s current surplus, 1, 2, 16, 31, and, 16, 201, 202, 218–219
200, 201, 217, 218f, 255 during Germany’s reemergence period
in Germany’s reemergence (2004–08), (2004–08), 16
1, 10, 14–16, 201 Great Recession effects, 19
in Germany’s slowdown period (1960s– obstacles to, in Germany, 57, 69–72,
2004), 7, 8f 219–220
imbalances prior to Great Recession, population aging and, 29–30
199, 200, 204–205 productivity lags related to investment
implications for recovery from financial lags in ICT, 49
crisis, 199 sectoral differences in Europe and
modeling methodology, 200, 205–207, Germany, 238f
252–254 sources of current global account
rationale for mitigation of distortions imbalances, 200
in, 199–200
strategies for reducing imbalances, 16,
201, 217–221, 220t E
structural factors in dynamics of, ECB, 26
202–204, 208–210, 253–256 Economic growth in Germany, 4f, 76t
structural sources of current imbalances, employment patterns and, 78–79
16, 199, 200, 201, 202, 220–221 future challenges, 1, 2–3, 27–30, 38,
unification effects, 7, 255 50, 255–256
U.S. economy, 3 Great Recession effects, 1, 19–23, 20f,
See also Target 2 system 21f, 22f, 38, 90, 239
intensive growth, 7
international comparisons, 2, 3
D phases of, 1–2, 3, 31
Demographics. See Population aging post-World War II period (1940s–60s),
Distribution services, 67–68 3–5, 6f, 30–31
Domestic demand and consumption projections, 239–241, 240f
course of Great Recession, 21, 23f reemergence period (2004–08), 9–13,
current account balances of 2000s and 31
16 reunification effects, 1, 2, 7
employment patterns and, 16, 17f, 23, slowdown period (1960s-2000s), 5–9,
23f 55
future challenges for growth, 2–3 sources of, 61, 62f, 64t, 240f
Germany as global engine of growth See also Exports, Germany’s; Potential
and, 25 GDP
growth correlations, 127–129, 128t Educational investments, 242

Index 263
Employment patterns obstacles to technology investments, 57,

cyclical patterns in Germany, 78, 69–72
80–84, 86f perceptions of Germany’s international
definition of potential GDP, 38–39 role and responsibilities, 2, 10,
domestic demand and consumption 25–26, 31
patterns and, 16, 17f, 23, 23f post-World War II recovery, 4–5
future challenges for Germany, 31, 49 productivity growth patterns, 55, 56–57
Great Recession outcomes, 20, 21f, recent wage rises, 11, 11f
43–44, 77, 80–84, 81f, 82f, 84f, 244, sectoral savings and investment
244t, 245, 245t behavior, 238f
international comparison, 43f, 79f, 80, 82f sensitivity to external shocks, 115–116,
intersectoral differences in financial 243
crisis outcomes, 244, 245t in slowdown period (1960s–2000),
post-World War II recovery, 4–5, 5–6, 6f
16–17, 17f sources of current account imbalances,
replacement rate, 201, 209f, 211, 212, 14–16
216, 220, 224, 253–254 sources of growth spillovers, 97, 102–
services sector, 66b 103, 112–114, 115–118, 130–131,
in slowdown period (1960s–2000s), 7, 247
78–79 spillover effects of decline in German
unification effects, 7 spending, 160–162, 161t
work-time adjustments in response to strategies for productivity improvement,
financial crisis, 12, 24, 83–84, 84f, 73
92, 242–243, 246–247 transmission of spillover effects, 102,
See also Labor market, Germany; Wages 124, 126, 127
and income See also Target 2 system; specific country
Employment protection legislation, 7, 24, European Monetary Union
90, 90n, 254 fiscal policy spillovers, 243
current account balance dynamics and, generation and transmission of shocks,
209f, 211, 212–214 102, 115, 130
data sources, 224 sensitivity to U.S. shocks, 116–118
See also Hartz reforms spillover risks, 110–112, 110t
Europe, Germany and trade channel transmission of chocks,
determinants of productivity 126, 127f
performance, 58b trade patterns, 110–111, 110t
evidence of spillover effects in recovery, See also Europe, Germany and; specific
97–98 country
export growth in 2000s, 13–16, 13f, European Recovery Program, 4
14f, 217, 217f Exchange rates
fiscal policy spillover effects, 25–26, in current account balance dynamics,
152, 166, 182 203
Germany as regional locomotive of synchronized fiscal consolidation effects
growth, 2, 25 on recovery, 149
Hartz-like labor reforms of 1990s, Exports, Germany’s
12–13, 24 future challenges, 2–3
investment patterns preceding financial Great Recession as export shock, 24,
crisis, 219f 36–38, 89–90, 239
labor unit labor cost evolution (1990– Great Recession effects, 19, 22–23, 22f,
2010), 9f 36, 242

