Germany between province and primacy.
Germany entered the Euro on an overvalued exchange rate; with a sclerotic labour market, high unemployment, a loss of international competitiveness, and burdened by heavy costs related to German unification. Between 1990 and 2003, the bank-corporate nexus put in place after the war to promote a stable national economy, began to unravel. But then in 2002-2004, the German government, with backing from business and unions, effected a major turnaround domestically, which propelled the country to undisputed leadership in Europe.
The German business system.
Continuity is much less observable in German business arrangements from the pre-1914 period than is the case of the UK. The reason for this, in the German case, in the words of Caroline Fohlin, “was the string of disastrous political institutions and movements in the aftermath of World War I, culminating in the Nazi regime, (that) dismantled the rich, highly functioning, hybrid financial system of the Second Empire” (1870-1918). “The post war political and legal climate, she continues,(is) one that continues to suppress the liberal tradition of the pre-World War I era”. 
The lesson drawn in the immediate post war years was to ensure a stable and constitutional order in a West Germany, solidly embedded in the western alliance and at the temporary cost of German unity. As in the case of France, priority was given to establishing a viable national economy. The banking acts of 1934 (in Germany) and 1941 (in France) in both countries served as the foundation for legislation in the post-war decades that protected national financial markets, allowed for bank financing of reconstruction, and later of corporate expansion. Insurance markets were even more protected, with both French and German law making it a criminal offense for insurance policies to be sourced abroad until these measures were reversed by the EU’s ECJ in 1986. The echoes from these founder years persisted into the 1990s. As Mr Kopper, the speaker for the Board of the Deutsche Bank, said in 1994, both communism and national-socialism saw the interest rate as a source of exploitation. “The systems collapse and the prejudices survive”.
There were three crucial dimensions to this post-1945 focus on national economy. First, the central principle permeating public policy in Germany is the “social market economy”. The concept derives from the Freiburg school of liberal economists, whose ideas found favour in the Economics Ministry in the 1950s. The doctrine delineates the boundaries between public authority and private interests, linking the respective roles of competition in markets, state supervision, and the law.
- Public authority sets the broad regulatory framework, within which competitive markets operates.
- Competitive markets provide the necessary but not sufficient condition for a liberal market order.
- Statutory law is required to broadly define and delimit the competences of the public powers and the banking profession.
In practice, this “organised liberalism” yields a dense field of regulatory institutions, where public authorities enjoy specific powers which are restricted in operation to a specialised area, and are often at variance with other functions of the state. This dispersion of public authority is reinforced by the workings of federalism, as supervision of stock exchanges and savings banks is in the hands of the particular German state government rather than of the federal authorities. The federal government also owns a plethora of specialised institutions. Detailed supervision of markets is by financial institutions, with the public authorities playing a limited and distant role.
Second, business is regulated by legislation on farm, industrial, financial, or service activities by the ministries in close cooperation with sectoral representatives and discussed in parliamentary committee. The ultimate court of appeal to parliamentary legislation, and now EU rule-making, is the Constitutional Court, which along with the Bundesbank, had the exclusive duty to guard the value of the currency. The Court, established in Karlsruhe in 1951, has the power to nullify legislative acts of parliament, and thereby not only interprets but makes law. It is the custodian of basic rights, the umpire on disputes between the federal authorities and the states, and the guardian of the social market. Law prevails over politics. Disputes tend to be referred to judicial review, making constitutionality the benchmark against which public policies are assessed. Banking and insurance does not escape its purview. The Court regularly pronounces on a range of issues from competition policy, to consumer interests, to bank secrecy and taxation, as well as on EU treaties and on the decisions of the ECB.
The legacy of history, the role of law, the prism of economic doctrine, and the workings of politics together yield a conservative, incrementalist policy style. Continuity along the track of proven practice is the golden thread around which decisions tend to be made. Liberal social market doctrine aims to preserve competitive markets and systemic stability. Custodianship, whether private or managerial, is secured by preserving narrow equity markets; by encouraging the development of shadow or offshore capital markets; by providing state support for cross-shareholding, or by extending membership on supervisory boards of corporations to trade unionists as symbols of the stakeholder culture. Inclusiveness ensures that change comes slowly, and as the function of multiple interests to be reconciled in negotiations. It also helps to ensure that unwelcome intruders find incursion problematic, and that EU legislation slowly fits into the domestic fabric. The leitmotiv however remains the same: capitalism in Germany must remain nationally rooted.
