Quotes of the Day

There's a Gerhard Schröder joke making the rounds in Germany that perfectly captures the hapless Chancellor's predicament. Schröder tries to console an unemployed architect, telling him, "If I weren't Chancellor, I'd be building houses." The irate architect shoots back: "If you weren't Chancellor, I'd be building houses, too."

Barely two months after he won re-election by a wafer-thin margin, Schröder's handling of the country's sputtering economy has made him the most unpopular leader in postwar Germany. People feel betrayed and lied to by Schröder, because during the election he promised no new taxes, yet now proposes to raise taxes by j26 billion next year. The opposition Christian Democrats have demanded a parliamentary inquiry into whether Schröder committed election fraud by concealing an j14 billion deficit and not coming clean about the new taxes. Opinion polls show the popularity of Schröder's Social Democrats collapsing. They're supported by just 27% of voters, compared with 50% for the opposition, while a DIMAP opinion poll shows 80% of voters are unhappy with his handling of the economy. A song attacking his tax increases hit the top of the pop charts, and then a German Web designer urged Germans to protest by sending Schröder "the shirts off our backs" — and now 1,000 shirts a day are arriving at the chancellery in Berlin. Schröder complained in a television interview that he and his family had received personal threats in an unprecedented tide of hate mail.

And now it gets worse: a steady stream of Mittelstand companies — the small- and medium-sized firms that have been the backbone of the German economy for decades — are pulling up stakes and leaving the country. They're voting with their feet to escape Schröder, his taxes and the onerous labor laws that they say prevent them from competing in the world market.

Take the luxury leather-goods industry. As recently as 1990, the sector employed 45,000 skilled craftsmen turning out hand-tooled bags and wallets. The industry now employs only 22,000 workers as companies have moved jobs to cheaper locations overseas. Joining the exodus is Goldpfeil, one of Germany's iconic leather-goods brands, which announced last week that it is laying off 70 of its 200 artisans and moving production to subcontractors in the Czech Republic and China, where labor costs are only a fifth of those in Germany. Hans-Jörg Seeberger, ceo of EganaGoldpfeil Group, says Germany is no longer competitive — and blames Schröder. "Nobody can pay these wages anymore. The unions are too strong," he says. "There's a general feeling that Germany is going down the drain."

Schröder fought back last week in a debate in parliament over his budget, denying that he had misled voters. "This country still has growth and can still hold its head up high," he said. He was feisty — but didn't offer a new recovery plan. Opposition leader Angela Merkel ridiculed his lack of new ideas. "You give us the impression of a man with his back to the wall," Merkel said.

Schröder will have to do better if he wants to stem the tide of departing Mittelstand businesses. One place to start: a planned increase in employer pension and health-insurance contributions, due to take effect next year, that has many businessmen considering a move. A late November poll by an association of entrepreneurs found that 7.4% of the 300 companies surveyed had already decided to set up their production facilities abroad, while another 32% are "investigating" a transfer of their factories.

Tens of thousands of production jobs have already migrated from Germany to Central European countries like the Czech Republic, Hungary and Poland, making everything from light bulbs to high-end Audi automobiles. Last month, for example, German auto-parts maker Bosch said it would eliminate 830 jobs at its factory in Hildesheim, Germany, and move production to a new plant in Miskolc, Hungary. The move will reduce the workforce at the German factory by almost half.

Some executives are thinking about even more radical moves, such as transferring not just their production facilities but their entire companies. Hans Brach, who owns an air-conditioning company that employs 50 workers, says he is seriously considering moving his headquarters to Switzerland or the Czech Republic. "If conditions [in Germany] continue, we will end up in a state administered by socialist principles and the free market will be controlled by the state," says Brach, who has fought against a German law that requires him to set up a factory council that includes workers' representatives. "I don't want to have anyone interfering in my company," he says.

