The Decline of Germany

With a weak economy and little political will to reform, is it fast becoming another Japan?

Drive down Berlin's Unter den Linden these days, and it's easy to imagine you're in the capital of a vibrant new Europe. The rebuilt, buffed-up avenue now rivals the Champs-Elysées as the Continent's most majestic thoroughfare. Daringly designed buildings are everywhere, the Berlin Wall a fading memory. The Brandenburg Gate is freshly cleaned and polished. Nearby, Chancellor Gerhard Schröder governs from a new, grandiose, nine-story residence and office complex that makes the White House look like a summer cottage. The refurbished Reichstag is a paean to the power and prosperity of unified Germany, the linchpin of the European Union.

That's how Germany's leaders want the world to view their country. But looks are deceiving. The showcase city of Berlin is in such a financial fix that it's firing teachers and closing swimming pools. Just four months after Schröder's reelection as Chancellor, his Social Democratic Party is so unpopular that it was clobbered in two key state elections on Feb. 2. Polls show Germans more pessimistic than they have been in decades.

The vaunted model of Rhineland capitalism, where the state and business work together, is in slow-motion collapse. Japan on the Rhine is a better way to describe what's going on. Germany has grown an average of 1.3% a year over the past decade--the lowest rate in Europe and not much better than Japan's rate of 1%. "In the '70s and '80s, Germany was the model of the world," says one leading executive. "Now we're being repeatedly referred to as the sick man of the world, the sick man of Europe."

As they enter a second decade of stagnation, Germans are beginning to wonder if the disease is chronic. What fooled many of them for a long time was that the real nature of the decline was often masked by short recoveries, global shocks, or outsize political promises that never materialized. There was usually a handy explanation for economic setbacks: a technology gap, a stock market bubble, or a slowdown somewhere else in the world. "The government always looks for reasons elsewhere," says Jürgen Donges, former chairman of Germany's five "wise men," the top council of economic advisers.

But now, decline has enveloped Germany's most vital institutions and industries. In the 1960s, the Germans were the world's No. 1 pharmaceutical producers. Now, the country that invented aspirin has no company in the top 15. In the 1980s, Frankfurt's elegant banks stood as bastions of stability. Now, Frankfurt's future as a major financial center is in doubt. Germany's once-hallowed universities are short of funds and overrun with mediocre students taking advantage of free tuition. Only a decade ago, when President Bill Clinton proposed a national medical system for the U.S., there were only two models worth looking at, Germany and Canada. Today, Germany's system is increasingly unaffordable, while the quality of care is declining. Germany's DAX 30 stock index was the worst-performing in the developed world last year. Bankruptcies are soaring. Even the trains don't run on time anymore.

If Germany's long slide into mediocrity were only robbing the future of 82.5 million Germans, that would be sad enough. But it's not that simple. As Europe's largest and richest nation and steward for the euro, Germany's failures radiate across the Continent, fraying the cords that have kept the sometimes fractious but workable Atlantic Alliance intact for half a century. Germans, like many Americans, have deeply held concerns about George W. Bush's determination to attack Iraq: "Saddam Hussein is no saint, but to me the whole thing smells like it's about oil--oil and Bush's personal prestige," says Alexandra Chmielewski, a Green Party stalwart. That's a commonly expressed opinion. But Schröder has taken such misgivings to a new level with his unqualified refusal to support the U.S. despite evidence that Iraq is building weapons of mass destruction. He is the first German leader in half a century to break so blatantly with the alliance.

This kind of political opportunism may play well at home, but it's turning out to be one more blow to Germany's standing in the world. "As far as international security is concerned, the Germans are becoming increasingly irrelevant," says former U.S. Ambassador to Germany John C. Kornblum, now chairman of the German unit of investment bank Lazard.

Indeed, instead of following Germany's lead, many European nations--Britain, Italy, Poland, Hungary, Portugal, the Czech Republic, Denmark--are voicing support for the U.S. position. Even some Germans are aware of the risk this split poses. "It's crude anti-Americanism," says Axel Wintermeyer, a lawyer in the town of Hofheim near Frankfurt who is active in local politics as a member of the center-right Christian Democratic Union. "The Germans are isolating themselves."

