During her first few months in office, German Chancellor Angela Merkel has attained the kind of approval rating that politicians the world over dream about, largely due to the way she has handled herself on international matters in visits to Washington, Moscow and Brussels. According to a poll by Der Spiegel, the newsweekly, 85% of Germans like the way Merkel is doing her job. But ask any politician — George Bush, Tony Blair, Jacques Chirac — about the likelihood of retaining such a lofty number and they’ll tell you that what goes up can just as readily come down, especially when tough domestic issues have to be addressed.

In Merkel’s case, that means trying to figure out ways to juice up Germany’s economy, Europe’s largest and the world’s third biggest. It is a challenge that has been staring German leaders in the face for a long time, for a number of reasons: lackluster GDP growth over the last five years; a vast, overburdened welfare state; an anemic service sector; stubborn protectionist sentiment, and an aging population that will place greater strain on the nation’s budget in years to come. In whatever policies she proposes, Merkel will have to tread softly so as not to alarm citizens and trade unions wary of change, yet firmly enough to achieve substantive results, say scholars at Wharton and business schools in Europe.

Nonetheless, surveys show that citizens and businesses alike are in the kind of upbeat mood that Germany has not enjoyed in years, an optimism that Merkel, who completed her first 100 days in office on March 1, and her coalition government may be able to capitalize on. German business confidence, as measured by the Ifo index, rose from 101.8 in January to 103.3 in February.

Mauro Guillén, a professor of international management at Wharton, says Germany has something of a schizophrenic economy. Its manufacturing base remains a powerhouse and highly competitive globally, but its service economy is a relative weakling.

Germany turns out some of the best products in the world, such as machine tools, automobiles, precision instruments and specialty chemicals. And Germany is one of only two large, developed economies (the other is Japan) that enjoy huge trade surpluses. “The manufacturing sector in Germany has been very innovative, and Germany has wonderful research and development systems,” Guillén says. “The Americans and the British wish they had competitive manufacturing sectors like the Germans. Unfortunately, the global economy is a service economy. Germany in this area is not very competitive.”

Germany’s service economy does boast some well-performing software and insurance companies, but the rest of the service sector is in sore need of global winners. “German banks are in dire straits,” notes Guillén, “and in other types of services like energy and infrastructure, Germany over the last 10 years has made a huge mistake in not deregulating and liberalizing. They’re suffering big time from this.”

Guillén believes two or three of Germany’s banks are so poorly managed that the government should allow them to be acquired by non-German financial institutions. But protectionist sentiment is strong in Germany, as it is in other European countries. “Germans have to get serious about the service sector — privatization and deregulation and letting foreigners buy German firms in those industries where the foreigners are better equipped to run those sectors,” Guillén says. “The government has been very protective. It has prevented takeovers.”

Although Germany’s unemployment rate has been gradually trending downward since mid-2005, it is still a worrisome 11.3%, according to seasonally adjusted figures for February. (America’s, by comparison, is only 4.7%). And Germany’s recent rates of economic growth can charitably be described as so-so. GDP was flat for the fourth quarter of 2005 when compared with the fourth quarter of 2004. During the third quarter of 2005, the economy posted a 0.6% increase over the year-earlier period. The Organization for Economic Cooperation and Development forecasts that Germany’s GDP will grow by 1.8% in 2006. A poll of economists by The Economist magazine projects a rise of 1.7% for the year, while the German government predicts growth of just 1.6%.

Bruce Kogut, a management professor at INSEAD near Paris, says Germany’s economic malaise can be traced, in part, to two important economic shocks in the 1990s. First, the former West Germany absorbed over 16 million people from the former East Germany. Then, the reunified Germany, like other members of the euro zone, placed its monetary policy in the hands of the European Central Bank.

“It thus had no economic instruments — such as devaluation or inflation — by which to respond to these shocks other than cutting wages and increasing hours of work,” according to Kogut. “Germany has managed to do both, largely in cooperation with the unions. I view these challenges as now met, and I am very optimistic on the economy.”

“From what we can tell, Merkel is very pro-market oriented,” says Wharton finance professor Richard Marston. “She realizes the kind of reforms that are necessary. I have a positive impression of her.” But Marston adds that he does not think Merkel will be able to do all that she may wish to accomplish given that she is presiding over a fragile coalition government comprising her conservative Christian Democratic Union (CDU) party, the conservative Christian Social Union (CSU) and the left-leaning Social Democratic Party (SDP). This so-called “grand coalition” was formed following Merkel’s wafer-thin election victory last fall. Merkel had a huge lead in the polls months before the election. But that advantage dwindled as Merkel — who grew up under Communist rule in East Germany, holds a doctorate in physics and has worked as a chemist — began to talk bluntly about the need for sweeping reforms that would chip away at Germany’s social programs.