Germany’s banking system is highly decentralised. The “big three” German private sector banks—Deutsche, Dresdner and Commerz, joined more recently by the HypoVereinsBank—have under 3% of savings deposits, and 16% of total assets. Public banking, which includes savings and communal banks, lend to local businesses and governments, and account for over 45% of banking activity. Their prime source of deposits are savings deposits, and they provide commercial bank, consultancy and market support for Germany’s small and medium-sized businesses. They benefit by local patronage and subsidy. Pensions are split between the pay-as-you-go public system, while tax deductible employer pension funds are available as a source of capital for corporate management. Given the strong reliance for finance of Germany’s small, medium and large companies on internally generated sources of funds, and on borrowings, the equity market has remained narrow. Pension reserves amount to around 50% of all company capital of German firms. Not surprisingly, the German system flourished best when pension payouts were relatively small, and when inflation and interest rates were low. From 1973 on, low interest rates were best assured through a freely floating exchange rate and with a trade sector in solid surplus. There was thus a very close association indeed in Germany between the macro-economic management of the currency, and the micro-economic management of firms.
If the bank system is decentralised, ownership in Germany is concentrated. Data from 1996 shows that the main private banks hold or manage shares—along with Allianz, the giant insurer–of the 100 big firms, which accounted for up to 50% of the huge trade surplus which Germany accumulated over the DM’s lifespan. The “big” banks, in other words, were part of a nexus of banks, insurance companies and industrial corporations that own each others’ shares and—with diminishing frequency– shared each others supervisory board seats.
Effective share ownership is concentrated.
At the heart of this nexus lay Allianz and Munich Reinsurance, the two Munich insurance and re-insurance giants. This cross-holdings of shares remains a principal feature of German corporate governance. It is also enduring: in the years following German unity in 1990, despite increased German dependence on global financial markets, the concentration of share management and ownership remained largely unchanged. In 2000, the 5% largest companies listed on the DeutscheBörse, centered in Frankfurt, –42 in number– accounted for 73.5% of total market capitalisation. Equity markets remain narrow in Germany, with only 14% of the population holding shares in 2016. 
This nexus of “bank power”- more truthfully of corporate power –proved a recurrent theme in the politics of the Federal Republic. One reason for keeping equity markets narrow, was to protect Germany’s listed corporations from takeover. Starting in the 1970s, these German networks came under increasing pressure as German corporations began to internationalise, global financial markets became less predictable and EU policy on the internal market pushed for market opening measures. The disadvantages of “bank power” became evident to the “big banks” in the deep recession of 1979-1982. When the Bundesbank raised interest rates to counter inflationary conditions, firms with high debt exposures died like ninepins.
As a result, the Bundesbank launched its programme in 1982 for “Finanzplatz Deutschland”, which proceeded at the lethargic pace permitted by Germany’s federal system, where stakeholders have multiple sources of access to participate in public policy. The result has been a stream of Laws to Promote Financial Markets in 1989, 1996, and 1998, during which the German Stock Exchange was set up, along with a an efficient settlements system and a US-type Securities and Exchange Commission, while market opening arrangements agreed internationally and in the EU were introduced. Despite the boom in technology equities in the second half of the 1990s, and a novel public interest in shareholding, equity markets remained narrow. The shadow capital pool of corporate pension funds was also shrinking as payouts rose.
The nexus begins to dilute.
