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Gerhard Schröder looks remarkably at ease for a man who's just called a snap election at a time when his Social Democratic Party trails by as much as 18 percentage points in the polls. Leaning back in a leather chair in an office tower overlooking the fairgrounds in Hanover, the regional capital where as Governor he started his long march to the chancellery, Schröder glances affectionately at his step-daughter Klara who is waiting patiently for him to finish the morning's business, eager to get on with a pleasant spring morning out on the town. But Schröder's cool, collected appearance is deceiving. He's facing the fight of his political life.

On May 22, the Social Democrats (SPD) got thumped by the Christian Democratic Union (CDU) in regional polls in North Rhine–Westphalia, a state the SPD had held for the past 39 years. It was the latest defeat in a string of losses that has left the ruling SPD in control of just five of Germany's 16 states; six years ago it had 11. The upper house of parliament is controlled by the opposition CDU; Schröder's legislative program has ground to a halt; unemployment recently crested at a postwar high of 12%; the rate of business closures has reached record levels; and the SPD has hit its lowest approval ratings since World War II. Oh, and about 92% of Germans think the SPD will lose the election, likely to be held on Sept. 18. Was Schröder, as one pundit bluntly put it, "committing suicide to avoid murder?" "Do I look that way?" Schröder joked to Time, tanned and dapper in a sharp, sky-blue shirt and green tie. "Giving up is not one of the character traits associated with me. I am not someone who throws in the towel."

Fair enough; but Schröder is rolling the dice in a huge political gamble that could bring down his government — or just possibly save its skin. In a survey published last week by the polling agency Forsa, 45% of respondents said they would vote CDU. Schröder's SPD polled just 28%, 10 points below its result in the 2002 election. In North Rhine–Westphalia, SPD supporters did not just stay home, as many feared they would; they voted for the other side. The CDU jumped almost 8 points to 45%, while the SPD lost nearly 6 points to 37%, its worst showing in 50 years. "The North Rhine–Westphalia election was a catastrophe for the SPD," Wolfgang Schäuble, CDU foreign affairs spokesman and former party chairman, said to Time. "The [SPD-Green coalition] is no longer accepted by the population."

If Schröder is in a hole, Germany is in an even deeper one. The country is still burdened by the massive costs of reunification and beset by increased competition from Eastern Europe and Asia, an aging society and an overregulated labor market. After squeaking back into office in 2002 by a margin of just 8,864 votes, Schröder accelerated the pace of reform. He cut corporate taxes, eased entry for foreign workers and reformed the pension and health-care systems. Those moves may have been economically justified, but they enraged the SPD's traditionalist left wing. "Schröder pushed through the necessary reforms against his own party's soul," says Heinrich Oberreuter, director of the Academy for Political Education in Tutzing, south of Munich. "He recognized what was necessary, but the party as a whole did not." Will it ever? In the run-up to the election — and in its aftermath, whoever wins — the central question facing Germany will be whether enough people accept that the policies that made the country such a startling success for 50 years have run their course.

Unlike some in his party, Schröder knows that they have. "Germany is a country in which, for a very long time, there was sufficient room for redistributing wealth," he told Time. "This is no longer the case, for two reasons. First, globalization and the economic changes it has caused, and second, a long-term development that affects the aging of the German population." The crucial difference between the SPD and the CDU, he said, is that "the Social Democrats will always try to find a balance between economic effectiveness and social compassion. Driven by the liberal Free Democratic Party, the CDU can't do this to the same extent."

Schröder's future will depend on whether voters share that judgment. Merkel — who this week will be anointed as Schröder's challenger, making her Germany's first-ever female candidate for Chancellor — has said that her party would push even harder for reform. The 50-year-old former physicist from eastern Germany has advocated deregulating the labor market, curbing the unions and lowering income taxes. "Policies that create jobs are what is socially responsible," she said in an interview with Focus magazine. At the same time, however, Merkel said she would not promise specific tax cuts or make other expensive election pledges. Europe has succeeded in linking "economic performance with social justice," she said, but "we can't disregard the laws of the economy."

One of the ironies of the North Rhine–Westphalia vote — and of Schröder's predicament in general — is that while the public punishes the SPD for its economic reforms, they may be flocking to a party that has vowed to go even further. A CDU government would likely continue with the labor-market policies introduced by the SPD as well as move to weaken job-protection laws and union control over wages. "Schröder was elected because he told people that reform could be carried out without radical measures," Roland Koch, the CDU Governor of Hesse, told Time. "But today we must have the courage to introduce challenging measures that for some people are not very comfortable, but that will lead to economic growth and jobs. We have to make the labor market more flexible and make Germany attractive again as a place for companies to invest."

Can Merkel convince Germans that she's the person to breathe new life into their once shimmeringly successful economy? Born in Hamburg in 1954, she grew up the daughter of a Lutheran pastor, studied physics at Leipzig University, and later became a protégée of Helmut Kohl, CDU leader and Chancellor from 1982 to 1998. At first she was derided in the German press as "Kohl's little girl," but soon Merkel demonstrated an independent streak and a fierce ambition. When Kohl was implicated in a party-financing scandal in 1999, Merkel — then general secretary of the party — quickly penned an open letter advising him to resign as honorary party chairman. Merkel's move won her both friends and enemies, and bolstered her image as a tough decision maker. In 2004, she forced out three major rivals to maintain the party leadership, and then moved quickly to mop up the financing scandal and turn her attention to winning nine state elections in succession. "She has exceptional analytical talent," says Koch. "When she decides on a path, she sticks to it."

