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The blog post: 'The Global Economy: Capitalism and Schizophrenia', provided several observations and forecasts regarding Germany. One of the most important view was that Germany is one of the very few developed economies running on trade surplus (exports higher than imports), budget surplus (public spending less than revenue from taxation) and low government debt (low public debt-to-GDP).
Source: World Bank Open Data and H-o-l-o-c-e-n-e.com
The blog post also provided several contingent possibilities, such as:
1. Germany could spend fiscally to grow its economy. The fiscal spending could be solely advantageous to Germany, or it could be fiscal support to the European Union.
2. If the German government would be stubborn regarding its decision to spend fiscally, then unemployment could rise in Germany.
3. If the German government does not support the EU through fiscal support, then countries such as Greece could decide to - default on its debt, leave the EU and devalue its currency to make its products more competitive. If this happens, then it would increase non-performing loans (NPLs) of German banks.
I received a lot of constructive feedback regarding these arguments. One of the most remarkable was - 'What do you expect from its population?; To laze around and spend like crazy?". Although, this could be one of the easiest ways for countries like Greece to form comparative advantage over Germany. But, the most prudent route would be to learn from Germans and adapt policies that helped them in the first place.
Although political, social, and economic changes span out over decades and centuries, it is fair to say policy changes in the 1990s and early 2000s in Germany were conducive to industrial strength and self-sufficiency. Germany was lagging behind its European and developed countries counterparts regarding trade, entrepreneurship, and employment in the early 1990s. So, it was labeled as `The Sick Man of Europe` by the foreign press.
In this blog post, and series of many, I would provide secrets of Germany that provide it the resilience in the globalized and disruptive world. Explicitly, in this post, I will give an overview of the backbone of the German Economy - 'Mittelstand.' I will start by defining Mittelstand, providing characteristics of Mittelstand, several advantages of Mittelstand, and some drawbacks of Mittelstand. For delivering the holistic overview, I will also contrast Mittelstand's entrepreneurship with Silicon-Valley based startups. And finally, I will end by providing some contingent possibilities of German Economy and non-German economies.
For professionals, who are less interested in macro-economics and comparative economics, they could use the framework of understanding Mittelstand to analyze enterprises.
I have borrowed several arguments from David B. Audretsch, Erik E. Lehmann, Andre Pahnke, Friederike Welter, and Hermann Simon. All opinions are my own.
Part I. Mittelstand
Mittelstand usually is a synonym for all the SMEs in Germany and German-speaking countries. Some people also refer to family-owned enterprises to Mittelstand. Also, it has a positive connotation in German society, so a lot of enterprises take pride in calling themselves Mittelstand. Specifically, Mittelstand can be defined based on their ownership and management of the business. The enterprises which are owned and managed by the family are called Mittelstand. Some enterprises which are owned by but not operated by the family; these are called extended Mittelstand.
Mittelstand's share in German Economy:
All the countries have SMEs, and they all emphasize the relevance and importance of SMEs. From a macro perspective, German Mittelstand enterprises would not be any different from SMEs in other countries. But if taken the bottom-up approach, the distinguishing factors of Mittelstand enterprises would become more apparent.
Characteristics of Mittelstand
Here are several characteristics that would distinguish Mittelstand from their counterparts in other countries:
1. Ownership & Firm Governance;
2. Product-Strategy focus;
3. Human Resources;
4. Organizational Structure;
5. Decision Making Time Horizon;
6. Ability to Leverage Local Resources; 7. Ability to Leverage Global Opportunities.
1. Ownership & Firm Governance
One of the most crucial characteristics is related to ownership, management, and governance. 'Core Mittelstand' enterprises are owned and managed by family members. If the family has control but is not actively managing the business, then those enterprises are categorized as 'extended Mittelstand.' The majority of Mittelstand enterprises legally operate as sole proprietorship, some-times as so-called registered merchant or non-incorporated firms, all without limited liability protections. In other words, for them, economic success and private wealth are inseparable linked.
