Germany, France: Growth for Both?

Are the neighbors exuding a glow of economic vitality at the same time? Merkel's popularity gain and Sarkozy's strong start signal reforms

Germany and France have spent much of the last decade taking turns being the "sick man" of Europe. What would happen if the Continent's two largest economies were both healthy at the same time?

Such a scenario seems more likely following the election last month of reform-minded Nicolas Sarkozy as President of France. On June 17, runoff elections are expected to award Sarkozy a strong majority in Parliament, giving him the political clout to carry out reforms such as loosening the labor market or curbing unions' power to shut down public transportation.

Meanwhile, Germany is already in its second year of relatively strong growth, thanks to massive corporate restructuring aided by a dose of government reform. For the first time in a decade, surging exports are spilling over into the domestic economy, pushing down unemployment and encouraging consumer spending. "German companies' competitiveness is now comparable to the late 1980s, and that's paying off," says Andreas Rees, chief German economist for Unicredit Markets & Investment Banking in Munich. He predicts German growth of 2.6% in 2007, after unusually strong growth of 2.7% last year.

There are still too many uncertainties for economists to predict a boom. Sarkozy's reforms could founder on public opposition, and Germany's reform momentum has slowed under a coalition government of the two major parties. Both countries are vulnerable to a slowdown in the U.S. or global economies. But if France climbs out of its political and economic stagnation, which includes the highest unemployment in Western Europe, the whole continent could benefit. "Every step in one country raises pressure on other countries to stay competitive," says Dresdner Bank's Gregor Eder.

New Strategy for France

After lagging Germany for several years in the reform department, France could be on the verge of major change. Sarkozy is likely to use a strong majority in Parliament to push through changes such as reducing the tax burden for companies and employees on hours worked overtime. "He has a clear strategy and plans to go for it as quickly as possible," says Aurore Wanlin, a research fellow at the Centre for European Reform in London.

Change is certainly needed: Among the European Union's 25 members, only Poland and Slovakia have worse jobless rates. France's rate is currently 8.6% according to EU methodology vs. 6.7% for Germany.

German Chancellor Angela Merkel of the center-right Christian Democrats is taking a more incremental approach to reform than Sarkozy. She has to. She governs in a so-called grand coalition with the center-left Social Democrats, requiring constant compromise. Still, the government's achievements include giving states more autonomy to regulate their own economies, and reducing the federal budget deficit.

Popularity Leads to Reforms

And Merkel, a clever tactician, could risk bolder steps as she builds political capital. Unlike Sarkozy, she came into office in November, 2005, with a slim plurality. But she has continually gained in popularity, winning support of 54% of Germans in a June survey by Berlin pollster Forsa for Stern magazine and broadcaster RTL. Her Social Democratic rival, Kurt Beck, scored just 19%. Numbers like that could encourage Merkel to begin tackling tougher reforms, such as deregulating the labor market.

Any reforms will take some time to bear fruit, and can even have short-term negative consequences. For example, reforms of French universities could lead to job losses, which would boost French unemployment, notes Iain Begg, visiting professor at the London School of Economics and Political Science. "You won't see the surge in employment and growth for a few years," Begg says.

Still, Begg and others point out, there could be a more immediate benefit as the reforms give business people more confidence to hire new employees and invest in expansion. "That's probably the trump card," says Eric Chaney, chief economist for Europe at Morgan Stanley (MS). "The business community is very happy that for the first time there is a reformist in the driver's seat."

With reporting by Cassidy Flanagan in Paris