Talk about good timing. With Germany assuming the rotating presidencies of the European Union and the Group of Eight (G8) developed nations, the country is enjoying an economic resurgence. It remains a formidable exporter of goods worldwide, its unemployment rate has eased and a recent major tax increase has not dampened economic activity as much as many had feared.

Still, there is some question whether the recovery is sustainable and whether Germany is up to meeting such long-term challenges as an aging population and a declining birth rate, according to faculty members at Wharton and German business schools, as well as other experts. The country continues to grapple with labor market issues that inhibit corporate flexibility at a time of increasing pressures from globalization. In addition, Chancellor Angela Merkel, operating in a so-called “grand coalition” government in which the opposition party has a lot of clout, remains politically constrained in her ability to carry out the kinds of economic and labor reforms she would like. Indeed, the country’s biggest industrial labor union is pushing this year for a large wage increase for millions of workers.

Some economists also question whether Germany focuses too much on exports as a driver of growth and whether the country’s vaunted small and midsize business sector, known as the Mittelstand, contributes as much to economic vitality as its proponents believe.

Economic Resurgence

As recently as 2005, Germany was derided as the “sick man” of Europe, with high unemployment and sluggish domestic demand, whose sole beacon of growth was exports, says Mauro F. Guillen, professor of international management at Wharton. “The German economy had been having troubles. Over the last 15 years or so it has underperformed other European economies. Unification [with the former East Germany] was a big shock in 1990.”

But then things began to change for the better, an improvement that was long in coming. Germany’s economy — Europe’s biggest and the world’s third largest in terms of gross domestic product — grew by 2.7% in 2006, according to Eurostat, the statistical office of the European Commission. Germany’s unemployment rate in October 2006 dropped below 10% — to 9.5% — for the first time since 2002.

Jay Bryson, an economist at Wachovia Bank in North Carolina, says Germany’s exports began to show signs of growth as far back as 2003, hit double-digit growth rates in 2004 and have been growing on a sustained basis in the high single digits since early 2005. Around the same time, investment by businesses in plants and equipment rose, further strengthening GDP growth.

“German corporations also have been making some structural adjustments over the last few years, reducing costs and becoming more flexible,” says Bryson. “The DAX [a leading index of blue-chip stocks] has more than doubled since 2003, while the [Standard & Poor’s 500] was up 50% to 60% over the same period. Profitability in German corporations has come back. And as they’ve become more profitable, that’s helped [increase] business investment spending.”

Bryson estimates that Germany’s GDP growth rate will slow a bit in 2007, to 2%. Part of the predicted slowdown is attributable to an increase in Germany’s value-added tax (VAT) from 16% to 19%, which took effect January 1. Consumers accelerated their spending in the weeks before the VAT increase took effect, which helped account for a successful Christmas season for retailers, adds Bryson. But consumer spending dropped off in January as people cut back on shopping.

Another factor expected to reduce GDP growth in 2007: higher interest rates throughout 13 nations that use the euro currency, known as the eurozone. The European Central Bank “has been tightening, and we think that will slow spending on consumer durable goods and capital spending,” Bryson says.

For the eurozone as a whole, economic growth will clock in at 2.4% in 2007, down slightly from 2.7% in 2006, according to a forecast by the European Commission, the executive arm of the European Union. The EC also estimates that economic growth for the 27-nation EU will be 2.7% in 2007, down from 2.9% in 2006.

Effect of the VAT Hike

Jean-Michel Six, an economist at Standard & Poor’s in London, notes that the three-percentage-point hike in Germany’s VAT represented a major uncertainty for the economy going into 2007 — as well as a bet by Merkel that the increase would not act as too much of a brake on economic acceleration. “In deciding the timing of this substantial hike, the German authorities gambled that the economy as a whole would now be strong enough, and consumer confidence sufficiently high, for the economy to maintain its momentum after a short blip in the first quarter,” Six wrote in a February 19 report.

