German capitalism: Locust, pocus

Some German politicians want to blame international business and finance, not themselves, for the country's sluggish economy

MANY of Germany's roughly 5m unemployed, and thousands of others whose jobs seem daily under threat, have understandably been looking for someone to blame for their plight. An economic-reform programme launched in March 2003 does not seem to have turned things around much. In fact, forecasts last week halved previous estimates for GDP growth this year to a mere 0.7%.

So when Franz Müntefering, head of the SPD, the leading party in Germany's governing coalition, found a scapegoat last month in the form of “international capital”, there was a spontaneous cheer from at least half the population, and furious rebuttal from business leaders and right-wing politicians. Mr Müntefering attacked the behaviour of certain financial firms whose profit-maximising strategies were a long-term threat to “our democracy”. He described them as “swarms of locusts that fall on companies, stripping them bare before moving on.”

This is all good rabble-rousing stuff in the run-up to a crucial election in North Rhine-Westphalia on May 22nd. (Chancellor Gerhard Schroder has so far kept out of the debate, but is undoubtedly listening with interest.) But it has actually touched a deep national nerve. This has to do with the painful transition that Germany is making from a social market economy, in which firms and services were supposed, at least publicly, to be run by consensus for the “general good”, to the starker mechanisms of the market and shareholder value. Competition from abroad, and especially from new EU members in central Europe, is driving this change in part. But the biggest factor is Germany's persistent economic malaise.

The social market economy is still hallowed by politicians, but it survives only in fragments: for example, in the two-tier structure of German companies, where the workforce is represented on the supervisory board; in the role of workers' representatives in even the smallest companies; and in collective wage agreements. A reform in January this year, called Hartz IV, controversially punched a hole in the social safety net, ending generous benefits for the long-term unemployed and penalising those too picky about job offers or who have working partners.

Hartz IV so far has brought only more woe: it has added to the social-services bill and unemployment has hardly fallen. Moreover, this year and last have been full of bad news from big employers: Volkswagen, DaimlerChrysler and Opel (a German subsidiary of General Motors), KarstadtQuelle and others have cut thousands of jobs. Wages have been forced down or frozen by companies threatening to relocate abroad. Even Deutsche Bank, despite rising profits, has been laying off staff, inviting the particular wrath of Mr Müntefering. “The economy (ie, big business) must realise,” he railed, “that it exists to serve people and not the other way round.”

The public are angered by the fact that big German companies are beginning to make record profits again, after three bad years, and have achieved that by cutting costs, particularly their wage bills, and by reducing investment, especially in Germany. Last year the 24 top industrial companies reduced their investment in Germany by 20%, and worldwide by 10%, according to Handelsblatt, a business daily. At the same time they increased their dividends and payouts to shareholders by 40%. So there is an impression that companies are rewarding their owners, but not cosseting their workforce as they did in the past - they are, in other words, adopting an increasingly Anglo-Saxon approach.

The debate raging in Germany is about whether the country is quite ready for this kind of capitalism rather than the more socially oriented Rhineland variety that is ailing, but not quite buried. Mr Müntefering is clear where he stands: “We want social market economy, not market economy pure.” But despite the populist bent to his rhetoric, not everyone supports his stance. Attending a rally on May 1st he was ritually pelted with eggs by trade unionists who are supposed to be his friends. Many people have told him in the past three weeks that what he wants just will not work any more, and that opportunistic foreign investors, far from being locusts, can be the reformer's friend.

Not child's play

Take the Children's Investment Fund (TCI), a hedge fund that has been making headlines because of its activism as a shareholder of Deutsche Borse, a financial exchanges group. Armed with an 8% stake accumulated in January, TCI spoke up against Deutsche Borse's attempt to buy the London Stock Exchange (LSE), saying that buying back shares would be a much better use of its spare cash. Rolf Breuer and Werner Seifert, respectively chairman and chief executive of Deutsche Borse, at first dismissed TCI as an opportunist that had no right to influence the firm's strategy.

But TCI was not the only disgruntled shareholder. Others, some of whom could scarcely be called short-term, were dismayed by the management's failure to consult shareholders before such a big takeover. A slanging match between Mr Seifert and Christopher Hohn, who runs TCI, resulted in Mr Hohn calling for a vote of no confidence in the supervisory board and for the removal of Mr Breuer as chairman at the next AGM on May 25th.