Ownership and Governance
Source: Small Business Economics, The German Mittelstand: antithesis to Silicon Valley entrepreneurship.
Ownership and Governance are not the primary differentiation per se, but the decisions and operating style of these businesses differentiate Mittelstand against global peers:
a. PE firms or public investors rarely hold them. b. They do not take debt to finance growth. The debt to EBITDA ratio is lower than the other companies. c. Despite low-interest rates in the last decade, they relied on internal funding for growth. d. They rarely compromise on independence, flexibility, autonomy, and security.
The motto of these companies is "Survival of the fittest, not the fattest."
2. Product & Strategy focus
Mittelstand's strategic focus is on the quality, innovation, technology of the products as a source of competitiveness. They rarely compete on price. It was due to post-war structural issues. After the war, Germany was operating with high labor cost as well as a high currency value. So, Mittelstand companies had to run effectively against low-cost producers. They had to produce the highest quality products to ward off competition from elsewhere.
The companies in Germany had a focus on innovation and technological improvements to enhance quality and maintain competitiveness in the global markets. Within a few decades, hidden champions emerged as the dominant producers.
Another critical feature is the long term focus of Mittelstand. As the family owns them, the focus is usually long term, spanning decades. It contrasts American or British peers, where attention is more on the short-term based on the demands of public investors or private equity firms.
Most of these companies live with the ethos quoted by Wolfgang Grof Von Faber-Castell in 1761 - "Tradition means preserving not the ashes, but the glow."
3. Nurturing Human Resources
Mittelstand leverage their ability to develop and retain highly skilled & capable human resources. For example, based on a survey of 14,700 employees working for a Mittelstand, 97% felt a sense of community at their company, and 97% said that their values coincided with the firm's values.
For example, Trigema, a manufacturer of T-shirts in Germany, has committed to its labor force by guaranteeing jobs for a lifetime. They also have guaranteed employment or apprenticeship for the children of employees. It contrasts American or other EU countries counterparts, where most of the manufacturers have outsourced jobs to developing countries. It has formed the culture of uber-motivation, which builds a work ethic of employees. Some scholars have performed empirical studies and discovered that sick days taken by the employees in Mittelstand are lower than other corporations in Germany. The higher cost of labor offsets by greater motivation and productivity.
Based on a study by Kiel Institute, Germany has developed a competitive advantage based on the creativity and the innovative capabilities of the employees. The work provides high flexibility, such as work from home, work during the mornings or evenings, and work on the weekends. The workforce offers brainpower for generating a high rate of new products & product development. Based on the number of patents granted by the European patent office (EPO) between 2003 and 2012 shows the innovative capacity of its workforce.
Number of Patents filed at European Patent Office
Source: European patent office
Another critical element in Germany is its dual system of education. German Mittelstand enterprises have invested in training, up-skilling, and training young people through the German apprentice system.
The German apprentice system has the following two crucial feature:
1. 50% to 75% time is at the work.
2. Rest is at a vocational school (Berufsschule) for formal education.
The advantages of the apprentice system are for both the employees and employers. On the one hand, the apprentice system imports general technological knowledge on both theoretical & a practical level to employees. On the other hand, it is also a source for employers for accessing & absorbing state-of-art technologies & ideas being developed elsewhere in the world. This way, employers can stay in touch with technological and economic changes in the world.
4. Organizational Structure
Mittelstand enterprises have decentralized and independent decision making. The top is a lot closer to the bottom. The owner is typically the executive and manager. Due to the flat decision-making structure, the top is able to learn from the workers in a relatively efficient and seamless manner. The ideas of everybody are well appreciated and rewarded over time. Based on a study undertaken in 2010, 41% of large corporations felt that their ideas are well-appreciated while 61% in SMEs felt that their ideas are well appreciated. Also, in SMEs, 75% of workers felt that they were engaged in the decision-making process. Although decision making is decentralized, the CEO makes the decision as well as bear the risk.