Some in the European press have taken to calling Germany the “sick man of Europe” in recent years, but that moniker is disliked by Paul Isbell, senior analyst for international economy and trade at the Elcano Royal Institute in Madrid. He says the term is “sensationalist and would be inappropriate in any case. If I could, I would throw the term into the ‘dustbin of history’ forever.”

Nevertheless, Isbell says, the economy ought to be stronger. “The German economy, still moving through a long period of adjustment to global realities and transformations within Europe, could be experiencing more dynamic growth [than it is]. Indicators are indeed mixed, but at least the confidence indicators finally have picked up. Despite disappointing growth in the fourth quarter, if business and consumer confidence can hold on through the first half of 2006, and if oil prices do not surge again too soon, and if the euro-dollar relationship maintains its recent stability, we could expect domestic investment — driven by dynamic exports — to continue to rise.”

Saikat Chaudhuri, a Wharton management professor who grew up in Germany and once worked in Dusseldorf as a consultant for McKinsey, describes the economy as “coming back and growing.” But, he says, Germany needs to lower corporate tax rates and accelerate labor-market and other reforms begun by Merkel’s predecessor, former Chancellor Gerhard Schroeder. Chaudhuri stresses that companies must be given more flexibility to adjust workforce levels and to reduce the associated costs of employee social benefits. “Corporate tax reform would be the least controversial; labor reform would take the longest amount of time,” Chaudhuri says.

But, he cautions, neither Merkel nor any other chancellor would “ever be able to — nor would it be wise to — abandon the socialized system in Germany and move to a clear Anglo-Saxon model. That’s difficult to do in Germany. The bulk of the opposition to Merkel is so used to it. There’s a large base that supports that system, including eastern Germans. You can’t radically transform systems overnight. It will have to be done in a piecemeal fashion.”

Isbell concurs. “Labor unions don’t like the idea of more labor-market reform, particularly if it is not part of a broader web of mutual concessions between business, labor and the government. Nevertheless, German labor unions have become more flexible in recent years, under pressure from the previous SDP government, and are aware that they can’t easily reject reforms wholesale and hope to hold out forever. Labor-market reform continues to be important over the middle run for Germany’s economy. And the government must achieve this goal sooner or later. Should Merkel try? Yes. Will she succeed? The answer is somewhere between possibly and probably.”

Jay Bryson, an economist at Wachovia Bank in North Carolina, agrees that the economy shows signs of strength. “It’s not to say that Germany’s coming out of the woods,” he says, but the country is “slowly moving in the right direction.”

One indicator of the positive movement for Germany, adds Bryson, can be seen by comparing the recent performances of the Standard & Poor’s 500 stock index and the German DAX index: Since 2003 the S&P 500 has risen about 50% while the DAX has more than doubled. “Part of the reason is that German corporations are becoming more profitable. They have done some restructuring, and labor costs are coming down,” he says. “A modest expansion started out as export-led but has now trickled into capital spending. The missing ingredient is consumer spending. That remains sluggish.”

Less Saving, More Shopping

Indeed, consumer spending is so sluggish that the German government is hoping citizens will spend more money than they have been in the last few years. Many German consumers, worried about job losses and the shaky future of the government pension system, have been squirreling their money away for a rainy day. The federal budget released by Merkel’s government during the week of February 20 postponed the kinds of major tax hikes and spending cuts that many feel are needed to reduce the government’s near-record borrowing to pay for social programs. “If consumer spending could register even a minor pick up before the imposition of the proposed new VAT tax next year, Germany just might move forward another step on this long road to adjustment,” Isbell notes.

German finance minister Peer Steinbruck has made it clear that the country’s enormous fiscal problems can only be solved if the economy picks up steam and the labor market is liberalized. “We can’t save our way out of the budget problems. That’s a hopeless prospect,” Steinbruck told London’s Financial Times. “There will only be progress if there is also movement on the economy, in the labor market and regarding our social security system.”

Holm Koehler, a native of Germany and a professor at the University of Oviedo in Spain, points out that domestic demand has been shrinking for several years due to real income stagnation, high unemployment and the slowly shrinking welfare state. But he also notes that Germany is suffering two structural problems with no easy solutions.

“First, for 15 years, more than 4% of west German GDP has been transferred to eastern Germany without bringing the eastern economy nearer to western competitiveness. Second, German companies are internationalizing and using cheaper locations, particularly in Central Europe. Both tendencies imply an employment problem and a public finance problem.” Koehler agrees with Wharton’s Chaudhuri that a seismic shift to the Anglo-Saxon model is unlikely to take root in Germany. “The neo-liberal dogma of less state, more private activity has always been a myth and dangerous ideology, particularly for Germany,” he says.

