The biggest economy in the euro area, Germany’s, is in a bad way. And its ills are a main cause of the euro’s own weakness

THE social-market economy devised in Germany after the second world war, with its careful blend of market capitalism, strong labour protection and a generous welfare state, served the country well for several decades. But it is now coming under pressure as never before. As economic growth stalls yet again, the country is being branded the sick man (or even the Japan) of Europe. This is inevitably casting a cloud over Europe's single currency, the euro, for Germany accounts for a full third of the euro countries' output. When Germany sneezes, its neighbours feel a chill—and nervous markets are likely to sell the euro. Thus the biggest economic problem for Europe today is how to revive the German economy.

The numbers certainly tell a bleak story. German GDP shrank by 0.2% in the fourth quarter of 1998, against growth of 0.5% for the rest of the euro area. The figures for the first quarter of this year, which will be published next week, are not expected to provide much cheer. A few forecasters—albeit in the minority—think that the economy may have shrunk for a second quarter in a row, which would put Germany technically in recession. Any growth that is recorded is sure to be small. The government has scaled down its forecast of GDP growth for this year to 1.5%. Even that may be optimistic; several private-sector economists' forecasts go as low as 1%.

Next year may bring better news, as exports at last pick up again, helped by the weaker euro. But few expect a stellar performance. Rather, Germany seems likely to persist with more of the sub-par growth that has characterised its economy in recent years. On average, indeed, German growth has lagged that of the rest of the euro-11 countries by almost one percentage point a year since 1995.

German consumers have remained surprisingly resilient amid this overall gloom. Not so its companies. They are still reeling from a showdown over tax with the pugnacious former finance minister, Oskar Lafontaine. The latest survey of business conditions shows that businessmen are at their gloomiest since mid-1996 about the current business climate, although there are signs that they expect things to improve slightly later this year. The red-green coalition government led by Gerhard Schröder since last October has “encouraged the suspicions of a corporate sector predisposed to fear the worst,” says Alison Cottrell, chief international economist at PaineWebber in London. The dark picture painted by Hans Eichel, Mr Lafontaine's replacement, to justify fiscal belt-tightening has further unsettled industrial bosses. And a lack of corporate confidence has been one of the main factors that has kept unemployment so high.

Mr Schröder came to power with job creation at the top of his agenda, but the new government has so far noticeably failed to get people back to work. Unemployment remains stubbornly high at 4m, or 10.7% of the workforce, seasonally adjusted. This may be lower than in, say, France, but it is nevertheless embarrassing in a country that still likes to think of itself as an economic powerhouse. So is the fact that new jobs are not being created anywhere near as fast as in other, comparable countries.

Germany can hardly claim that its malaise is a rich-world commonplace. The American economy is still booming, for now. Closer to home, Italy may be in a pretty bad state, but France and several smaller European countries are growing quite comfortably. In the early 1990s, France struggled while the Germans enjoyed a short-lived post-unification boom. Since 1997 the opposite has been true.

Some of the blame for this can be laid at the door of a tight macroeconomic policy. For much of the 1990s, the Bundesbank kept interest rates high in response to pressures from German unification and from an expansion in the budget deficit. In the run-up to the euro's launch, German monetary policy was constrained by the need for most European countries to converge on a single euro-wide interest rate; and fiscal policy has been kept in check by the need to comply with the single-currency countries' “growth and stability pact”. These constraints still bind: left to itself, Germany might respond to its latest bout of weakness with lower interest rates and a bigger budget deficit, but it no longer has these options.

Germany's weakness has, indeed, come at an especially awkward time for the euro. The new currency's almost uninterrupted slide against the dollar since its introduction in January owes much to gloom over the German economy. The country's exporters may be breathing a sigh of relief after repeated bouts of D-mark appreciation in the 1990s, but central bankers are not amused. This week, Otmar Issing, the European Central Bank's chief economist, who was formerly in the same position at the German Bundesbank, pinned much of the blame for the sagging euro on German policymakers, who have failed to tackle their overly generous welfare net. The ECB's president, Wim Duisenberg, has said that Germany's problems are not cyclical but the result of too little basic reform to social security, the labour market and so on. Mr Duisenberg also said this week that he was inclined to “play down” the short-term fall in the euro.

Shocks and spanners

Some argue that Germany's ugly recent statistics can be blamed as much on a series of one-off shocks as on the economy's structural faults. Once these have passed, the optimists go on to argue, growth should start to take off again.

The first and biggest shock was the unification of East and West Germany in 1990. This was always going to hit the much bigger and richer western part of the country hard, especially after the less productive easterners won over-generous wage rises. Much of the early, tax-driven investment in the east went, in effect, down a black hole. The pain continues. The level of subsidy to the east, which accounts for roughly 5% of overall German GDP, has barely fallen since 1990. The rejoining of Germany led to a series of mini-booms and busts, exacerbated by further wage rises at the first hint of recovery and a sharp appreciation of the D-mark, which stung exporters.

