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Schroeder faces economy crunch

By Juergen von Hagen

Monday, Oct 21, 2002, Page 9

ILLUSTRATION: MOUNTAIN PEOPLE

A month before his re-election last month, Chancellor Gerhard Schroeder seemed a certain loser. People resented his failure to keep his promise from 1998 to reduce unemployment. Now, with Schroeder back in power, it's Germany's economy that seems the certain loser.

Chancellor Schroeder's job, as everyone now recognizes, was saved by floods in eastern Germany and his opportunistic crusade against America's Iraq policy. Each allowed him to preen successfully as a crisis manager.

But the price of switching the terms of the debate away from economics is that the chancellor now lacks a mandate to undertake serious labor market and other reforms. Indeed, Schroeder committed himself strongly to trade union demands during his campaign.

At the beginning of his first term, Schroeder appeared to be a modern social democrat who understood business. When he ousted his first finance minister, Oskar Lafontaine, Germans became optimistic about reform and an economic upswing.

Those hopes have vanished. Germany's vital small and medium-size businesses -- the famous mittelstand -- has not only lost its dynamism, but investment in this sector is grinding to a halt. Together with today's weak consumer demand, this is a recipe for economic malaise.

Equally troubling, Schroeder embraced the misguided reform proposals put forward by the "Hartz Commission," a panel of representatives from industrial and trade union interest groups. Its proposals are based on the illusion that a key factor in German unemployment is an ineffective labor market bureaucracy that fails to match those searching for jobs with the many jobs on offer.

The real problem

In reality, German unemployment is primarily a problem of a lack of jobs for low-skilled workers. Germany's welfare system effectively creates a minimum wage for the low skilled that is so far above the market price that it effectively prices such workers out of jobs. Implementing the Hartz Reforms has now become a primary government commitment that will distract attention and political will from the reforms that are really needed, namely an overhaul of Germany's social support system.

Making Germany's economic prospects even gloomier is a looming round of tax hikes. An increase in gasoline taxes is set for January next year. Income tax relief due next year has been postponed. Post-election talk abounds about higher wealth taxes, business taxes, and an increase in value-added tax -- precisely the opposite of what Germany's economy needs.

Tax hikes will not solve the government's fiscal problems, because weakening growth ultimately means less tax revenues. Finance Minister Hans Eichel's policy is bound to become as erratic as the fiscal policies pursued by the last Kohl government. Efforts to find new revenues will chase spending cuts that in recent years have led to a decline in public-sector investment and education spending and a shift in responsibility for welfare spending from the federal to local governments.

Eichel's commitment to balancing the budget is certainly important, but balancing the budget is no substitute for a medium and long-term strategic perspective for fiscal policy that promotes sustainable growth and recognizes the need to invest in Germany's ailing education system. In many German schools today the youngest teachers are well beyond their mid-forties, while universities find it increasingly hard to attract young researchers and faculty.

Europe's experience over the past 10 years teaches that fiscal consolidation must be supported by growth-friendly tax and spending policies. Both spending and taxes must be used to strengthen the incentives to work, invest, and innovate.

Even if Schroeder wants to push for reform, his political position will make such efforts difficult. His thin majority in the lower house of the Bundestag faces an upper house dominated by the opposition Christian Democratic Union/Christian Social Union (CDU/CSU). So any proposal will be subject to tricky negotiations and the need to cater to the special interests of laender governments, further reducing the prospect of serious reforms being undertaken.

Short-term focus

This last point has broader implications. Germany's political center, where elections are won and lost, remains undefined and unstable concerning policy priorities. So long as the campaign's focus was on economics, Schroeder's government was a clear loser. When the focus shifted to flood relief and foreign affairs, a majority in the center embraced Schroeder's disregard of international commitments and alliances.

This suggests that a majority of Germans still do not yet perceive economic weakness as more important than other, more short-term issues. It also signals, correctly, that both main opposition parties did not appreciate the implications of Schroeder's victory in 1998. For much too long, they saw it as an unhappy accident to be corrected at the first opportunity. So neither the CDU/CSU nor their liberal allies, the Free Democrats, offered convincing policy prescriptions for dealing with Germany's economic problems.

Indeed, Edmund Stoiber's economic policies as premier of Bavaria were and are no less interventionist than those of Schroeder. The opposition's main campaign claim was a suggestion that the right is more competent than the left in managing the economy. But this was merely rhetoric. The right's lack of clear alternative policies made it easy for voters to turn back to the Chancellor when he decided not to talk about the economy.

The next four years will challenge both the government and opposition. Schroeder will be confronted by the need finally to address Germany's real economic problems. The CDU/CSU and the FDP will be forced to present convincing alternatives to Schroeder's policies. Until one side or the other acts decisively, Germany will remain economically weak and politically unpredictable.

Juergen von Hagen is professor of economics at ZEI, University of Bonn, and the Center for Economic Policy Research.

Copyright: Project Syndicate
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