Germany may no longer be divided in a political sense, but in terms of its economy, there is a growing disparity between the confidence shown by captains of industry and the average citizen. With unemployment hovering just below four million, can Chancellor Merkel push through the overdue reforms needed to deliver domestic growth, while keeping ordinary Germans on side? Adrian Simpson reports.
Following a lengthy period of restructuring, corporate Germany is looking healthy again. Larger companies, which have spent the last few years restructuring their balance sheets and divesting non-core assets, are at last returning to the acquisition trail amid growing business confidence.
Where corporate expansion has taken place, boardrooms have been quick to take advantage of the greater flexibility offered by the EU accession countries and other emerging economies to keep wages and other costs of production in check. This has created a leaner, more competitive business sector that is enjoying the current surge in external demand, which in turn is leading to a strong export-led recovery for the German economy.
Domestically, however, the picture is very different. "German companies have benefited from the pick-up in external demand, but structural changes have been paid for by private households. This has led to high unemployment, which in turn reduces disposable incomes and therefore private consumption," said Stefan Bielmeier, senior European economist at Deutsche Bank. Unemployment pushed through the four million mark for a brief period earlier this year, and a substantial percentage of those affected are now classed as long-term unemployed. Unsurprisingly, this has become the key domestic election issue and one of the greatest challenges for the new administration.
The improvement in business confidence is unlikely to translate to jobs growth any time soon, however. "As long as overseas demand remains strong, manufacturers will do well. But the labour market is different, and hiring remains lacklustre due to the level of protection afforded employees under German labour laws," said Bielmeier.
The business lobby maintains that in the continuing absence of reform, German companies are unable to remain competitive because of higher labour costs, including the burden of high social security contributions and the barrier to rationalising workforces according to demand. As a result, much of the recent jobs growth has come via the advent of part-time and casual positions, or so-called 'mini-jobs'.
Companies' reluctance to add costs may also be symptomatic of a deeper concern that the trend towards higher interest rates may stifle underlying economic growth, which remains weaker in the central Eurozone than in the peripheral European countries.
"The ECB has already raised rates twice to 2.5%", said Bielmeier. "We expect rates to peak at 3.5% in the first half of 2007 before they fall back to 3% by the end of 2007. The beginning of 2008 will mark a low point in the world economy, and unemployment is likely to remain high." As the interest-rate gap closes between the Eurozone and the US (where interest rates are currently at 4.5%), the euro is likely to gain in value relative to the dollar, further eroding the currency advantage that is supporting European exports.
It is against this backdrop that the size of Chancellor Merkel's task becomes apparent. "Growth is dependent on internal demand, not just exports," said Lothar Spaeth, chairman of Merrill Lynch Germany, Austria and Switzerland, and a former prime minister of the Baden-Wuerttemberg region.
With wages currently stable and the tax burden set to rise via a planned increase in sales tax from January 2007, Germany's consumers are facing an increasingly difficult decision in how to spend their dwindling disposable incomes. "Consumers are being asked to make greater contribution towards healthcare, pension provision and taxation, yet they are expected to increase their consumer spending at the same time. With incomes currently flat, the same money clearly cannot achieve both objectives", said Spaeth.
Moreover, the German government's most recent pensions report shows that retirement provision is down by over 20%. Faced with the uncertainty brought by lower state provision, the predictable reaction of German consumers is to increase their savings rate at the expense of consumer demand.
Unfortunately, this outcome is unlikely to help Germany's unemployment situation.
"We need to achieve a growth rate of over 2% if we are to influence the labour market", said Spaeth. "For the remainder of 2006, growth of between 1.7% and 1.9% is possible and consumer spending should remain strong as people buy more ahead of the sales tax increase. By the start of 2007, however, the first evidence of strong reforms will be needed, otherwise consumer spending will begin to drop."
If Merkel is to push through the required reforms, she will have to build significant momentum for the changes in the first two years of her 'Grand Coalition'. According to her current approval ratings, she is off to a good start. "The first 100 days of Chancellor Merkel's office have been excellent. She has surprised people with her strong and stable progress and her very clear politics," said Spaeth. "She has also shown herself to be a strong figure with the US and Russia. Now that her foreign policy is stable, the honeymoon period is over and it is time for the reform process to begin."
This means the real test of her leadership and influencing skills may be about to begin. "The question is whether both parties will follow her if the reforms start now. It is possible that too many compromises will be necessary to keep everyone on her side," said Spaeth.
The fear is that the number of deals Chancellor Merkel will be required to make in order to keep her CDU/SPD coalition together may weaken the strength of the reform process that finally emerges. If she attempts to drive radical change, she risks losing the support of the social democrats, who are likely to pounce on any move that will lessen job security at a time when unemployment is already high.
If she errs on the side of caution by introducing reform in a series of smaller steps, she risks losing the support of her own Christian Democrats, who will insist on stronger tactics if the expected consumer spending crunch of 2007 is to be avoided.
Either way, the Germany will not have to wait long for the new Chancellor's decision. "Not much will happen before the regional elections at the end of March", said Spaeth, "although Chancellor Merkel's actions must come in 2006. The emotional environment is still good and people still believe that things will be better in the future."