A second spanner in the works was the economic crisis in emerging markets. Germany sends more of its GDP abroad than any other big European country (around 30%), with roughly a quarter of that going to emerging economies—and so has suffered more than most. The collapse of Asian markets hit basic producer goods especially hard; along with capital goods, these make up as much as four-fifths of Germany's exports. Many German exports, such as chemicals and aluminium, were already suffering from global overcapacity before the crisis hit Thailand in mid-1997. The meltdown in Russia, formerly another big export market, has not helped either. It is striking how far Germany's share of world exports has fallen since the early 1990s.

Nor did last year's interest-rate convergence in the run-up to monetary union do much to bolster Germany. As interest rates in other euro-area countries fell towards German levels, their economies received a boost that has increased the gap between their performance and Germany's. The slowdown in Britain, which is one of Germany's biggest export markets, has made matters worse as well.

Yet much as these temporary problems may have hurt the German economy, they are not the root cause of its ills. Nor would it be fair to lay the blame entirely on macroeconomic mistakes in the 1990s. In the longer run, the main factors tugging down German (and indeed European) economic performance do indeed remain structural and microeconomic: a byzantine and inefficient tax system, a bloated welfare system and excessive labour costs.

The tax issue has already come to the fore in Germany in the recent showdown between business and government. Mr Lafontaine infuriated company bosses by threatening to close some DM7 billion-worth ($3.7 billion) of tax loopholes, without shaving much off corporate tax rates, which run as high as 60%. Some of the biggest insurers and utilities even threatened to move their headquarters abroad unless the government made firm promises to lower their tax bills.

Businessmen have been equally incensed by the government's treatment of fringe workers. Low-paid, part-time jobs (so-called “DM630 jobs”) have long been exempt from tax and social-security contributions. Many economists think that the government's plans to end this exemption, drawn up by the labour minister, Walter Riester, will destroy many of the 6m such jobs, just when the government should be encouraging workplace flexibility. The German Chamber of Commerce reckons that over 500,000 jobs may be at risk. Some service industries, such as cleaning and catering, fear losing up to a fifth of their workers.

Yet another planned reform, to raise the levy on small consultancies and their clients, is equally controversial. Businessmen complain that it will discourage the formation of innovative new companies. Such is the opposition to these measures—from employers, workers and some regional governments—that they may yet have to be scrapped or amended.

The appointment of the business-friendly Mr Eichel has calmed some corporate nerves, not least because he has pledged to cut corporate taxes. But the fear lingers that the ruling Social Democrats remain bent on redistributing income at the expense of big business, which explains the continued sag in corporate confidence. This fear is hitting investment. “What we have is uncertainty. We are investing less in our German sites until we are sure which way things are going,” says Franz Nawratil, chairman of Hewlett-Packard's European operations.

Hire and fire

Another big reason not to invest is the cost of hiring and firing workers. Holger Schmieding, senior European economist at Merrill Lynch, thinks that Germany has got itself caught in a vicious circle. The welfare state is largely financed by payroll taxes, half of which are paid by employers and half by individual workers. As welfare costs have swollen, non-wage labour costs have shot up too, from 36% of gross wages in 1990 to a painful 42% last year. This encourages companies to shed workers, reducing payments into the welfare system while ratcheting up the benefits that must flow out.

Mr Schmieding thinks that Germany's high costs relative to what it produces help to explain why unemployment has risen from cycle to cycle since the 1960s. German workers may be productive, but not enough to justify costs that are running at 50% above levels in any other G7 country. Getting rid of workers is costly too. Severance pay is typically a month's salary per year worked, plus generous retirement pay-offs for older workers. “The jobs market doesn't really deserve to be called a market,” says one disgruntled company manager.

This has not, however, stopped many German companies from shedding workers by the thousand, at home and abroad, as they restructure in response to globalisation. This has created an irony: corporate Germany has gone from strength to strength even as the economy, beleaguered by high costs and rigidities, has faltered. Companies such as DaimlerChrysler and Hoechst have set the pace of change in their industries. Even sleeping giants such as Siemens are shaking themselves up.

Why has such industrial success not fed through to the economy at large? One answer is the way in which German firms have learnt to deal with their country's rigidities: by shifting operations abroad. Last year they invested some DM150 billion in other countries (by contrast, Germany attracted a mere DM35 billion in foreign direct investment). Many big companies now make more than half their profits abroad. But smaller firms that make up the backbone of Germany's famous Mittelstand have also been packing up and moving abroad, especially into lower-cost and more flexible countries to Germany's east. Some 20,000 such firms have invested in Central and Eastern Europe, largely to escape steep wage bills at home.

Thomas Mayer, an economist with Goldman Sachs, thinks that euro-area countries, and Germany in particular, are now stuck in what he calls a “restructuring trap”. Since Germany's last recession, in 1993, its companies have greatly increased their return on capital as they have shed unproductive workers and subsidiaries or moved to low-cost locations. The same thing happened a few years ago in America (and before that, in Britain). In both these countries, slimmed-down companies soon started to create new jobs. In Germany, however, firms have been reluctant to rehire because of the soaring non-wage costs of labour. “The framework is not there to encourage the replacement of jobs lost in restructuring,” Mr Mayer says. “It is only the enduring strength of the export sector that has stopped things getting really bad.”

