Germany's Challenge

Can Europe's top economy lead the Continent to reform?

German Chancellor Gerhard Schröder spent only about four hours in Islamabad, Pakistan, on Oct. 28. After stepping from his Luftwaffe Airbus A310, Schröder met with Pakistani President Pervez Musharraf to promise $50 million in aid and repeat his support for U.S. military action in Afghanistan. Then Schröder flew on to India, whose leaders, suspicious of Pakistan's motives, badly needed a pep talk.

A Western head of state visits a frontline nation in the war against terrorism. In these scary times, that hardly seems significant--until you consider the decades of history Schröder was trying to shed with his shuttle diplomacy. In the 52 years of the German Federal Republic's existence, chancellors have made a point of avoiding war zones. The stamp of Nazi boots, after all, still echoed in the ears of the world, so even a hint of militarist zeal by a German leader was verboten.

But Schröder, a former peace activist and the son of a Wehrmacht soldier who died in combat, is trying to create a new epoch for Germany, an epoch where the nation's geopolitical strength matches its economic force. That means asserting Germany's "unlimited" solidarity with the U.S. in the current crisis. On Nov. 6, Schröder said he will send up to 3,900 German troops to help the U.S. fight the war against terrorism. "It is a new phase," says Karsten D. Voigt, coordinator for German-American cooperation in the German Foreign Office. "It's our chance to contribute to a cohesive Western response" to terrorism. There's more to it than that, though. Schröder's stance is also a declaration of strength, of the essential role Germany must play in the West.

It certainly is time Germany played a larger role on the world stage. The nation has spent half a century apologizing for Nazi crimes and making financial reparations to victims. Now virtually all of its political and business leaders were children during World War II or not even born. As the biggest country in Europe, Germany should lead the Continent to a new era of statecraft.

But Schröder is pursuing his geopolitical dreams at a risky moment. Any wider influence that Germany will wield rests squarely on its economic might--the financing power of its well-capitalized banks, the intelligence of its highly trained workforce, the exceptional quality of its manufactured goods. Yet this huge machine is slowly but surely falling into disrepair. German economic growth, which hit 3% last year, is once again reverting to the subpar rates of the 1990s. If this keeps up, then over the long term Germany cannot develop into the global player Schröder envisions. And if Schröder neglects the economy, he does it at Germany's--and Europe's--peril. Germany accounts for 24% of the gross domestic product of the entire European Union. If Europe goes into recession, as now looks likely, only Germany can lead it out.

TAX CUTS. Just a year ago, Schröder thought his pace of reform was right on target and would help Germany avert the recession that stalked the U.S. After all, he cut taxes, took the first steps towards mending the broken pension system, and encouraged the immigration of foreigners with needed skills. He made it easier for companies to sell unwanted assets, setting the stage for far-reaching corporate restructuring. He even convinced the nation's factory workers, the world's best paid, to keep wage demands in check.

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%, and business confidence is at an eight-year low. 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 wake-up call. Sure, he faces reelection next year and doesn't want to anger voters with unpopular spending cuts or pension reforms. But a lot more needs to be done. Some of the tasks are longstanding ones: loosening up the labor market, redesigning social welfare to get the long-term unemployed back in the workforce, cutting red tape, and slashing taxes further.

But the Chancellor should try thinking out of the box, as well. As the economy slows dangerously, he's got to find a way to stimulate growth without fueling inflation. Schröder could reduce taxes for personal corporations, cut capital gains levies for smaller companies to encourage restructuring, and exempt smaller firms from some of the more onerous provisions of German labor law. Most important, though, Schröder needs the courage to face up to interest groups and push through the most difficult reforms, such as changes in job-protection laws.

"A BRAKE." Besides, although times are tough all over, signs are mounting that Germany's place in the world economy could be eroding. The nation just fell again in the Geneva-based World Economic Forum's rankings of national growth competitiveness--from 14th to 17th. That means Germany's potential for five-year growth lags such places as Hong Kong and New Zealand. Among other things, the WEF faulted Germany for its inflexible job market. Meanwhile, personal wealth in Germany has declined from 80% of the U.S. level in 1991 to 70% in 2000. "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."