In the mid-1990s, the forces at work, undermining the inherited German national business system, intensified. Only a handful of hostile takeovers had been launched in Germany in the 1990s, and the last trans-national bid in 1990 of Pirelli for Germany’s tire manufacturer, Continental, failed. But the signs that significant changes were underway in German corporate practice came in 1997, when the three “big banks” supported the hostile takeover between Krupp and Thyssen. Then in 1999, Vodafone, launched its successful hostile takeover bid of Mannesmann, 60% of its shares were circulating outside national territory. The battle symbolised the “battle of systems”. Here was a 109 year old, blue chip German company being taken over by an upstart Anglo-Saxon company, Vodafone AirTouch, which had only been in existence for 15 years. Vodafone’s bid involved a straight share swop, giving unprecedented leverage to smaller shareholders; the bid took place with the concurrence of IG Metall-the core of German trade unionism; Deutsche Bank, Mannesmann’s “Hausbank” did not play a lead role, nor did the government mobilise a constituency to oppose the bid, despite that fact that Vodafone was targeting only 10% of Mannesmann’s business, and announced intent to sell off the rest. Vodafone’s successful bid evoked much heart searching among the prominenz of Deutschland AG.
The role of banks role in corporate governance in Germany continues, though, to provide stable long term finance for German firms—large, medium, and small. Private limited companies in particular have expanded in number from 70,000 in 1970 to under 400,000 by 2000. These family-owned, Mittelstand firms form the bed-rock of German business, being highly specialized on world export markets, tied in often as sub-contractors to the large corporations, and financed largely through retained earnings or borrowing from banks when the occasion requires. They are notably averse to public listing on the German stock exchange, for fear of diluting their owners’ control over the business. In particular, they are embedded in local policy networks, where local banks play a key mediating role between local politicians, firms, trade unions and trade associations. Their battle field resides in competition on product markets, as the national economy remains open to foreign suppliers. Because they have to satisfy the demands of their stakeholder constituency of workers, suppliers, clients and the local community, there is an incentive for firms to invite shareholders to patience and to reduce dependence on banks through strategies aimed at conquering market shares. More recently, purchases of Mittelstand firms by Chinese buyers has elicited concerns in boardrooms, and in government.The fear is, especially in the Social Democrat Party, that Chinese takeovers could hollow out the German technological base.
German banks, particular local banks, also stood in as co-guardians of a stable, property-holding democracy which co-opts labour unions through their representatives’ acquired positions on works councils and on corporate supervisory boards. Yet here too, the ideal differed from the reality. In each recession, supervisory boards were charged with incompetence. Managers bore the brunt of German firms’ growing dependence on more volatile, and less predictable world markets. In the case of AEG in 1982, of Metallgesellschaft in the winter of 1993, and of the Schneider construction group in April 1994, the impending disaster had not been monitored; the banks were seen as ready to lend to large groups, regardless or unaware of the risk; supervisory boards were accused of operating as closed shops. There was also a marked propensity for senior managers to defend the status quo, and to lay the blame for failures not at on the financial system of corporate governance, but on personalities.
What to do?
Model Deutschland had prospered on the back of a stable domestic monetary policy, highly competitive domestic markets, increasingly generous welfare provisions, a strong national training system, longer term financing arrangements for corporations big, medium and small, and from 1973 on a flexible exchange rate system, enabling the Bundesbank to calibrate its domestic mandate to ensure price stability, and the external exigency of an open economy to ensure a competitive DM. This latter task proved increasingly arduous in the 1970s and 1980s, while a variety of market forces and political factors contributed to a gradual dilution of the cross-shareholding structure inherited from historical legacies dating back to the 1920s. In the 1990s, die Wirtschaft came to question two key inherited policy assumptions: one was to came round to the conviction that holding on to the DM was no longer tenable; the second was that ideas of shareholder value were more compatible with the development of transnational corporate structures. Both involved radical changes from the past.
Questioning the DM.
One policy that would have cured the German economy of its propensity to run trade surpluses was a market-oriented reform of the German financial system, and the development of a highly liquid, transactions-based capital market in the manner of London. A starting point would have been for the Bundesbank to have met the commercial banks’ demands and repatriate the Euro DM bond market (to which the banks’ surplus funds were recycled) by ending the tax disadvantages weighing on domestic bond business. This would have promoted a liquid secondary market, flanked by a short term money market. Dearer credit would encourage firms to move away from bank borrowing as the primary source of external funding, to the new issue of equities. An enlarged primary issue market for equities would in turn foster a demand for a secondary market for equities. National ownership would be diluted. Germany would become a major source of international capital, and move to a regular deficit on trade account. European integration would be accelerated.