Mr Mayer thinks that the eastern part of Germany, where economic growth is even lower than in the west, is in a different kind of trap. Political compromises have prevented the kind of creative destruction that might have led to robust growth. Instead, the east has become a “colony of pensioners”, consuming with the help of subsidies but not producing enough that others want. Large parts of the eastern economy have become so addicted to subsidies that he fears they may become a German version of Italy's poor south, the Mezzogiorno, whose economy depends on handouts from Rome and Brussels, and has been plagued by low growth.

In search of flexibility

To be sure, there are some rays of hope. The strength of opposition to the DM630-job changes shows how important part-time work has become to many Germans, often supplementing full-time work. “It has shown that there was more flexibility than many people realised,” says Ulrich Beckmann, an economist with Deutsche Bank.

Red tape is slowly being unravelled too. Yet Germany is still smothered in regulations that crimp markets. Many prices are still regulated, and consumers remain “protected” in bizarre ways: shops can be fined for discounting or making three-for-the-price-of-two offers if these are deemed to send confusing signals to consumers.

But other constraints are being lifted. Shopping hours are getting longer. In the eastern state of Saxony, for instance, high-street stores will soon be allowed to open on Sunday afternoons. Banks may soon be able to open on Saturdays. Progress will come only gradually, however. “We got 90 minutes extra shopping after a decade's debate, or nine minutes a year. Call it the German way,” sighs Ulrich Ramm, chief economist at Commerzbank.

There are also signs of new flexibility in the one-size-fits-all system of collective bargaining. The concept of Mitbestimmung—or seeking consensus between managers and workers—remains a powerful force, and worker representatives still have half the seats on firms' supervisory boards. But the number of wage deals being negotiated at company level, rather than regionally or nationally, has doubled since the early 1990s. Around 10% of the western workforce has wriggled out of old-style collective-bargaining arrangements; in the east the figure is over 50%. This has allowed many companies to adjust to their own market conditions.

Mr Beckmann argues that Germany's unions became more accommodating after seeing how hefty pay increases cut short economic recovery in 1995. They accepted three years of scant pay rises that have helped to reverse a previous rise in unit labour costs. The question now is whether they can maintain the restraint that economists reckon Germany needs to stay competitive.

The omens are bad. IG Metall, the largest union, recently won its 3m members a pay rise of roughly 3.5%, way above inflation, after its boss had called for “an end to modesty”. Commerzbank forecasts a 2.5% rise in unit labour costs this year and a smaller rise in 2000. The only silver lining is that the wage deals will boost flagging demand in the short term: real consumer spending should grow by 3% this year. Retailers are starting to emerge from the hole in which they have spent most of the past few years.

In any case, none of this cheer will last long unless Mr Schröder's government enacts some radical structural reforms. Slashing the top rates for corporate and income tax could bring substantial benefits at little cost. Germans would spend less time seeking tax shelters or ploughing money into tax-driven investments that make little sense—whether east German property or Asian shipping.

Many economists also argue that the state could actually make money out of a cut in capital-gains tax, as the current high rates discourage banks from selling industrial stakes they want to unload. The main barrier is politics: this government, like the last one, worries that such reforms will be unpopular if they are widely perceived as a handout for the rich at the expense of the average citizen.

The other big challenge for the government is to defuse Germany's welfare timebomb. That will necessitate cutting benefits and encouraging private provision for pensions and healthcare, as the workforce declines and the number of pensioners grows. This is the only way to bring down payroll taxes for good—and thus to reduce the tax on jobs—without running an ever widening budget deficit.

The government could also do the economy a favour by speeding up privatisation and further deregulating the underdeveloped services sector. The federal government has been slow to fulfil its sell-off pledges, while most of the regional states have clung to their banks and utilities—one reason that more than half of all German spending is done by the public sector. Putting state-owned companies on the block would bring extra money to cash-strapped budgets as well as improving efficiency. Deregulating services would have a similar effect. Professional services, such as legal and tax advice, are still highly cartelised: for instance, tax advisers agree a common price list through their guild, and may not undercut one another.

Unfortunately, progress in most of these areas is likely to be agonisingly slow—indeed, it could even go into reverse. The Schröder government has already backtracked on the efforts to cut pension entitlements that were made by its predecessor. Its Alliance for Jobs, a roundtable involving ministers, employers and unionists, has achieved little. Its health-care reforms have become bogged down by battles with various interest groups.

It is, perhaps, not surprising that market-friendly politicians, including one or two in the government, now complain of Germany being a blockierte Gesellschaft (blocked society). Unblocking it will take determination. Without that, Germany is unlikely soon to shed its title as the sick man of Europe. Germans must find it more galling since it was coined in the last century by the Russian tsar, Nicholas I, to describe Ottoman Turkey—a once dynamic polity that failed.