German reforms: Mind the gap

Two governments are in trouble, in large part because of their lacklustre economies: a look first at Germany, then at France

MAKING fun of themselves doesn't come easily to Germans. But Chancellor Gerhard Schroder is actually pretty good at it. When talking about his reforms, he describes himself as a guinea pig, trying to avoid falling into the gap between the time when painful changes are implemented and when their benefits are felt.

It looks as if Mr Schroder is heading for a fall, because the gap between reform and benefit seems to be getting wider. Last week saw another batch of bad economic figures. Several forecasters reduced their growth predictions for 2005, in the case of the International Monetary Fund by a full percentage point to 0.8%. Reports showed that poverty is up, particularly among children, for whom it is growing faster than in most other rich countries. Worst of all, unemployment hit a post-war record of 5.2m (12.6%, unadjusted) in February, with a new high likely in March.

After his brief comeback early this year, Germany's chancellor is again under siege. The ruling coalition of Green and Social Democratic ( SPD) parties is now expected to lose the election in North Rhine-Westphalia on May 22nd. This is, in effect, Germany's mid-term election, as the state is the country's most populous and is also the SPD's heartland. Now on the defensive, Mr Schroder has also had to accept an offer by the centre-right opposition to meet on March 17th for a “crisis summit” to discuss further economic reforms.

It remains to be seen whether the chancellor and opposition leaders can come up with anything substantial. But the mere fact that an informal “grand coalition” is being talked of illustrates the country's state of mind in the face of its economic problems, almost two years after Mr Schroder announced his Agenda 2010 reform measures. “Germany helpless”, ran the headline in the Suddeutsche Zeitung, a leading daily, summing up the mood.

Such frustration is easy to understand. Over the past two years, Germany has done many things right. Although Agenda 2010 came late and did not go far enough, it was more than a respectable start. It tried, for the first time, to enact labour-market reforms that merited the label. Tax cuts were part of the deal too. Less visibly, the wage-bargaining system was overhauled from the bottom up: employers' associations and trade unions managed to agree to low pay increases and more flexible wage agreements, allowing for longer working hours. Last year, unit labour costs fell by 1.1% in nominal terms.

As The Economist noted two weeks ago, this drop has helped to make German companies far more competitive. The country was the world's biggest exporter in 2004. Profits have reached new highs. Industrial production is growing at its fastest rate in a decade. But the drop in nominal labour costs also helps to explain why the reforms have had such mixed results. Domestic demand, particularly consumption, is flat, partly because of stagnant wages, and partly because cuts in benefits have increased uncertainty and raised fears of unemployment. As a result, growth is too meagre to stop unemployment rising, let alone reduce it.

Unsurprisingly, pressure for more active demand policies is increasing. Several new books have appeared that criticise the government's structural reforms and demand monetary and fiscal easing instead, including one by Peter Bofinger, a member of Germany's council of economic experts. Even more orthodox economists, such as Michael Huther, president of the Institut der Deutschen Wirtschaft, an industry-sponsored think-tank, say that something must be done to boost demand and create more jobs.

Within the government, the focus also seems to be shifting. Mr Schroder has let it be known that he likes Mr Bofinger; he even wanted to put him at the helm of the Bundesbank, Germany's central bank (a move blocked by Hans Eichel, the finance minister). The chancellor wants to weaken the EU's stability and growth pact, which seeks to keep budget deficits below 3% of GDP, even more than he did, which explains why this week's negotiations in Brussels to reform the pact failed yet again. The economics minister, Wolfgang Clement, has repeatedly called for tax cuts for businesses and for more public investment to foster growth.

Such calls reflect growing panic more than changed policy. Mr Clement, a former premier of North Rhine-Westphalia, has bet his job on the success of his labour-market reforms. Mr Eichel has ruled out any quick tax cuts or new spending plans, arguing that such measures have proved ineffective before and would just add to Germany's debt burden. Still, the government needs to show it is fighting unemployment, and Mr Schroder has promised to announce some new measures after his meeting with the opposition.

An ad hoc package seems a given, but a “pact for Germany” between government and opposition is unlikely. The open letters that the two have exchanged do little more than list each side's well-known demands, which the other has already rejected. Both camps seem intent mainly on avoiding being the one that gets the blame for a failure to agree. But then again, shifts do sometimes happen, even in Germany; neither side can afford the risk that their talks yield absolutely nothing. Some observers now expect a deal on corporate-tax reform, at least.

The discussions about a growth package and about some kind of reform pact suggest that both the government and the opposition believe that Germany could solve its economic problems quite quickly. They are probably wrong. Rather than further tactical manoeuvring, what the country really needs is a serious debate about where it wants to be in 20 or 30 years' time. Such a debate might make it easier to launch a broader second round of Agenda 2010 reforms, focusing on such pressing long-term needs as a simpler tax system, better schools and more elite universities, as well as an overhaul of the country's federal structure, which has become a big impediment to change.

It is such a long-term plan that Mr Schroder needs if he is to bridge his reform gap. Yet even if his coalition loses North Rhine-Westphalia, that may not mark the beginning of his end. The economy is not as sick as it seems: most of the recent jump in unemployment stems from labour-market and benefit reforms, not the economic slowdown; growth may pick up later in the year. Unemployment could come down as fast as it shot up. After 5.2m, 4.5m would look quite good. In the end, the comeback chancellor may have the last laugh, and it may not be at himself.

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