Germany and the European Disease

This chapter is concerned with the growth of unemployment in Europe in the late 1970s and early 1980s. Unemployment has risen to double digit rates in many countries, rates which are not considered likely to fall much in the rest of the 1980s. A theory — ‘the disease’ — is expounded, with empirical evidence from the Federal Republic of Germany. The disease is characterised by high unemployment and low output growth, these being systematic rather than the consequence of some temporary phenomenon such as the downphase of the business cycle. Consequently we present a ‘natural rate’ explanation as an underlying determinant of unemployment with consideration given to the role of the business cycle in recent German unemployment. The latter role is examined with the use of a full macroeconomic model of the Federal Republic. The model is new-classical with two of its most distinguishing features being the assumption of rational expectations throughout and the endogenous determination of natural rates. We find that the natural rate of unemployment in Germany more than trebled its 1973 level by the end of the 1970s, reaching 1.21 million by 1982 before falling to 1.16 million in 1983. We suggest that Germany may have caught the now familiar ‘British disease’ — that is, the prevention, by way of unemployment benefits and social aid, of real wage adjustment.