Special report. Germany’s economy. Ready to motor

There are encouraging signs that Germany's economy is set to grow more strongly

THERE has been much pessimism about Germany's economy in recent years: too much, perhaps, judging by recent evidence that it has quietly started to do better than most people expected. Among the positive signs has been a strong performance by its big companies, which have reported healthy profits. Even unemployment, for long a black spot, is beginning to fall. And although many Germans still question the case for further economic reform, they have to admit that their country is doing much better than, say, France or Italy, partly because of recent reforms. Suddenly Germany looks relatively healthy, and there are grounds for cautious optimism that things could get better still--but only if the political winds blow in the direction of more reforms. This is why German's general election campaign, which leads to a parliamentary election scheduled for September 18th, could be decisive economically as well as politically.

Unfortunately Germany's reform programme, known as Agenda 2010, became bogged down after meeting fierce opposition soon after its launch in 2003. Since May 22nd, when the election was called, there has been near paralysis. But there have been some positive results from Agenda 2010. These have raised hopes that fresh impetus could set the economy on to its strongest track for years.

The most radical measure has been Hartz IV, a restructuring of unemployment benefit and social security. From January this year things became less cushy for the 1.8m long-term unemployed, who comprise a staggering 38% of the total jobless. Continued benefits are now means-tested, and unwillingness to accept job offers is penalised. Hartz IV has not been an unqualified success. It has added euro8 billion ($9.8 billion) to this year's government costs, but failed to create many new jobs. It has, however, made employees more fearful of the consequences of losing their jobs. That has strengthened the hand of firms negotiating new wage deals, and weakened the power of trade unions.

And yet this fillip for the corporate sector has, arguably, been less good for the economy as a whole. In Germany there is a close relationship between fear of unemployment and consumer confidence. In recent years low consumer confidence has held back domestic demand--Germans have been saving more and holding off spending. That has become the single biggest drag on growth.

It was partly the issue of creating new jobs that precipitated the call for new elections. Government and opposition could not agree on the lowering of corporate tax from 25% to 19%, a controversial measure that required their joint agreement.

Why have Germans been so lukewarm over far-reaching economic reforms? Otto Graf Lambsdorff, a former economics minister from the liberal Free Democratic Party, blames what he calls "snuggle-capitalism". Germans, he said in a recent interview, would rather have certainty and equality than freedom. Instead of getting on their bikes to look for work, or setting up on their own, they have a tendency to cling to what they know, consoling themselves that they are all in the same boat.

Change has been happening, however, albeit slowly. The number of self-employed has risen from 4m four years ago to 4.4m at the end of June. So-called "one-euro" jobs, which dignify unemployed people by paying them one euro an hour plus their benefits, have proved popular, with over 200,000 being created, as have "mini-jobs" paying euro400 a month, although it seems that these have mostly been snapped up by students and full-time workers wanting to work less, rather than by the long-term unemployed.

One plank of Agenda 2010 was a pact between business and government to create more jobs and trainee positions. In reality it had little impact. The "capital for jobs" scheme was shelved in March 2004 as unworkable. Many firms have failed to deliver their quota of trainee posts, while others that did found the posts were not filled anyway.

Yet the corporate sector offers a striking example of Germany's broader positive economic trends. German companies have shown a remarkable improvement in their competitiveness thanks to a relative fall in their unit labour costs. Big companies have learned that their main battle is now a global, not a domestic, one. Their profits stem largely from exports to countries where demand is thriving. Indeed, the profits and activities of leading German companies have become somewhat dislocated from the economic fortunes of Germany as a whole.

That trend was hastened in 2003 with a new tax law which allowed firms to sell their cross-shareholdings in other German companies without paying capital-gains tax.

This prompted a wholesale unbundling of what had become known as "Deutschland AG". Companies could concentrate on their core business. Their ownership became more international and more demanding of shareholder value.

That has led to huge tensions between the way big companies such as Volkswagen, DaimlerChrysler and Siemens are perceived at home and their efforts to survive as global players. At home they have to deal with a highly unionised workforce and a supervisory board heavily influenced by employee and union representatives, while internationally they must compete with companies whose labour costs are as much as 80% lower. West German workers cost on average euro27.60 ($34) an hour, including euro12.20 of ancillary costs--the highest in the euro zone--compared with euro19.90 an hour in Britain and euro18.80 in America. (In east Germany the average is a more modest euro17.20.) But in central Europe labour costs are well below euro5 an hour.