Many economists and business leaders doubt Germany can sustain growth much above 2%, even in good times. That's not enough to pay for Germany's generous social welfare system, which still bankrolls free university education and such luxuries as health-spa stays and has to support a growing number of retirees. And it's not enough to ensure Germany a leadership role among Western nations. "Germany will be a dying star if it fails to adapt to the new world economic order," University of Chicago economist James J. Heckman warned a Berlin audience earlier this year. Nor is that kind of growth enough to power Europe, especially as the EU takes on the burden of expanding to the East. Long term, Germany must be able to sustain growth of 3% or more to protect its privileges and lead the Continent.

HARD HATS. Like it or not, Germany sets the tone for reforms elsewhere in Europe, as well. Last year, when Germany cut corporate and income taxes, France and Italy followed--however reluctantly. German Foreign Minister Joschka Fischer has framed the debate for the future of the European Union with his call in May for a United States of Europe with stronger federal powers. Germany has the most influence over expansion of the EU to Central European states. "Germany's essential," says Noël Goutard, chairman of the supervisory board of French auto-parts maker Valeo. "Europe can't prosper without Germany."

Schröder, for all the bad news, has allies he can call on. In every sector in Germany, companies and individuals are trying to figure out a way to recapture the growth rates of 30 years ago. Many of them are drawing on Germany's core strengths in designing and assembling complex products. "Germans are by nature engineers and not entrepreneurs," says Ulrich Steger, a former member of the management board of Volkswagen who is now a professor at the International Institute of Management Development in Lausanne, Switzerland.

The massive factories of steelmaker ThyssenKrupp in the Ruhr Valley city of Duisburg offer some clues on how that engineering strength can transform companies. The complex, which has produced steel since 1891, exemplifies both old and new Germany. Yellow cranes unload rust-colored ore from river barges. Workers in hard hats and tan work suits bicycle past corrugated metal factory buildings covered in brown soot.

That's the old Germany. The new Germany lies inside a factory that's as clean as any office building. Here, with the help of Siemens electronics, steel ribbon is squeezed to the exact thickness required for the roof of, say, a Volkswagen Golf. The brand new factory, known as the Beeckerwerth cold strip mill, requires just eight workers per shift to produce 172,000 tons of steel a month.

That's called productivity. And it's one reason why ThyssenKrupp, even though it is still weighed down by older, overstaffed mills, is still eking out a profit while Bethlehem Steel Corp. and other U.S. steelmakers face bankruptcy. Even with the highest manufacturing wages in the world, Germany remains among the world's most productive countries.

CAUTIOUS. But even under the most optimistic scenarios, ThyssenKrupp and other big companies won't create the jobs the country needs. For that, Germany needs fast-growing new companies. When it comes to new-business creation, Germany falls in the middle of 21 countries surveyed by the Global Entrepreneurship Monitor, a consortium of researchers managed by Babson College in Boston and the London Business School. Germany ranks behind countries such as Argentina and South Korea, not to mention the U.S.

Risk-takers are starting to emerge from the corporate canyons. Management consulting firms such as Munich's Roland Berger Strategy Consultants report losing up to a quarter of their consultants during the dot-com boom. One was Hendrik Gottschlich, a former Berger partner who in 1999 founded Advanced Commerce, a Munich-based provider of software, services, and consulting for companies that want to market products online or via catalog. "It was always my dream to start a company," says Gottschlich, 36. Today, his company has 22 employees. He's not the only brave entrepreneur. Even after the catastrophic collapse of share prices, companies listed on Frankfurt's Neuer Markt, the bourse for many startups, employed 139,000 people in Germany as of July. That's about double the number a year earlier. The total is sure to decline as some Neuer Markt companies go under or lose their stock listing, but the net effect will still be positive.

