By taking steps to help victims of summer floods and by sharply criticizing the United States for considering a war against Iraq, German Chancellor Gerhard Schroeder found a way get votes and eke out a victory last month over his conservative opponent, Edmund Stoiber. Whether Schroeder can now find a way to extract his country from the quicksand of economic stagnation is another challenge that will keep Germans on the edge of their seats in the months to come.


Wharton faculty members, several of them native Germans, say Germany’s problems are so acute that little can be done in the short term to reduce unemployment and achieve economic growth. Over the long haul, they say, an economic turnaround will depend heavily on a radical reform of the country’s rigid labor markets.


“Unemployment is a disaster and the growth rate is a disaster,” says Christian Terwiesch, professor of operations and information management. “And while politicians like to blame this on world macroeconomic developments, the fact is Germany has been outperformed by almost every other European country over the last couple of years. The current situation is very frustrating. We’re in a complete political deadlock. Nothing is moving. Der Spiegel [a German newsmagazine] came out last week with a headline, ‘The Deadlocked Republic.’ Nothing moves in Germany.”


Another German, Alexander Meurmann, professor of insurance and risk management, agrees that the economy is in poor shape but disagrees as to why. “National economies are much more related to each other in a globalized world. I think the German economy depends much more on other economies than it used to. An economic downturn in the U.S., for example, has a big effect on the German economy.”


Germany’s growth rate hasn’t been that high over the last 10 or 15 years,” says Skander Van den Heuvel, professor of finance and a native of the Netherlands. “Added to that problem is high unemployment, which has been going up a lot in every recession in the last 25 years but has not been going down much in the subsequent booms.”


Schroeder and his coalition government face a situation that seems intractable. In 2001, GDP growth in Germany was 0.6%, the worst performance in the European Union. The economy was actually in recession during the last six months of the year. The International Monetary Fund projects 0.5% growth for 2002.


In 1998, Schroeder ran as a business-friendly free-marketer. He pledged that his Social Democratic Party (SDP) would reduce unemployment to 3.5 million and that voters should judge his performance in office by how well he fulfilled that promise. Today, more than four million are unemployed, or 9.7% of the labor force. In some parts of the formerly communist eastern Germany the jobless rate is twice that. What’s more, Schroeder has supported government bailouts of struggling companies and has at times favored legislation supported by organized labor.


And consider these factors:

·         The Ifo Institute for Economic Research’s index of business confidence in western Germany declined to its lowest level in eight months in September – to 88.2 from 88.8 in August.

·         ZDH, an association of small and medium-sized companies, has predicted that Germany will lose 200,000 jobs in 2002.

·         Some 40,000 companies are projected to go bankrupt this year, 25% more than in 2001, throwing 600,000 people out of work, according to The Economist magazine.

·         The 2002 World Competitiveness Yearbook, published by the International Institute for Management Development, ranked Germany just 15th out of 49 countries for its ability to provide an environment that sustains the competitiveness of businesses. In a category that rated the flexibility of labor markets, Germany stood near the bottom of the list.

·         The Neuer Markt, Germany’s answer to America’s NASDAQ stock trading system, is being closed down by its parent, Deutsche Boerse. The tech-heavy, scandal-plagued Neuer Markt has lost about 95% of its value since its peak in 2000 during the dot-com craze.


Anemic economic growth has led to lower tax revenues and boosted welfare spending. On Sept. 26, Finance Minister Hans Eichel forecast that Germany’s budget deficit will be 2.9% of GDP for 2002, which is 0.4% higher than previously predicted by the finance ministry and perilously close to exceeding the 3% ceiling established for EU members by the EU’s Stability and Growth Pact. Germany was a key player in pushing for the ceiling in the 1990s. The fear of exceeding the 3% ceiling means that Berlin cannot rely on fiscal policy to spend its way out of the crisis. In any event, taxes are already high and Schroeder on Sept. 30 rejected calls by some SDP members to boost them higher.


Using monetary policy to jump-start the economy does not appear to be an option either. The Bundesbank no longer sets interest rates; the European Central Bank does. Interest rates in the euro-zone are higher than the ECB’s target, so the ECB is unlikely to lower rates soon.


Because the coalition government of the SDP and Green parties holds such a slim majority in parliament, it is unclear if Schroeder has the political leverage to push through major reforms. The opposition Christian Democrats control the upper chamber of the legislative branch of government, the Bundesrat, where Germany’s states are represented. And the 2003 state elections probably will not shift power in the Bundesrat.


“There’s a broad consensus across German society that we need bold changes; the difficult question is what should be changed and how,” says Christian Leuz, an accounting professor who also is from Germany. “The problems are extremely complex, so some experimentation would be good. But Germans are not known to have a change culture. Most Germans fear change. On top of that, very strong interest groups like the unions make it difficult to initiate change.”


Terwiesch says that he is not a member of the “choir of people blaming the Schroeder government” for economic malaise. “I think we saw this stagnation during the last couple of years of the [Helmut] Kohl government. The problem is not the politicians. The people in Germany take for granted everything they have, including free education. Germans go to university for seven or eight years and study a little of this and a little of that because it’s free. Germany has an outrageous health care system. Health care is free; there’s no co-pay. Even if they are told they are fine, people don’t give up until they have seen three other doctors. In Germany, we’ve gotten to the point where people don’t take responsibility for their lives. They are used to a state that makes all the decisions for them and pays for everything. If it’s for free, people tend to consume too much.”


The faculty members say reforms of Germany’s rigid labor market are essential. Germany is a country with extraordinary unemployment, sick leave and vacation benefits, and job security. Indeed, one reason the jobless rate remains high is that companies hesitate to hire people because it may prove impossible to get rid of them later if business heads south.