Schröder's plunging popularity could still provoke a course change, especially in the wake of the Feb. 2 elections. But his failure so far to revive the fortunes of Germany raises a troubling question: What kind of Europe will emerge if Germany cannot be the locomotive of growth and policy? Some prominent Germans are already talking about losing their crucial postwar role. "We used to speak of the British disease," says Donges. "For the next 10 or 20 years, we'll talk about the German disease."

If Donges is right, then Germany will at best muddle along while its industrial capital shifts offshore and its brightest young people leave. Meanwhile, Europe's fringe states--the more dynamic economies of Ireland, Finland, Britain, Spain, and Central Europe--will take on the responsibilities of powering European growth and shaping European Union foreign policy.

In contrast, Germany--with France not far behind--will constitute Europe's unchanging core, where taxes remain stiflingly high, growth is glacially slow, and labor rigidities kill chances to dent unemployment. Growing anti-Americanism will warp foreign policy, and U.S. policymakers will both tune out and work around these difficult allies. That happened even before the current Iraq crisis, when Germany and others criticized U.S. plans to scrap the Anti-Ballistic Missile Treaty with Russia. The Bush Administration went deaf. Ignoring German protests, the U.S. ditched the treaty anyway and cut a new deal. "The message was, `We don't depend on you anymore,"' says Burkhard Schmidt of the European Union's Institute for Strategic Studies.

What's astounding is that Germany has studied all these problems for the past two decades, and that many of its most committed reformers have long argued the need for more flexibility if the country is to preserve its power and influence. For example, Count Otto Lambsdorff, now age 76, authored a famous analysis of Germany's problems in 1982 that could have been written today.

So what prevented reform? In a sentence, a reverence for stability at any cost. Shaped by a tumultuous past, the entire country is wired to resist change. Politicians from Schröder down to the local Burgermeister bend over backward to avoid confrontation, particularly with labor. Amid a dire budget crisis in early January, for example, federal and local governments caved in to wage demands by public workers rather than risk a strike. Leading conservative politicians supported the capitulation.

The aversion to change extends right to the factory floor, where companies must negotiate with employees just to install a new machine. No wonder bosses yearn for places with fewer restrictions. "If we want to invest in Slovakia, we aren't bound by those rules," says Jürgen Geissinger, CEO of INA-Holding Schaeffler, a maker of roller bearings based in the Bavarian town of Herzogenaurach that employs 54,000 worldwide.

While these problems were festering over decades, enough was going right for the Germans to convince themselves that no crisis was looming. The miracle of postwar growth--the Wirtschaftswunder--created one of the most financially powerful states on the planet. By the 1980s, Germany was so rich that its banks could extend floods of credit to Eastern Europe and the Soviet Union.

Unification with East Germany seemed to give an unparalleled political boost to German might by creating overnight Europe's most populous state--one that would be at the epicenter of the post-cold war European order. The fall of the Soviet bloc threw the East wide open to more German investment. Then, Germany played a key role in forging monetary union--and insisted on a stability pact that required the severest fiscal probity from the states that joined the euro zone. Now, Germany's inability to rein in its own budget deficit threatens to throw European economic coordination into chaos.

Enormous structural impediments keep Germany from taming its spending and revitalizing its economy. At the core of it all is the Kündigungsschutz, the job-protection law, which has been little changed since the 1950s. In effect, the law makes any employer pay through the nose for laying off workers. The unions--which claim the allegiance of three-quarters of the Social Democrats in Parliament--will defend this law to the death. Even Christian Democrats are afraid to confront the unions.

While the politicians stall, the law slowly but steadily corrodes the job base by making companies loath to hire. The result is unemployment of more than 11%. "It's a catastrophe," says Jennifer Knoblach, 24. Knoblach expects to earn an M.A. in journalism in June from the Catholic University of Eichstätt-Ingolstadt in Bavaria, but she's thinking of looking abroad because of her sorry prospects.