As long as the DM ruled, financial market reforms fell shy of such radical change. A constant theme of the Bundesbank was its hostility to fast money markets, and new financial instruments. Indeed, during the internal market negotiations of 1988 to 1993, the German delegation insisted on legislation to protect monetary policy by keeping a firewall between the domestic monetary market and short term capital flows. This preference for stable domestic monetary and financial conditions helped to underwrite Germany’s growing structural predominance registered in the trade surpluses. The surpluses in turn became a perennial subject of European diplomacy from the mid-1960s on. Europe’s “great affair”, how to create an exchange rate or monetary system for a highly interdependent region of separate states, may be dated from then.
In the early 1990s, there was very little enthusiasm in Germany to exchange the DM for an untried EU currency. There was of course limited trust in Germany that Latin member states would stick to the rules of the Maastricht Treaty. On the other hand, there was a long history of concern about the DM’s vulnerability to sudden re-valuation due to global events, outside Germany’s control. Sharp revaluations jeopardized German exports on global markets.
It was only in 1995, when the DM revalued sharply in response to the outflow of dollars from the Mexico financial crash and from the yen after the Kobe earthquake disaster, that Germany’s business community was won over to Kohl’s policy of abandoning the DM. The DM spike prompted shouts of anguish from corporate managers, their workforces and their financial backers. Better to have the protection of a stable financial area within an European monetary union, the 1996 message of German business ran, than the constant volatility of the DM fully exposed to global financial markets. This was the moment when Kohl in effect won his battle for the hearts and minds of corporate Germany, die Wirtschaft, to go ahead with the Maastricht plan to introduce the Euro in the years 1999-2002.
There is an inherent contradiction between the bank-industrial crossholding system, which requires open markets for exports and for corporate assets in other countries, while at the same time curtailing foreign market access and ownership at home. The home market serves as launch pad for the conquest of foreign markets, and the domestic market may be protected by all manner of corporate practices. This is national mercantilism’s Achilles heal. When corporations build market share, and profits soar, they become detached from banks as their external sources of funds grow, while regulatory segmentation within the financial system breaks down as financial institutions compete across boundaries for new clients. This is what has happened increasingly in Germany over the past four decades.
Meanwhile, Germany’s big private banks had long since seen domestic business as a declining proportion of their activities. As their global investment banking arms grew, they reduced their own shareholdings and developed a sharper shareholder-friendly policy with regard to the major listed corporations whose shares they continued to manage, and whose boards they continued to frequent. As they went abroad, to London or to New York, Germany’s leading banks learnt “Anglo-Saxon” ways. Global markets helped fund the cost of German unification, and with a sharp rise in equity funding as a proportion of corporate external borrowing.
Management in German corporations adapted the style and strategies associated with shareholder value, while the German state withdrew from financing infrastructural sectors in response to EU directives on market opening combined with the rising costs of German unity. Deutsche Telekom went public in 1996, providing a boost to the capital market. Wealthier and older German savers joined in the boom for hi-tech stocks, equated with the Deutsche Börse’s opening in 1997 of the Neuer Market, fashioned on the US technology stock exchange Nasdaq. Legislation was also passed to encourage private funded pensions, with the funds managed by the banks. Parliament also passed a law with barely any opposition, making Germany the first country in Europe to develop a one share, one vote rule- a massive turnaround from 1989, when Alfred Herrhausen, talking to die Wirtschaft’s prominenz, said in so many words that shareholder capitalism would be sound the death knell of Germany’s social market economy.(see Chapter 4). But when boom turned to bust in 2001, and Deutsche Telecom stocks plummeted, the equity market turned sour. With investors learning time and again that they had been taken for a ride, the market was closed in 2003.