In the general-election campaign, Merkel will need all the determination she's got. As Germany's first female candidate for Chancellor, she will have to overcome gender stereotypes within her own party and within the country as a whole. The CDU, which draws its strongest support from conservative Catholics, has long advocated traditional family values. When Schröder's government passed legislation to help women pursue careers, the CDU argued in parliament that a woman must have the right to choose to stay home, warning against reverse discrimination of women who opt to raise families. Germany has never had a woman as Chancellor, Foreign Minister or Economy Minister. Of the top 30 blue-chip companies listed on the Frankfurt stock exchange, not one has a female ceo. The ascent of women to positions of power may be taken for granted in some northern European countries, but gender equality is only now being implemented in Germany. "It's hard for a conservative party with a strong southern German wing to get used to the idea of having a woman leader," says Everhard Holtmann, a political scientist at Martin Luther University in Halle in eastern Germany.

Nor has Merkel yet convinced the wider public of her fitness for high office. Her association with Kohl, who left power deeply unpopular, could come back to haunt her. She's never governed a state, which for most Germans is seen as a necessary prerequisite for national office. And many West Germans look down on her simply because she hails from the east. Where Schröder is smooth and urbane, Merkel is earnest and down to earth. Schröder likes to relax with a Cuban cigar; Merkel prefers a brisk walk. Though the CDU leads the SPD in polls, Merkel's personal ratings still trail Schröder's in some surveys. Schröder will no doubt exploit the charisma gap in the campaign. In 2002, he made up a 7-point deficit after serious floods threatened much of Germany. He donned rubber boots to trudge through the affected areas, and pledged immediate financial support for victims. His rival, Edmund Stoiber, hesitated and talked about the need for responsible spending.

Merkel — less flamboyant and more reserved than Schröder — may not match him in the black arts of political campaigning. But she has excellent contacts with the grassroots of her party. She also has a will to win. "She has great discipline, single-mindedness and focus on power," says Gerd Langguth, a political scientist at the University of Bonn who has written a biography of the CDU leader (see Viewpoint). "As a natural scientist, she approaches issues differently, more rationally and more in a disciplined way. She does not avoid decisions and debate." If she became Chancellor, her focus and excellent networking skills would help her maintain the internal party support she'll need to push through painful economic reforms.

Whoever wins in September, those reforms are coming. The issue facing Germany is whether people can be convinced that change will not come at the expense of their cherished tradition of social welfare. It's the same worry that propelled the no vote in France's referendum on the proposed European Union constitution. In France, Socialists like Henri Emmanuelli and Laurent Fabius see the constitution as an invitation to more liberal economic policies that would jeopardize workers' rights and protections. In Germany, Schröder's reform plan is the villain. Emmanuelli interpreted the SPD defeat in North Rhine–Westphalia as a "deep rejection of the social liberalism proposed by Schröder." According to Hüseyin Aydin, an executive member of Election Alternative Labor and Social Justice (WASG), a four-month-old, left-wing party founded by disgruntled SPD supporters, "Germany has to return to values like solidarity and social justice. To achieve that end, all anti-neoliberal forces have to cooperate." Indeed, last week Oskar Lafontaine, the former SPD party leader who served a brief, tempestuous stint as Schröder's Finance Minister, proposed a new party made up of WASG and the left-wing Party of Democratic Socialism. Germany's election laws will make it hard for Lafontaine to get the new group on the ballot in September.

It's an open question how much the old slogans of the left still resonate. In the run-up to the North Rhine–Westphalia vote, Social Democrat party leader Franz Müntefering found a target in "Anglo-Saxon" capitalist avatars such as Goldman Sachs, Blackstone and even Germany's own Deutsche Bank, accusing them of buying up companies, "stripping them clean and moving on." But for all Müntefering's rumblings, the SPD lost decisively, and Schröder himself doesn't use that kind of language. "Germany has to be open," he told Time. "As an export champion, we need other markets, and as a consequence we can't close our markets. Foreign capital is more than welcome in Germany. This discussion is really a question of the ethical and moral responsibility of business for the development of society. Of course, the business responsibility has priority. But does industry have social responsibility? Or can we only make the government responsible for providing the right answer to the challenges of globalization and the aging of society? It's about the social aspects of the social market economy and not attacking the market economy as a principle."

Schröder seems determined to stick to that line; at a contentious meeting of the SPD leadership last week in Berlin, he said he would stand again as Chancellor only if the party continued with its reforms. But the party is still divided. At the Berlin meeting, Economy Minister Wolfgang Clement was attacked by reform opponents for refusing to extend the length of time the elderly can receive unemployment benefits. Müntefering didn't repeat the inflammatory rhetoric of the past few weeks, but it was clear that the excesses of the market would feature in the SPD campaign.

So here's Germany's irony as it prepares for an election campaign in which both main candidates accept the need for economic and social change. Merkel is trusted by her party, but not — or at least, not yet — by the country; Schröder is still broadly trusted by the country, but not entirely by his own party. If Schröder is to keep the SPD in power, he must convince the party that his vision for the future is the only one possible. He then must convince the country that he's the only one capable of taking it forward. Either one will be tough to pull off, but then they don't call Schröder a gambler for nothing.

• ANDREW PURVIS / Berlin
• Inside Schröder's gambit to defeat opposition leader Angela Merkel