Growth at Risk Slow Pace of Reform Threatens German Prosperity

Germany may like to present itself internationally as a model of modern economic policy, but in reality much-needed domestic reforms have been stalled for years. The OECD has warned that German prosperity may be at risk if Berlin doesn't take action.


By and

The titans of industry presented Angela Merkel with a long wish list. They urged the German chancellor to reduce energy prices and simplify the tax system. The world isn't standing still, they argued, and Germany is running the risk of losing its international competitiveness as a center for commerce and industry.

Some 80 representatives of companies and business associations, including Hans-Peter Keitel, president of the Federation of German Industries (BDI), and Dieter Hundt, president of the Confederation of German Employers' Associations (BDA), recently used the traditional annual meeting with the chancellor at Munich's skilled trades' exhibition, the Internationale Handwerksmesse, to present their concerns.

Merkel listened for one-and-a-half hours to the wishes and complaints from the engine room of German industry. Finally, she made a pledge that actually constituted an admission of guilt. Half jokingly, half out of irritation, the chancellor promised that she would again focus on problems at home -- as soon as Greece's financial woes and the euro debt crisis had been resolved. "You can count on it," she said.

Presiding over Gridlock

Berlin has allowed a number of important projects to languish. For nearly four years now, German policy has focused on combating the ongoing financial, banking and euro crisis. During this same period, the chancellor has been preaching to her partners, both inside and outside the European Union, about the merits of the German economic model -- but in reality she's been presiding over a gridlock when it comes to domestic reforms.

Germany's key economic indicators paint a deceptive picture. In 2011, the country posted growth that was larger than any other major economy in the Western world. This year will also most likely be better than what many experts were predicting just a short while ago. Economic analysts are revising their forecasts upwards, and the unemployment rate is declining. Germany's industrial sector serves as a model around the world. Even the US -- once the measure of all things -- now gazes across the Atlantic with envy and admiration.

But the numbers are misleading. A number of underlying weaknesses are becoming entrenched -- and these could quickly put an end to the recent German economic miracle. International economic organizations are warning of disastrous trends, yet Germany's politicians have taken little notice.

Recently the Organization for Economic Cooperation and Development (OECD) gave Berlin a little wake-up call. The OECD acknowledged that Germany has weathered the financial turbulence of the past few years relatively unscathed, thanks to labor market reforms and savvy crisis policies. But the experts had an important warning, writing: "In other areas, however, reform efforts should continue."

The finger-wagging has gone unnoticed. Merkel's center-right coalition of the conservative Christian Democratic Union (CDU), its Bavarian sister party, the Christian Social Union (CSU), and the pro-business Free Democratic Party (FDP) has failed to find common ground on tax policy. No progress has been made on liberalizing Germany's all-important service sector, while Germany's school and higher education system is producing too many young people who lack marketable skills and qualifications.

Slap on the Wrist

What's more, Germany is about to get another slap on the wrist, this time from the International Monetary Fund (IMF). The Washington-based organization is preparing a new evaluation intended to remind the German government of its responsibilities toward the European monetary union and the world economy.

The official talks, known as Article IV consultations in IMF-speak, don't begin until May, but during informal preliminary meetings, the IMF experts have already conveyed a clear message to their German partners: They shouldn't count on too much gushing praise this time around. The country's economic prosperity could be at risk because of Germany's aging population, the experts warn. They say that the country's growth potential -- in other words, the ability of German industry to produce more, in a more efficient way, year after year -- will shrink to under 1 percent in the future.

To make matters worse, the IMF analysts have noted a significant lack of investments in Germany, which is further exacerbating the growth problems. They say that German industry is putting too little money into new plants and machinery, and they criticize Germany for allowing its public infrastructure to deteriorate for quite some time now. According to the IMF, the German government annually invests less money in roads, bridges, railway lines and canals than would be required to maintain this infrastructure.

The IMF emissaries will urge Germany to increase its investments. They argue that the government should spend more money to expand the country's infrastructure and thus boost the economy. Furthermore, they recommend restructuring the tax system to stimulate business investments and consumer demand.

Too Much Tax

Labor costs in Germany are still weighed down by too many taxes and charges. Studies show that countries that rely more on consumption and capital taxes achieve higher growth rates. Indeed, many economists recommend that Germany scrap its reduced rate of value-added tax on certain items such as food and books, which is currently set at 7 percent and well below the country's regular rate of 19 percent. In return, Berlin could reduce the tax burden on low and average income earners.

German Finance Minister Wolfgang Schäuble (CDU) established a working group on this issue one year ago. It hasn't held a single meeting. Schäuble has also failed when it comes to reforming Germany's trade tax, which is levied by local authorities. This was supposed to be abolished entirely, but Schäuble couldn't push it though due to resistance from municipalities that are afraid it will erode their tax base.

Taxes for large companies should also be reduced. Clemens Fuest, an economist at Oxford University and a member of the Scientific Advisory Board of the German Finance Ministry, says that with a tax rate of 30 percent on profits, Germany may now be more competitive than it was years ago, but it still doesn't rank in the top group of countries. "The debate has only died down," he says, "because things are currently going so well."

Clinging to Outmoded Regulations

The OECD experts also urgently advise the German government to do away with the income tax splitting provision for married couples. This benefits couples where only one partner earns money and thereby creates an incentive for the spouse -- usually the woman -- to remain at home. That reduces the labor pool, which results in a decline in growth and prosperity.

The German government, though, is not about to roll back this controversial tax privilege. On the contrary, with its planned child care supplement, which will reward women for staying home to raise their children (rather than putting them into day care), Berlin has made the problem even worse.

Analysts from the OECD have pinpointed additional job killers and growth inhibitors. For instance, they say that Germany's highly efficient industrial export economy stands in stark contrast to a service sector that is performing below its potential. They argue that this is an area where Germany is squandering opportunities for growth because it still clings to outdated protective regulations.

There's a great deal of validity to such criticism. A considerable number of skilled trades in Germany are still protected by the age-old privileges of the master craftsman. Anyone who wants to establish an independent business as a confectioner, baker, carpenter or mason first has to complete a long and costly period of extra training after their apprenticeship. It is only then that enterprising individuals are allowed to establish companies and create jobs.


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