Constraints on Merkel

Douglas Webber, professor of political science at INSEAD, says the 2005 election results left Merkel constrained in a couple of ways. “She couldn’t form a coalition with the Liberal Party [also known as the Free Democratic Party], which certainly would like to do the economic reforms that she wanted. The second message from the election result was that radical economic reforms are still quite unpopular.” This resistance to reforms is shared by the working class and middle class alike, he adds.

While the presence within the coalition of the SDP, which is committed to income redistribution and social justice, does put limits on what Merkel can achieve, the Social Democrats have seen their poll numbers slip. “This gives her greater latitude,” Webber says. At the same time, however, a sizeable portion of Merkel’s own party is less of a free-market adherent than Merkel, thus constraining her from the inside. “The Christian Democrats have always been in favor of a social market economy and in favor of strong state intervention to correct inequities in the distribution of income that arise from the working of market forces.”

With Merkel riding high in opinion polls, it has been suggested that she call an early election to capitalize on her popularity and strengthen her hand vis a vis her coalition partners. But Webber says that move would not be easy. “The German chancellor is not entirely free to call a new election,” he says. “Such decisions must meet certain criteria laid down by the constitutional courts. Second, politically it may be a dangerous move to undertake unless there is a substantive issue with respect to which the chancellor can say, ‘This is important and the views of the Christian Democrats and the Social Democrats are irreconcilable,’ and use this as a pretext to call new elections. My view is the Social Democrats may be willing to make concessions to the Christian Democrats rather than call new elections.”

Kogut notes, too, that any chancellor in Germany, especially one in a coalition government, must always work with labor and business to achieve political and economic goals.

“Germany differs very much from the U.S. [in that] German business often — though, of course, not always — appreciates a cooperative and strong labor partner,” Kogut says. “Labor, too, wants a legitimate partner. I do not expect great changes here, nor do I think their continuity will hamper recovery. I do, however, expect a lot of pressure to change the law that puts labor onto the Supervisory Board of German corporations. I don’t think this has been effective or useful for good governance, though symbolically, it will be hard to change.”

According to Marston, Merkel has a long road ahead of her. In his view, German citizens — and many politicians — have reacted to Merkel’s calls last year for economic reform in much that same way the Americans and American politicians reacted to President Bush’s attempt to make changes to the Social Security system.

“It’s difficult for politicians to make decisions because German voters probably don’t believe there is a crisis yet,” Marston notes. “Merkel, or people working for her, made too clear [during the 2005 election campaign] what her agenda was. Toward the end of the campaign, she lost more and more support. Now she’s in a position where she has to rely on the Social Democrats for support. It’s going to be difficult for her to make major decisions. She’s not in a position like Margaret Thatcher was when Thatcher won a big majority [which allowed her to introduce major reforms in Britain in the 1980s].”

Merkel has already achieved much and has the talent to do more, says INSEAD’s Webber. “Anyone who has managed to make it to the top of the heap in the German Christian Democratic Party is a very savvy political operator. They don’t have a long record of forgiveness for failed political leaders…. And she has built up in the CDP a network of supporters which should protect her against any inner-party dissent if her popularity should decline. The second thing is she is not primarily an ideologue. She is a pragmatist. She is something like a political technician as opposed to being the kind of political orator that Schroeder was.”

Isbell, of the Elcano Royal Institute, thinks the existence of a coalition will actually help Merkel. “I feel that both her popularity and her government’s coalition status will help her in achieving further reforms. Her popularity can’t hurt, and the fact that she is in a coalition with the SDP — a party with, in my opinion, a much more convincing record of economic reform as of late — should eliminate the possibility that the CDU will betray its reformist principles yet again in order to pander to a broad constituency so as to shoot for an easy reelection.”

A Remarkable Story

Guido Stein, a professor at the IESE Business School in Spain, says Merkel’s rise to power — she is Germany’s first woman chancellor — and surge in popularity since the election have been remarkable.

“President Harry Truman used to say that ‘the seat of the power makes the president,'” says Stein. “This has been the case of Angela Merkel, a 51-year-old housewife coming from the Eastern Bloc. With such a low profile, nobody would have even dreamt of what they are seeing now. Taking into account the short span of time we are considering, I think that she is doing quite well. At the beginning of her term, her most potent weapon has been the people’s reluctance to put too high an expectation on her.”

Despite the domestic challenges, some think Merkel has what it takes to mature into a formidable leader, both within and beyond Germany’s borders.

Says Kogut: “I heard Chancellor Merkel speak at the opening of the new building for the European School of Management and Technology in Berlin. She speaks with a striking clarity and candor that engages the public. She will be a major European politician, not simply the German chancellor. She has tremendous intellectual and leadership gifts. She has arrived at a perfect time, economically and politically, to restore Germany as the dominant European country, at least on the continent. For her, the critical polls will be European, and I see for the first time a continental European politician in the making.”