5. Long-Time Horizon for Decision Making
The Mittelstand enterprises take a long time for making decisions. It contrasts the public corporations' decision making time horizon, which is short term and tied to quarterly results. It is due to their ownership structure, where decisions taken with a long term perspective. The focus is on the sustainability of enterprises for future family generations. The primary focus is on building a long-lasting relationship with customers, suppliers & other businesses.
These enterprises have low employee turnover, and there is rarely any restructuring. The employees usually celebrate 40-year jubilees at their workplace. Based on the last decade of research, the Mittelstand enterprises have 2.7% employee turnover. Daimler, which is famous for worker's loyalty, has a turnover of about 5.3%. The worker turnover in Germany is about 7.3% and while in the US, it is about 30.6%.
6. Ability to Leverage Local Resources
Mittelstand enterprises can draw on the active & supportive involvement of the companies, including owner-manager, in other firms, people spanning the entire value chain of the company's main product. While on the other hand, SMEs in other countries usually say it's none of my business. In Germany, there is a long term sustainable and robust relationship among the value chain members and local resources. For instance,
Epp points to the case of the development of the textile industry in the Swabian Jura region. Globalization has led to a crisis in the textile industry due to lower cost competitors, principally in Asia and Eastern Europe, which rendered textile production in the Swabian Jura region unprofitable and seemingly unsustainable. However, in a strategic response to such global competitive pressures, the leading companies in the region shifted away from the production of textiles for the mass market and instead developed high-quality, specialized niches. Examples of these high-quality, specialized product niches include airbags and seats for cars and trains and wings for airplanes. In order to produce these specialized products, the textile companies had to work with several key hidden champions in the region, such as Mayer & Cie, which produces knitting machines, Groz-Beckert, which produces knitting needles, and Stoll, which also produces knitting machines. These hidden champions originated from the traditional textile industry and are now part of a cluster for the technical textile industry. Together with clients from the automotive sector, the life science industry, and medical technology and with the local university of applied science (Fachhochschule) in Reutlingen, a globally recognized focal point and cluster for technical textiles has emerged. The pride this region displays in building on its roots from the traditional textile industry but seizing the global opportunity afforded by its wings is evidenced by a bridge in the city of Albstadt. Rather than being constructed of steel and cement, the bridge is instead woven together by technical (p.35) textiles. Spanning some one hundred meters, this bridge must be, if not the longest bridge in the world, the longest one consisting solely of technical textiles.
6. Ability to Leverage Global Opportunities.
Mittelstand enterprises have an aggressive and successful orientation toward opportunities beyond the national borders. The owners and managers spent a lot of time in foreign countries, building relationships and finding new opportunities for business. These enterprises have high participation in exports, about 20% output exported out of Germany. The trading partner mainly within Europe and some are outside Europe in Asia.
Part II. Mittelstand and Economy, Society and Entrepreneurship
Mittelstand and the German Economy
The importance of Mittelstand for employment, sales, exports and apprenticeship could be quantified via its presence in the German economy.
Importance of Mittelstand in the German Economy
The economic importance of Mittelstand is even higher than these numbers suggest. These enterprises are SMEs only, but if we recall the definition of Mittelstand, then even large corporations with family ownership and control are considered as core Mittelstand.
For example, based on a research of 15,000 large firms in Germany, approximately 3700 of these large firms are family-owned and managed. In comparison to large non-family owned and operated firms, based on research conducted by Schlomer-Laufen et al. (2014), show that these large Mittelstand ventures have higher relative growth in employment and higher relative return on equity.
Mittelstand and the German Society
The ownership-management structure of the Mittelstand is co-existing with social, inter-generational, and regional responsibilities. These enterprises are firmly embedded in their regions, locally contributing to economic and social welfare and stability. In contrast, Silicon Valley has taken the approach to short term significance of human capital, instead of people in general, while the Mittelstand has pronounced sense of responsibility to people and places.
The Mittelstand companies are responsible for vocational training in their respective regions, the retention of employees throughout the crises, regional contributions of these enterprises in rural and peripheral areas, for employment, infrastructure, and connectivity to the rest of Germany.