In October 2004, the EU introduced the European Company Statute, whereby companies operating in more than one member state had the option to chose under which country’s corporate law they could operate. The draft had meandered by fits and starts through the EU’s complex and thickening institutional processes, but permanently was stalled by different national labour laws, particularly with regard to the presence of trade union representatives on boards. The Co-Determination law came onto the German statute book in 1976, against the wish of German business leaders. Subsequently, German management went along with the law, not least because it made trade union leaders de facto allies against foreign hostile takeovers. The Vodafone-Mannesman takeover showed that this condition no longer held, while German private banks had espoused many components of shareholder value ideas. The 2004 EU Company Statute thus met a more favourable response: it opened the option for German corporations to establish themselves in UK law, therebying side-tracking the co-determination rules and two-tier corporate board of German law and practice.
The Schroeder reforms.
The years 2002-2004 proved a crucial turning point in German capitalism. The old defensive mechanisms were wearing thin. The Euro was in place, with the reality that German corporate equities and bonds—as for other member countries—were converted into Euro-denominated assets, exchangeable across a much wider territory than before. “Globalisation” brought China and India onto global markets, widening the world labour market to incorporate three billion potential workers, with unit labour costs anything up to 60 to 100 times lower than those prevailing in Europe, the US and Japan. The countries of central and south eastern Europe entered the EU in 2004. Capital movements were now free across the western world. Shareholder capitalism had shown itself to be volatile, and crosshareholdings no longer possible to sustain. .
To talk of a coherent response would be an exaggeration. After the Vodafone episode, the German government passed a law granting managers the right to fend off a hostile approach without consulting shareholders. Yet the government also introduced tax reforms, which came into practice in 2002, lowering the high taxes hitherto charged on the sale of share packages.
One way out of the low growth and high unemployment problems of post unification Germany would have been the opening up of the service sector to international competition. That is where new jobs could be created, to compensate for the shrinking of the manufacturing workforce. But that would have involved taking on the corporatist interests entrenched in local politics across the Republic. These would include the local banks, insurance, retail, and small business networks that remain crucial components of local life, in what is a de-centralized federal state. Given the snail pace at which such reforms could be introduced, if at all, pushing for an opening of the broad service sector to international competition was not a viable solution within one, let alone a number of electoral cycles.
As always in the history of the Federal republic, the thread of continuity with the past was the key question asked : how to preserve Germany as a production Standort ? Chancellor Schroeder decided that it had to be in Germany’s industrial heartland. His government embarked on a major labour market overhaul The reforms, collectively known as the Hartz reforms, named after its chairman, former Volkswagen executive Peter Hartz – boiled to down to this: the bundling of unemployment benefits and social welfare benefits into one neat package. The reforms were put in place in three steps between January 2003 and January 2005. They eased regulation on temporary work agencies, relaxed firing restrictions, restructured the federal employment agency, and reshaped unemployment insurance to significantly reduce benefits for the long-term unemployed and tighten job search obligations. Labour market competition, and tougher managerial policy, kept wages down; unemployment fell; labour participation rates shot up; German business drove unit labour costs down. With consumption held relatively constant, domestic savings soared, as can be seen in the graph on private sector saving and investment, above. Domestic investment did not, as growth remained modest, compared to business opportunities on world markets.
The gap between savings and investment translated into massive trade surpluses. The externalisation of the German economy is evident in the size of the export and import business as a per cent of gdp: it rose to 90% compared to France and Italy, which stayed, as in 1990, at 50% gdp. Germany’s exports boomed to China, Russia, Brazil and India, whereas lower value added producers in the Mediterranean states faced direct competition from Chinese producers on their traditional markets. Germany, along with Austria, The Netherlands, Denmark, Sweden and Finland, was thus much better prepared than France and southern EU member states when the downturn hit in 2008-2016.
With the EU’s enlargement of 2004 (Czeck Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia, plus Malta and Cyprus), of 2007(Bulgaria, Romania) and of 2013 (Croatia), the countries of central, north eastern and south eastern Europe came to be regarded as the second most attractive foreign investment locale after western Europe, notably in manufacturing, and well ahead of China, as businesses outsourced production there.  The reasons were familiar: the availability of cheap, skilled labour forces; geographic and cultural proximity to the large western European markets; transitions to market economies supervised by the European Commission; demand for technological transfers, and the privatization of assets.