Arndt Rautenberg, 35, says he didn't think much about the Kündigungsschutz when, in 2000, he and two partners founded a tech consulting company in Düsseldorf that eventually merged with Cambridge (Mass.)-based Sapient Corp. After the tech boom petered out, Rautenberg had to lay off a few dozen people. But under the law, he couldn't lay off the worst performers: He had to get rid of those best able to find a new job. Rather than fire some of his most qualified people, Rautenberg opted for costly severance agreements with the others. Now, he says, "my view on hiring has changed totally." When there's extra work, Rautenberg farms it out to other Sapient offices rather than hire locally. Some of his executives even have assistants in India. They can answer calls to the German offices without callers knowing the voice on the line is in New Delhi.

Rautenberg is simply following the initiative of giant German companies in seeking friendlier climes. Just look at the 30 companies that make up the DAX index of Germany's biggest stocks. All but a handful do most of their business abroad--and even domestically oriented companies like Deutsche Post, the publicly traded national postal service, are internationalizing. German companies are investing more abroad than foreigners invest in Germany--$43.3 billion vs. $31.8 billion in 2001. That's a sure sign of slipping competitiveness. Drug producer Schering and software maker SAP, for example, are shifting more and more research and development to the U.S. and other countries. Ball-bearing maker INA is farming out design to Romania. "Once the R&D has left Germany, it does not come back," says Hans-Dietrich Winkhaus, former CEO of chemical maker Henkel.

Thus, Germany winds up with a Toyota-Sony economy: great companies, lousy growth. In fact, exports have risen steadily over the past decade even as domestic consumption has slumped. Those who can't escape the local economy find their own solutions. The workers at Cornelia Perna's "wellness" salon in the Frankfurt suburb of Fechenheim, where she offers manicures and foot massages, may look like employees. But they're independent contractors who pay her rent and split the proceeds from sales of cosmetics. Perna says she couldn't afford the social security costs of a full-time employee. If they can't find legal loopholes like this, entrepreneurs increasingly cheat to dodge the crushing weight of payroll taxes. Off-the-books labor and other black-market activity has risen to 16% of gross domestic product from 13.9% in 1995. Some $363 billion in economic activity went untaxed in 2001, according to Friedrich Schneider, a professor at the University of Linz in Austria who tracks the black market.

The job law is one huge burden. The former East Germany is the other. After the Berlin Wall fell in 1989, Chancellor Helmut Kohl was obsessed with making unification work politically and didn't want to hear about the economic consequences. Everyone now knows the big mistakes: swapping East German marks for Deutschemarks at five times the Ostmark's real value, overinvestment in East German construction, and massive taxes on workers in the West to bankroll transfer payments to the East. That's one reason Germany has the second-highest nonwage payroll costs in the world after Belgium. Since 1990, reunification has cost Germany an estimated $700 billion and still devours 4% of GDP a year.

Trouble is, the rebuilding is far from over. "From an economic point of view, there are naturally things we shouldn't have done," says Finance Minister Hans Eichel. "You can't take an economy that has been cut off from the world for 40 years and make it competitive overnight. It will take until 2020 to conclude the process of reuniting Germany." Electorally, meanwhile, East Germany now plays the same role California plays in U.S. politics: It's extremely tough to win national elections without it. Clearly, politicians are afraid to prescribe harsh measures to deal with the economy in the East, where the heirs to the old Communist Party still sometimes outpoll the mainstream parties.

Another great constraint on change is that Germans still feel rich. Pension benefits can equal 70% of a person's average lifetime pay, actually enabling older Germans to save income. Unemployment benefits are nearly as generous. Thus only 2% of the population suffers from persistent poverty, and urban decay is nothing like what it is in the U.S. On paper, the eastern city of Magdeburg is one of the worst places in the country. Unemployment in the region is 21.5%. After the fall of the Berlin Wall, its industry crumbled--literally: A few miles from downtown are the deteriorating remains of a heavy machinery complex that in communist times employed 12,000 in Magdeburg alone. But in the city's center, a new mall is thronged with shoppers. There are some boarded-up buildings, but thanks to transfers from the West, even more buildings are either new or renovated.

