For all its stolid reputation, Germany has become surprisingly flexible, says Brooke Unger (interviewed here). But it needs to keep working at it

ULM, like many German towns, is arrayed around a central church like an expectant congregation. Its Gothic spire is the tallest in the world. The city is also famous for being the birthplace of Albert Einstein. But Ulmers do not live in the past. They are too busy making things, or working out how to make them better, and dispatching them to the rest of the world. The family-owned Mittelstand firms that cluster in and around this modest town alongside the Danube river were among the prime beneficiaries of Germany's export boom, the main source of growth until the world economy slumped in late 2008.

That disaster has not shaken Ulm's self-confidence. Since the financial crisis Germany's economy has shrunk more than most, by around 5% in 2009 (see chart 1). That of Baden-Württemberg, Ulm's home state, dived by as much as 8%. But the region around Ulm itself held up better than the rest of the state because its economy is diversified, reckons Otto Sälzle, managing director of the region's chamber of industry and commerce. Some local firms are in hard-hit industries like cars and machine tools but many are not: Ulm also makes pharmaceuticals and James Bond's favourite firearm, the Walther PPK. The region's unemployment rate rose from 3.3% to 4.6%, still well below the national rate. “We are the strongest region in Germany,” crows Mr Sälzle.

Feistiness is an all-German trait these days, bolstered rather than subdued by the crisis. Although Germany's economy has plunged, its unemployment rate has so far barely budged, a “German miracle”, economists proclaim (see chart 2). As the global economy recovers, Germany's will do better than the rest by selling cars, chemicals and capital goods to markets such as China, India and Brazil. “Germany is still outfitter to the world,” says Bert Rürup, a former head of the government's council of economic “wise men”.

The crisis seemed to discredit the “Anglo-Saxon model” of growth based on financial wizardry and property bubbles—and vindicate the German one, in which workers co-operate with bosses, managers invest for the long term and manufacturing holds pride of place over services. The chancellor, Angela Merkel, is promoting a “charter for international economic management” based on Germany's “social-market” principles. Crisis-prone members of the euro zone could cure their woes by becoming more like Germany, many Germans think. Its hottest export could be the German model itself.

Repeat after me

Germany does have some important lessons to teach the world, as this special report will explain. But the idea that Germany has got everything worked out requires some big qualifications. It has an ageing population, a growing share of which is either of non-German origin or poorly educated, or both. And Germany's towering export surpluses are at risk because its trading partners cannot sustain deficits for ever. Strikingly, too, the German model is no longer all that German. Over the past decade the country has rewritten its recipe for success, incorporating many foreign ingredients, including some from the much-maligned Anglo-Saxons.

Ulm shows that a springy economy makes the challenges easier to tackle but does not remove them. People with a “migration background”—immigrants, their children and grandchildren (including ethnic Germans who arrived after the fall of the Berlin Wall)—account for 37% of the city's 116,000 inhabitants and a majority of its children under ten. Those who came as “guest workers” in the 1950s and 1960s quickly adopted Swabian habits of thrift and hard work, says Ulm's mayor, Ivo Gönner, but “the kids have problems.” Many are unsure where they belong; some have not mastered German.

Ulm and Neu Ulm, its Bavarian sibling across the river, became briefly notorious in 2007 when police captured would-be terrorists who were on the verge of blowing up American installations in Germany. Two of the suspects, one a convert to Islam, belonged to radical outfits in the twin towns. These have nothing to do with the established immigrant community, Mr Gönner insists. But foreigners are often associated with the threat of terrorism.

A bigger worry is what will happen as ageing Swabians retire. By 2025 a quarter of the workforce will be older than 55, compared with 15% now, and the number of school-leavers will shrink by a third. Within ten years the region will be short of 60,000 workers, 7,500 of them engineers, the soul of the Mittelstand. Mr Sälzle wonders whether the next generation is ready to step in. “We've imported the educational problems of Turkey and Italy,” he says. Integrating young immigrants into the workforce is the “biggest challenge by far”.

Much therefore depends on how gracefully Germany becomes greyer and browner. Other countries have even fewer babies, but none “has such long-term experience in low fertility”, notes Reiner Klingholz of the Berlin Institute for Population and Development. The number of children per woman dropped below the replacement rate of 2.1 in the 1970s. The women born then in relatively small numbers are in turn having small families. Until 2002 Germany let in enough immigrants to stave off demographic decline, but the influx has slowed. In 2008, for the first time in a quarter-century, more people left the country than came in.

