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Overhauled: why Germany is again the engine of Europe
By Bertrand Benoit in Berlin

Published: March 30 2007 03:00 | Last updated: March 30 2007 03:00

Attention surrounding the French presidential campaign is focused on the youthful trio of leading candidates. Yet there is another protagonist in the race. With less than a month until polling day, Germany is on every-body's lips: there is hardly a candidate who has not drawn lessons from its remarkable economic recovery in the past year.

Nicolas Sarkozy, running for the ruling UMP party, has toyed with the idea of a value-added tax rise, as implemented in Germany in January. Ségolène Royal, the candidate of the left, has praised the strength of German organised labour. For François Bayrou, representing the centre-right UDF, Germany's success lies in its "grand coalition" of Social and Christian Democrats, which he wants to replicate at home.

For all the talk, however, France's would-be presidents are all conveying a distorted image of Germany and misrepresenting the factors that led to its recovery. "Germany has made a comeback in the French political discourse," says Dominique Reynié, a professor at the Paris institute of political science. "But the question 'How did they do it?' is simply not being asked. It is not that politicians do not know - it is that they are afraid of spelling out the answer."

How did Germany really do it, and what should the French and others - not least the Germans themselves - deduce from that? In fact, the realisation that their country is no longer the "sick man of Europe" and is again acting as the continent's economic engine is more widespread outside Germany than at home, where the populace is taking time to shed the gloom of the preceding downturn.

"It is perhaps excessive to say that Germany has become a model again," says Philippe Moreau-Defarges, a senior fellow at the French institute of foreign relations. "What has returned is a certain envy, the old inferiority complex, and a certain perplexity as to what their success means for us."

Germany's return to health struck home late last year, when it emerged that its economy had finally shaken off the after-effects of reunification and would grow faster than that of France for the first time since 1994. With estimates of German growth for 2007 ranging between 2 per cent and 3 per cent, this outperformance is likely to be repeated this year.

Unemployment, the most visible symptom of the "German disease", has been receding fast. At 7.5 per cent in February, according to figures from the International Labour Organisation, it was lower than France's. In the past 12 months almost 1m jobseekers have found work.

The election of Angela Merkel as chancellor and the non-confrontational stance she has adopted - a shift from the at times abrasive style of Gerhard Schröder, her predecessor - has also contributed to the shift in perceptions.

It is when identifying the factors behind Germany's latest re-naissance, however, that French political discourse parts with reality. The distinctive feature of the German economic recovery is that it was firmly led by exports. Of all well-performing western economies in the current decade, it is virtually alone in not having experienced robust consumption growth.

The dramatic improvement in labour-market data and the fact that investment in capital goods is booming again after coming to an almost complete halt in 2000 show that the recovery now has a strong domestic component. This, however, did not come without sizeable sacrifices - and it is these sacrifices that the French candidates are not keen to mention.

The spark that got the German engine running was the painful restructuring that companies undertook after the bursting of the "new economy" bubble at the turn of the century. Either unilaterally or in concert with trade unions, managers slashed costs, working time rose, wages were frozen and production was moved to low-cost countries.

The short-term effects were devastating. Unemployment shot up to an all-time high of 5m in 2005, while real wages plunged. As the numbers of those dependent on state benefits rose, the public deficit soared.

Rocketing unemployment and eroding income left a deep mark on the public's psyche, turning Germany into a nation of compulsive penny-pinchers. The country's retail sector is now dominated by discount chains, marketing for consumer goods tends to revolve around price, and bargain-chasing - even among the affluent - has become a favourite national pursuit.

The result, however, was a partial reversal of the dramatic loss in competitiveness suffered by German companies following the country's reunification. In the decade to 2005, unit labour costs fell 10 per cent while they rose 15 per cent in the UK and 26 per cent in Italy.

Offshoring, meanwhile, integrated Germany more deeply into the world economy. Almost half the value-added of German exports is now produced abroad. Many companies sell more products made by their overseas subsidiaries than they export.

Postwar Germany was always an exporting economy but in the past five years it has become virtually the only old industrial nation to raise its worldwide market share. Its share of international trade rose from 8.6 per cent in 2000 to 10 per cent today, the highest in the world, ahead of the US, China and Japan. Although it uses the currency that French candidates claim is choking their own economy, Germany is undoubtedly one of the biggest beneficiaries of globalisation and one of very few mature economies to have fully harnessed its opportunities.

"The case of Germany is pretty much without equivalent," says Elga Bartsch, economist at Morgan Stanley. "It is the only country that is standing up to the Chinese today."

Politicians played a supporting role, mainly by keeping at arm's length from the wage settlement process. The raft of labour market, tax and social security reforms that Mr Schröder initiated in 2003 at considerable political cost played a role in raising Germany's potential rate of growth, though whether and to what extent these reforms have even begun to bear fruit is a matter of controversy among politicians and economists.

