In November, Germany celebrated the 20th anniversary of the fall of the Berlin Wall in style. But that wasn’t the only reason Europe’s economic powerhouse had to celebrate. A few weeks earlier, Germany reported that its economy grew for the second consecutive quarter — albeit at a modest 0.7%, according to the European statistics agency, Eurostat — marking the end of its recession. Along with equally good news from France, German’s recent growth record has provided welcome relief for the rest of Europe, indicating that perhaps the worst of the global economic downturn is over.

All eyes are now on Germany. After all, "it is the most powerful economy in Europe, and the one that pulls the most weight,” says Rafael Pampillón, professor of economics at IE Business School. “It is also [Europe’s biggest consumer] and, as a result, Germany is the main customer for most European countries.”

Encouragingly, manufacturing and exports — which have long been two critical components of Germany’s economy — have been regaining their strength. According to the Federal Statistical Office of Germany, its exports were 2.5% higher in October than in September. (Though imports dropped 2.4% amid sluggish consumer demand and falling factory orders, causing the country’s trade surplus to rise to 13.6 billion euro.) Meanwhile, consumer prices fell 0.1% in November from the previous month — the first time since June 2009 that Germany has reported positive inflation.

Yet Germany can’t rest easy. With a population of 82 million making it the largest country in the EU by population and GDP, it is also heavily dependent on the pace of recovery of other economies, particularly those buying its exports. And it, like the rest of the E.U., knows too well that rising unemployment levels, the heavy economic burden of government stimulus measures and the strong euro can still weigh down a recovery among all its 27 member states in the year ahead. Can Germany lead the way to recovery, especially in countries such as Spain that have been hit hardest by the downturn?

Made in Germany

What the downturn highlighted was just how dependent Germany’s economy is on its exporting might. According to the country’s economic ministry, German exports were the equivalent of nearly 50% of its GDP in 2008 (compared with, say, 20% in Japan and 13% in the U.S. about 13%). Today, the country, which is world renown for its high-quality, yet comparatively expensive cars, heavy machinery and engineering products, “has based its recovery on its strong point — that is, its exports,” notes Pampillón.

Federico Steinberg, chief researcher in international trade and economics at the Real Instituto Elcano, a Madrid-based think tank, notes that the collapse of international trade during the economic crisis immediately had a strong impact on Germany’s economy, whose GDP in the last quarter of 2008 contracted 2.2%, month on month, according to Eurostat, having shrunk 0.2% the previous quarter.

“But now the global economy is beginning to awaken, and especially because of the boost from sales of consumer goods and heavy machinery to emerging Asian nations, external demand is beginning to pull Germany ahead strongly,” says Steinberg.

The two consecutive quarters of growth make that clear. Steinberg adds that to some extent, the country has the reunification to thank for its strength today. It was in the 1990s, after reunification, that "they made significant structural adjustments to lower their unit labor costs and increase the external competitiveness of their exports," he explains.

Despite the bounce back of the country’s export-focused model, it still hasn’t fully shaken off its old reputation as "the sick man of Europe" (a moniker now given to Spain). For years, it has struggled with structural weaknesses, such as inflexible labor market policies that have hamstrung many companies by making hiring and firing of staff extremely difficult and burdening them with hefty social charges.

An editorial in the Financial Times Deutschland published shortly after the anniversary of the fall of the Wall noted that despite the recent upbeat economic news, it is too early to say that Germany has recovered its position as an exporting nation par excellence — especially since China overtook Germany as the world’s leading exporter in the first half of 2009. The editorial advised the country to shed its reliance on exports and turn its focus to increasing efforts to revive domestic consumption. In some ways, the country is heeding that advice.

Consider Germany’s automotive sector. Robert Tornabell, professor of finance at ESADE, says it might be one of the keys to the country’s economic resurgence, citing an effective stimulus program aimed at German automakers. In 2009, the sector — having faced a drop in its exports of about 19% — was buoyed by a government program for exchanging and scrapping vehicles, including a 2,500 euro rebate for consumers buying cars that are new or less than 12 months old and comply with the Euro4 emissions standard. Since the program began, car sales in the country have increased 25% year on year, according to the German Automobile Industry Association. It forecasts that car exports will increase between 1% and 3% in 2010.

Pampillón adds, “For the time being, the incentives are pulling [both] the European and German economies along." But he also notes that the German auto sector has excess capacity of about 20%, which "will have to be turned into scrap and reconverted.” All told, the sector could be undergoing “something similar to the textile industry years ago, when the emerging nations began to produce textiles and ruined the European [textile] industry.”

German Lessons

Tornabell notes that Germany’s export-led growth has had a positive domino effect, particularly when it comes to job creation – "three out of every five jobs depend on exports,” as he notes.

