VIEWS FROM THE CAPITALS

Spring 2007

by Michael Hüther

The German economy staged a significant recovery in 2006, having lagged behind its European neighbours since the early 1990s. Surprisingly enough, economic activity and employment are expected to continue to grow in 2007, despite the 3% hike in VAT that took effect at the start of this year. Exports and investment appear strong enough to sustain the economic upswing and rising employment is strengthening domestic demand.

But Germany’s economic success could still backfire. The ruling Grand Coalition of Christian Democrats and Social Democrats prefers a “policy of small steps” rather than hard-hitting reforms, despite its vast majority in both chambers of parliament. Such political myopia, coupled with Germany’s popular dislike of change in general, could prevent Chancellor Angela Merkel’s coalition from tackling the nation’s many deep-rooted economic ills.

Perhaps chief among these are labour market problems. The government’s piecemeal approach to reform so far has displayed the distinct lack of any underlying concept about how to reduce excess labour market regulation. And it certainly hasn’t added up to a comprehensive strategy for integrating low-skilled employees into the workforce. Meanwhile, high long-term unemployment is still being fuelled by disincentives for those out of work to find jobs.

Germany needs to do far more to break the vicious circle of unemployment and high non-wage labour costs especially the extremely high welfare contributions paid both by employers and employees. Their contributions fund unemployment benefits, pensions, public health services and long-term care, but are so high that for many years they have encouraged manufacturers to downsize their workforces and have also inhibited job creation in services.

These structural problems are well known, but effective reform remains elusive. For example, this year’s reductions in unemployment insurance contributions are to be offset by rising tariffs for statutory pensions and health insurance. The government’s decision to raise the standard retirement age from 65 to 67 will eventually reduce some of the pressure, but only comes into effect stepwise from 2012 to 2029. What the government really needs to do is to encourage private insurance and lump sum fees to finance welfare spending, and to ensure there is greater supply-side competition so as to increase economic efficiency.

Other policies of the Merkel government to sustain economic expansion also seem contradictory. Last year’s economic upturn allowed Germany to at last meet the EU budget deficit criterion in 2006, having breached the Stability and Growth Pact’s limit of 3% of Gross Domestic Product for four consecutive years. But instead of reducing public spending to cut the budget deficit further, the federal government raised taxes for 2007, notably through the hike from 16% to 19% in the standard VAT rate, which is expected to depress consumer spending.

To stimulate private investment and keep the economy growing, the Grand Coalition instead plans to reduce the current 38% corporate tax rate from next year onwards to less than 30%. However, it is also introducing complicated new rules to limit the net revenue loss to €5bn, thus spoiling the potential benefits from lower tax rates and perpetuating an already inefficient and complex tax system.

During the first half of this year, domestic economic reform is in any case likely to slip down the political agenda while Berlin is preoccupied with its EU presidency. Expectations are high that the German presidency can give European integration renewed impetus after the doldrums of the EU’s constitutional debacle, yet in reality Germany’s options seem limited.

Since the mid-2005 Dutch and French referendum “No” votes, there have been a number of proposals for getting Europe out of its constitutional impasse. One is, that the EU draft a “mini-treaty” under the German presidency to allow parts of the original text to come into force without the entire constitution having to be ratified by all member states. Yet the full treaty was already a compromise that balanced many competing interests, so such an elaborate compromise still seems highly doubtful.

Key decisions are anyway unlikely before the French presidential elections in the Spring. So the chances of the German presidency making great constitutional strides seem remote. Berlin instead, plans to develop a “road map” in the hopes that the constitutional issue can be resolved during France’s turn in the EU presidency in 2008, in time for the next European Parliament elections in 2009.

Germans are hoping, though, that their presidency will be remembered for more than a road map. On March 25, which will mark the 50th anniversary of the Treaty of Rome, Germany is to host a special session of the European Council at which EU heads of government will reaffirm their support for European integration in a Berlin Declaration.