Surprisingly flexible

German efficiency and once-matchless engineering can reduce that differential and justify higher prices, but only to a degree. Last year and this, most of these companies had reached a point at which only a reduction in their labour costs would support continued production on their home soil. Yet Siemens, DaimlerChrysler, VW and many others managed to cut deals with their workforces, lengthening working hours and limiting perks, while to some extent guaranteeing employment for the next few years. IG Metall, once Germany's most powerful trade union, had little choice but to go along. Recent research by Morgan Stanley, an investment bank, found that more than 30% of Germany's workforce are now employed in part-time or temporary jobs, meaning that firms can deploy their labour much more flexibly than in the past.

Collective wage-bargaining is not dead--even Germany's conservative political parties hesitate to campaign for its removal. But unions have been pragmatic behind the scenes in order to save jobs. The contrast with, say, France is stark.

For the majority of German workers, companies' growing willingness to shift production to wherever labour and capital costs are cheapest is a direct threat to their jobs. Changing the mindset of a population to think globally rather than locally is likely to be the work of a generation rather than a year or two. But leading companies are growing more assertive about their economic role at home. Continental, a tyre-maker, and one of the best-performing companies in Germany, has located much of its production abroad. But it still employs 32,000 people in Germany and keeps its headquarters there. In the age of globalisation, national champions are national only in the sense that they must have their headquarters somewhere. If it is to keep a quota of champions, then Germany will have to make it attractive for them to stay, and for others to come.

An important measure of progress is that business leaders are beginning to feel more confident. Last month a much-watched index of business confidence rose by more than analysts had expected, perhaps because of the strong profits performance that was evident when the latest set of quarterly results were announced. Two-thirds of Germany's top 30 listed companies produced improved results for the second quarter of the year. That includes jumps of more than 20% over the same period last year by chemicals firms Altana, BASF and Bayer and respectable earnings from energy producers, insurance companies and banks.

Perhaps most important for the health of the economy is the improved position of the banks. All the biggest banks now have their costs and their balance sheets under control. Much of the banks' real-estate portfolios and their non-performing loans secured against property have been sold off at distressed prices. The challenge now is for the banks to take more risk in their lending to medium-size companies. Good performance from them will be needed to underpin a sustained recovery.

The accumulation of positive economic developments includes evidence that the labour market has stabilised. In July unemployment fell for the fourth month in a row. There are 50% more job vacancies than there were a year ago, and surveys suggest that employers are becoming more bullish, expecting to hire more workers in the coming months. Manpower, a recruitment consultant that tracks employers' intentions across the world's big economies, notes that the rise in Germany's indicator has been stronger than movements anywhere else.

Learning to innovate

There are also signs that efforts to improve Germany's long-term economic performance are beginning to pay off. Apart from lowering labour costs still further, Germany can strive to be more competitive only through innovation and improved conditions for investment. A perceived "innovation gap", which is closely linked to failings in education and research, has attracted much more atttention in recent years. Academics and business analysts have pointed out the Germans remain excellent at inventing things, but are far less effective at perfecting them and bringing them to market. Germany has been hostile to technology, says Ludolf von Wartenberg, managing director of the BDI, Germany's Industry Federation, and has missed out, for example, on both green (agricultural) and red (medical) biotechnologies. "It has to do with our education system," says Mr von Wartenberg. "We need an Aufklarung (an age of enlightenment)."

This is where he believes politics can make a difference. In 2004 Chancellor Gerhard Schroder formally launched an initiative with leading companies, dubbed "partners for innovation". Various working groups have been set up, including ones for stimulating new approaches to information technology, specialist materials, education, energy conservation, computerising health services and harnessing venture capital and state aid. Some of these groups have begun long-term projects that will survive any change of government that results from next month's election. And there is money available to publicise the long-term importance of innovation for the economy.

Of course, encouraging economic signs do not mean that Germany has conquered its big structural problems. Studies by research institutes dotted around the country point to the need for tax and pension reform and solutions to a looming demographic problem. "More babies--preferably this instant!" was one alarm call that graphically illustrates the problem: 1.3m births in 1960 but only 700,000 in 2004. The Berlin Institute for Population and Development proposes that 10% of the women born in the 1960s, now aged 35 to 45, should have an extra child in order to strengthen the number of wage-earners who will be needed to support their generation in retirement.

Both former West Germans and East Germans have been accustomed to a high level of social security and health care. New charges for medical registration, introduced last year, alerted them that things are changing. Warnings that state-sponsored pensions will fall short are beginning to force people to buy, reluctantly, private pension schemes.