Mittelstand and Entrepreneurship
There is a common perception in Germany as well as outside Germany regarding lack of innovativeness in Mittelstand firms relative to Silicon Valley entrepreneurship. The perceiver and observers are unable to grasp the diversity and many colors of entrepreneurship. It is similar to comparing oranges with apples.
There are several major differences in the innovativeness of Mittelstand and Silicon Valley entrepreneurship. These are as follows:
1. Mittelstand is respectful of the existing incumbents, and most of the innovation is towards incrementally advancing the products and improving the value chain. The process is slower and more considerate. While, in contrast, silicon valley is more disruptive and is trying to replace the existing value chains. The start-ups are either able to identify valuable opportunities or failing. The process is fast, and payoffs are binary, skewed more towards the failure.
2. Also, innovation in Mittelstand is by no means dependent on research and development activities, which questions the clear focus of proponents of the Silicon Valley model on technology-oriented and R&D-intensive businesses as representing innovativeness. Mittelstand's focus is on secrecy and staying hidden rather than patenting their products. Some Mittelstand firms understate their R&D investments due to this problem.
3. Silicon Valley's approach is towards the ground-breaking technologies which are visible to almost everybody, while Mittelstand operates B2B, where the deep tech is hidden in products and processes of other companies. Due to the lack of the public awareness, it creates a perception that Mittelstand enterprises are not innovative.
Part III. Limitations of Mittelstand
The Impending Recession
The blog post: 'The Global Economy: Capitalism and Schizophrenia', I mentioned about the policies that the government can take to shift wealth from spenders to savers. I received some criticism with the argument; the main criticism was regarding my criticism of policies that support businesses over consumers. I would reaffirm my arguments using the example of Germany and Mittelstand.
The policies that support businesses or consumers are good for economic growth for some time. The government gets positive feedback that some plans are working for economic growth and social welfare. They further promote such policies and discard the policies that used to hamper growth. This mechanism could be likened to a pendulum where the pendulum moves from one extreme to another. Due to this mechanism, the policies which were used to promote economic growth starts to benefit specific individuals and groups in the economy and harms the rest of the population. And eventually, we reach to a point, where it promotes economic decay rather than growth.
For instance, the political discourse in Germany has always favored an ownership - and value-driven understanding of the Mittelstand, thus albeit more implicitly - emphasizing its contribution to both the economy and society. When introducing the very first economic policy measures for SMEs in the 1970s, the German government stated that a "general and schematic definition of SMEs is not meaningful, "because the German government wished to support enterprises that are "[...] led by their contributory owners bearing thee entrepreneurial risks and liabilities of their business decisions."
These policies indirectly supported the owners of businesses and these enterprises (savers). Based on the principle of accounting, if plans are taken to favor one type of group (say savers), the other policies that support other groups (say spenders) will have to be sacrificed. For example, all else being equal, tax cuts for Mittelstand will be funded by increasing taxes on consumers. The German plans shifted towards more investments and production than consumption.
This worked for Germany because the global economy was in the situation where there was more consumption and government spending than investments.
World GDP = World Consumers + World Savers/Producers/Investors
In 1970's, the consumption was greater than production, creating inflationary environment in the world.
World GDP = World Consumers + World Savers/Producers/Investors
As I mentioned and explained in the blog post, 'The Global Economy: Capitalism and Schizophrenia', that in 2019, we have more production than consumption in the world, creating a deflationary environment.
World GDP = World Consumers + World Savers/Producers/Investors
Due to these policies, Germany is heavily dependent on the world consumption as the domestic consumption is very low. In the next chart, we can see that Germany's net export is ~ $250 billion. This makes Germany the most vulnerable economy to global slowdown.
Net export/import (in $ billion) vs Gross National Savings
Source: H-o-l-o-c-e-n-e.com, World Bank
Wealth Inequality and Wealth Re-Distribution
The policies that support Mittelstand, promotes the following:
1. Increases wealth for the Mittelstand's owners.
2. Helps employment in the economy.
3. Increase Germany's industrial strength in the world.
If you see the following chart, you would see that based on labor criteria, Germany is one of the best economy among G7 peers but based on wealth inequality, Germany is lagging behind the peers.
