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Insight: The Mittelstand - one German product that may not be exportable

By Sarah Marsh

BERLIN (Reuters) - Philipp Klais, who runs the organ manufacturer in Bonn that his great-grandfather founded in 1882, gets requests every week from foreign officials as far away as Korea to visit his company. This baffles him.

"They want to find the secret to our success," said Klais, whose organs stand in concert halls and churches from Taiwan to Argentina, as well as in Germany. "But we don't see any, we just do what we do, and have been doing for the past 130 years."

Germany's "Mittelstand", the medium-sized and often family-owned manufacturing firms to which the country owes much of its exporting prowess, has become the envy of political and business leaders all over the world and they are keen to emulate it.

"Other countries wouldn't be in as much of a crisis if they had a stronger Mittelstand," said German Deputy Economy Minister Ernst Burgbacher, exuding pride in a sector that accounts for half of national output and has helped Germany to weather the global financial and euro zone crises.

But the Mittelstand, with roots in the disparate statelets of mediaeval Germany and sustained by a conservative, small-town culture, is a model that cannot be automatically exported to fundamentally different societies.

French industrialist Louis Gallois, who oversaw a recent study on boosting competitiveness in France, does not believe in copying the German model. Gallois described the fashionable adulation of the Mittelstand as "a passionate fixation" that ignores its weaknesses.

Others argue that the Mittelstand model is not well suited to the 21st century. Younger generations are increasingly reluctant to take over family firms, which may struggle to find bank funding in an era of more cautious lending.

"Members of the Mittelstand tend to be geographically immobile, inherit professions and companies from one generation to the other, follow rather conservative life-style patterns and usually prefer the status-quo," said Andreas Woergoetter of the Organisation for Economic Co-operation and Development (OECD).

Woergoetter and other critical economists note that while Germany has long improved the products it already manufactures, it is not as skilled at "radical innovation". It is not at the forefront of the digital revolution, financial innovation or luxury good creation, and has no Google or Apple.

"Rather than thinking outside of the box, the Mittelstand has always been for enlarging it, making it more cozy and securing its foundations," said Woergoetter. "They prefer incremental over radical innovation."

A recent survey by consultancy McKinsey points out that Germany is still focused on labor-intensive exports. In areas such as high-tech, it trails European peers France and Britain.

ENVY AND EMULATION

The cautious and industrious Mittelstand business model embodies Germany itself and offers an alternative to the short-term, debt-fuelled growth perceived to have led to the financial and euro zone crises. It is a modern fable of the tortoise who outran the hare.

Mittelstand companies are generally defined as those with up to 500 employees and 50 million euros in annual revenue, although larger firms also consider themselves part of the sector.

The main difference between a Mittelstand company and others is that the manager is often also the owner, according to the BVMW lobby for the Mittelstand. "The owner must vouch for the firm with home and hearth," it says.

Because those who run Mittelstand firms are often focused on passing them on to future generations, they tend to favor long-term goals over short-term dividends.

Klais noted proudly that his firm has been the same size since 1896. Like many Mittelstand managers who fear rapid expansion may jeopardize their business, he is not aiming for growth and has avoided shifting work to sub-contractors to improve profits.

"I don't want to grow, why should we?" he asked. "It's a small market and we would rather participate in the most interesting projects than build more."

While European peers were racking up debt, the Mittelstand built up its own equity. According to the BVR association of cooperative banks, the Mittelstand's overall equity ratio - the proportion of share capital used to fund a firm's assets - rose from 3.8 percent in 2001 to 22.6 percent in 2011. This has produced less spectacular but more secure profit growth.

"The Mittelstand has been more cautious in its financing and therefore suffered a couple percentage points of profitability in the boom times compared to more leveraged firms," said Armin Schmiedeberg, a partner at management consultants Bain & Company. "But this has given them much more financial stability, particularly in the crisis."

This long-term and sometimes paternalistic attitude, and a reluctance to lose skilled workers, meant Mittelstand firms avoided laying off staff when exports slumped during the 2008-09 crisis. Instead they made use of a government scheme subsidizing shorter working hours to weather the storm.

A preference for consensus in labor relations allowed the Mittelstand to curb wage costs which, along with government reforms, helped it to keep and create jobs. The BVMW Mittelstand lobby reckons 1.8 million were created between 2005 and 2011.

The Mittelstand's focus on manufacturing also seems to have paid off, as producing goods is now back in fashion, with service economies such as Britain's looking to re-balance.

Business consultant Hermann Simon, who coined the term "hidden champion" for mid-sized firms that have become world leaders, said 48 percent of them come from Germany. Some register more patents a year than entire European countries.