264 Index
international comparison of growth in future prospects, 186–187

2000s, 14f, 217, 217f growth impact of coordinated
post-World War II growth, 1, 2, 4, 4t, 5 relaxation, 182, 183t
product specialization, 13, 13f, 28 growth outcomes, 170, 171t, 172f
in reemergence period (2004–08), 10, impact of spending reductions, 159–
13–16, 13f, 14f 166, 164t, 165f, 166f, 190–191t
significance of, in Germany economy, 1, limitations, 25–26
35–36, 36f, 36n outcomes of 2011–12 consolidation
in slowdown period (1960s–2000s), plans, 166–180, 169t, 170f, 192–
7, 8f 197t
source of Germany’s current account trade balance outcomes, 182–186, 184t,
surplus, 217, 218f 185t
use of real revenues and expenditures in
F simulation, 174–179
Financial integration Foreign direct investment
current account balance dynamics and, current account balance dynamics and,
202, 206, 223 203
spillover transmission and, 1–3, 102, domestic corporate investment and, 219f
110 spillover effects, 100
Financial sector France
cross-border spillover risk, 110, 111t, 112 generation and transmission of shocks, 97,
German bank claims on foreign banks, 98–99, 113–114, 121, 122, 124, 127,
250–251, 251f 129, 130, 142–143f, 162, 170, 247
linkage to current account balance, 203, German trade with, 15
204 Great Recession impact in, 19
mechanisms of spillover transmission, sensitivity to external shocks, 113,
103–104, 110, 111t, 112, 130 116–118, 126, 153
policy strategies for reducing global
current account imbalances, 201 G
in post-World War II recovery, 5 GDP. See Gross domestic product
productivity, 67–68 German Council of Economic Experts,
public share of, 201, 220, 221 growth projections of, 239, 241
response to Great Recession onset, Germany
20–21 banking sector competitiveness, 254
Finland, 121, 122, 127, 129 credit market regulation, 214
Fiscal spillover effects on recovery current account surplus, 200, 201, 217
analytical methodology, 150–151, current economy, 255
155–159 economic resilience, 1, 2, 19, 30–31
automatic stabilization effects, 172–174 explanations for recovery from Great
concerns, 149–150 Recession, 1–2, 20–24, 31, 35, 93b,
current expectations, 149 239, 255
data sources, 159 fiscal policy spillover effects, 150–151,
effect of increased consolidation, 160, 166–180, 182–184
180–182 generation and transmission of
effects of higher multipliers and import spillovers, 97, 98, 99, 112–113,
elasticities, 150, 154, 179–180, 181f, 116–118, 121, 122, 129, 130–131,
189t 140–141f
within Europe, 103 investment patterns in Reemergence
findings from literature, 151–155 period, 16, 201

Index 265
obstacles to investment, 57, 69–72, lessons from German experience, 93,

