The German labor market is set to remain tight

When the German economy was slacking after the reunification, the unemployment rate in Germany reached double digits. The Hertz reforms and the subsequent economic boom turned the labor market around, earning Germany the reputation of having a low and stable unemployment rate. Germany’s economic boom has been so successful that the demand for labor now even outpaces the supply (Figure 1) and businesses find it difficult to find qualified workers to thrive and expand (Figure 2).

Policymakers are now concerned that the extremely tight German labor market will lead to higher wage increases and inflation. Given that Germany is the eurozone’s largest economy, whether this concern proves well founded is a question worth investigating. Therefore, we would like to address three main questions in this report: How tight is the German labor market really? Can we expect any slack going forward? What does this mean for wages and inflation?

Since the start of the pandemic, 690,000 new jobs have been added to the German economy, and the unemployment rate has fallen from 3.5 percent to 2.9 percent. These are impressive figures, but the headlines mask important dynamics. The number of jobs in the private sector has actually declined slightly, implying that the impressive rise in employment is entirely driven by an increase in workers in the public sector (Figure 3).

In the private sector, the Accommodation and Food Services sector has experienced the largest outflow of workers, while the Wholesale & Retail trade and Administrative Services sectors has seen a smaller, but still significant, exodus of workers. This has been offset by an increase in sectors such as Information and Communication, Utilities, and, of course, in the public sector. In the latter, the job growth has been roughly equally strong in Public administration, Health, and Education.

Aside from the question of whether a strong expansion of the public sector is desirable, the increase in the number of public sector employees can be misleading. The actual labor input, i.e. the total number of hours worked, has actually decreased since Q4 2019. It seems that the pandemic accelerated the trend of working fewer hours. The drop in average hours worked could also be explained by the composition of the economy, as the average number of hours worked in the public sector is slightly lower.

We don’t expect any reversal of this public sector growth, i.e., a major flow of employment from the public to private sector. In part because one would already expect that temporary effects, such as an increase in health sector jobs during the pandemic, would have faded by now. Moreover, given the huge societal challenges (such as the energy transition, an ageing demographic and the revival of the German army), we expect a structural increase of workers in the public sector.

So can we expect any relief in the short term? The good news (at least with regard to an overly tight labor market) is that the German economy is slowing down. Consequently, the number of vacancies, and thus the demand for labor, is falling.

But one swallow does not make a summer. Even though the economy is slowing down, we expect the unemployment rate to rise little if at all. A key factor in this consideration is Kurzarbeit, a furlough scheme implemented during the financial crisis. It allows companies to retain workers at reduced hours, with the government largely compensating the lost wages. This scheme has proved to be wildly successful in upholding employment, both during the financial crisis (Figure 5) and during the pandemic. One of the biggest drawbacks of the scheme however is that it reduces labor market flexibility since workers feel no urgency to find a new job.

Additionally, companies have an incentive to hoard labor in such a structurally tight labor market. It is often more expensive to rehire, retrain and reintegrate new workers in a company than to simply keep ‘redundant’ workers on the payroll until the situation improves. Especially when the economic downturn is expected to be short, and the government subsidizes their wages. Consequently, the textbook correlation between output and the numbers of employees has practically disappeared in Germany (Figure 6). We therefore expect a modest uptick of the unemployment rate and forecast an unemployment rate of 3.1% in 2023, 3.1% in 2024, and 2.9% in 2025.

It's also worth considering the structural features of the labor market. Germany is one of the fastest aging societies in the world and its demographics are changing on a structural level. In the 1960s, there were roughly five people of working age for every retiree; by 2050, that number is expected to fall to just two. That will have a profound impact on Germany’s labor market. Not only are fewer people actively participating in the labor force, but as a result of its ageing society the demand for certain jobs will change as well. For example, the healthcare sector, is expected to expand rapidly, displacing jobs from the private sector. Taken together these effects are so profound that researchers estimate that Germany will face a seven-million-worker shortage by 2035.

That’s not the only cause for concern. Germany doesn’t have many options left to turn the tide. Germany’s participation rate for example is already very high (71% for people aged between 15 and 74). At the same time, people seem to prefer to work fewer hours not more (as shown by Figure 4). Germany’s retirement age is also one of the highest in Europe and in the world.

The only option would seem to be to increase the number of working people. Given that it’s difficult to raise birth rates and since it takes time before any such increases translate to more people of working age, immigration seems to be a more straightforward solution to a labor shortage. Over the last three decades, migration already accounted for most of Germany's population growth (Figure 9). Germans are well aware of this and have recently passed legislation to relax immigration policies for skilled workers. Even if they lack officially recognized educational qualifications, foreign workers with demonstrable skills will find it easier to relocate to Germany.

It remains to be seen whether this is enough, however. According to the various United Nation scenarios (Figure 10), the current expected migration flows are insufficient to turn the tide. A dramatic policy shift may be required, but this is easier said than done given the fierce political opposition.

For several years, the German unemployment rate has been lower than the non-accelerating wage rate of unemployment (NAWRU). This structural tightness affects wages as employers compete for scarce talent. However, in the past year, the real gamechanger for German nominal wages has been the rapid rise in inflation.

Since wage growth leads to inflation, and vice versa, we expect both to remain elevated for the coming years. We expect hourly wages to grow by 6.2% in 2023, 5.2% in 2024 and 4.0% in 2025 (see the Appendix for more details), while we expect consumer prices to rise by 6.0% in 2023, 3.2% in 2024 and 2.2% in 2025. Core inflation is likely to be the main driver of inflation going forward, as food price inflation is easing and energy prices are expected to stabilize.

The German labor market is very tight and there’s no substantial loosening in the cards. Germany’s only viable way out of this structural labor market tightness seems to be immigration. This is far from an easy solution. Loosening immigration standards may spur political backlash at home while, at the same time, migrants’ skills do not necessarily match with the skills Germany requires. Additionally, Germany has plenty of competitors that are also trying to attract skilled workers. Canada, for example, has an equally developed welfare state, as well as lower taxes and arguably a lower language barrier.

This means that the German labor market is likely to remain tight, bringing with it a slew of problems. A scarcity of skilled workers, for example, may cause tensions between the public and private sectors. The former is attracting an increasing number of workers to carry out its strategic agenda, which includes the energy transition, maintaining a welfare state, and revitalizing the Bundeswehr. All of these require significant investments, both in money and in manpower. The tighter the labor market, the bigger the cost of those investments and the bigger the risks of those investments not happening at all.

We forecast German wages using a simple linear OLS regression. The major determinants are i) core inflation; ii) nominal labor productivity; iii) the tightness of the labor market (captured by the difference between the unemployment rate and the non-accelerating wage rate of unemployment) and iv) the output gap. We have included the regression results in Table 1.

Inflationis an important factor for labor unions in setting wage demands. Core inflation, the most sticky part of inflation, is the most structural driver and therefore an important determinant as well.

Labor productivity determines to what extent companies have room to increase wages. Without an increase in productivity, wage increases would come at the expense of margins.

The tightness of the labor market determines to what extent workers can demand higher wages. By comparing the unemployment rate to the NAWRU (non-accelerating wage rate of unemployment) we can capture structural shifts in the labor market. While an unemployment rate of, say, 5% would have been considered extremely low during the 1990s, it would currently signify a significant loosening of the labor market.