G7 Economic Indicators and Comparison
If the recession happens, it could lead to lower employment if Mittelstand enterprises start laying off its employees. If they decide to retain the employees during the global slowdown, then there will wealth transfer from the owners to employees. Since World War II, Mittelstand enterprises have retained the employees during the crises. But the crises in the last several decades have lasted only 2-5 years in the world.
In the 1920s, the US was the world producers and net exporter. When the global slowdown happened, it was hit the hardest in the world, causing the great depression. Germany is in a similar position and based on my opinion; if the policymakers in the world do not revert the policies, the impending slowdown will be similar to 1930s. These three critical criteria will decide the outcome of the workers, wealth distribution, and politics in Germany:
1. Policies by world leaders. 2. The time of the next slowdown or the crises. 3. The decision of Mittelstand owners regarding laying off or retaining employees.
The Outcast German Self-Employed Workers and New-Comer Entrepreneurs.
The core focus of the German government in promoting the classic Mittelstand business model and pronounced long term orientation have benefited the family owners and workers in those enterprises. But, due to the one-sided focus, Germany has lagged behind global peers regarding the structural shift to service and experience-based economies and digitization. If we compare, tangible and intangible investments between 1999 and 2013, the argument would seem more evident.
Intangible Investment vs Tangible Investments
Source: Capitalism without Capital
Solo-enterprises have lower income than the Mittelstand enterprises, but the wages for the solo-entrepreneurs is still higher than wage employment at a Mittelstand. Solo-entrepreneurs with a university entrance degree earns more than employed counterparts. A lot of these hybrid and solo entrepreneurs feel that they are being left behind by the government with the one-sided focus on Mittelstand and 'the chosen few' (family members).
On a positive note, the German government has emphasized investments in R&D, IT, and education. They are also promoting new forms of entrepreneurship and trying to take a more holistic approach to policymaking.
Since the last 30 - 40 years, the US has celebrated their failed entrepreneurs while not so long ago, in the 1990s, the German society was very harsh on failed entrepreneurs. There was limited freedom to fail, and failed entrepreneurs did not get a second chance. The German society treated failed entrepreneurs as honest but insolvent entrepreneurs more or less like fraudulent criminals. On the one hand, in Britain, the debt forgiveness of failed enterprises took a very short time, and in the US, it was even more lenient. On the other hand, in Germany, failed entrepreneurs had to wait six years to get a fresh start. They were banned from taking an executive position at the large, flagship companies. Many aspiring entrepreneurs left Germany to the US and founded successful companies such as Kollabora, Kitchensurfing, wywy, etc. The US has a robust funding environment for startups as well as the network was way stronger than in Germany.
The German government shifted gears in the early 2000s with new policies such as creating new sources of funding for financing startups & small businesses, including loans and equity financing, is provided. The local governments in Germany, non-profit enterprises, and universities are collaborating to promote investments in intangible economy. For example, 4 Bavarian cities are in its way to become the top 15 tech hubs in Europe. There has also been a rise of top venture capital firms such as Rocket Internet.
Tech Hub Potential - Germany
Source: Deloitte Study
Although the Mittelstand business model is highly successful for Germany due to its unique characteristics, Germany has to diversify its economy. Through fiscal policy, the German government will have to offset the adverse impact of the trade war, protectionism, and global slowdown on the GDP growth and employment. It will also have to promote investments in intangibles, R&D, and technology to compete against other G7 countries. Germany will also try to encourage internal consumption for resisting shocks due to the global trade war. The failure to do so will have negative repercussions.
Mittelstand also means middle-class. The German government and its history supported ownership of businesses by the middle class and empowered these groups in the society. The US and other high trade deficit countries will have to promote similar policies to encourage the rebuilding of the industries and the middle class. The US has taken the route of promoting too-big to fail or too big to manage firms, but Germany has proved it that small is indeed beautiful.