Germany enters euro era on an economic tightrope

There was no Christmas pudding on the menu in Germany this year but rather a sizeable slice of humble pie.

Once Germany led the way towards monetary union, despite fears that it would be dragged down by the unstable economies of other member-states.

But now, with E-Day just around the corner, it's Germany that seems to be dragging down the rest of the euro zone. What's more, the German finance minister, Mr Hans Eichel, is being beaten with the Stability Pact stick fashioned by his predecessor, Dr Theo Waigel.

"I never thought I'd see the day when Germany would be bringing up the economic rear in Europe," said Dr Waigel recently.

But the arrival of the euro will solve few, if any, of Germany's economic woes. Stalling growth and rising unemployment look almost certain to push up the national debt. Add what will be a tough round of wage negotiations in the spring, and Germany will be walking an economic tightrope in 2002.

First, the bad news that no amount of spin can disguise. The German economy will shudder to a halt, and even shrink, for most of next year, according to leading economic institutes. Annual growth is expected to be around 0.7 per cent, although even that is dependent on the economy turning a corner in the second half of the year.

In its revised budgetary report, the government said this could push up borrowing to 2.5 per cent of gross domestic product (GDP), and push back the date of a balanced budget to 2006. This would breach Stability Pact guidelines, which oblige euro-zone countries to keep their budget deficits under 3 per cent of GDP and balance their budget by 2004.

But finance ministry officials in Berlin deny Germany is in line for a reprimand from the European Commission similar to that given to the Republic earlier this year.

"Germany is still fulfilling the broad economic policies of the Stability Pact and is not in line for a reprimand," said a senior finance ministry adviser, who helped draft the pact. "I know there are certain smaller countries who would feel a certain amount of schadenfreude at such a reprimand, but it won't come to that."

As justification, he cites the original purpose of the Stability Pact, "to prevent bad economic policy in preparation for the euro, not to punish economies that experience shocks, like Germany this year".

The largest shock was the US slowdown, to which the German economy was particularly exposed.

The shocks of unification continue to be felt, such as in the long-depressed construction sector.

But internally, the finance ministry knows it is "increasingly unlikely if not impossible", according to the spokesman, that the government will find the DM100 billion (€51 billion) it needs to balance the budget by 2004. But German Chancellor Mr Gerhard Schr÷der has more immediate concerns, namely negotiations for a new national wage agreement that already threaten to create further economic problems.

One of the country's largest unions is demanding a 7 per cent rise, which they say is their due after three modest agreements. Other unions are likely to follow.

"It is obvious that wage restraint on our part has not, as we were told, created jobs and reduced unemployment," said Mr Klaus Zwickel, leader of the IG Metall union.

With 3.7 million Germans out of work, and the number likely to reach four million in the spring, unemployment will be one of the key issues at the polls in the autumn.

Mr Schr÷der has distanced himself from his 1998 promise to reduce unemployment to 3.5 million next year. But the opposition CDU is gearing up to make it an election issue and cannot wait to tar Mr Schr÷der as the "Recession Chancellor" who failed the unemployed.

The CDU says employment market reforms and further tax cuts are necessary to get Germany back on track.

They are supported by several leading economists and prominent conservative commentators, who say that that underlying weaknesses of the German economy will not be solved by a US recovery.

"Germany is an economic wimp, with taxes and social contributions so high as to deter any investor even approaching Germany as a potential business site," said Mr Hans Barbier, a commentator with the conservative Frankfurter Allgemeine Zeitung.

But Mr Schr÷der has long since ruled out such short-term measures as incompatible with his "steady hand" politics.

He is following the advice of the "five wise men", who advise the German government on economic policy. In their most recent report, they said that sustained recovery in 2002 depended on the German government sticking to its austerity plans. "Losing budgetary discipline now and going for a big stimulus package would sow doubts about the government's budget consolidation course and would have little actual impact," the experts warned.

Even if it wanted to, the government cannot afford a package of significant tax cuts or increased spending ahead of the election because of the "precarious nature of federal and state budgets", said the report.

"Now Mr Schr÷der is caught in a trap," said Mr Stefan Schneider of Deutsche Bank Research.

There are only a handful of home-grown measures that will ease, if not solve, Germany's economic woes. These include continued low inflation, low oil prices and a new job creation programme.

The greatest single influence will be the anticipated US recovery. Until then, however, Mr Schr÷der can do nothing but sweat it out.

"He's a bit like a rabbit trapped by a snake," said Mr Schneider. "He is frozen in a no-win situation and can only pray for a US recovery that will spill over soon enough to be felt in Germany before election day."

In a post-euro Europe, any further economic deterioration in Germany will affect its euro-zone partners like never before.

To that end, Germany's economic performance in 2002 will be as crucial to Mr Schr÷der's hopes of re-election as it will be to German hopes of calming the nerves of other euro-zone finance ministers.