Why Germany Can't Restart The Engine

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You know a politician's world is getting grim when he starts telling voters about the need to "sacrifice." Last week Chancellor Gerhard Schröder did just that, saying, in a paraphrase of John F. Kennedy, "Let's stop asking ourselves what doesn't work; let's ask what each and everyone of us can do to make it work." Scarcely a month after he won a wafer-thin re-election victory on promises of no new taxes, Schröder is under fire for trying to solve Germany's economic woes through a series of planned tax hikes and spending cuts, expected to save the government €14 billion in next year's budget. Consumers will pay higher fees on everything from visits to the dentist to overseas airplane tickets, while businesses will see their tax bills rise, too. Germans are now so upset with Schröder that if the election were held today, polls show the Chancellor's coalition of Social Democrats and Greens would be handily beaten by the conservative opposition.

Long regarded as the locomotive of European industry, Germany has recently been behaving more like the caboose. If the Germans can't turn their economy around soon, it risks going the way of Japan, which has suffered a decade-long slide into high unemployment and deflation. Since Germany's industry is closely tied to exports within the euro zone, the faltering economy threatens recovery in other E.U. states like France and Italy. "Deflation is coming into the system and that's what happened in Japan," says Gustav Horn, an economist with the German Institute of Economic Research. "I'm afraid this could start in Germany too next year."

This gloomy outlook was underlined when six economic think tanks issued a joint report slashing in half the growth estimates they made only six months ago. According to consensus figures, growth this year will be a dismal .4% while the forecast for 2003 is an anemic 1.4% (the government estimated growth at .5% and 1.5% for 2003). Even those pessimistic figures were too high for some economists, including Horn, who reckoned next year's growth at only .9%. To top it all off, Finance Minister Hans Eichel acknowledged that Germany would probably breach the rules of the European Union's Stability and Growth Pact this year by running a deficit of more than 3% of gdp — a humiliation for the country that insisted on the 3% ceiling in the first place.

The opposition is making the most of Schröder's woes. Angela Merkel, the head of the Christian Democratic Union, called the tax increases "the biggest deception of voters in post-war history." Guido Westerwelle, head of the Free Democratic Party, accused Schröder of breaking election promises not to raise taxes. For the Chancellor, "renewal means new taxes and new debts," Westerwelle said. "Justice means that everyone has a chance to be unemployed."

Schröder portrayed his budget plans as "balanced overall," arguing that the savings and cuts agreed by his coalition "are only serving the aim of winning new leeway for future investments, growth and employment." He told parliament that some aspects of the welfare state were no longer defensible, but didn't detail planned reforms.

Schröder said he was giving the highest priority to reducing unemployment, which now stands at 9.5% and 17.2% in the economic backwaters of the former East Germany. Wolfgang Clement, who was appointed to a new "superministry" combining economics and labor, said "Initiatives will be rewarded, passivity is no longer acceptable."

Clement said he plans to get the unemployed off the dole and back into the economy. Well, he'd better do it soon. In the first six months of this year tax revenue fell by 4.3% while government spending increased by 4.2%, partly because of the benefits paid to those recently made jobless. "Germany seems caught up in a vicious circle of low employment, which leads to higher claims on the welfare state, which raises wage costs, which leads to higher unemployment," says Dirk Schumacher, German economist at Goldman Sachs in Frankfurt.


Why can't Germany get its financial house in order? A study by the European Union issued in May says that the growth rate in Germany averaged just 1.6% between 1995 and 2001, a full percentage point behind its euro-zone partners. The report adds that despite a massive €700 billion investment in the new states of eastern Germany, the long-term effects of reunification, particularly in the construction industry, have sapped employment. "When in the mid-1990s infrastructure investment leveled off and fiscal incentives were reduced, construction investment in the new states imploded, imparting very negative contributions to growth ever since," the report states. In addition, the higher taxes needed to finance spending in the east are curbing consumption across the country.

Another factor damaging the economy is the drastic sell-off in the stock market. The main dax index of stocks has declined from a high of 8065 in March, 2000 to around 3170 today — a fall of 60%, higher than losses in the U.S. or British markets. The high-tech Neuer Markt has effectively evaporated, suffering a 95% drop from its all-time high in March, 2000, and is slated to close down next year. Economists believe the fall in Germany's "wealth effect," the sense of well-being created by the long-gone bull markets, has hit spending much harder than declines elsewhere. In the U.S. and Britain, consumers still have gains from a real-estate boom, while Germany's renters don't have property profits to fall back on.

Also hurting the construction business is a planned phase-out of a so-called private home bonus that the government used to pump billions of euros into the single family home market. Buyers of new homes had been entitled to yearly payments of €2,556 to help finance their homes. "This is the final blow," said Michael Knipper, head of the Building Industry Association.

Higher social benefits costs are also causing Germans to grumble. Contributions for state pensions will rise .4% to 19.5% of salary next year. At the same time, state health insurance premiums are slated to rise from 14% to 15%. Unofficial estimates suggest that a couple with one child who earn €5,400 a month would pay an extra €402 per month next year under the suggested changes. Dieter Hundt, president of the employers' association, called Schröder's budget plans a "slap in the face" to the economy. "Reforms are not tackled," Hundt said. "Instead, the burden on companies and employees is increased further."

It will be hard finding a way out of this morass. Rather than take the medicine prescribed by leading economists — labor market reform — Clement has disparaged their advice. "They don't know what they are talking about," he said last week. He reportedly plans to alter German employment statistics to conform with European standards, which will show that Germany is not so badly off. But the economy's problems are too deep to be solved by statistical fudges. If the government wants to tackle unemployment, it will have to make painful reforms. Perhaps Schröder is the one who really needs to make a sacrifice.