Germany's Political Revival Has Run Out of Steam: Matthew Lynn

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By Matthew Lynn
October 8, 2006

Oct. 9 (Bloomberg) -- When German Chancellor Angela Merkel took power last year, many people painted a rosy scenario for Europe's biggest economy.

A pro-business government leading a grand coalition with the power to push through real change? It sounded precisely like the medicine needed to kick-start the German and euro-area economies.

And now? Merkel's government, led by the Christian Democratic Union and the Social Democratic Party, looks even less effective than its predecessor, made up of Social Democrats and Green Party members.

Investors have been betting big that Germany has changed fundamentally -- and might even start to repeat the economic miracles of the 1950s and 1960s.

They should think again. Germany's political revival has run out of steam. It won't be long before its economy does the same.

``They want to, and will, stay in power,'' Thorsten Polleit, Barclays Capital's chief economist for Germany, said in an e- mailed response to questions. ``Little if any progress will be made.''

In the past few months, there have been signs of life in a German economy that until recently had been written off.

This year, the economy may expand at its fastest pace since 2000. Overall, it is expected to grow 2 percent, double last year's rate, according to the International Monetary Fund. Retail sales grew for a sixth straight month in September, as consumers went shopping before a planned increase in value-added tax.

Unemployment is heading down, and hovered at 10.6 percent of the workforce in September, compared with a record 12 percent last year. Meanwhile, confidence among German households was running at its highest rate in almost five years last month.

`Finally Shifting Gears'

It sounds good. Certainly, the revitalized German economy is starting to pick up fans in the global investment community. ``I left with the distinct impression that the biggest engine of Europe is finally shifting gears,'' Morgan Stanley Chief Economist Stephen Roach said in a recent note to investors.

Well, that's one view, and in fairness one widely shared. The benchmark DAX index has been powering ahead. It is up 12 percent this year and 21 percent over the past 12 months, putting it among the better-performing European bourses. And corporate Germany looks in better shape than it has for years.

So what's the problem?

The recent economic improvement reflects changes made three or four years ago -- as well as a general cyclical improvement.

To drive forward, the economy still needs more liberalization. And Merkel's administration appears to have given up on delivering it.

In the past few months, her government has been bogged down in party squabbles and disagreements with coalition partners.

Tax Burden

It has taken months to agree on a package to rescue Germany's expensive health-care system. And even then it hasn't gone far enough to satisfy most employers, who are obliged to pay 50 percent of a worker's monthly health-insurance premium.

The unions and the political left have been pushing for a minimum wage to be introduced in Germany, and although the government hasn't conceded that yet, it may be hard to hold the coalition together without it.

And far from cutting taxes, as the Christian Democrats promised to do during the election campaign, the grand coalition has worked to increase them. At the beginning of 2007, the VAT will rise to 19 percent from 16 percent. Tax breaks have been reduced, and income-tax rates for people earning 250,000 euros ($315,000) or more a year have been raised to 45 percent. Even as the growing economy boosts government revenue, there is no sign that any of it is being used to cut the overall tax burden.

How will that create the new generation of entrepreneurs that Germany needs? Or tempt any high-earning financiers back to Frankfurt from London or New York?

Coalition in Question

Apart from some cuts in corporate-tax rates, it is hard to think of a positive step the government has taken to improve the long-term economic performance since Merkel came to power.

One obstacle may be that the economic resurgence has robbed the political process of any impetus. After all, when the economy is growing and unemployment is falling, why go through any more painful change? The appetite is completely gone.

A bigger issue may be the coalition itself.

With the two main parties in office, one would expect them to have the power to push through unpopular legislation. After all, it wouldn't face any opposition.

The trouble is, it is a weak and divided government that can't agree on anything. Merkel lacks the leadership to impose discipline even in her own party, never mind on her Social Democratic partners.

It took some doing to make Gerhard Schroeder's government look strong and decisive. Merkel appears to have achieved it. As Polleit points out, the CDU will probably cling to power. But it won't do much.

Investors betting on the German recovery need to stop looking at what has happened in the past few years, and start concentrating on the present. Forget the new miracle. Right now, Germany looks likely to return to its old stagnant ways.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net .
Last Updated: October 8, 2006 19:55 EDT