Mr Breuer, who is also chairman of Deutsche Bank, is almost the personification of Germany's old-style capitalism. He used to be Deutsche Bank's chief executive, so the fact that he holds the bank's chairmanship already offends one principle of corporate governance recommended by the European Commission. He has survived several gaffes that would have unseated a chairman in an Anglo-Saxon environment. Perhaps his biggest was not to recuse himself when it emerged that his bank was both adviser and financier of Deutsche Borse's bid for the LSE, a conflict of interest of heroic proportions.

If not for TCI, Deutsche Borse might still be attempting an LSE takeover, without knowing or caring whether it had majority shareholder support. Yet the knee-jerk reaction of Hans Eichel, the German finance minister, to this corporate-governance row, was to threaten new laws against short-term profiteers - a threat he sensibly modified the next day, although this week he pointedly attacked TCI for disrupting Deutsche Borse's strategy.

Yet it should be clear, even to the most socially minded in Germany, that the clock cannot be turned back without inflicting enormous damage on the country's prospects. Germany has signed up to EU treaties that prescribe the free flow of capital across national borders. Repudiating these is impossible without leaving the EU. The same applies to taxing foreign-exchange transactions or introducing a minimum holding period for an equity investment - both recent suggestions. Hedge funds and private-equity funds have open access for the long or short term.

It is true that foreign private-equity funds have been the most active players in restructuring corporate Germany in the past two years. Their methods are often unsentimental, to say the least. Costs and staff can be slashed, equity is quickly turned into high-yield debt, and a positive return is sought sooner rather than later. The effect on a company's culture can be traumatic. Life in the boardroom and on the shop floor (for those who still have a job) is never the same again. Performance targets and personal assessments can radically change the atmosphere.

However, it is hard to argue that this is a bad thing when the former model has clearly become uncompetitive. The alarming aspect, for those who would like some elements of German corporate culture to survive, is that there is no alternative for the time being. There is no process of renewal whereby companies whose management becomes fossilised are replaced locally by new risk-takers. Private-equity firms have sometimes been the only bidders when German companies, or divisions of them, have been up for sale.

In the past two years private-equity firms have often sold their German investments to other private-equity funds - so-called secondary sales - for want of other buyers. The usual option of an initial public offering is rarely available. Burned by the stockmarket bubble of the late 1990s, German investors are mostly not buying equities these days. It seems that trade buyers - companies in the same or a related industry as the target - have also temporarily lost the risk appetite or the financial fire-power to compete.

In a parallel development, foreign buyers are frequently the only bidders for portfolios of non-performing loans that undercapitalised German banks have been keen to sell. It is a simple game of buying the loans at a deep discount and then collecting the collateral pledged against them, but few German banks have had the nerve or the spare cash to play it. Fortress, Lone Star, and Goldman Sachs have been among the buyers. Only Dresdner Bank, among those stricken with bad loans, had the resources to create its own loan-restructuring unit.

Bidding for Germany

Private-equity firms have funds behind them and the skill to leverage a company that they have bought (that is, to load it up with debt) and to achieve a quick return on the capital they have committed. But it is pointless to blame them for taking the opportunity, even though it may cost jobs inside Germany, or for repatriating their profits. The only intelligent response is to reverse the trend by outbidding the foreigner. That happened recently when Siemens, Germany's giant electronics and engineering group, fought off two rival private-equity bidders to buy Flender Holding, a maker of gears for industrial engines. More often, however, there is little or no competition.

The mistake made by Mr Müntefering and his supporters is to believe that the government can do much more than cheer, or jeer, from the touchline. As a stop-gap measure the government plans to lower the corporate tax rate, in a bill to be presented this week, from 25% to 19%, to give companies more incentive to create jobs at home rather than abroad. But that is clearly a response to the flat-tax alternatives that are on offer in central Europe.

And it will take more than that. What appears to be missing, except among Germany's cadre of internationally minded companies, is a combination of entrepreneurship and a willingness to take risk. Companies buying back shares, rather than investing in expansion, in an environment in which younger entrepreneurs are few and far between, offer a sign that domestic entities are running out of ideas.

The government is right to be concentrating on education and innovation to foster new business. But that is a long-term programme that cannot address today's crisis. Germany's misfortune is that its federal government cannot implement today what it thought of yesterday or even two years ago. Take the initiative to improve Germany as a financial centre. In 2003 plans were proudly unveiled to introduce alternative investments (hedge funds) to Germany; to kick-start a big programme of asset securitisation; and to introduce American-style real-estate investment trusts (REITS). None of these has happened, either because of legal obstacles or the fear of creating tax loopholes.

