Commentary: Why Germany's Economy Is Stalling Out

By Jack Ewing

German Chancellor Gerhard Schröder wants to close a chapter of his nation's history, when Germany played a limited role in foreign affairs. So in early November, Schröder publicly committed to sending 3,900 troops to help Washington's fight against terrorism. If these soldiers of the Bundeswehr do end up in service on the Afghan border, it would mark the first time German forces joined an offensive action since the final days of World War II.

The thought of German soldiers in action can still trigger a shiver. The stamp of Nazi boots, after all, echoes yet in the ears of the world. But Schröder is right to take this step. A former peace activist and the son of a Wehrmacht soldier who died in combat, he is trying to create a new epoch for Germany, where the nation's geopolitical strength matches its economic force. "It is a new phase," says Karsten D. Voigt, coordinator for German-American cooperation in the German Foreign Office. And it's time for that phase to begin. Virtually all German political and business leaders were either children during World War II or not even born: These are not warmongers. And as the biggest country in Europe, Germany should lead the way to a new era of statecraft.

And yet Schröder will commit a major blunder if he focuses on his diplomatic forays at the expense of the home front. In the same week Germany announced plans to field troops, some frightening economic statistics made the headlines. Factory orders in September had their steepest slide in six years, and the economy lost some 27,000 jobs in October--the biggest loss in almost three years.

Clearly, the downward turn in the business cycle is hitting Germany hard. But this is more than just a cyclical bout of bad news. The sad fact is that Schröder's own drive to reform the German economy has stalled. He has to revive reform fast--for the sake of Germany's 3.9 million unemployed and for the sake of Europe, which takes its cues from German policy. "Germany's essential," says Noël Goutard, chairman of the supervisory board of French auto-parts maker Valeo. "Europe can't prosper without Germany."

Finally, the success of Germany's new foreign policy depends on getting the economic formula right. Europe's ability to assert itself in the world depends on the outcome of its bold economic experiments, especially monetary union and its decision to expand the European Union to the east. Neither of those experiments will work if Germany steadily weakens.

Unfortunately, that's just what is happening. German economic growth, which hit 3% last year, is once again reverting to the subpar rates of the 1990s. If Europe goes into recession, as now looks likely, only Germany can lead it out. But Berlin's ability to lead is sadly diminished. "Germany used to be one of the growth motors of Europe," says Peter Müller, prime minister of the western state of Saarland and a member of the opposition Christian Democrats. "Now we're a brake."

Just a year ago, Schröder's pace of reform seemed right on target. He cut taxes, took the first steps towards mending the broken pension system, and encouraged the immigration of workers with needed skills. Critics said these steps were needed, though not bold enough. Schröder, however, seemed to promise more. And there was indeed a growth spurt.

But it didn't last. This year, growth will slip to 0.7%. Unemployment, at 9.5%, remains far ahead of the U.S. rate of 5.4%. The downward lurch shatters any idea that Germany can quickly recover the economic dynamism of the 1960s and 1970s.

Schröder should consider the grim news a call to action. Sure, he faces reelection next year and doesn't want to anger voters with unpopular spending cuts or tougher pension reforms. But he has left so much undone: loosening up the labor market, redesigning social welfare to get the long-term jobless off the dole, cutting red tape, slashing taxes further.

Those are longstanding tasks: The Chancellor should try thinking out of the box as well. As the economy slows dangerously, Schröder could reduce capital-gains levies for smaller companies to encourage them to restructure. He should push harder on some innovative ways to tweak the welfare system. One idea is to offer some unemployment payments for those who actually get minimum-wage jobs. It's a smart way to lure people back into the workforce, and it's time to do it. He could also exempt smaller companies from some of the more onerous provisions of German labor law.

GUNG-HO. And just as Schröder is using his statecraft on the world stage, he has to use considerable diplomacy to prod both his party stalwarts and the corporate Establishment to accept change. The left wing of his party is holding Schröder back: He has to spell out the political advantages of faster action.

And the Chancellor needs cooperation from Germany Inc., which has a lot to answer for. Industry associations are gung-ho for tax cuts and less regulation. But threaten their interests, and they clamor for protections as much as any line worker. Earlier this year, for example, German business torpedoed reforms that would have created Europewide takeover rules and made hostile bids easier to pull off. Schröder has also made it possible for banks and insurers to sell, tax-free, their huge stakes in industrial companies. That tax break, effective on Jan. 1, was supposed to trigger the restructuring of Corporate Germany. Instead, few sell-offs have been announced.

The irony is that ordinary Germans may be more willing to change than their leaders give them credit for. For example, 56% of Germans believe unemployment benefits are too generous, according to a poll by the Allensbacher Institute. "People voted for Schröder in the expectation that he would modernize the country," says pollster Manfred Güllner, CEO of the Forsa Institute in Berlin. Timid leaders, not reluctant citizens, are the biggest obstacle, he says.

Schröder should put aside his fears, harness this public opinion, and push hard to get things done. It may be easier than he thinks. When Germans do decide to change, they can move in a hurry. "You're seeing a near-critical mass among the elite," says John C. Kornblum, former U.S. Ambassador to Germany and now the chairman of Lazard Freres in Germany. "I think we're on the verge of major change." For Germany's sake--and Europe's--he had better be right.

Frankfurt bureau chief Ewing covers German politics and business.

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