But that extra saving does little to help prospects for a consumer-led recovery. A good half of German households are already sitting on abundant wealth if their house ownership is taken into account, which it is not by the German Institute for Retirement Provision, notes a recent article in the weekly Die Zeit. If Germans just felt richer, like Americans, they would surely borrow and spend more. Some economists have been urging changes that would make it much easier for Germans to borrow.

Not enough demand

That is because Germany's biggest problem, on which economic recovery could yet founder, is its lack of domestic demand. Unless consumer confidence rises, some analysts argue, there remains a risk that Germany might fall back into a deflationary spiral. Some think higher wages offer a solution. On August 8th Mr Schroder urged German businesses that were doing rather better to give their workers a "decent swig from the bottle". Peter Bofinger, a member of the Sachverstandigenrat, the government's independent economic council, believes that wages should be allowed to rise by 2% to 3%. Dirk Schumacher, an economist at Goldman Sachs, an investment bank, argues that size and economies of scale should allow large efficient companies to charge more, pay better and still remain globally competitive.

However, the real issue, says Mr von Wartenberg of the BDI, is to separate wages from ancillary costs such as social security. He fears that one possible move in that direction--a 2% increase in value-added tax proposed by the Christian Democrats--will be squandered by regional governments that want to balance their budget deficits.

Hans-Werner Sinn, head of Ifo, a Munich-based economic research institute, points out that Germany is battling the consequences of five economic shocks: globalisation; the European Union and its enlargement; the introduction of the euro; the opening up of central and eastern Europe; and German re-unification. Each one of these big events has been good for the world as a whole, but has posed particular problems for Germany. It is perhaps remarkable that the country has weathered so many unanticipated blows so well, a tribute to the economy's resilience.

As the biggest economy in the euro zone, Germany has a double straitjacket that prevents it from stimulating a consumption-led boom: interest rates set by the European Central Bank, whose concern is curbing inflation throughout its region, and a stability and growth pact that inhibits countries from borrowing and spending their way out of trouble. Zero-growth, however, is not acceptable politically, even if it were economically.

Government help is also needed to sort out Germany's biggest black hole, the former East Germany now known as "the new Lander". It was a political decision to reunite West and East Germany within a year of the Berlin wall coming down in November 1989. To smooth the deal and to avoid an exodus of East Germans to the west the government made huge transfers, including a pari passu pension and social-security system and comparable wages: within four years wages were approaching North American levels. Tax incentives created a construction boom followed within three years by a bust from which the region is still trying to recover. It has left east Germany's poorer Lander with over 20% unemployment and few prospects of attracting significant investment.

The multiplier effect

Saxony and parts of Thuringia have become hubs for auto manufacturers and suppliers, and Saxony has also attracted semi-conductor manufacturers. Another former industrial region, Saxony-Anhalt, has high unemployment, but can boast a cluster of chemical firms. Mecklenburg-Pomerania has little but agriculture, some shipbuilding and tourism potential. Brandenburg has seen some ambitious investment projects fail. The upshot is a region that in total still requires transfers of around euro90 billion per year, or 4% of the country's GDP. In addition to the unemployed, some 850,000 workers have jobs that depend on the transfers.

Yet the worst aspect, according to Ulrich Blum, head of IWH, a research institute based in east Germany, is that hardly any companies have their headquarters in the region. Successful companies that originated in the east have tended to move their headquarters west. This is a phenomenon not experienced by other central European or even former Soviet countries. The result is east German cities that lack a business elite and, worse still, their high-spending wives and families. Among the few exceptions is Jenoptik, an optical company in Jena. DHL, a subsidiary of Deutsche Post, recently decided to move its logistics hub to Leipzig. Mr Blum told an EU delegation in Dresden recently that the dearth of headquarters was costing the region about 30% of the value-added that companies usually bring.

Mr Blum has a proposal for the region's development that would reward companies for investing there and subsidise research and development. It would focus on smaller successful companies to ensure that they developed the critical mass to survive and grow. This is in contrast to the federal government's "watering-can" approach which has tried to distribute benefits evenly. The current federal approach won't get the private sector investing, claims Mr Blum. It makes more sense to put money where it can have the most impact. And yet even this would not be a quick fix. It will take the new Lander 15 to 20 years to get to the level that Bavaria is at today, says Mr Blum. If Germany's politicians make sure that today's foundation for future growth is built on, not undermined, it might just happen sooner.

There are encouraging signs that Germany's economy is set to grow more strongly.