The ferociousness of Germany's restructuring led to accusations of a beggar-thy-neighbour policy and, at home, to concerns that the country was turning into a "bazaar economy" - an expression coined by Hans-Werner Sinn, head of the Ifo economic institute, to describe a business model whereby goods are manufactured abroad and assembled in Germany before being re-exported.

The rapid fall in unemployment and rise in domestic investment, however, have done much to validate this model by demonstrating that profits were in fact being redirected into the domestic economy. Taking advantage of globalisation did not necessarily come to the detriment of workers at home in the longer term, it became clear - although the average gross wage rise was only 0.7 per cent last year.

"Offshoring may seem worrying from the point of view of job creation in Germany," says Klaus Bräunig, managing director at the BDI federation of German industry. "But the truth is that as long as our firms' activities abroad help strengthen competitiveness and increase market share - which is the case - we are creating more jobs at home than we are moving abroad."

Rising profits also led to rising tax revenues, allowing Germany to reclaim its lost reputation for fiscal rectitude. Last year, the public sector's budget deficit stood at 1.7 per cent of gross domestic product, much lower than the government was anticipating a year earlier. Germany's reputedly bloated social security system booked a €20.5bn ($27bn, £14bn) profit last year, compared with a 2005 deficit of €3.3bn.

So are there lessons to be drawn, by France and by others, from this German miracle? The Bundesbank thinks so. In its monthly report published this week, the central bank identified wage moderation and corporate restructuring as determining factors in redressing economic fortunes. Eurozone countries experiencing an erosion of their competitiveness, such as Portugal and Italy, faced "no sustainable economic policy alternative to the path followed by Germany", the bank wrote.

A second lesson is that, although it is governments that shape the legal framework determining the room for manoeuvre of economic actors, there is little they can actually do to stimulate growth. "Politics has relatively little to do with the current recovery," says Ms Bartsch.

A simulation conducted by the IfW economic institute in Kiel, which published its findings this week, showed the central role played by wage moderation in improving German competitiveness. Although the fall in real income between 2004 and 2006 hit consumption, the institute wrote, the net effect of wage moderation was positive for growth and job creation. Calculations by the Bundesbank suggest that unemployment would be much higher today if wages had risen by 2.5 per cent a year since 1999.

Today, it appears that Germany's botched reunification acted as a delayed trigger for corporate and political reform. The introduction of the D-Mark at the wrong exchange rate saddled the former East Germany with unbearably high labour costs, making it uncompetitive and a burden for the rest of the country. Reunification not only sent competitiveness plummeting: it also made structural weaknesses built into its social security system, wage-setting mechanisms and labour law acutely visible.

"Reunification was a catalyst," says Dirk Schumacher, an economist at Goldman Sachs. "It exposed all the breaking points in the system and prompted a general renegotiation of the price of labour. Luckily in this case, you can say the system re-sponded the right way."

Arguably, the best thing about the "German model" is less the model itself - with its superficially attractive mix of economic liberalism, a generous welfare state and consensual politics - than the adaptability the country has demonstrated through crises. "It is not that we did not make mistakes," says Toni Pierenkemper, professor of economic history at Cologne university. "We made huge mistakes. We completely underestimated the cost of reunification. But we showed a certain ability to confront and correct these mistakes."

The third and fourth lessons are for Germany itself. If getting costs under control has allowed German industry to prosper, generous pay increases in the future could have the opposite effect. As many politicians call on managers to share the spoils of success with workers, and as the coalition toys with the idea of a minimum wage, economists are growing worried. In the current wage round IG Metall, the engineering union, has called for a 6.5 per cent rise and will probably achieve about 4 per cent.

For Wolfgang Franz, president of the ZEW economic institute and one of the five "wise men" who advise the government on economic policy, a settlement that exceeded productivity gains this year would undermine Germany's position in international markets and stop the labour recovery. "In the past years, the moderate settlements achieved by the negotiators made a considerable contribution to employment," he says. "We are in danger of losing sight of this."

Last, because of its heavy exposure to world markets, Germany is also more vulnerable than its neighbours to a slowdown in global growth. Its reliance on trade played a big role in shaping Ms Merkel's agendas for her country's twin presidencies of the European Union and Group of Eight industrial nations this year. Completing the Doha round of trade liberalisation, lowering non-tariff barriers between the EU and the US and improving the international protection of intellectual property rights all figure high on her list.

The French candidates are right about one thing: their country has much to learn from its bigger neighbour. But if embracing free trade and globalisation, keeping wages low and selectively offshoring are the main ingredients, the German recipe is unlikely to win anyone the French presidency.

Additional reporting byMartin Arnold

Copyright The Financial Times Limited 2007