The outlook for Germany is bleak - meeting stability pact obligations while fostering growth will not be easy. That's bad news for the euro zone. Derek Scally, in Berlin, reports

There's a saying that when the US coughs, Germany catches cold. Already, 2003 looks like the year when Germany's dose spreads to the rest of the euro zone.

Western Europe will be the slowest-growing economic region in the world next year with just 1.7 per cent growth, according to a new report from the Economist Intelligence Unit (EIU), and Germany is to blame.

The country has been in an economic funk for well over a year but things have taken on a darker hue of late. Economists are now warning that Germany could be heading for a period of sustained economic underperformance - what some have dubbed the Japan Syndrome.

Worse still, in this post-euro era, the fear is that Germany could drag other euro-zone countries down with it.

The EIU seems to think so. Its report yesterday said that Western Europe was in such a bad way that even the Latin American economies would perform better next year.

Germany's economic troubles have played out like a slow-motion nightmare for Mr Hans Eichel, the German finance minister. He spent the past two years steering Germany onto a course of consolidation: keeping a tight rein on spending and reducing the huge debts that arose from unification in line with euro-zone guidelines.

But everything started to go wrong in the aftermath of the general election. Mr Eichel announced that this year's tax take was down at least €30 billion on expectations while unemployment was growing at an extraordinary rate, up nearly 10 per cent or four million was pushing up expenditure. Mr Eichel told a shocked German public: either we get our house in order or Germany is on the road to ruin.

Within weeks the government introduced supplementary budgets as a stop-gap measure, pushing up borrowing by 64 per cent to €34.6 billion this year and by one-fifth next year to €18.9 billion.

This year's borrowing is running at 3.8 per cent of GDP, shattering the 3 per cent ceiling set down in the Growth and Stability Pact.

Faced with a reprimand from Brussels, Mr Eichel has promised to bring borrowing under the 3 per cent limit by next year and says he is confident he can present a balanced budget by 2006. To do that, however, he has introduced new taxes and increased others.

But administering shock treatment to the already enfeebled German economy could backfire. With a record number of bankruptcies this year, economists are warning that Mr Eichel is making irresponsible financial decisions on the fly.

"Trying to please Brussels in the short term with a lower deficit will have a serious impact on medium-term growth in the euro zone," said Dr Klaus-Jürgen Gern, head of international analysis at the Institute for World Economy (IfW) in Kiel. Yesterday the IfW revised its growth figures for the German economy in 2002 and 2003 to just 0.2 per cent and 1 per cent respectively.

It's just one in a wave of downward revisions of already poor economic figures in recent weeks. Falling business confidence, falling output and falling demand mean that the long-heralded recovery remains perpetually six months in the future. Many economic institutions believe that current government policy will keep it that way.

Germany has yet to come to terms with the fact that it no longer has the luxury of the Bundesbank to solve its problems with an interest rate cut, says Dr Gern. The decisions now being made in the European Central Bank (ECB) are far less expansive than Germany would wish for and the government has few alternative remedies ready.

Another core weakness in Germany is the government's weak appetite for reform, particularly a loosening up of the labour market, which economists say is necessary to restore Germany's competitiveness.

That was the view of Mr Wim Duisenberg, the ECB president, yesterday. Germany, "perhaps more than any other country needs a liberalisation of its labour market", he told Germany's Deutsche Welle.

Few outside government circles are optimistic about new measures to do just that, known as the Hartz proposals. Ideas include reforming state employment offices into temporary work agencies, opening the market to employment agencies and cutting down on red-tape surrounding employment.

"The Hartz proposals are completely overrated. They tackle the symptoms without addressing the illness, which is primarily the expense of hiring and firing employees," says Mr Stefan Schneider, of Deutsche Bank Research.

"The lack of progress on labour regulations is screwing Germany over big time," agrees Mr Joe Dunphy, who liaises with the German banking sector on behalf of Bank of Ireland. But while frustration with the government for its lack of vision and its poor appetite for reform is understandable, he points out that no-one else seems to have any reform vision either.

"There's a very gloomy atmosphere and a certainty that things will get worse next year before they get better," he said.

Nevertheless, he says, things could be a lot worse. Germany's cultural aversion to credit, for example, means the country is in a better financial state than it appears at first glance. "Germany isn't the type of country where people keep the economy going with borrowing. You don't see banks pushing credit cards or loans on their customers," he says.

Last week, a former Bundesbank president likened Germany's problems to those experienced by Japan in the last decade.

At first glance, there are many parallels: both countries were considered "model" economies in the 1980s and are now viewed as "fallen stars". The two countries also face similar difficulties in reforming the employment market and problems with their banking sectors. Reforms in both countries are hampered by close links between politicians, business and interest groups.

"Japan has had less than 1 per cent growth for a decade. Germany's growth hasn't been much better than that for many years," said Dr Gern. "Medium-term growth is not likely to change any time soon, which is a real cause for concern."

Despite the parallels, few believe Germany is doomed to copy Japan's deflation-driven downward spiral. But mounting concern about growth is likely to heat up the debate surrounding the Growth and Stability Pact and the 3 per cent ceiling already breached by Germany, France, Italy and Portugal. Mr Duisenberg ruled out any changes to the stability pact yesterday, pointing out that eight of the 12 euro-zone countries had met their targets.

"You don't change the rules in the middle of the game when things get tight," he said.

Despite swingeing cuts, however, many wonder if Mr Eichel will meet the 3 per cent target and, if not, what the consequences will be for the single currency and for the euro-zone economy.

"To be honest, I don't see any way that Mr Eichel will bring the deficit under 3 per cent next year," says Mr Schneider.

"He may show that Germany is heading in the right direction with considerably savings and cuts during a period of economic stagnation. But cuts are a huge burden for an economy already on its knees."

There is a growing fear that in his rush to please Brussels, Mr Eichel could be heading for a greater fall, with effects far beyond Germany.

"Increasing taxes to reduce the deficit will hit market demand and increase the danger of recession: it's that simple," said Dr Gern. "We must not forget the 1993 recession in Germany that dragged in several of our neighbours. Now, with closer ties in the euro zone, the danger is greater and continues to grow."