CIAO DATE: 06/06

CIAO DATE: 06/06

European Affairs

Fall 2005

 

Cover Story

"Grand Coalition" Must Create a Vision of a Modern Germany

By Alexander C. Dibelius

 

The difficult birth of the “grand coalition” linking Germany's two greatest political adversaries, the center-right Christian Democrats and the Socialists, under the leadership of Angela Merkel, shows that it will not be easy to govern Germany in the period ahead. Many supporters of economic reform, both inside and outside Germany, had hoped for a clear victory for the two Christian Democratic parties (the CDU and its Bavarian counterpart, the CSU) with a firm mandate for change for Ms. Merkel, the CDU leader.

But there is no point in dwelling on missed opportunities. Following the unexpectedly strong showing of the Social Democratic Party (SPD), which produced the inconclusive result of the September 18th elections, the formation of a grand coalition is the politically optimal outcome. The alternative would have been paralyzing instability. So an arranged marriage for a limited period is the best solution available.

The elections resulted in deadlock largely because many Germans sought to reject any speed-up in the pace of the economic and social reforms that Germany must undertake. Former Chancellor Gerhard Schröder and his center-left coalition of Socialists and Greens were ousted from power; but the CDU/CSU and the smaller, business-friendly Free Democratic Party (FDP) did not win enough support to form the new center-right coalition that had been almost universally predicted.

The result can be explained partly by a deep-seated fear of change, and by the German angst that foreign commentators so widely evoked. But the most important factor was the failure of large segments of the population to understand that lavish social policies can only be sustained by successful economic policies. A majority of Germans still expect to be looked after generously by the welfare state, while regarding the market as an unavoidable evil that must be kept under control.

Belief in the state and skepticism toward market forces can be easily explained. After Germany's unparalleled, post-war economic recovery under the banner of Ludwig Erhard's social market economy, the country had by the late 1960s settled comfortably into its all- encompassing welfare state. Thanks to its wealth, Germany could easily afford this luxury for many years.

It would be too simplistic, however, to interpret the surprisingly high vote for the Socialists merely as an attempt to preserve the rigid social and economic structures of Rhineland capitalism and the German version of the welfare state. Even if the CDU/CSU and the FDP had succeeded in forming a new government, they would not have launched a Thatcherite social revolution or a German version of Reaganomics. The CDU/CSU cannot be compared to the British Conservatives or the American Republicans.

As Chancellor, Ms. Merkel is certain to continue the reforms begun by Mr. Schröder with his so-called Agenda 2010 in March 2003, at much the same pace. It is in the vital interest of both major parties to come to grips with the daunting structural problems plaguing Germany's labor market, social security system and government finances. The experiment of the grand coalition thus has a good chance of lasting for the full, four-year legislative period that ends in 2009.

During this period, the government will continue to prepare Germans for the changed realities of life in a globalized world in a series of small steps. The gap between the welfare state diehards and the other half of the population that is calling increasingly loudly for consistent reforms will be reflected in a stop-and-go style of government.

This is already apparent from the policy agreements negotiated by the coalition partners. Many of these measures fail to meet the requirements of the German economy or are actually counterproductive. They include the planned rise in Value Added Tax (VAT) from 16 percent to 19 percent in 2007 and the fiscally useless and psychologically even more damaging wealth tax.

Overall, the grand coalition's program presents a conflicting picture. On the positive side are plans to reduce the huge number of tax concessions encumbering German tax law – the most complicated in the world – and to abolish tax subsidies to help simplify the tax system and make it fairer and more transparent. In contrast, the proposed VAT increase will regrettably be used only partly to reduce ancillary wage costs, such as social security contributions. So the net result, in view of the notorious reticence of German consumers, is likely to be a dangerous drop in consumer spending.

“Plans for labor market reform go in the right direction, though not far enough”

The steps agreed to deal with the country's inflexible labor market are not sufficiently far-reaching, but they are at least going in the right direction. This applies both to proposals to relax protective measures against dismissal and to cut unemployment benefits. Only the next few years, however, will show whether Germany is to retain its comparatively attractive tax rates, and it is to be hoped that corporate taxation will be reformed in 2008 at the latest, as announced.

Plans to reform the structure of the federal government may also represent a major leap forward, although this cannot be judged until legislative procedures are completed in mid-2006. It is long past time to untangle the highly complex federal system, which allows the Bundesrat, the Parliament's upper chamber, to block all legislation, and which has effectively paralyzed political decision making for many years. The future federal structure of the German constitution should make governing easier. Above all, however, the political decision making process should become more open and comprehensible to the citizens than the current maze of federal and state jurisdictions.