Preliminary figures point to a modest increase of 1.6% for the overall retail price index (RPI), suggesting that the effect of the VAT hike was rather small, according to Six. “This is probably because retailers and suppliers absorbed a significant portion of the VAT increase,” he wrote. “Some of that absorption may be temporary, and the tax increase may be passed on to consumers in the coming months. But it is also reasonable to assume that the entire hike will not be fully reflected in retail prices, which is good news both for inflation and for consumers. In this scenario, growth in domestic demand in Germany would experience a pause in the first quarter of this year, before bouncing back in the second half of the year and continuing strongly in 2008. At this juncture, it seems reasonable to assume that Angela Merkel … has won her VAT bet.”

Michael Frenkel, dean of the WHU-Otto Beisheim School of Management in Vallendar, Germany, says exports were not the sole reason for the resurgent economy. “This is one of the big questions that economists deal with here,” notes Frenkel. “Unlike in previous years where growth has been export-driven, this is the first time the economy has been stimulated [to a large extent] by domestic demand — partly consumption and partly investment. Investment has gone up because of a more optimistic outlook. And on the consumer side, there is less pessimism about the labor market; unemployment is going down.”

Frenkel is quick to point out, however, that the current jobless rate is far from acceptable and reflects the enormous challenge of integrating the former East Germany into the country’s economy. Frenkel says he is “relatively optimistic” that economic growth is sustainable — a view shared by many. In a report on Europe’s economy, Jean-Philippe Cotis, chief economist of the Organization for Economic Cooperation and Development, has said that Germany’s strong rebound will “last well into 2008.”

According to Wachovia’s Bryson, if Germany’s growth does stall, it may be due to a lack of consumer spending. “The Achilles’ heel of the German economy remains personal consumption expenditures. In 2003, personal consumption expenditures were negative 0.5%. The most recent data, for the third quarter of 2006, shows expenditures were up only 0.8%, year over year. That’s pretty weak. In some sense, I don’t know if the expansion is truly self-sustaining. You really need consumer spending. If the world goes into a downturn, that won’t be good for Germany.”

In the short term, however, Wharton’s Guillen warns that a strengthening euro will put pressure on Germany’s export sector. A stronger euro makes exports more expensive for customers in the United States and other nations whose currencies are weak against the euro. “The German economy doesn’t grow unless exports grow,” Guillen says. “From a macroeconomic point of view, a strong euro is a problem. All of this is happening at a time when the dollar is weak. This may take away some momentum [in GDP growth]. If I had to choose one possible problem over next year — or two or three — that would be the one.”

Meanwhile, the European Central Bank remains concerned that inflation could emerge as a major issue in Germany and elsewhere in Europe in 2007. At its January meeting, the ECB left rates unchanged at a five-year high of 3.5% for the euro zone countries. ECB President Jean-Claude Trichet has, in public statements, left room for a possible quarter-point hike in March.

One reason for the ECB’s inflation worries is that the 3.4-million-member IG Metall, Germany’s largest industrial labor union, has said it will seek a wage increase of 6.5% in talks with employers this year. In 2006, IG Metall proposed a 5% wage hike and settled for 3%, plus a one-time payment of about $400 per worker. Six, the S&P economist, says that productivity increases would “probably allow” an annual increase of 3.5% to 4% in wages before stoking fears of inflation.

“A Huge Social Challenge”

Joerg Himmelreich, senior transatlantic fellow in the Berlin office of the German Marshall Fund, is one of those who is a bit skeptical about the continued strength of the economy over the longer term. “I still have doubts that this is sustainable,” he says. “In this grand coalition, the German government was not able to really reach compromises and make progress on the fundamental issues. The fundamental issues are the social health system, the pension system and the labor law system.”

