Hamish McRae: The tantalising prospect of a Teutonic revival as long as the electors can tolerate change

The elections a week from now have come to take on a much wider significance, affecting not just the future of Germany but of the whole continental European economic model. Whatever happens, they will be of huge importance.

The economic background has not changed. It has been clear for some months that the reforms so far enacted by the Social Democrats have not yet produced the more dynamic growth that many Germans want. There has been real underlying progress - of which more in a moment - but the immediate effect of the reforms has to increase unemployment and make Germans more fearful for the future.

What has changed is the political scene. A month ago it seemed inevitable that the Christian Democratic Union led by Angela Merkel would achieve a strong enough mandate to carry through a more radical programme. Now that is not at all clear. Support for the CDU and its sister Bavarian party, the Christian Social Union, has been falling. Even adding in the Free Democrats, the traditional CDU/ CSU coalition partner, the polls suggest that Ms Merkel will be short of an overall majority. Three polls in the past week have put her camp on less than 50 per cent of the vote.

Were that to happen, one possible outcome would be the so-called "grand coalition", with the CDU joining Gerhard Schröder's SDP. That has happened before but from an economic point of view would be a nightmare. Not only would policy be jammed, it would signal that the German electorate was not prepared to face further reforms even if the politicians were prepared to put them forward.

Now it may well be that this is a blip and support for the CDU will pick up. It may be the polls are wrong - not an unknown occurrence. But what is fascinating is the narrowness of the political balance between those who accept the present economic stewardship and those who want change of some sort.

To a British observer, the most striking thing about the German economy (aside from double-digit unemployment) is the contrast between its very successful export performance and the slow overall growth. As you can see from the left-hand graph, the economy has only been inching forward in recent years, and growing consistently more slowly than neighbouring France. The right-hand graph shows the extent to which living standards have been squeezed, even for people in jobs, for real wages are falling again. Why on earth are the Germans prepared to put up with this?

Well, I think you have to appreciate that the system does work adequately for most "insiders" - people in secure jobs or on good pensions. Yes, real wages may be declining, but not very fast and they were very high to start with. Working hours are rising, often for no increase in pay, but they are still shorter than in the UK. And it is now fashionable to scrimp and save; people have become proud of being cautious and economical, rather like the post-war British middle-class.

The "outsiders" - people entering the workforce but finding it hard to get a good job, the unemployed in the former East Germany and many in the immigrant communities who cannot get secure work - are indeed penalised. But there are fewer of those and they would not in any case be natural supporters of the CDU.

So what will happen? If the CDU does get an adequate majority then Ms Merkel will press on with her stated reform programme. This does not include the controversial plan for a flat rate of income tax, which is not official policy - but would involve a shift of taxation to spending. So income taxes will come down and VAT go up. Saying you will do this is a pretty good way of encouraging people to bring forward big-ticket purchases, so in the very short run the programme would lead to a boost in demand. But that would be a one-off. Other changes - for example, trimming some social security payments - might actually cut demand in the short term.

So the prospect would be for another two years of cold turkey. Germany would press on with reforms that would make life tougher for most ordinary people at first, in the hope there would be a supply-side revolution leading ultimately to faster growth and higher living standards. If the policies were sustained and Germany did indeed emerge from stagnation, it would give a wake-up call to the rest of Europe.

There are two reasons to be quite optimistic. One is that the very latest figures for exports and production are encouraging. It would be too much to say that the success in exports is at last spreading to the rest of the economy, but the Ifo Institute in Munich says it might increase its forecast for growth this year. The institute has been a noted (and accurate) bear of the German economy, so this is significant. Its present estimate is only 0.8 per cent but better to revise up than down.

The second reason for optimism is that five years of squeezing down costs since Germany locked into the eurozone are at last bearing fruit. That is why exports are doing so well. Once the country has got its costs in line with its productivity and quality, the export sector could indeed start to stimulate domestic demand. The period of cold turkey could have run its natural course.

Suppose, however, Ms Merkel does not get the clear majority and there is a grand coalition. What then?

What it would mean, I suppose, is that it is very difficult in Europe to win an election on a reform ticket. That would not mean there could be no serious reforms, of course, either in Germany or elsewhere - just that they would be harder to sustain. The next French president, whoever he (unlikely to be a she) turns out to be, would have a tougher job on his hands.

The likelihood would be that the big continental European economies would continue to under-perform relative to the smaller ones and to the rest of the world. That would not be an immediate catastrophe, just a loss of time because eventually the present model will become unsustainable. The next downward swing in the world economic cycle, whenever it comes, would be serious indeed.

For those of us here who know and like Germany, its politics are tantalising: so near and so far; so hard to deliver what the majority of the German people do want. Maybe the paradox will continue: wonderful products and companies but not enough jobs or money spent in the shops. Maybe, on the other hand, there will be a supply-side revolution and the economy will start to fulfil its true potential. It would be good for all of us were that to happen.

Shares strong enough to resist the blows

The puzzle gets, well, more puzzling. We have just had the worst natural disaster in the US since the San Francisco earthquake of 1906. We have the oil price, in money terms at least, close to its all-time high, and with the prospect of staying high for the foreseeable future. We have the US Federal Reserve raising interest rates and, maybe after a pause, doing so again. And we have the underlying threat from all the various global imbalances that economists (including me) have rabbited on about for ages.

Yet financial markets are calm, with shares climbing across the world this year and seeming utterly unfazed by all this bad news. Global bond yields are low, too, despite unsustainable public deficits. It makes you wonder what markets might be doing were there not all this negative stuff around.

One broker paper caught my eye last week. It was from Citi- group and concerned prospects for the UK stock market. The authors point out that the market has delivered a healthy return of 15 per cent this year, and they have increased their target to 6,000 on the FTSE 100 index by the end of 2006.

There seem to be two drivers. One is company earnings - these have been upgraded by 7 per cent for both this year and next. The other is the extent to which equity is being replaced by debt. Thus companies making takeovers are paying off equity by relying on debt finance. There is a string of buyouts and buybacks, plus big dividends.

The result is a prospective price/earnings ratio back to around 12, pretty much the level of the middle 1990s compared with 22 at the peak of the dot-com boom.

Much the same arguments support the US markets - though partly perhaps because they offer worse value, they have not done so well this year - and most global ones.

The big point here, surely, is that markets are back to "normal", in the sense that the excesses of the 2000 boom have been worked off and, thanks to an easy money policy from the main central banks, there is a lot of cash around. It is not a bull market. It is not a bear market. It is a normal market - and because of this it can take big blows in its stride. Useful that, especially as there may be quite a few more financial blows around the corner.