Surprisingly, some of the most promising signs of entrepreneurship are in East Germany, where hard-pressed executives, government officials, and workers are determined to undermine the inflexible system inherited after reunification from the West. One of the most ambitious efforts is taking shape in Frankfurt/Oder, a city of 71,000 on Germany's eastern border. In a field outside the city, so close to Poland that cell phones switch back and forth between Polish and German providers, Klaus Wiemer is pouring concrete for a $1.5 billion semiconductor factory.

CHIP SHOT. With backing from Intel Corp., the former Texas Instruments Inc. executive plans to create 1,500 jobs, enough to make a dent in the region's 18% unemployment. Using new technology developed by a local research center, Wiemer plans to build a foundry to make custom chips for the communications industry. He's gambling that the current chip downturn will be over by the time the factory starts producing in 2003. In fact, he expects to have a cost edge, because he's extracting big discounts from makers of chip-manufacturing equipment.

This must be how Germany felt in the "Economic Miracle" years after World War II, when the collapse of the old order drove a tidal wave of entrepreneurship. Something similar is happening in Frankfurt/Oder, once the capital of East Germany's semiconductor industry. Desperate city officials nag Wiemer to submit forms faster so they can approve them. Labor unions are staying out of his way. Locals are already lining up for jobs--three for every opening. "These people have fire in the belly," says Wiemer, who speaks English with a trace of Texas twang. "Some of them are in their 50s. This is the last chance they have to do something with their lives."

Elsewhere in Germany, other bureaucrats are fighting the country's formidable forces of inertia. The Saarland is littered with depleted coal mines and abandoned factories. Since winning election as state prime minister in 1999, Peter Müller has tried to get things moving. Besides cutting bureaucracy, Müller's government has trimmed a year from the time it takes to finish secondary school, so most students are eligible for university at 18. Seems like a small thing. But it helps address business complaints that Germans are too old by the time they enter the workforce. Business has taken note of Saarland's friendly attitude. "We have easy access to the economics minister and prime minister," says Hans Schardt, director of European vehicle operations for Ford of Europe, which builds Focus cars in Saarland.

Can the spirit of reform blossom nationwide? It's easy to be pessimistic. Sometimes Germans seem to be in the grip of complacency brought on by 50 years of prosperity. When Darmstadt-based pharmaceutical maker Merck looked for a site to build a $200 million protein-production facility, it received pitches from the U.S., Singapore, Ireland, Spain, and Taiwan. One country that didn't bother to make a pitch: Germany. "So far, Germany hasn't tried very hard to get us to invest here," says Merck CEO Bernhard Scheuble. "There's still a certain hostility to innovation."

Schröder seems to embody the nation's ambivalence. After chasing Helmut Kohl from office in 1998, the former prime minister of Lower Saxony got off to a good start. Schröder, a lifelong socialist, pushed through steep corporate- and income-tax cuts. Business rates of 38.6% are competitive with the U.S.

Schröder still pals around with top business leaders, such as Jürgen Schrempp of DaimlerChrysler or Jürgen Weber of Lufthansa, and they are urging him to pick up the pace. But with elections in less than a year, Schröder seems fearful of any move that might upset organized labor and other elements of his party's left wing. With the opposition Christian Democrats in disarray, insiders say, Schröder is less worried about them than about dissenters within his own center-left Social Democratic Party, or SPD.

The threat of recession is bolstering those voices on the left. Economists such as Gustav Horn of the German Institute for Economic Research in Berlin now question whether Europe's tough job-protection laws are really so bad. "I consider that argument highly exaggerated," says Horn, head of macro analysis and forecasting for the institute. It doesn't help that the U.S. model looks tarnished in the current downturn.

Yet 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. Especially timid leaders who are uninformed about business. In Schröder's cabinet, just 1 out of 14 members, Economics Minister Werner Müller, has experience in business management. The demographics are similar in parliament. There's a "fundamental readiness to reform" among the populace, says Güllner. "But the members of Schröder's party are telling him to step on the brakes."

STAYING PUT. Waffling on reform has not done anything to stem the rising tide of the jobless, now 9% of the workforce. A third haven't worked in at least a year. More exasperating is the fact that even in the downturn, businesses still report problems finding enough skilled workers. "We have trouble getting qualified people, especially engineers," says Hans-Ulrich Lindenberg, a member of the management board of ThyssenKrupp Steel. Some candidates refuse to move 50 miles to take a job in Duisburg, he says.