Thus Germans don't see the decay in the system. They also don't see the quiet retreat of entire industries and sectors. Excessive bureaucracy and poor research support, for example, have decimated pharmaceuticals. A bizarre example: Birgit König, a partner at consultant McKinsey & Co. in Berlin who specializes in health care, recalls using her own blood for experiments as a student. That was easier than the time-consuming approvals needed for animal experiments. She wound up completing her research in the U.S.

Can anything turn Germany around? Some politicians are starting to recognize the scale of the crisis. "We need much faster growth," says Economics & Labor Minister Wolfgang Clement. Indeed, Clement may have been the first Social Democrat ever to propose relaxing the Kündigungsschutz. But that prompted howls from labor unions, who have enough influence to block most legislation they don't like, and Schröder has been noncommittal. "The entire party backpedals before Clement finishes a sentence," complains Sapient's Rautenberg.

To be sure, the Feb. 2 elections delivered a shock to the Social Democrats. In the aftermath, Schröder has promised to cooperate with the opposition to speed up the pace of change. But advocates of reform have seen many false dawns before. "I don't think the current government will have the courage to go for fundamental reforms," says Karl-Heinz Paqué, finance minister of Saxony Anhalt in Eastern Germany.

If the central government is showing little inclination to act, local administrations are showing some signs of vitality. Although Eastern Germany is mostly a basket case, some states there have turned into laboratories for reform. Paqué is cutting the state bureaucracy and challenging labor by threatening to withdraw from the government employers' association that negotiates nationwide wage agreements. SKET Machine & Facility Construction in Magdeburg employs a nonunion workforce that is much more flexible about working hours and wages. "Sunday, holidays--it doesn't matter. The problem will be solved," says Managing Director Dirk Pollak. SKET expects 2002 sales to reach $64 million, up from $45 million in 2001.

Other entrepreneurs want dramatic changes in policy. Randolf Rodenstock, CEO of the Munich-based eyeglass maker that bears his family name, proposes a 50% cut over three years in subsidies and tax breaks, many of which favor selected industries. Then the government should slash taxes for individuals and corporations alike. "We've got to get away from all these petty measures," says Rodenstock.

If Germany cannot reignite growth, the implications for a two-speed Europe are profound. The European Central Bank, for example, cannot slash rates forever to prod Germany into growth, especially when smaller states like Ireland and Finland are prone to overheating. And if Germany can't patch up the holes in its budget, then the newfound strength of the euro also will be threatened.

The architects of Europe never planned for a weak Germany. They also failed to plan for the extraordinary changes in the world beyond Europe's borders. While they foresaw a United States of Europe, Kohl and Schröder--and France's François Mitterrand and Jacques Chirac--never came to grips with the rise of China as the world's manufacturer. High-cost, slow-motion Europe--especially Germany--will find it increasingly hard to match its exports against those of China and other low-cost centers.

Germany will see its role in world affairs diminish further if it cannot address these issues. Schröder showed courage in 2001 by committing German forces to Afghanistan. But Berlin's refusal, even after September 11, to significantly boost its low defense expenditures still makes it a less reliable strategic partner, either for other Europeans or for the U.S.-led NATO. Now, an increasingly strapped Germany will find it hard to beef up the armed forces that would give it greater weight in foreign policy debates. "Germany would have a stronger role if we had a stronger military, there is no doubt," says a senior German diplomat.

The most likely outcome for Germany is that nothing will change substantially. When a country this rich and aging turns inward, it loses its claim on any vital role in world affairs. Stagnation even feels comfortable. You won't see masses of homeless on the streets; Munich will still celebrate Oktoberfest every year. But if they don't shake themselves up and figure out a way to revitalize growth, Germans will end up part of a once-great nation that's slipping into irrelevance.

By Jack Ewing in Frankfurt

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