219–220 245–246
sensitivity to external shocks, 115–116 outcomes in Germany, 19–20, 35, 38,
strategies for reducing current account 50, 90, 254
imbalances, 201, 217–221, 220, outcomes in U.S., 80
220t, 221 output declines, 19–20, 20f, 35
tax system, 220 projected outcomes in potential GDP,
transmission of shocks, 115–116 39–40, 43–46
unemployment benefits in, 220 protective factors in German labor
See also Domestic demand and market, 35, 77, 90–92, 93b, 242–
consumption; Domestic investment 243, 245–247, 255
and savings; Economic growth Target 2 balances, 26, 26f, 27f
in Germany; Europe, Germany trade outcomes, 2, 19, 22–23, 22f
and; Labor market, Germany’s; See also Fiscal spillover effects on
Manufacturing sector, Germany’s; recovery; Spillover effects in recovery
Productivity, Germany’s; Service Greece
sector, Germany’s fiscal consolidation spillover effects, 184
Globalization generation of spillover effects, 122, 127,
competition and trade during Germany’s 128, 160, 247
reemergence period (2004–08), 12–13 growth spillover effects, 122
future challenges for Germany’s sensitivity to external shocks, 113–114,
manufacturing sector, 10 115, 124, 160, 166, 172, 176
Germany as transmitter of global trade Gross domestic product
impulses, 25 adjusting spillover effects for size of, 248
Germany’s economic slowdown of Gross domestic product (GDP)
1970s/80s and, 7 adjusting spillover effects for size of, 248
Germany’s labor reforms in 2000s and, external and domestic demand and,
12–13 127–129, 128t, 129f
Germany’s post-World War II economic in Germany’s slowdown period (1960s–
performance, 1, 2 2000), 5, 7
perceptions of Germany’s roles and Great Recession effects, 19, 20f, 34, 36,
responsibilities, 10, 25–26, 31 37, 37f, 38, 80
See also Fiscal spillover effects on recovery; growth composition in Germany and
Spillover effects in recovery; Trade U.S., 62f
Great Recession (2008–09), 1 growth expectation in 1990s and early
capital flows in eurozone, 26 2000s, 8–9, 9f
employment outcomes in Germany, 12, growth spillovers in crisis and recovery,
20, 21f, 23f, 24, 44, 77, 80–84, 81f, 118–123, 118t, 119–120f
82f, 84f, 244, 245, 245t international comparison of growth,
explanations for Germany’s recovery, 14f, 36f, 37f
1–2, 20–24, 31, 35, 93b, 239, 255 per hour worked and per capita GDP,
as export shock for Germany, 24, 60f, 76t
36–38, 89–90, 239 post-World War II per capita, 6f
Germany’s institutional and policy unification effects, 7
responses to, 23–24, 88 volatility of Germany’s, 2, 3, 17–18, 18f
global current account imbalances and, See also Economic growth in Germany;
199, 204–205 Potential GDP
international comparison of Group of Seven, 118–121
employment outcomes, 82f Group of Twenty, 20–21

