The German economy

The beguiling path of non-reform

The economy is likely to slow sharply next year, but that may not be enough to revive the cause of reform

GERMANY had no property bubble. Its workers have long settled for modest pay rises. Its businesses and its consumers have been prudent about debt. Recent governments have endured political pain to enact growth-boosting reforms. Yet none of these things will spare Europe's largest economy from the turbulence beyond its borders. In a global slowdown, Germany's three-year-old economic recovery is likely to continue, but at a slower pace. In a way this is a pity, for only the prospect of more serious meltdown could goad Germany's political leaders to make further reforms.

At first sight Germany looks well placed to cope with adversity. It is one of few countries to “reindustrialise”, notes Bert Rürup, head of a committee of economists who advise the government. This is largely built on its prowess as an exporter, especially of capital goods. Less than 9% of Germany's exports go to the United States, so its direct exposure to an American slowdown is modest. Buyers of German machines are less sensitive to price than, say, consumers of Italian clothes, offering some protection against a strong euro. The credit crunch begun by the American subprime-mortgage mess will rattle Mediterranean companies more than German ones, which finance themselves mainly out of profits. “The private sector is not overstretched at all,” says Dirk Schumacher of Goldman Sachs.

Even so, German growth is expected to sag, from about 2.6% this year to 2% or less in 2008 (see chart). And that actually overstates the economy's strength. The 2008 forecast is boosted by an overhang from this year's strong growth and by some extra working days (February 29th, for example). Without these props, growth might be just 1.1%, says the Kiel Institute for the World Economy. In 2009 it may bounce back, but only to 1.8%. Export growth is likely to fall from 8% in 2007 to 5.6% in 2008 and 4.8% in 2009, predicts the Ifo research institute in Munich. Investment growth will weaken, largely because a corporate-tax law taking effect on January 1st will stop businesses from writing off factories and equipment so rapidly.

Fortunately 2008 is supposed to be the year of the consumer. In 2007 shoppers were sideswiped by a sharp increase in value-added tax and by jumps in food and energy prices. In November annual inflation hit a 14-year high of 3.1%. But in the meantime job creation, plus a pick-up in pay, have put extra cash into consumers' pockets. In 2008 they should begin to spend it. The risk that they will not, along with the possibility of a serious American slump, are the main threats to the economy next year. After a slow start, Christmas shopping has met “merchants' high expectations”, reports the German Retail Association.

In the longer run German growth prospects will depend more on politicians' progress with reforms than on the whims of consumers. Since 2003 political leaders have helped, first under Gerhard Schröder, a Social Democratic chancellor, and now under his Christian Democratic successor, Angela Merkel, who leads a “grand coalition” with the Social Democrats as junior partners. Labour-market reforms have added a fifth of a percentage point to German growth potential, mainly by drawing unskilled and older workers back into employment, reckons the Bundesbank. The government has restrained overall spending but is starting to raise investment, a further boost to growth.

Lately, however, Germany's leaders seem to have lost their nerve. Reforms have met popular hostility not applause; voters seem to crave economic justice more than growth. Fewer people now describe their situation as “good” or “very good” than did five years ago, when the economy was in worse shape, according to a survey by Allensbach, a pollster. More than half the population thinks that economic conditions are “unjust”. This mood unnerves both main parties in the grand coalition. Each hopes to govern without the other after the next election in 2009. The Social Democrats, the original authors of Germany's reforms, are panicked by the rise of the anti-reform Left party. And Ms Merkel is positioning her Christian Democrats as the party of “the middle”, which means sticking with reforms only if the political price is not too high.

And so the coalition has started to whittle away at Germany's growth prospects. In November it decided to extend the duration of unemployment benefits paid to older workers, which will encourage employers to dismiss more during the next downswing. Then it agreed to introduce a minimum wage in the postal industry, upsetting competitors' plans to challenge Deutsche Post when its monopoly of letter delivery expires on January 1st. On their own such retreats will cause minor economic damage, but Alfred Boss of the Kiel Institute worries that “steps in the wrong direction will multiply” in the next few months. There is talk of extending the minimum wage and of tightening the regulation of temporary work, which accounts for much recent job creation.

The upswing has increased the government's revenues and so the temptation to spend. Already it has chopped the payroll tax that finances unemployment insurance, which should encourage employment but may erase the federal labour agency's surplus in the next downturn. The government wants to spend more on children and vocational training, but may not be ready to make offsetting cuts, for instance in subsidies to farming or the railways, to pay for them. Its plan to balance the budget by 2011, which once looked easy, may be in danger, fears Mr Boss.

Hans-Werner Sinn, Ifo's president, thinks this is a counterattack against globalisation that could last for decades. He sees the creeping introduction of a minimum wage as a “fundamental change” in Germany's liberal tradition of letting markets set prices and dealing with inequality through taxes and spending. That may prove too pessimistic. So far, the reversals championed by the Social Democrats seem to be aimed at gaining big political payoffs at low economic costs. Still, driving in reverse makes it harder to bring in further reforms of health care, labour markets or the welfare state. There is little prospect of daring moves until after the 2009 election. And even then, it may take another bout of economic pain to make anything happen.