Germany’s labour pains

Some reforms concerning the German labour market could provide more security for employees while offering dynamism for firms, however, labour shortages are the real problem.

While the labour market in Germany is cooling off, tempers are heating up over questions of how it should be organised. Although discussions of capitalism versus socialism can lead to interesting dinner table conversations for German politicians, experts see the main problems of the country’s labour market in manpower shortages and demographic changes. Nonetheless, there are some issues regarding worker safety and company dynamism worth talking about.

Significant parts of labour market policy can be characterised as a trade-off between preserving existing structures to protect companies or workers in the short-term and embracing change for long-term prosperity. For Germany, the current status quo of its labour market is largely a reasonable compromise between dynamism and social protection. Looking at the dismal pace of labour productivity growth over the last few years, however, one area with the largest reform potential might be the ease of talent acquisition and dismissal.

The status quo

The German labour market has come a long way since it was dubbed as the “sick man of the euro” in 1999 given low growth and high unemployment. Between 2003 and 2005, the Social Democrats (SPD) then implemented the Hartz reforms meant to improve job search efficiency, increase employment flexibility, and restructure unemployment insurance and social assistance. On one hand, economists generally agree that it lowered unemployment and improved the working conditions of German workers. However, on the other hand, this came with some cost for the unemployed as benefits were reduced in both value and duration while triggering an expansion of low-wage sectors.

Although such reforms and wage restraint in the 2000s lowered the unemployment rate over time as seen in Graph 1, this was a highly contentious issue within the SPD. As the SPD returned to power in 2021, the centre-left government rolled back the harshest elements, raising support levels and easing sanctions for refusing employment – and already, there are early signs of higher joblessness. As such, the Christian Democrats proposed a rollback that will come into effect by July 2026 to reintroduce some of the sanctions and abolish some exemptions for wealth and support of living costs.

Internationally, the German system seems to be doing okay. It offers workers stronger-than-typical protections by the Organisation for Economic Co-operation and Development’s (OECD) standards, with a relatively high degree of coordination and long-term cooperation between employers and employee organisations. Collective bargaining in Germany is organised at the industry-region level, with some space for firms to deviate if needed. This model could be relaxed a little to remain in adherence to OECD recommendations.

Coming from the peak joblessness rate of 11.2 per cent in 2005, the reduction of working hours in lieu of worker layoffs seemed to curb unemployment. The advantage of retaining workers and not recruiting new ones after a fiscal crunch is thought to have worked well for Germany in periods of financial crises, particularly during the COVID-19 pandemic. It also supported aggregate consumption by preserving household incomes. However, there are concerns that this inhibits necessary resource reallocation towards more productive tasks as the measure ends up protecting unproductive firms in its goal of avoiding shorter but sharper swings in unemployment, such as incidents in the US. The limited duration of support is therefore crucial for a well-functioning system: one that supports the unemployed in the short run but will nudge them to look for a new job sooner rather than later.

Areas of improvement

Three structural issues persist in Germany’s job market. First, the minijob category – low-tax, capped-earnings work which one out of six employees hold – limits an employee’s chances of progressing into regular, full-time jobs. Despite its intention of helping part-timers generate income, minijobs do the opposite as workers tend to be trapped in low-paying work. Gaps in the unemployment protection for atypical workers and perpetual long-term unemployment, referring to those without work for 12 months and longer, are also major concerns that weaken income security.

Germany’s whole labour market is rather unflexible, meaning workers often remain employed or unemployed for long durations as hiring and turnover rates are low. While this might be beneficial in keeping good employer-worker matches, this could lead to the retention of long-time employees at the expense of losing out on the potential of the unemployed. This is prevalent in larger and older companies: employers would rather keep a worker out of loyalty while employees are forced to choose the security of keeping the same job despite the possibility of greener pastures. In contrast, shifting to a more flexible labour market structure could reduce the unemployment gap and allow for job transitions towards better opportunities and wages.

For businesses, there is evidence that overly strict regulations on worker dismissal leads to less innovation and limits the redeployment of labour and capital, both of which weaken productivity growth. Additionally, long probationary periods and strict reinstatement rules tend to reduce labour market fluidity the most.

While these topics are hotly debated among political parties, it is far more likely that the whole of Germany has something to gain from labour market reforms. Graph 2 shows that Germany’s real problems have more to do with labour scarcity, which is the highest among OECD countries. About 36 per cent of German firms reported difficulties in recruiting new workers in 2022-2023. Among those numbers are women, half of which are working part-time, which is also the main reason for low average working hours among Germans.

To address this, Germany could introduce severance pays and job protections independent of one’s employment duration, as well as transfer employer-specific pension schemes. This would take it closer to the Danish “flexicurity” model that offers more flexible talent acquisition and reduction, high income security, and active labour market policies – reforms that could put the German economy out of stagnation in the long run. Beyond individual job security, the larger goal should be greater labour productivity and efficiency.

This original article has been produced in-house for Lundgreen’s Investor Insights by on-the-ground contributors of the region. The insight provided is informed with accurate data from reliable sources and has gone through various processes to ensure that the information upholds the integrity and values of the Lundgreen’s brand.