266 Index
H See also Information and

Hartz reforms, 11–13, 24, 49, 49n, 77, communications technology
80, 85–88, 92, 93b, 96, 210n, 242, Insolvency law, 71
243–244, 245, 255 Interest rates
as mechanism of spillover transmission,
I 103
ICT. See Information and communications recent patterns, 18, 19f
technology risk aversion and, 18
Immigration policies, 7, 49, 49n synchronized fiscal consolidation effects
Imports, Germany’s on recovery, 149–150, 186
international comparison of growth in International Monetary Fund Article IV
2000s, 15f, 219f consultations with Germany, 3
post-World War II patterns, 4, 4t Ireland, 11
source of current account surplus, 217, fiscal consolidation spillover effects, 150,
218–219 160, 162, 167–170, 174, 176, 180, 184
sources, 15, 15f, 217, 218f generation of spillover effects, 115, 122,
transmission of spillover effects, 249–250 127, 160, 247
India, 162 sensitivity to external shocks, 113–114,
Inflation 126, 165, 166
future challenges for Germany, 255–256 Italy, 5, 12, 24
projected outcomes of Great Recession, generation of spillover effects, 98, 113–
44–45, 46f 114, 121, 122, 123, 124, 127, 130,
Information and communications 144–145f, 162, 170, 247
technology sensitivity to external shocks, 113,
education of workforce for, 242 116–118, 126
future challenges and opportunities, 10,
55, 72 J
German investments, 61, 68–69 Japan, 2, 3
Germany’s infrastructure, 59, 69 current account surpluses of 2000s, 16
Internet access, 69, 69f, 71 domestic investment patterns, 16
obstacles to investment in Germany and European trade, 111, 112
Europe, 57, 69–72 generation of spillovers, 97, 98–99, 101,
private sector productivity, 65, 65f, 66b, 102, 111, 112, 113, 115, 121, 122, 124,
67 127, 129, 130, 135–137f, 162, 184
productivity lags related to investment as global competitor, 28
lags in, 49, 55, 57, 58b, 59, 60–62, Great Recession effects, 19
63–64, 66, 70, 241 interest rate historical patterns, 19f
productivity patterns, 56 manufacturing sector, 10, 11f
public procurement, 10, 71, 241 output volatility, 17, 18f
as source of productivity growth, 56, population aging, 28, 28f, 29f
56b, 70b, 72–73, 241 stock market volatility, 18f
strategies for productivity improvement,
73 K
Innovation and technological advancement Knowledge economy
determinants of productivity, 58b Germany’s current status, 55
future challenges and opportunities, 10 measures of, 60
in Germany’s slowdown period sources of, 61–62
(1960s–2000), 7 U.S. growth, 66b
patent applications, international See also Information and
comparison of, 59f communications technology

Index 267
Korea future challenges of global competition,

fiscal consolidation spillover effects, 184 1, 2, 10, 27–28
as global competitor, 28 growth in reemergence period
transmission of spillover effects, 162, 176 (2004–08), 10
Kurzarbeit, 23–24, 88, 93 growth trends, 66b
international comparison of importance
L of, 11f
Labor market, Germany’s investment behavior, 218–220
Beveridge curve, 91, 92f post-World War II (to 1960s) recovery,
current account balance dynamics and, 1, 4–5, 10
203–204, 215–216, 253–254 productivity patterns, 55, 56, 59,
current supply, 90–91 66–67
demographic challenges, 2, 28–30 projected output gaps, 44, 45f
educational preparation, 242 responses to onset of financial crisis,
future challenges for Germany, 31, 49, 242–243
92–93, 239–241, 255–256 as source of economic resilience, 1
Hartz reforms of 2000s, 11–13, 77, 80, as source of Germany’s economic
85–88, 92, 93b, 96, 242, 243–244, resilience, 28, 30–31
245, 255 Marshall Plan, 4
human capital factors in productivity, Mexico, 102
58b, 63n Minimum wage levels
human capital in service sector, 70b current account imbalances and, 199,
implications of population aging trends, 201, 204, 210, 211, 212–214, 215,
30, 30f 221
institutional and policy responses to Great data sources, 224
Recession, 23–24, 35, 88, 242–243 Monetary policy
post-World War II period, 4–5 in current account balance dynamics,
protective factors mediating financial 203
crisis, 23–24, 35, 77, 90–92, 93b, transmission of spillover effects,
242–243, 245–247 251–252
in reemergence period (2004–08), 9f, See also Exchange rates
10–13
rigidity, 203–204 N
significance of experiences in 1990s and Netherlands
2000s, 77–78 fiscal consolidation spillover effects,
in slowdown period (1960s–2000s), 7, 150, 170, 176, 180, 182
8–9, 78–80 trade patterns, 110
strategies for reducing current account transmission of spillover effects to,
imbalances, 201, 220 121, 122, 124, 127, 129, 162,
unit labor cost evolution (1990–2010), 186, 247
9f
See also Employment patterns; O
Productivity, Germany’s; Wages and Oil shocks of 1970s, 1, 7, 31
income Okun’s law, 81–83, 83b
Organisation for Economic Co-Operation
M and Development countries
Manufacturing sector, Germany’s current account balance dynamics, 206,
effects of Great Recession, 245 212, 214, 253
employment patterns preceding fiscal policy spillover effects in, 153
financial crisis, 242–243 ICT infrastructure, 59, 68–69