Himmelreich points out that unemployment exceeds 10% in large swaths of eastern Germany, which is still struggling to be fully integrated into the powerhouse economy that emerged in the former West Germany after World War II. Many people in the East are “living either by social subsidy as pensioners or as unemployed,” he says. “This is a huge social burden.”

Six agrees that Germany faces a long-term challenge to boost its growth potential against a backdrop of unfavorable demographics — an aging population and a low fertility rate. One part of the solution, in his view, is more business investment.

“To raise the economy’s growth potential, or ‘speed limit’ — that is, the highest GDP rate achievable without triggering overheating and hence higher inflation — a sustained growth in investment appears critical,” Six writes in a report titled, “European Economic Forecast: Toward a More Balanced Growth Model for the German Economy.” This is because “strong investment growth will lead to a faster expansion in the capital stock and a correspondingly strong rise in production capacities. Yet, after the boom recorded in the late 1990s, the share of investment in GDP (the investment ratio) started a marked decline to 17% at the beginning of 2005 from 21% in 2000.”

To increase investment, Six adds, Germany needs to constrain labor costs. But he also notes that lower growth in labor costs is likely to reduce domestic demand. “To exit what appears as a vicious circle, leading to deflation (lower costs, lower prices, lower demand), the only trump card available is the ability to capture more market share abroad while reducing labor cost growth during the first stage of the investment-boosting process,” Six writes. Germany has already had success in increasing its market share abroad in such areas as machinery and equipment and construction: Its trade surplus averaged 3.2% of GDP between 1992 and 2002, but reached 6% in 2003 and 7% in 2005.

Overall, the German economy is likely to return gradually to a more balanced growth model, predicts Six. Investment will continue to rise and consumer demand will benefit from greater growth in disposable incomes.

Wharton management professor Saikat Chaudhuri, who grew up in Germany and worked for several firms there before joining Wharton, says he believes the economic recovery is sustainable because Germans realize that labor market reforms must continue as the country, like other developed nations, continues to come to grips with the forces of globalization.

“You’re seeing negotiations to change the rules and regulations of unions,” Chaudhuri notes. “It’s happening slowly, but it’s driven more by the ever-increasing demand in the world, especially by Asian economies, as opposed to being driven solely by changes in German corporations. What needs to happen is more reforms on the German side to really capitalize on lower costs.”

The Mittelstand

Since the early years of the 20th century, small and midsize businesses in Germany, most of them family owned, have been seen as the backbone of the economy. Collectively, they are known as the Mittelstand. The Mittelstand is not only important economically; it looms large in the German psyche.

Chaudhuri says these small and midsize companies remain vital to Germany because they are key suppliers to large German corporations, such as automakers and engineering firms, as well as to consumers. But the Mittelstand faces major challenges.

“That segment of the economy has been struggling over the last year to find its footing,” Chaudhuri says. “Why? Larger firms like Siemens and Henkel have been able to capitalize on global resources to reduce costs fairy easily. They’re present in all markets and can look at demand and supply and take advantage of new markets. But the midsize firms are having a lot of difficulty … competing with new products and services from other countries. The question that arises for these smaller players is whether to become players in all markets or niche players in the high-end sectors in which they have traditionally operated.”

One economist who feels that Germany is far too fond of the Mittelstand is Adam Posen, senior fellow at the Peterson Institute for International Economics in Washington.

“Most people say they’re wonderful; I say they’re evil,” says Posen. “The argument I make is you have small- and medium-size companies that don’t achieve economies of scale, are very loyal to locality, have entrenched incumbent management and work in collusion with local politicians and banks. They’re not accountable to shareholders because they’re not publicly listed, they’re closed to consolidation and they like to stay open whether or not business makes sense. They tend to be in old business sectors, which leads to barriers to entry.”

Posen says “it is by no means clear these businesses do much for the German economy,” and there are no statistics showing that they do. If these firms were vital to the economy, they would be highly competitive, creating jobs and reducing unemployment. But that does not seem to be the case, he notes.