But there may be some hope for those who believe that loosening the labor market can stimulate growth and reduce unemployment. A government commission established last year and headed by Peter Hartz, the head of human resources at Volkswagen, has issued a 343-page report containing labor-reform proposals aimed at reducing unemployment by two million jobs in three years. Schroeder has said that the Hartz recommendations, if fully implemented, would mark a major shift in German labor politics.


The report does not rely on accelerated economic growth to provide jobs. Rather, its 13 “innovation modules” are aimed at creating incentives for the jobless to find work in existing job openings or in low-wage sectors of the economy where current regulations inhibit job creation. According to Hartz, the recommendations would shorten the average length of unemployment from 33 to 22 weeks, and the government could save as much as 19.5 billion euros annually in jobless benefits by the third year of the plan’s implementation.


Among other things, the proposals call for the BfA, the federal employment agency, to restructure its local offices into job centers to serve as one-stop shops for the unemployed. In addition, the commission also recommended that BfA workers should be offered incentives to find jobs for people; that rules on temporary work be relaxed; and that tax incentives be offered to help unemployed people working in the underground economy to set up small businesses.


The federal employment office is seen by many to be a bureaucratic giant that thwarts rather than helps people find work. Previously, private employment agencies were restricted in helping the jobless find work, but they are now allowed to compete with Germany’s state employment offices.


Leuz has some doubts about how effective the Hartz recommendations will be. “They were generally welcomed by economists,” he says. “But they don’t go far enough. The key issue in my mind is not how to efficiently administer the unemployment agencies. The key issue is to create new jobs, to create growth in the economy.”


Van den Heuvel calls the Hartz plan “a step in the right direction,” but wonders if some of the jobs it will create will be “really permanent or artificially created … My overall impression of the plan is it’s not very radical. These are small steps in the right direction. But they’re small steps because there isn’t the political will in Germany to change things.”


According to Terwiesch, the Hartz report will be a “big step forward” if most or all of its recommendations come to pass. “But the Hartz commission is not about improving the overall economy. It’s a paper that describes how to match jobs with unemployed people and a reorganization of the state employment agency. It’s a very focused piece of work. By and large it does a good job. But there is more to be done.”


Terwiesch suggests that Schroeder should implement the Hartz proposals immediately. “It’s now or never. They are going to have to start working on it this year. Schroeder is a politician who has a voice on both the union and employer sides of the fence. He is the kind of guy who could get this going. But if it doesn’t happen immediately, it’s too late.”


On October 7, Schroeder named Wolfgang Clement to a new “superminister” post, with responsibility for both the economy and jobs. Clement, 62, vice chairman of the SDP and premier of the state of North Rhine-Westphalia, will be in charge of implementing the provisions of the Hartz commission. Clement will succeed two ministers in Schroeder’s cabinet – the labor minister and the economics minister – and the two departments will be combined into one. North Rhine-Westphalia is Germany’s most populous state.


For his part, Meurmann is optimistic about the Hartz plan. “I have a good feeling about this. Peter Hartz himself changed his contracts with workers at Volkswagen to make them much more flexible. He introduced a week with only four working days and reduced wages an average of something like 15%. Now when there is higher demand for cars and employees work longer hours, they are not compensated directly through overtime pay. Instead, they get time which they can use in several ways, like for early retirement. I think the Hartz plan is a very good way to go.”


Peter Cappelli, management professor and head of Wharton’s Center for Human Resources, makes another point. The Hartz proposals “sound very much like actions that have been taken in the U.S.,” he says. “The ‘one-stop’ job centers, for example, were put in place by the Clinton administration, and the other actions are designed to help the labor market work better. These are individually small initiatives, but they represent a very different approach toward finding jobs – away from the notion that it is the government’s responsibility to find work or assistance and toward the idea that the government will simply help the market do it.”


Cappelli also notes that while labor market reform in Germany may be needed to some degree, many Europeans simply do not believe that American-style capitalism is in the best interests of either their companies or their countries.


“The issue is what makes companies and economies competitive,” Cappelli says. “The American view is that what drives competitiveness is a company’s ability to restructure quickly. If you think that’s the case, then the European countries in general are at a disadvantage because it’s harder for them to restructure. But the Germans and other Europeans don’t believe that the key to competitive advantage is the ability to restructure your company quickly to get costs down. German companies think about lifetime investments in employees much more than U.S. companies do. They take that as a fact of life.”


In a sense, the collapse of the tech-heavy Neuer Markt could be emblematic of Germany’s economic hard times. Companies went belly up. The reputations of some corporate high fliers were damaged. And average Germans, traditionally averse to equities to begin with, may not be interested in small company growth stocks for a long time.


But Leuz, who has conducted research on the Neuer Markt, says the upstart exchange had more than a few positive effects and that Germany’s budding equity culture may not have disappeared altogether. “The reports on the closure of the Neuer Markt, often throw out the baby with the bathwater,” Leuz notes. “The Neuer Markt created a lot of good things. It raised transparency standards; quarterly corporate reports were not standard prior to the Neuer Markt; and it also instituted lock up periods for insider trading, meaning you could not sell shares for six months after the IPO.”


In general, Leuz adds, the Neuer Markt’s regulations “were a lot tighter than those of regular stock market segments. Many of the concepts they had were right. The Neuer Markt far exceeded corporate accountability requirements under German law. What the Neuer Markt revealed were weaknesses in corporate governance and securities regulation. People now realize it’s not good enough to adopt high-quality accounting standards; you have to enforce them. The accounting scandals in the Neuer Markt suggest that the enforcement of standards was not tight enough.”