A dogged focus on innovation, quality and impeccable after-sales services has made the "Made in Germany" brand renowned, compensating for high labor costs and helping the country to remain one of the world's top exporters.

Germany is the world's third largest exporter of goods behind much bigger China and United States, although it held the top spot as recently as four years ago.

Some believe the Mittelstand shows how manufacturers in the developed world can compete with rivals in low-cost emerging economies. "We are inspired by German companies and their ability to take products that could be banal and to make something innovative of them," said Alexandre Montay of a French lobby group for medium-sized firms.

Manfred Bogdahn, for example, invented the retractable dog leash 40 years ago. His firm still makes them in Germany, has 70 percent of the world market, and he is excited about the next generation of leashes to hit the market.

Another factor in the Mittelstand's success is the "dual" vocational scheme, which combines theoretical and practical training for young workers. Closer links between regional education bodies and firms means these schemes are designed according to companies' needs - one reason, economists say, for Germany's low rate of youth unemployment.

Andreas Pieper of the Federal Institute for Vocational Education says other countries are asking ever more questions about how Germany has kept youth unemployment at 8 percent when the EU average stands above 20 percent.

A VERY GERMAN AFFAIR

Yet many experts believe other countries cannot simply copy the Mittelstand model, which arose from centuries of unique economic and political developments.

"Germany itself does not know how to duplicate this model within its own borders," writer Jacqueline Henard said in her recent study "Germany, a model, but for whom?". In it she argues that the country has failed to repeat the Mittelstand's success in its struggling former communist eastern states.

She concluded that each economy should focus on reforming its own business model - just as Germany did.

Olga Vaulina, who organized a visit this year of Russian regional officials to Mittelstand firms, said most agreed the factor lacking in Russia after decades of communism was entrepreneurial spirit - something that is not easy to copy or impose.

The Mittelstand traces its roots to the Middle Ages, when the country that is now Germany was divided into hundreds of states. Competition between them created a number of industrial regions with their own educational institutions, banks and political administrations. This is very different from the centralized economies such as in France.

World War Two cemented the Mittelstand's importance, as big corporations were tainted by their association with the Nazis and often based in big cities destroyed by allied bombing.

The Mittelstand had to export early on, given that some German states were smaller than two football fields. Nowadays firms receive state aid to identify and enter markets, and have multilingual staff, said business consultant Simon.

Germany's more decentralized system has fostered close links between the Mittelstand and politics. Ministers invite mid-market firms on foreign trade delegations and take them into account when formulating policy.

By contrast, French politicians did not even have a name for the Mittelstand until 2008. "When there was no word for this category of companies, it was like it didn't exist, and so there were no policies promoting it either," says lobbyist Montay.

In the end, France came up with a more cumbersome term for medium-sized firms: "entreprises de taille intermediaire".

CHALLENGES

An Asian official, who was studying the Mittelstand but asked not to be named, said the model was problematic for emerging economies because it developed too slowly.

"Germans like things to stay the same," he said. "If an economy is developing and looking at resolving its unemployment problem it looks for big investments, quickly, in order to employ lots of people," said the official.

The Mittelstand has had no trouble securing financing through the global and European crises. But that could change in the longer-term.

International "Basel III" rules designed to protect lenders from failure will make financing tougher for family-owned companies that traditionally rely on bank credit, according to Germany's BDI industry association.

More firms are turning to bond markets for funds that would not mean relinquishing family control.

While the Mittelstand is going strong now, younger Germans may not want to be stuck in the provinces making the same products as their parents and grandparents.

Doubts also remain over whether the next generation of owner-managers - whose numbers seem sure to dwindle due to Germany's falling birth rate - will be any good at running the family business, simply by virtue of their genes.

Deputy Economy Minister Burgbacher said demography was a big problem: "We have had a lot of Mittelstand firms where there are no children or they don't want to take over."

Berlin has introduced incentives such as lowering inheritance tax on firms to encourage younger generations to stay put. Companies are making their job offers ever more attractive to recruit skilled workers.

Organ maker Klais remains optimistic about managing the challenges ahead while preserving traditions. He hoped his children would learn to love the instruments by playing in the workshop, but if not, he would train someone else up.

"At the end of the day, the important thing is to prepare someone for this job," he said. "It doesn't matter so much if it is in the hands of family or not, I would just like to see it in careful, caring hands."

(Additional Reporting by Daniela Pegna in Frankfurt, editing by Gareth Jones/Noah Barkin/David Stamp)

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