TCS Daily

Germany: Not Dead Yet

By George A. Pieler - October 18, 2005 12:00 AM

Conventional wisdom has it that Germany's muddled election and left-right "grand coalition" government show the nation is fundamentally resistant to economic reform. Free-market conservatives saw Angela Merkel's center-right coalition convert a massive poll lead into a dead heat, while fans of Euro-style big government renewed their sense of smug satisfaction with Germany's economic stagnation, which they see as essential to preserving the myth of the "European social model" (i.e. a generous welfare state coupled with high taxes and regulatory overreach).

It may be tempting to extrapolate from a single, big moment in politics to predict the future, but here the temptation should be avoided. The emerging CDU/CSU/SPD coalition is not the last word on Germany, or on Europe for that matter. To understand that you have to dispel the myths surrounding an admittedly messy election.

First Myth: Germany lacks the will to escape economic stagnation. Since German voters failed to embrace Angela Merkel's plans for modest labor market reforms, the theory is that Germans will never do so. This is a stretch. While labor reforms were indeed a point of controversy, voters faced a choice between modest reforms (Merkel) and very modest reforms (Schröder). Indeed, reaction to Schröder's initial reform measures provoked his call for early elections and gave him a perfect opportunity to triangulate by suggesting that, while his reforms were necessary, Merkel's would go so far as to destroy the nation's social welfare compact.

As Jens Laurson of the International Affairs Forum wrote in June, Schröder "probably won't win, but he may well see the SPD finish significantly better than anyone would be willing to predict now, thus consolidating his power within the party...and at the same time ensuring that the reform policies will be continued." So it proved. The bottom line: since Germans voted overwhelmingly for candidates who offered some labor market reforms, it is silly to write off the prospect of reducing labor costs, even under the divided "grand coalition".

Second Myth: Tax rate cuts, and serious tax reform, are a dead issue in "Old Europe". Schröder's successful assault on Merkel for daring to consider a flat-tax advocate for finance minister is the source of this myth. But there was also controversy over Merkel's plan to swap out a modest payroll-tax cut for a small VAT increase. Further, since Merkel never embraced the flat tax, she made herself vulnerable to being hammered over its redistributional impact, while unable to preach its economic advantages for ordinary Germans. The worst of both worlds, surely. Meanwhile the Free Democrat Party (FDP) plan for across-the-board rate cuts got lost in the haze.

Since the case for serious tax reform never reached the voters in this election, it's premature to claim that Germany is a lost cause regarding tax reform. Indeed that cause remains economically urgent: as Nico Wirtz observes, "reform economies in Central and Eastern Europe which have embraced the flat tax...are growing, while Germany's economy is stagnating." And the flat tax may be coming closer to home, since Donald Tusk, the leading candidate in Poland's October 23 Presidential runoff election, wants a 15 percent flat rate tax. Ironically, Poland's new center-right parliament is as conflicted as Germany's over restraining social welfare costs. More economic growth, anyone?

Third Myth: Germany is irrevocably aligned with Old Europe's welfare state. Nothing is irrevocable but change. While Germany today shows little interest in aligning with the UK and the fledgling economies of New Europe, it can't stand still. Social benefits in the UK and New Europe are quite ample, in any event. More critically, the massive welfare state can't be financed without strong economic growth, and Germany's near-12 percent unemployment can't square with its welfare obligations. The Baltic states and the Slavic nations are moving towards boosting growth with the flat tax. Geopolitically, Germany can maximize its leverage in Europe only by gravitating towards those neighbors, and providing a more progressive bridge between Old and New Europe than it has been willing to build so far. If Germany can't compete with these upstarts, it will never assume the role of economic leadership the EU seems to expect of it.

Indeed, Tony Blair and other EU leaders invested too heavily in pre-election predictions of a dramatic Merkel-led reform agenda that would somehow jump-start EU-wide reforms. That was never realistic, and now Merkel is saddled with a cabinet heavily dominated by Schröderites who can block her more ambitious plans. For these reasons no one should underestimate the challenges ahead, or expect Germany to reform rapidly. Yet Merkel, like Schröder, has consistently been underestimated as a politician. If she can press ahead and rightly assign blame to the Left for obstructing economic reform, the next election can yield a better result.

Ultimately, despite Europe's enthusiasm for global regulation and high taxes, Europe knows it must reform to compete with Asia and the United States. German voters, however cautious they may seem today, ultimately will grasp that unleashing market forces is their only way forward. They will grasp that sooner if their personal stake in the outcome-lower taxes, less red tape, more jobs, and the genuine economic security provided by a robust, efficient economy-is spelled out for them clearly. Sticking relentlessly to that message will help the center-right parties get it right next time.

George A. Pieler was Tax Counsel to the Senate Finance Committee in the 1980's. He is a Research Fellow with the Institute for Policy Innovation. The views expressed herein are his own.


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