“Developments in 2006 will decide whether the German locomotive starts moving again”

Cutbacks in the social security system are also urgently necessary. There is no way to avoid freezing pension contributions, resulting in real reductions in state pensions. It must also be hoped that viable, long-term reforms of the healthcare system can be devised, in an atmosphere free of crippling ideological disputes.

There are good reasons to believe that the national mood will lighten next year, after initial outrage over the new government's austerity policies has calmed down. The government was right to defer the rise in VAT to 2007, even at the cost of violating budgetary procedures, and to plan a series of economic initiatives next year – starting with improved depreciation conditions for small and mid-sized businesses. These should provide opportunities to release greater dynamism into the country's economic life.

Developments in 2006 will thus decide whether the German growth locomotive starts moving again. The new cooperation between previously opposite poles of the political system needs time to be accepted even by its supporters on both sides. Four weeks of coalition negotiations were not enough suddenly to turn adversaries into like-minded allies after so many bitter clashes in the last decade over how to modernize Germany to meet the challenge of globalization.

The fall of Germany's per capita income from sixth to eleventh position in the European Union between 1995 and 2003 does not concern Germans alone. It is in the fundamental interest of all Europeans that the German locomotive be fired up again. The European Union is only as strong and healthy as its member states, and that is especially true of the 12-member euro zone. This explains why the European Commission has eased the pressure on Germany to remedy its fiscal deficit. The common interest of Brussels and Berlin in German economic recovery provides a useful framework for German policy.

The two main political parties, and especially the CDU/CSU, also see continuation of the reform and consolidation process, no matter how reluctant, as a service to the European ideal. The realization is finally gaining ground in Berlin that the economic decline of Europe, for example vis-à-vis Asia, must be prevented.

This ought to imply that Berlin will keep its distance from the protectionist attitudes of France. As the Berlin-Paris axis was forged primarily for political reasons, rather than as a result of common economic convictions, there is no reason why Germany should not again adopt a stronger economic profile in the European Union and resume its traditional advocacy of free trade and EU enlargement. That would definitely be in Germany's interest as a world champion exporter.

The rise to the Chancellorship of Ms. Merkel, an Atlanticist and free-trader, suggests, to put it cautiously, a shift of emphasis in Germany's European policy and in its relations with the United States, in both political and economic terms. In future, Berlin may well take a middle position on many of the economic and political issues that divide the French and southern Europeans from the Anglo-American camp. On this front, however, it is still too early to make reliable forecasts, as the relative influence of the coalition partners remains to be determined.

Germany's plight is neither as good nor as bad as it often seems. On the one hand, the country's problems are greater than the defenders of the German welfare state wish to admit; on the other hand, the country's prospects are very much better than Teutonic pessimism is prepared to acknowledge.

This can be seen with particular clarity in the activities of German corporations. The companies have done their homework, reduced their unit labor costs and thus removed their most important competitive disadvantage vis-à-vis their western European rivals. Responsible labor leaders have contributed to this shift with moderate wage claims.

When the British weekly, The Economist, spoke of Germany's “surprising economy” in August 2005, it was not primarily hailing German economic policies but rather successful restructuring by German companies. Thanks to its comparatively high productivity, the German economy has once again become as competitive as those of France, Italy, the Netherlands and Britain – a big reason why Germany became the world's top exporter again in 2004.

Politicians must now follow in the wake of this success. In the coming four years, nothing less than the restructuring of the German welfare system is on the agenda. Broadly speaking, what is needed is a renaissance of economic and regulatory freedom that must include the following goals:

• The complicated and internationally intimidating German tax system must be comprehensively reformed and simplified. Corporate tax rates must be reduced, without any increase in taxes on individuals.

• The welfare state must be modernized to enable it to remain financially viable in the light of dramatic demographic changes. The priority must be sustainable reform of the healthcare and pension systems.

“What is needed is a renaissance of economic and regulatory freedom”

• Labor is central to achieving these aims. Ancillary wage costs must be significantly reduced, and wage structures and working hours made more flexible.

• The competitiveness of the economy must be further strengthened. As Germany's largest corporations have demonstrated, this is feasible thanks to the country's high productivity. But increased productivity will have no sustained effects on the domestic labor market as long as a political taboo remains on issues such as increased weekly.

Alexander C. Dibelius is a managing director with Goldman Sachs in Frankfurt, in charge of business in the German-speaking region. In addition he is co-head of Goldman Sachs' Investment Banking operation in Germany and Austria. He was previously co-head of Mergers & Acquisitions for Germany, Austria and Switzerland, and worked in London and New York.