The belief that the Mittelstand is an economic engine “just doesn’t meet the smell test,” argues Posen, adding: “It’s just a group of self-interested lobbyists. They’re totally controversial. They hold up the machine-tool industry — a few of [whose companies] are world caliber — to say, ‘We’re all great.’ Well, one German in the NBA [America’s National Basketball Association] doesn’t mean all Germans are good basketball players.”

Posen’s is also a contrary voice when it comes to assessing the importance of exports to Germany, the recognized world champion export nation, arguing that Germany would be better off not focusing on exports as a driver of growth. He discusses his views in a Peterson Institute working paper titled, “Exportweltmeister — So What? Better Goals for Foreign Economic Policy,” which is based on a forthcoming book titled, Reform and Growth in a Rich Country: Germany.

“For more than 50 years, exports have been seen as the primary driver of German economic growth, and their promotion has been the nearly sole focus of German foreign economic policy,” Posen writes. “That this focus on exports has persisted through periods both of economic success, as during the 1950s and 1960s, and of economic decline, as during the last 25 years — and thus cannot be said to be clearly associated with one or the other — seems to have escaped notice.”

He adds: “Germany’s pursuit of export competitiveness has been at best a deceptive distraction from the country’s underlying economic problems, if not a complete waste of effort that promotes distortions at home. Neither a country’s share of exports in GDP nor its relative rank in world export league tables has a significant positive effect on its economic or productivity growth.”

A Transatlantic Relationship

As Germany and other EU nations work to keep their economies healthy, Merkel’s government is casting an eye on the United States for a possible long-term trade relationship. In February, Matthias Wissmann, a member of Merkel’s center-right Christian Democratic Union party, said that a single transatlantic market between the EU and the United States could pave the way for a comprehensive opening of world trade. Merkel has said that she wants to use Germany’s current six-month presidency of the EU, which began January 1, to harmonize U.S. and EU laws and standards to boost investment and trade in both directions.

“In the long run, a transatlantic market could become a pathfinder and a pace setter for an opening of world trade which would go beyond” the World Trade Organization’s Doha round of global trade talks, aimed at liberalizing world trade, said Wissmann, chairman of the European affairs committee of the German parliament. However, creating a single EU-U.S. market for investors was not meant as a substitute for the stalled Doha round. Wissmann said that such a transatlantic deal would not come at the expense of other countries. Instead, it could benefit both American and European economies, while at the same time giving a fresh impetus to boosting global investment flows and trade.

“It’s not about fencing in Europe. It’s exactly the opposite that we want,” Wissmann told the press, according to a report of his remarks on a German government website. A transatlantic market would not be a fortress to keep out other countries but would act as a magnet for foreign investors, he said, adding that it would help the EU and the U.S. to prepare for tough competition from Asian markets.

In the years to come, Germany will continue to face formidable challenges from globalization. One thing Germany still must do, as it prepares to meet those challenges, is to loosen regulations on its service sector, according to Wharton’s Guillen.

“The service sector is a drag on growth,” he says. “Germany is still a few years behind other countries in terms of deregulation and structural reforms. Electricity, communications, banking and finance — all of these sectors are still highly regulated in Germany and they have fallen behind. This is high on Chancellor Merkel’s agenda. German banks 20 years ago were the best in Europe and the world. Today, they are no longer the best. They have fallen behind the Dutch banks, American banks and, in many ways, the Spanish banks.”

Bryson, the Wachovia Bank economist, says Germany must also think long and hard about its tendency to be protectionist, especially among the Mittelstand.

Germany “is more protectionist than the U.S., is more resistant to globalization. Some German companies are world leaders, whether in the auto industry or capital-goods producers. But the small and middle-size companies aren’t going to be as world leading if they [use] political power to make it less likely that the German government will embrace globalization in the long run. That would not be in Germany’s interest. If you become protectionist over time, economic theory says your standard of living doesn’t go up as much as it could.”