Germany’s surprising economy

The reviving health of a previously sick country

AT FIRST blush the news from Germany seems wearisomely familiar. In the second quarter, Europe's biggest economy tipped back to zero growth once more. Although unemployment is at long last starting to fall, the number out of work is still almost 5m, a shocking 11.6% of the workforce. Consumer spending seems stifled by lack of confidence in the future. And the centre-left government's plans for more reforms to the labour market, the welfare state, health care and the tax system were all put on hold in May, when Chancellor Gerhard Schroder called an early election for September - which, in another case of deja vu, he is trying to win, as he did in 2002, with the help of an attack on American hints of military intervention in the Middle East, this time in Iran rather than Iraq.

It all sounds depressingly like a rerun of the same old story. But behind it lurks another, altogether more hopeful one. Thanks to the intense pressure that they have been under in the past few years, Germany's big companies have restructured and cut their bloated cost base. This process has for once been helped by the trade unions, which had been a stubborn obstacle to change. German workers have belatedly recognised that change has become essential, which is why they have been ready over the past year or so to accept such innovations as more decentralised pay bargaining, longer hours and even wage cuts. Thanks in part to this new flexibility, unit labour costs, a benchmark of competitiveness, have fallen sharply relative to other countries. In the past five years, Germany, long the most costly place in Europe in which to do business, has won a new competitive edge over France, Italy, the Netherlands and even Britain. That is a big reason why, last year, it regained its position as the world's biggest exporter.

Given this corporate turnaround and strong export performance, it is not surprising that both profits and the stockmarket have been rising sharply. More significantly, recent surveys of business confidence have been encouraging. Consumers remain nervous, largely because they are still fretful about their jobs; but, with unemployment now starting to come down, consumer confidence looks set to revive too. This suggests that domestic demand, the weakest link in the German economy, may be poised for a rebound. Indeed, some forecasters are now predicting that Germany, which has for so many years disappointed on the downside, could be about to surprise on the upside (see pages )62-64.

Spreading its wings

The impact of such a turnaround would be felt far beyond Germany's borders. What happens in Germany is critical for the rest of Europe, and thus for the world economy too. There are many reasons why the continent's economic performance has been so lacklustre since the heady days almost six years ago, when it launched its single currency, the euro. But the near-stagnation of Germany, which accounts for nearly one-third of euro-area GDP, lies at the root of most of them. So long as its biggest economy is stuck in a rut, the euro area as a whole is bound to remain stuck too. Germany's ills have also cast a shadow over other neighbouring economies dependent on its market, such as those of central Europe.

That is also why the German election, scheduled for September 18th, matters, and not just in Germany. As it happens, despite Mr Schroder's recent invocation of Iran, there is little chance of its being a rerun of September 2002, when he came from behind to snatch a narrow victory. It is true that the election no longer looks a shoo-in for the centre-right under Angela Merkel, partly because she has shown herself unusually gaffe-prone, and partly because of the rise of a new Left Party in Germany ()see page 27. But the outcome is almost certainly not going to be another win for Mr Schroder's party: it will be either a clear victory for Ms Merkel, or a messy result in which her party emerges as the biggest, but is forced into a "grand coalition" with the centre-left.

On one level, the restructuring of corporate Germany and the glimmerings of a revival of business and consumer confidence should augur well for the economy whatever the election result. But on another, the commitment of the new government to further reforms will make a big difference. The politicians may not be able to control the economy, but they can certainly muck it up. A centre-right government under Ms Merkel would have the advantage that her party also controls the upper-house Bundesrat, making it far easier to push through legislative change. Conversely, if a grand coalition is assembled by politicians who see the election as confirmation of voters' resistance to change, the entire reform process could be shelved. That could quickly knock business confidence back, reverse the positive trend in unemployment and nip an incipient revival of consumer spending in the bud.

The new government needs to be careful about taxation as well. It is true that the outlook for Germany's public finances is dreadful, but any talk of higher taxes to fix the problem is decidedly premature. Corporate and income taxes need to be cut, not raised. The opposition's call for a two-point increase in value-added tax is dangerously reminiscent of the consumption tax imposed by the Japanese government in 1997, which set back an incipient recovery in the economy for several years (and thereby, incidentally, failed to improve the public finances). Tax increases are not what the German economy needs right now. A better idea would be to cut government subsidies, and to defer any indirect tax rises into the future, thereby both reassuring markets that a messy fiscal situation will be dealt with eventually and encouraging consumers to accelerate long-deferred spending plans.

The sickly German economy has been infecting the neighbourhood ever since the brief euphoria that followed unification in 1990 withered away within a few years. Indeed, Europe and the rest of the world have become so used to Germany's economic malaise that they have largely missed the recent signs of its revival, both in business and in the wider economy. The story from Germany is about to become surprisingly good - so long as the politicians do not foul it up after next month's election.

Editorial discusses the recovering health of the German economy