268 Index
P measurement challenges, 57n

Population aging patterns and trends, 55, 67f
current account balance dynamics and, policy recommendations to improve, 73
202, 206 post-World War II recovery, 55, 60
data sources, 223 private versus public services economy,
future challenges, 2, 28–30, 242 62–64
implications for labor market, 2, 30, 30f projections, 241
international comparison of trends, 28f, significance of, in future growth, 50
29f U.S. productivity versus, 58–64, 60f,
savings and consumption behavior and, 60t, 61t, 64t, 65–68, 65f, 66b, 66t,
29–30 68t, 241
Portugal See also Total factor productivity
fiscal consolidation spillover effects, 184 Public procurement
sensitivity to external shocks, 113–114, cautions in, 241
124, 166, 172 in current account balance dynamics,
transmission of spillover effects, 122, 203
127, 128, 160, 247 of ICT services, 71, 241
Potential GDP
definition, 38–39 R
future concerns, 38, 47, 50 Regulatory environment
German unification effects, 39 current account imbalances and, 200,
labor market outcomes of Great 201, 203, 204, 210f
Recession, 43–44 data sources, 224
modeling methodology and data insolvency law, 71
sources, 41–42, 41t, 52–53, 239 technology investment in Europe and,
output gap modeling, 41, 42, 42f, 44, 57, 71–72
44f See also Credit market regulation
output measurement, 39, 41 Risk aversion, 17–18
per capita, 50f Russia
projected outcomes in growth fiscal consolidation spillover effects, 184
accounting model, 47–49, 239–241 transmission of spillover effects, 162
projected outcomes of Great Recession,
35, 38, 39–40, 43–46 S
transmission of growth shocks to, 37, Service sector, Germany’s
41–42 future challenges and opportunities,
Productivity, Germany’s 2–3, 10
cyclical factors in recent growth, 62 government procurement for public
data sources, 57 good, 10
determinants of, 58–59, 60–62 growth of, 10, 66b
future challenges and opportunities, 10 human capital supply, 70b
growth in reemergence period (2004– productivity patterns, 55, 56–57, 59,
08), 10 65f, 67–68, 68t
ICT investment and growth in, 10, projected output gaps, 45f
49, 55, 56, 56b, 57, 58b, 59, 60–62, U.S. service economy and, 3
63–64, 66, 70, 70b, 72–73 SoFFin, 21, 21n
international comparison, 55, 56–57, Spain, 97, 99
57n, 59f domestic and foreign growth spillovers,
intersectoral differences, 10, 55, 56–57, 118–121
59, 64–72, 66t fiscal consolidation spillover effects, 184