Brach's path out of Germany may be smoothed by a ruling in November by the European Court of Justice. The case involved a Dutch company owned by two Germans that was denied the right to sue in a German court because the firm was not registered in Germany. The court held that a company registered anywhere in the E.U. should receive equal treatment with local companies. Götz-Sebastian Hök, an attorney specializing in European law, says the ruling may cause companies to pick up and move to countries with the lowest taxes, like Ireland. "I think a lot of companies will think about going elsewhere," Hök says. "We will have a big competition for the best place for doing business in Europe." In an effort to head off the problem, Germany and a number of other E.U. countries have been trying to garner support for harmonization of corporate taxes. With a level tax, the theory goes, companies will have no incentive to move. But the lower-tax U.K opposes the idea.

If the trickle of companies leaving Germany does become a flood, that could prove disastrous to Schröder's political future. The government reported last week that unemployment had crossed the psychologically important 4 million barrier and stands at 9.7% of the workforce. The country's leading banks cut their growth forecast to .3% for 2002 and only 1% next year. Germany's state deficit is projected to be 3.75% of gdp, which breaches the limits in the European Stability and Growth Pact. The country is likely to exceed the 3% limit again next year.

One thing that infuriates voters is the knife-point targeting of the taxes being introduced by Schröder and his Finance Minister, Hans Eichel. Dog owners will get slapped with a tax of 16% on pet food; company cars will be hit with a 1.5% tax, leading the auto industry to predict 150,000 fewer cars will be sold next year. Air travelers were threatened with a 15% tax on frequent-flyer miles, prompting national airline Lufthansa to say it was considering moving its program overseas, which would eliminate 500 jobs. The government will impose a flat 15% tax on capital gains from the sales of shares and houses, boost gasoline taxes and offer fewer subsidies for new home construction (hence the architect joke). At the same time, unemployment benefits will be cut by j6 billion next year. "These policies will push a country already stagnating into recession," says Norbert Walter, chief economist of Deutsche Bank.

Support for Schröder's Social Democratic Party is so weak that the upper house of parliament, the Bundesrat, which is narrowly controlled by the opposition conservatives, voted against adopting the higher pension and health-insurance contributions as well as Schröder's much-maligned proposal to reform the labor market by turning unemployment offices into temporary job agencies. The labor reforms were suggested by an independent commission headed by Peter Hartz, the personnel chief at Volkswagen. But even Hartz has complained that his recommendations have been so watered down because of pressure from labor unions that they weren't likely to succeed. Following the defeat in the Bundesrat, the legislation was sent to a mediation committee where it was approved unchanged. It will be voted on again in the lower house, in which Schröder has an absolute majority.

Big business has been a vocal critic of Schröder ever since he started hinting that higher taxes are necessary. "We are on the wrong path," says Ulrich Schumacher, ceo of chip maker Infineon. "I do not know anyone who is not worried." Ludwig Georg Braun, president of the Association of Chambers of Commerce and Industry, attacked Schröder's reforms. "Emergency repairs are not enough to get the economy working again," Braun said. "The government must show willingness for comprehensive reforms that break Social Democratic taboos." Business has been particularly alarmed that sdp state governments are proposing the reintroduction of a wealth tax in a drive to balance their state budgets. Critics maintain that the estimated j350 billion that wealthy Germans have already hidden in bank accounts in tax havens like Switzerland would only grow if a wealth tax is introduced.

The opposition says it will press ahead with its plans for a special parliamentary investigation of whether Schröder lied to the voters about his tax plans. "Tax increases are economically unreasonable in the current situation and therefore we will not consider them," Schröder promised voters on July 26. A parliamentary inquiry only requires the support of 25% of the members of the Bundestag, so the investigation seems certain to go forward. The Social Democrats said they would demand a parallel investigation of election promises made by Schröder's defeated opponent, Edmund Stoiber.

Social Democratic operatives desperately hope the negative mood will dissipate before February, when state elections will be held in Lower Saxony and Hesse. If the Social Democrats lose Lower Saxony, it could make passage of legislation even harder. And with the government in gridlock, many more German entrepreneurs will be tempted to find new homes in lower-tax, business-friendly climates.

• CHARLES P. WALLACE/Berlin
• A faltering economy and Schröder's policies have companies fleeing Germany