The Crisis Facing Germany

Why does Germany need reforming? Because a decade of sluggish growth has taken its toll on the public finances.This year, the government deficit is likely to be 4% of GDP, far exceeding the 3% maximum allowed under the Stability and Growth pact. Growth this year is likely to be almost zero, unemployment currently stands at 9%, domestic consumption has stalled and foreign investment has collapsed. Recently, there has been the faintest hint of an emerging recovery after years of near-recession. But this is now at risk from the strengthening of the euro against the dollar. The fear is that this will snuff out German exports to the US - until now, one of the few successes of the German economy.

How did it get this bad?

Many Germans blame the high cost of reunification in 1991. The decision to allow East Germans to convert their ostmarks into deutschmarks at par crippled the economy and saddled the West with years of vast subsidies to the East that had to be paid for with higher taxes. Others argue that Germany has paid a high price for joining the euro at the wrong exchange rate: the over-valuation of the deutschmark left German goods less competitive in European and world markets. There is truth in both arguments. But Germany's economic stagnation also reflects its failure to reform in the 1980s and 1990s. As Britain and the US led the way with deregulation and liberalisation, Germany increasingly lost the battle to attract investment and its own companies found it harder to compete.

How far has the reform programme progressed?

The government of Gerhard Schrder is pursuing a package of reforms known as Agenda 2010. Last year, the government cut corporate taxes in a drive to make business more competitive. More recently, the government has been focused on cutting public spending and liberalising the jobs market. Earlier this month, measures to cut health expenditure, including forcing higher patient contributions to medical costs, passed into law. But the government faces a tougher problem with other parts of its agenda. The Bundesrat, the upper house of parliament, has rejected a package of labour market reforms designed to cut unemployment benefit and make the long-term unemployed take jobs. Last week, a package of pension reforms, including raising the retirement age from 65 to 67 and cutting pensions from 48% of average gross earnings to 40%, passed in the lower house, the Bundestag, only after Schrder threatened to resign. But these too could be defeated in the Bundesrat.

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What happens next?

The labour reforms could face months of wrangling between the Bundestag and the opposition-dominated Bundesrat, in which the original bill could be watered down. A similar fate faces the pension reform proposals if they are defeated in the upper house. The worst case scenario is that all the reforms are defeated, in which case the government will be forced to raise indirect taxes that do not require Bundesrat approval to close the fiscal deficit. This would lead to slower growth, hit business and consumer confidence, and leave Germany even less competitive. But on balance, investment bank UBS expects that a compromise will be reached.

Will these reforms do the trick?

They are helpful as they go, but they lack ambition, says UBS. If passed in full, the Agenda 2010 reforms will help to shore up Germany's precarious public finances. But the labour market reforms are not far-reaching enough to give much of a boost to investment and employment. UBS expects the reform package to lead to lower growth, since the social spending cuts will lead to lower consumer spending. The reform programme does not go nearly far enough to tackle the real problem in the German economy - the lack of domestic demand. Germany needs growth in consumption and investment.

How can it do this?

High on the agenda should be wholesale reform of the banking sector, says Wolfgang Mnchau in the FT. Germany's banking system is fragmented and dominated by state banks. Its capital markets remain undeveloped, so companies still find it easier to raise capital via the banks rather than by issuing shares or bonds, leading to overly cosy relationships with the banks, which can often be an impediment to industry consolidation. The government also needs to tackle other barriers to entry to German markets, including reform of its "outdated competition laws", relaxing the rigorous qualification requirements for craftsmen that make it hard for outsiders to compete, and lifting tight restrictions on shopping hours. And still more needs to be done to reduce Germany's high indirect labour costs. Even if the current crop of reforms go ahead, German firms will still have to pay 19% of each employee's salary in pension costs.

How likely is this?

There is huge resistance to Agenda 2010 from members of Schrder's SDP party, which thinks it goes too far, and from the main opposition party, the CDU, which thinks it does not go far enough. Many have already been watered down to get them through the Bundestag, yet they still face massive union opposition. Even if the political will was there to face down the unions, progress could still be derailed by power politics. This is a recipe for stalemate. What's needed, many Germans believe, is a "German Thatcher", with the vision to drive through reform. Indeed, a book by historian Dominik Geppert, Maggie Thatcher's Radical Cure - a Recipe for Germany? has been a bestseller.