Critics say the current benefit system encourages lethargy. Hans-Jürgen Ott, a 48-year-old father of two who lives in Offenbach, a city near Frankfurt, has been out of work for nearly 10 years, ever since arthritis in his knees forced him to give up his job as a municipal truck driver. Ott says he's capable of doing lighter work but has never undergone retraining. His only offer in a decade: a government-sponsored job as a gardener. Ott said he wasn't healthy enough. "What prospects do I have? Not many, not many," Ott says. Ott is trying to qualify for full disability so he can collect retirement benefits, a move that would put him on the dole for good.

So far, Schröder has been reluctant to make major changes in the welfare system that supports Ott and others. That may finally change, perhaps even before the election, one government source says. Schröder probably has enough public support to introduce a so-called negative tax that would reward the working poor. The French government already is doing so, paying a tax credit of up to $500 to workers who earn minimum wage or a little more. "The design of these transfer systems is what we really have to think about," says Jürgen von Hagen, director for economic and social issues at the Center for European Integration Studies in Bonn. "We have to make working more worthwhile."

Economists at the European Central Bank also urge Germany, as well as France and Italy, to make it easier for companies to hire and fire people. Schröder is unlikely to tamper with the system until after elections in fall 2002. But quietly, his government already has eased enforcement of laws that make it harder to hire people as outside contractors, a way of getting around labor rules. That suggests that Schröder, if re-elected, may be open to easing work protections.

But government isn't the only problem. Plenty of people in Germany pay lip service to reform. Action is something else, and in this regard Germany Inc. 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 like any line worker. Earlier this year, for example, German business torpedoed reforms that would have created Europe-wide takeover rules and made hostile bids easier to pull off.

Corporate Germany also doesn't know what to do with a massive gift from Schröder. At the urging of CEOs such as Deutsche Bank's Rolf Breuer, the government eliminated the capital-gains tax for companies that sell their stakes in other companies. That was supposed to allow banks and insurance companies to sell their stakes in industrial companies. The law takes effect on Jan. 1, so companies should already be announcing deals structured to close in the new year.

So far, there's no sign of a big bang. Deutsche Bank, which owns stakes in such companies as DaimlerChrysler (DCX ) and builder Philipp Holzmann, will take up to five years to unwind its holdings, predicts Supervisory Board Chairman Hilmar Kopper. Prices are depressed. But tradition also plays a role. "There's an emotional connection to some of these assets," he says.

To their credit, German companies have changed plenty in the past decade. As they have pushed abroad, companies learned from their counterparts in the U.S. Munich-based electronics giant Siemens (SI ) copied General Electric Co. (GE ), selling off units that weren't tops worldwide in their field. In the current downturn, German companies have reacted much more quickly than they used to, cutting costs and breaking the old taboo of laying off workers. Siemens has announced 17,000 job cuts, more than half in Germany. Layoffs are still more costly than in the U.S. because companies are required to pay severance. But, with the help of pragmatic workers' councils, German companies have become more adept at swiftly cutting staff. While painful, job cuts set the stage for low-inflation growth later on.

Still, there's something missing--the kind of hustle people have when they really want to change something. Then again, Germans handle change differently. After the strife of two wars, they treasure consensus. They debate for years.

When some magical degree of popular assent is reached, though, change can happen like an avalanche. John Kornblum, former U.S. ambassador to Germany and now the chairman of Lazard Frères in Germany, recalls that in the 1970s Germany opposed the policy of détente toward the Soviet Union. Later the Germans became some of the most zealous advocates of tighter ties with the Russians. Kornblum senses a similar shift in attitudes about Germany's economy. "You're seeing a near-critical mass among the elite," says Kornblum. "I think we're on the verge of major change." For Germany's sake--and Europe's--he had better be right.

By Jack Ewing in Frankfurt, with Andrea Zammert in Offenbach, Christine Tierney in Paris, and Frederik Balfour in Islamabad

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