Index 269
generation and transmission of shocks, Stock markets

97, 99, 113, 115, 118n, 121, 124, initial public offerings in Germany, 71
127, 128, 129, 130, 146–147f, 162, mechanism of spillover transmission,
170 103
German bank claims on banks in, volatility, 18, 18f
250–251, 251f Structural vector autoregression modeling,
sensitivity to external shocks, 113, 97, 98
116–118, 172 Sweden
Spillover effects in recovery fiscal consolidation spillover effects, 184
adjusting for GDP size, 248 transmission of spillover effects, 122,
cross-border linkages, 109–112 127, 129, 172
current understanding of spillover Switzerland
dynamics, 100–105 fiscal consolidation spillover effects,
domestic and foreign contributions, 182, 184
118–123 transmission of spillover effects to, 122,
domestic demand and, 99, 249–250 124, 126, 127, 172, 174
evidence for, 97–98, 99f
findings from vector autoregression T
modeling, 98–99, 104–105, Target 2 system, 25
130–131, 248–249 capital flow patterns, 26, 26f, 27f
German fiscal policy as regional in Great Recession, 26, 26f, 27f
stimulus, 25–26 Tax systems
inward growth spillovers, to Germany, current account imbalances and, 199,
115–118, 247 200, 201, 212, 214, 220, 221, 254
mechanisms of transmission, 25, 101, current German, 220
103, 107–109, 123, 130, data sources, 224
250–252 obstacles to ICT growth, 69
modeling methodology, 97, 98, 100, spillover effects of fiscal policy, 152,
104, 105–109, 123, 123n, 126, 153–154
129n, 248, 251–252 Total factor productivity
nonstandard channels, 113 European performance, 58–59, 58b
outward growth spillovers, from future challenges and opportunities, 72
Germany, 112–115, 247 human factors in, 58b, 63n
possible sources of growth, 97, 130 international comparison, 49f, 241
research needs, 99–100, 131, intersectoral difference, 57
248–249 patterns in Germany, 57, 241
role of Germany in, 25, 99, 130–131 policy recommendations to improve, 73
size of, 101–102, 126–129, 133t projected potential growth in Germany,
synchronized fiscal consolidation and, 35, 47–48, 48f, 49–50
149–150 significance of, in productivity growth,
third-country effects, 123–126, 124f, 58, 61–62, 67–68
125f, 247 sources of, 241
through Target 2 system, 26 Trade
time-variation, 248 current account balance dynamics and,
trade channels in, 249–251 206
transmission of one-percent growth export patterns, 110t
shocks, 102, 134–147f generation of spillovers from, 25, 103,
Stimulus spending in response to Great 109–112, 123–126, 128f, 129, 129f,
Recession, 20–21, 22f, 152 130

270 Index
Great Recession effects, 36 Great Recession impact in, 19, 80

growth correlations, 127–129, 128t, growth projections, 38, 45–46, 46f, 47
129f growth rates, 76t
spillover effects of fiscal consolidation, interest rate historical patterns, 19f
182–186, 184t, 185t labor market outcomes of Great
spillover effects of spending decline in Recession, 44
Germany, 159–166, 164t, 165f, 166f labor market structural characteristics,
transmission of spillover effects, 249– 80
251 manufacturing sector, 11f
unification effects, 7, 8f output volatility, 17, 18f
See also Exports, Germany’s; Imports, population aging, 28f, 29f
Germany’s potential GDP patterns, 39–40, 46, 47f
private versus public services economy
U productivity, 62–64
Unemployment benefits productivity growth patterns, 49, 55, 56–
current account balances and, 201, 203, 57, 56b, 58–64, 60f, 60t, 61t, 64t, 241
204, 211, 212, 216 sectoral differences in productivity, 66t
current German, 220 sensitivity to external shocks, 121, 153
in Germany’s slowdown period (1970s), services sector growth, 66b
7 services sector productivity, 65f
Hartz reforms, 12, 85 sources of productivity growth, 58–59
Unification of West and East Germany, 1, stock market volatility, 18f
2, 7, 31, 39, 79, 255
United Kingdom V
European trade, 111 Vector autoregression modeling, 97, 98,
generation of spillover effects, 113, 101, 104, 248
115, 116, 121, 122, 123, 127, 128,
138–139f, 162, 170, 172 W
Great Recession impact in, 19 Wages and income
insolvency laws, 71 determinants of current account
United States, 6 balance, 202, 206
economic challenges and opportunities, future challenges for Germany, 31
3 post-World War II recovery, 5
European trade, 111 in recent years, 10–11
future of ICT, 72 in reemergence period (2004–08),
generation of spillovers from, 97, 98– 10–13, 11f, 12f
99, 101, 102, 103, 110, 111, 112, in slowdown period (2004–08), 7, 8, 79
114–115, 116, 121, 122, 124, 127, See also Minimum wage levels
128, 130, 134f, 153–154, 162, 170, Work-sharing and work-time adjustment
174, 247 schemes, 12, 24, 83–84, 84f, 92,
as global competitor, 28 242–243, 246–247

Germany in An Interconnected World Economy

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