The Mittelstand Model

A look at the German-Austrian Mittelstand as a model forward for the former USSR

20 Minutes

The Good 30 Years

When the Berlin Wall fell and the Soviet Union unraveled, expectations ranged from catastrophic to the unbridled optimism of the unipolar moment. Much of it proved true, at one point or another, and eventually at once.

But, overall, most of the former USSR did fairly well in terms of GDP growth after the first turbulent years. At least considering that mass malnutrition is very much of living history - and so is that mentioning that might get you an, admittedly state-provided, stay in a psychiatric facility.

The Polish economy was 2.5 times larger in 2016 than in 1990, famously moving from middle income to high income in less than 15 years and being the 40th in the world on the World Bank’s Ease of Doing Business Index. Notably this has been in the context of enjoying a declining overall Gini coefficient of 0.343, a Gini coefficient for net wealth of just 0.58 (for comparison, it’s 0.76 in next-door Germany) and an increase in the number of 25-34 year old with tertiary education from 14% in 2000 to 41% in 2014.

By GDP growth figures, if not state development, these were the boom years. They have also resulted in the rise of several regional companies, which can show a way forward for the former USSR. With fairly under-developed equity markets, most are family owned and have primarily domestic revenue centers but, in aggregate, could one day act as national champions.

After The Boom

In Central and Eastern Europe, that transition is turning from agreeable want to urgent need. Unfortunately, the factors which made broad economic growth relativity straightforward are declining or going into reverse :

The French Plague

Overall, that leaves many CEE economies in a bind. The domestic market on which many companies are dependent on is facing relative decline. Price-competitiveness based on a fairly cheap yet well-educated labour force is a thing of the past.

Even the rosy picture of Total Factor Productivity (TFP) convergence has a grey lining. Convergence with Western Europe on sectoral composition, moving labour from low-productivity agriculture to higher productivity manufacturing and services, was the easy part. Inter-sectoral productivity convergence, which is to say companies defeating Western rivals is much more difficult. If the model of Spain, Greece or Italy is to be followed there is a stark reminder : much of the productivity convergence with Western Europe seems to have been based labour reallocation. When that stopped, TFP growth stopped. When that stopped, real income growth stopped.

Such an extrapolation may mean that Eastern European countries do not even achieve the 60% of Western countries' average incomes by 2050, as currently hoped for.

Just as that happens, the postponed pension and healthcare bills are coming due.

The Need For Mittelstand

Lacking miracles, the most straightforward way to escape the bind is the German Mittelstand. This is the patchwork of highly-specialised, often family-run, business which proved globally competitive enough to turn a small niche into a thriving business. Eastern Europe’s family businesses never evolved in this direction because the post-Soviet space was mostly a matter of presence : without competitors, whoever could have access to bank lending for the financial capital to enter a market would likely win that market. Based on that success, a business could use internal revenue and collateralized debt to enter another market. Efficiency of production was trumped by expansive marketing. Specialization and development was trumped by first-mover advantages.

The result tended towards a lot of big fish in small ponds. Those fish cannot compete with automated business, putting the jobs created at high risk and risking a stagflationary spiral. The Mittelstand model implies going beyond that – jumping to being a small, specialised fish who can deliver the best in a large, global, pond.

Percentage of jobs in sector expected to be automated. Tap or click for risk breakdown. Deloitte

The Challenges

Many hurdles would be self-evident. Equity markets aren’t developed enough to support high-risk foreign expansions, leaving even family members who convince others to expand with bank loan managers to deal with. The domestic market is still cosy enough not to force established businesses to seek opportunities and accept the challenges that comes with that. Compounding the former, the best and brightest often seek opportunities elsewhere, such that successful East Europeans seem to be everywhere but in Eastern Europe – and these would have been the ‘superstar’ employees needed for companies to compete globally.

Perhaps hardest to change is the culture. While German feudalism included a large proportion of craftspeople learning from one another, East European feudalism was often almost wholly agricultural and based on serfdom. Over a hundred years later, “being smart” is praised while pride in one’s work is dismissed as perfectionism. “Good enough” is the norm, and the standard of that is often the absence of failure rather than global competitiveness. “Who you know” remains a far surer path to success than “what you know”.

Meanwhile, that success is often associated with leisure and what may be politely called the enjoyment of life, rather than any Weberian capital-saving austerity. Even Soviet-era focus on the hard sciences which, for better or worse, mass produced emigrants for Western companies’ engineering and research departments has given way to a generation more focused on logo design and social media.

In other words, the ingredients for a globally-competitive Mittelstand are often scarce. Without these companies becoming globally competitive, tax revenue is simply not going to cover fiscal outlays. Without companies investing in the research and development needed for competitive specialization and gaining technical advantages in the market, even the best and brightest less interested in monetary rewards will leave simply to have where to apply themselves. Without a focus on efficiency, export markets will increasingly be the preserve of those who invested whole-heartedly in automation and digitization.

The Brightside of Life

But the ingredients are still there – and the former USSR needs this transition to happen. While at times constricting, the common market of the European Union brings the small specialist the opportunity of rapid scaling with relatively minimal regulatory risk or currency risk. Lacking their own export-focused METI, well-connected East European family businesses can still access European Union funding. While emigration remains a problem, a well-placed diaspora can also mean quick internationalization, technology transfers, exposure to the newest ideas and a warm welcome in a foreign market.

Such problems turned advantages can add up. One may simply look at Poland as charting a path in this direction. Trade as a proportion of GDP rose from 61% in 2000 to 94% in 2014 and while initially export growth was dominated by a few companies, the contribution of large companies to exports actually fell from 80% in 2006 to 52% in 2013.

In other words, it might be possible – and it’s one of the few options left.