Even a tax amnesty, declared for German residents who have salted away an estimated €300 billion-500 billion ($390 billion-$640 billion) of their savings in Swiss bank accounts, Luxembourg funds and other tax havens, has garnered a mere €1.2 billion of extra tax. The poor showing was due partly to tax dodgers' fears that despite owning up they would still somehow be stigmatised. But the main reason is the poverty of investment alternatives in Germany.

For foreign investors, including hedge funds and private equity, the local apathy has been their opportunity. Mr Hohn of TCI believes that Deutsche Borse is far from being alone: shares of many other companies are trading at a discount because of the perception among investors that these companies are poorly governed. The prospect of better management coming in, or even just of bad management being thrown out, will raise their share prices. This is precisely what has happened in the case of Deutsche Borse: since Mr Hohn started making a fuss its share price has risen from €45 to €60.

The car industry provides two more opportunities of this kind: at DaimlerChrysler whose shareholders are disgruntled with Jurgen Schrempp, the carmaker's chief executive; and at Volkswagen, in which the state of Lower Saxony has 18% of the voting rights and two seats on the supervisory board, and voting rights are capped by law at 20% per shareholder. The sniff of a real change in the status quo would lift the share price in both cases.

Mr Müntefering, after his blunderbuss attack on “international capital”, has little to offer by way of remedy. He would like to see more companies comply with a requirement of the voluntary corporate-governance code, which is to disclose individual executives' salaries: ten of the 30 big firms in the DAX stockmarket index insist they will give only an aggregate figure for the board. But the entire dismantling of the old boy network would be more to the point, and there are no signs of that happening on the supervisory boards of Germany's big companies.

Mr Müntefering would also like to see incentives for firms to create jobs rather than just to maximise profits. That is being discussed in the aftermath of a “jobs summit” held by the government on March 17th. The population's fear of job losses increased sharply after ten more countries joined the EU a year ago. Workers feel threatened not only by the relocation or outsourcing of production by German companies to central Europe, but also by the influx of cheap labour at home. Some occupations such as farming and building are specially protected for the next six years, and the government last week proposed extending this buffer to more types of labour. The protection would set a de facto minimum wage for each occupation. But a minimum wage could be a two-edged sword. The success of the social-security reform, Hartz IV, depends on subsidising the unemployed to accept low-paid jobs (in some cases for one euro an hour) as a way back to work.

The government's deliberations over such social and economic engineering have been slow and inconclusive. Even if it does act boldly, it may have real difficulty in getting any radical proposal through the Bundesrat, the opposition-dominated upper house of parliament.

So the forecasts for German economic performance in the short term remain gloomy. The half-yearly assessment by Germany's six leading economic research institutes predicts a growth rate of only 0.7% of GDP in 2005, followed by 1.5% in 2006. The unemployment rate, which it puts at 11.1% this year, up from 10.2% in 2004, will sink to 10.4% in 2006, it says (but the Hartz IV reforms, which from this January merged benefits for the long-term unemployed with those on social security, make historical comparisons difficult). The subsidy of low-paid jobs, the report says, is actually frustrating efforts to increase job mobility and flexibility.

Pest controls

Perceptions that the reform programme, Agenda 2010, which the government has so far doggedly stuck to, may still not be producing results, are a drag on the SPD as it heads into the most crucial regional election before the general election due in the autumn of 2006. Hence Mr Müntefering's rallying cry and his selection of a scapegoat. Embarrassingly for him, his private hitlist of “locust” companies was discovered and published: it had Goldman Sachs, an American investment bank, at the top, followed by Deutsche Bank and a string of private-equity firms. Such apparent naivety has allowed the opposition, and conservative business leaders, a chance to rubbish Mr Müntefering and the rest of the ruling SPD. Edmund Stoiber, the prime minister of Bavaria, jeered sarcastically: “That kind of criticism means you would actually have to close the domestic market and erect national borders again.”

Norbert Walter, chief economist at Deutsche Bank, believes that Mr Müntefering has done enormous damage to his own party: there are no quick fixes, either to win the election or to solve Germany's economic problems. Mr Walter advocates patience while the Agenda 2010 reforms are given a chance to work.

In the meantime, international investors remain the prime moving force in Germany's drooping economy. They are forcing some change in a Germany which needs more of it, despite Mr Müntefering's efforts to put the clock back.

Some German politicians want to blame international business and finance, not themselves, for their country's sluggish economy.

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