Germany: Off the Rails?

Its stalled reforms are slowing growth

About a year ago, German Finance Minister Hans Eichel appeared at the Frankfurt stock exchange and made a brash prediction: Europe, he declared, was poised to supplant a flagging U.S. as the motor of global prosperity. As if on cue, German growth zoomed to 4.4% in the first half of 2000, the best performance in a decade.

But the party didn't last long. Growth dived to just 1% in the second half, and now economists are frantically scaling back their forecasts for 2001. While Eichel still insists that growth will hit at least 2.6%, a growing number of private economists think Germany will be lucky to top 2% as slower growth in the rest of the world hurts exports.

Instead of powering a European economic revival that would put the U.S. to shame, Germany is expected to hold growth among euro countries this year to 2.5%, after 3.4% in 2000. "Both the German and European economies will slow down more than the consensus is forecasting," says Morgan Stanley Dean Witter economist Joachim Fels. He predicts German growth of 1.8% in 2001 and European growth of 2.25%.

If this scenario seems depressingly familiar, it's no wonder. Since its last recession ended a decade ago, the German economy has struggled to get out of first gear. Growth averaged a mediocre 1.4% in the 1990s. Economists, business people, and politicians always figured the sorry performance was just a temporary product of West Germany's costly and poorly handled reunification with the ex-Communist East.

But what if they're wrong? No one's predicting recession. Yet lately there has been a barrage of worrying economic indicators, including nine straight months of sinking business confidence, an uptick in unemployment, and a puzzling collapse in auto sales. The fact is, no one really knows how bad things could get. "We don't fully understand what's happening in Germany," admits Louis Schweitzer, CEO of French auto maker Renault. "Are they more exposed to the U.S. than we thought?"

WARNING. Schweitzer's concern is understandable: Renault's German car sales plunged 20% in the first two months of 2001. That's bad news for the French economy. New data released on Mar. 21 prompted the French Finance Ministry to lower its 2001 growth projections from 3.3% to 2.9%.

It may be bad news for all of Europe, too. Ireland, Finland, and Spain may be humming, but Germany's 82 million people account for a third of gross domestic product among euro countries. It's the biggest market in the European Union, whose members depend on one another for most of their trade. No lasting regional boom is possible without German help.

So what's holding Germany back? If you're an optimist, its slower growth is a temporary effect of economic malaise in the U.S., Japan, and other world markets. When those economies recover, Germany will boogie again.

There's something to the argument. More than its European partners, Germany still depends heavily on overseas exports of industrial products such as cars and machine tools. Meanwhile, companies such as DaimlerChrysler, Siemens, and software maker SAP have built or bought major operations in North America. A slowdown there threatens the corporate bottom line. Steel- and auto-parts maker ThyssenKrupp warned on Mar. 2 that 2001 profits are expected to decline largely because of a U.S. slowdown. "The only risk is North America," says Stephan Kessel, CEO of Hanover-based Continental, which saw flat tire sales in the U.S. last year.

To a pessimist, though, the problems go deeper. They relate to Germany's persistent welfare state, its coddled workers, maybe even its risk-averse culture. A year ago, German businesspeople were applauding Chancellor Gerhard Schröder for cutting taxes and trimming the budget deficit. Now, they're angry at concessions Social Democrat Schröder has made to organized labor, such as a law passed this year that expands worker power to influence corporate policy. Yet the workforce needs to be more flexible, not less. Thousands of workers lack skills needed in a modern economy. German companies must import information-technology specialists from India and Bulgaria. There aren't enough retraining programs for older people--and not enough incentives for people to change.

CEOs fear business-friendly reform has come to a standstill as politicians gear up for national elections next year. "Despite all the reforms, tax and social-security laws are too complicated, and the burden is too high," complains Martin Ebeling, a member of the board of management of Graphit Krophmuhl, a maker of specialty graphite and silicon for products such as auto brakes.

There's even fear that, deep in their hearts, the majority of Germans don't really want U.S.-style fast growth. They prefer stability to booms punctuated by scary downturns. So far, economic reform has fallen flat as an election theme. For example, the business-friendly Free Democratic Party tried to win votes in Frankfurt municipal elections by calling for longer shopping hours--good for consumers, but hard on workers and small shopkeepers. The Free Democrats managed only 4.5% of the vote. "We can be happy with growth of 2.5% or 3%," says Werner Schulz, a member of parliament who speaks for the Green Party on economic issues. "A hire-and-fire system would create social strife here." That kind of attitude helps explain why Schröder isn't pushing further change.

The problem is that only sustained growth of at least 3% can continue to cut unemployment, economists say. Last year, Germany created 550,000 jobs and pushed the unemployment rate down to 9.3%. That compared with 12.6% in 1998. The gain was impressive, but more is needed to get the hard-core unemployed into the workforce. One worrying sign: Unemployment rose in January as the construction industry laid off more workers, especially in the East. Sages at the German Bundesbank dismissed the uptick as a one-off seasonal effect. But it was hardly a sign of a roaring job machine.

TECH TAKEOFF? This situation may not be as bad as it seems. Income-tax cuts will put an extra $14 billion in consumers' wallets this year. And Chancellor Schröder may push forward with more pro-business reforms once his re-election seems assured. Meanwhile, the next phase of the technological revolution could favor Europe. "Companies are spending money on making their processes more efficient," says Geoff Unwin, CEO of Cap Gemini Ernst & Young in Paris, Europe's biggest information-technology-services company.

That's the positive view. But there are land mines ahead. Resurgent labor unions are looking for payback after keeping wage hikes in bounds for several years. "This is the major danger," says Munich-based management consultant Roland Berger. He and others worry that the European Central Bank, anxious to establish its inflation-fighting credentials, will cut interest rates too slowly. Consumer confidence, solid so far, could wobble if the U.S. economy gets worse. Some tough months lie ahead--for Germany, and for the entire Continent.

By Jack Ewing in Frankfurt, with Christine Tierney in Frankfurt, and Carol Matlack in Paris

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