The newcomers are not as well educated as the native Germans, but they have more babies. Ulm is not unusual. In some towns in the Ruhr region the share of under-fives with migrant backgrounds tops 60%. Overall, they account for a third of the youngest children. By mid-century half the population will have non-German origins, says Klaus Bade, head of the Expert Council for Integration and Migration in Berlin.

By then Germany will be a different sort of place. It will have 8m-14m fewer people than it does now, and perhaps a smaller population than Britain and France. If Turkey joins the European Union Germany could be pushed into fourth place, the spot Italy occupies now. Germany's economy will shrink relative to that of its neighbours. If it is not careful, so will its living standards. It will have more pensioners and fewer workers. One possible future is that it will become less innovative and less productive, and indeed less German in ways it would not welcome. But that is not inevitable.

The great thaw

Germany strikes people as being set in its ways. Revolutions, whether of the Thatcherite sort in Britain or the spasms of discontent in France, hold little appeal. From history's convulsions Germany has learnt to prize a quiet life. The fall of the Berlin Wall in 1989 and unification a year later was excitement enough for a while. Change, if it must happen, is painstakingly negotiated by everyone concerned, from political parties to the governments of the 16 Länder (states) to the “social partners” (trade unions and employers' representatives).

Yet the country has spent the past decade smashing its own taboos. In 1999 it sent its armed forces into battle for the first time since the second world war as part of a NATO operation to protect Kosovo from Yugoslavia. In the same year Germany reluctantly surrendered the D-mark, an anchor of its post-war identity, in favour of the euro, with notes and coins appearing in 2002. In 2000 the government changed the definition of what it is to be German, which had been based on bloodlines since imperial days, by giving non-ethnic Germans born in the country a right to citizenship. Meanwhile “Deutschland AG”, the clannish system of cross-shareholdings among banks and enterprises, was killed off by Anglo-Saxon notions, and no one wants it back. That brought “more shareholder democracy into the real economy”, says Frank Mattern, who heads the German operation of McKinsey, a consultancy.

More contentious than all of these was a series of economic reforms prompted by stubbornly high unemployment and intimations of demographic decline. Agenda 2010, the handiwork of a left-wing coalition of Social Democrats and Greens in 1998-2005 led by Gerhard Schröder, tried to tackle many of Germany's economic maladies. It made joblessness more painful but provided more support for jobseekers. That, along with buoyant world trade, seemed to help. Unemployment dropped from 5m in 2005 to 3m in 2008; in the last two years of the upswing long-term unemployment fell by 40%.

But Agenda 2010 both symbolised and contributed to changes in economic and social relations that Germans find unsettling. New forms of work and welfare spread: “mini-jobs”, temporary employment and, most menacingly, Hartz IV, the handout that awaits anyone who does not find a job quickly. Workers in western Germany were already scrambling to compete with more flexible eastern Germans and cheap labour on Germany's doorstep in central Europe, and Agenda 2010 increased the pressure. This did wonders for competitiveness, sharpening Germany's dependence on exports, but wages stagnated and the middle class shrank even as high-income earners enjoyed a tax cut. Germany's income distribution was fast becoming less equal.

Punishing the messenger

In the 2005 election voters evicted Mr Schröder from power and demoted his Social Democratic Party (SPD) to second fiddle in a grand coalition led by Mrs Merkel's conservative Christian Democratic Union (CDU). Disgruntlement with Mr Schröder's reforms fuelled the rise of the ex-communist Left Party, largely at the SPD's expense. Mrs Merkel proved to be more social democratic than her combative predecessor. She avoided giving offence, sought consensus, inched reform forward when she could and back when she thought she had to. In last September's elections she was rewarded with a victory that allowed her to boot out the SPD from her government and form a more coherent, supposedly more reform-minded coalition with her preferred partner, the liberal Free Democratic Party (FDP).

Germany may not need another abrupt shake-up. It no longer suffers from an arthritic labour market, an obese state or a suffocating tax burden. As the labour force shrinks, the number of jobs is likely to become less of a worry than the number and quality of people available to fill them. But this special report will show that plenty of problems remain to be solved. Between 2000 and 2009 the share of Germans who considered society unfair jumped from 54% to 71%. The state is better at supporting idle citizens than preparing them for today's world of work. Social welfare is not yet ready for the coming demographic storm. The economic recovery is still shaky and, if it lasts, will be followed by years of fiscal belt-tightening. Unless export surpluses keep rising, Germany will need to find new sources of growth. Mrs Merkel's job is not to haul Germany out of a ditch but to retune the engines of its success—in some ways a harder task.