Perhaps Germany’s biggest achievement has been its ability to keep unemployment under control. In November, it was 7.6%, according to its federal labor agency, which was lower than most of its trading partners, including France (9.1%) and Spain (19.3%). The key is its "Kurzarbeit", subsidy scheme, which gives many companies much-needed flexibility to adjust working hours as their businesses began slowing down. The idea is to avoid layoffs and further damaged to consumer confidence by combining unemployment benefits with reduced working hours. The government compensates up to 60% of the salary employees lose and permits them to have other jobs, while also paying for some of their employers’ onerously high social expenses. Steinberg says the plan makes sense for a number of reasons, particularly in that companies can make temporary adjustments to cope with the downturn, yet aren’t incapacitated by decimated workforces when it’s time to ramp up as the recovery gains momentum.

Now, other countries facing escalating unemployment are considering their own Kurzarbeit programs. That includes Spain. Like Germany, Spain also has a long history of rigid labor policies and strong trade unions, which strongly question any structural reforms that might negatively affect workers’ rights.

Experts believe that Germany’s plan could be adapted to Spain. But as Steinberg notes, unlike in Germany, some of the damage from the downturn in Spain is irreparable and require permanent structural changes. “In Spain, things are different because the crisis is going to force clear changes in the pattern of growth, which has been very dependent on the real estate sector until now," he says. "For example, it does not make much sense to job share in the construction sector because after the crisis, we are not going to continue with the same level of production. In the automotive sector, that could happen, but not in construction. You have to deal with things case by case."

According to Tornabell, the Kurzarbeit approach is, nonetheless, attractive to many sectors in Spain because “it enables training for workers, which improves productivity and makes it easier for workers to remain tied to a company.”

Spanish politicians have been saying that some sort of Kurzarbeit plan will be introduced in the country at the beginning of 2010. However, the details of how the model will be adapted to Spain have yet to be hammered out.

The Political Autobahn

Politics, of course, also has a role to play in the recovery. According to experts, the new centre-right coalition government — with Chancellor Angela Merkel’s conservative CDU party and the liberal (and business-friendly) Free Democratic Party (FDP) — is positive for the business community. “The certainty of a stable framework for institutional relationships is definitely going to generate economic growth,” asserts Pampillón. “Although the coalition partners are in a confrontational phase right now [as they hammer out issues around] healthcare, education and taxes, it will pass because this is a [political] marriage that people want.” He adds that Merkel — “a quiet person who generates consensus” — is pivotal in resolving the internal squabbling.

Merkel was also a pivotal leader during the early days of the financial crisis, says Tornabell. “She was very brave and reacted very well during the first moments of uncertainty about the financial system," he says. "She said that the government would guarantee the money that all of the people – not the companies – had in the banks,” which had a calming effect.

However, the crisis isn’t over and Merkel faces a number of skeptics who question whether the government measures will lead the country to a full recovery. Among the skeptics: The opposition Social Democrats Party (SDP). Its members have criticized recent tax-reform measures as arbitrary and favoring higher-income families.

The tax reform is indeed a major part of Merkel’s recovery plan. In a bid to stimulate local consumption, Merkel’s government has been pushing for a broad tax reform package helping families and businesses alike. It was passed by Germany’s lower house of parliament in early December and if passed by the upper house, tax deduction for families will increase in the beginning of January for each child, from 6,024 euro to 7,008 euro, and a family subsidy has been increased as well.

But Merkel’s new government also needs to address the public-sector deficit, which rose to around 1.5 trillion euro after the massive government bailout. Standard & Poor’s, the ratings agency, estimates that it will reach 3% of GDP in 2009, in contrast with the balanced budgets of 2007 and 2008. It could go as high as 5% of GDP next year if unemployment levels increase.

Meanwhile, S&P forecasts that the burden of the German government debt will reach a up to 80% of GDP in 2011, compared with 66% last year, before decreasing again. Despite these forecasts, S&P has maintained its AAA long-term rating for Germany, and A-1+ for the short term.

As for overall economic growth, many are cautiously optimistic. In its biannual forecast released in early December, the German central bank expects the country’s GDP to contract 4.9% and forecasts 1.6% growth in 2010, slowing to 1.2% in 2011.

But Tornabell reckons that “if global trade continues to strengthen, it is possible that Germany will end the year much better [than expected].” The rest of Europe is collectively holding its breath. As he notes, “If Germany recovers, it will bring France along, and the two of them will pull other countries along," including Spain — whose economy contracted 0.3% in the third quarter — "since our main customers, aside from the United Kingdom, are Germany and France.” And his wish for the holiday season? “May the growth engine pull us forward soon!”