Europe, east and west, remains the main target for German investors. It is Germany’s home market(see Bundesbank Chart below) accounting for over two thirds of trade. Overall, the Euro area and the new EU member states, remain, as can be seen in the bar chart on primary and secondary direct investment stocks. Germany also retained its position as the hub for inter-corporate linkages in the Euro area, as well as for eastern European countries. German corporations unraveled the inherited bank-industry cross-shareholding structures and moved to become global players responsive to the demands of global institutional investors. Most impressively, Germany retained its attraction as a Standort for local manufacturing, particularly in the transport sector.
The chart above also illustrates another trend: the ever greater importance attached by German businesses to investing in non EU member states. In 2013, , China overtook the euro area as the primary destination for German foreign direct investment. China now hosts about 5,200 German owned companies and accounts for about 14% of total German FDI.  Trade expanded too: China became Germany’s fifth key market after France. In May, 2011, Premier Wen Jiabao signaled China’s view of Germany as Europe’s hegemon by holding a joint cabinet meeting with the German government in Berlin. That year total German corporate sales in China, both exports and turnover of German plants in China, totaled about E190 billion—compared to E101 billion to France. German business thinks globally, and German politics has to, too.
In conclusion to the last three chapters: In the two decades following German unification, the signing of the Maastricht Treaty, and the opening of China and India on to the world economy, London moved to the forefront of global financial markets; France failed to implement the domestic reforms that would be needed to make a French success of the single currency; Germany reformed labour markets, but massively accentuated thereby its trade surplus with Europe. The stage was thus set for the showdown on global financial markets and in the Eurozone in 2008 to 2010.
 Caroline Fohlin, “The History of Ownership and Control in Germany », in Randall K.MLorck, ed. A History of Corporate Governance around the World: Family Business Groups to Professional Managers, University of Chicago Press, 2005. Pp.2234-281
 ‘Kopper gesteht Arroganz’, Handelsblatt, June 15,1994.
 Mary O’Sullivan, (2000) Contests for Corporate Control: Corporate Governance and Economic Performance in the US and Germany, Oxford University Press, pp:262-3.
 Pension Funds for Europe, DB Research, Frankfurt a.M. 1999. p.7.
 Martin Höpner, Lothar Krempel, (2003) “The Politics of the German Company Network”, MPIfg Working Paper 03/9. Max Planck Institute for the Study of Societies.
 As Wolgang Schieren, the head of Germany’s leading insurance firm, admitted, “Allianz is today a holding company, whose objective is to hold participations”. Interview with Wolfgang Schieren, Die Zeit, September 12, 1991.
 DeutschesAktieninstitut e.V.(ed) 2001 : DAI-Factbook 2001, Frankfurt a.M.
 Deutsches Aktieninstitut, Aktionärszahlen des Deutschen Aktieninstituts, 2016.
  Jürgen Beyer, Martin Höpner, “The Disintegration of Organised Capitalism: German Corporate Governance in the 1990s”, West European Politics, 26 (4), October 2003. pp.179-198.
 On the incompatibility between Bank of England and Bundesbank central banking with regard to financial markets, Bernard Connally, The Rotten Heart of Europe: The Dirty War for Europe’s Money, Farrar Straus & Giroux . 1996
 See Rudiger von Rosen,” The storm gathering over corporate Germany”, Financial Times, September 29, 2004.
 Allen and Overy, Foreign Direct Investment in Central and Eastern Europe, LLP, 2006; PriceWaterhouseCoopers, Foreign Direct Investment in Central-Eastern Europe: A case of boom and bust?, March 2010. Yama Temouri, Nigel L.Driffield, « Does German Foreign Direct Investment Lead to Job Losses at Home ? « , Applied Economics Quarterly, Vol.55. No.3. 2009. Pp.1-21.
 Joao Amador, Rita Cappariello, Robert Stehrer, Global value chains: A view from the euro area, Working paper Series, European Central Bank System, Compnet, No.1761, March 2015.
 See German Business in China : Business Confidence Survey, German Chamber of Commerce in China, 2015.
 This is the conclusion of Stephen F. Szabo, Germany, Russia and the Rise of Geo-Economics, Bloomsbury Press, 2015.