UK plc, a subsidiary of Germany GmbH

Our miracle economy is fading before our

VOLKSWAGEN'S victory inacquiring Britain's most prestigious car maker is a sign of the times. As a shareholder at Friday's extraordinary general meeting of Vickers said: "Rolls-Royce cars are part of our history and heritage. Because they are quintessentially British, they are unique."

But the "quintessentially British" is fast disappearing, while the uniquely Germany goes from strength to strength. German companies are expanding overseas, creating global companies. Daimler-Benz's $39bn (pounds 24bn) merger with Chrysler is the largest to date. Bertelsmann has become the largest book publisher in the world through the $1.4bn purchase of Random House.

More big deals are sure to follow. Springer, the leading German newspaper company, is lining up a bid for the Mirror Group. Giants like Siemens, Bosch and BMW are investing heavily in key export markets. Germany GmbH is booming just as Britain plc is beginning to look more than a little sick.

Since the early 1990s, Britain has styled its economy as the envy of Europe. There is some independent support for this view: World Economic Forum league tables show the UK leaping from seventh to fourth place in world competitiveness. While Germany struggled with recession, unemployment, overmanning and inefficiency, we benefited from higher growth and lower unemployment. Thatcherite reforms and premature ejection from the ERM seemed to have set Britain on the path to greater prosperity.

New Labour repackaged the old philosophy. Cool Britannia emitted better economic vibes than fuddy-duddy Europe. Tony Blair presented himself abroad as the modern leader of a modern economy.

On Tuesday, Gordon Brown repeated his belief in Tory economics, pledging to permit new borrowing only for investment purposes. He also unveiled pounds 240m in support for hi-tech industry. Symbolically, the money came from the European Investment Bank, not the Treasury. Direct government support for industry is no longer British.

Meanwhile, British manufacturing is struggling. Siebe, the pick of British engineers, said last week it was transferring some production from Britain to Asia, with the loss of 400 jobs; it cited the strong pound. Then, on Thursday, the Bank of England raised interest rates, continuing its support for a rate unsustainable for manufacturing. "At this rate, the Bank will put the whole economy in recession," said Roger Beedell, European economist at Banque Paribas.

Britain now looks set for more restructuring and job losses, while Germany and France are recovering. This should finally kill the myth that our economy is the envy of Europe. Germany's population is 40 per cent greater than Britain's, but its output is 68 per cent higher. While Britain struggles with trade deficits, France and Germany have surpluses. The average West German is 40 per cent richer than his UK counterpart.

To be sure, German politicians have failed to balance budgets or deliver tax and pension reforms. But German business has lifted its productivity by a combination of investment and restructuring. Exports and profits are soaring, fuelling a stock-market boom.

This surge is epitomised by Volkswagen. In 1993 the company was heading for disaster: it was losing money, its German cost base was too high and its Spanish and Czech subsidiaries, Seat and Skoda, looked wrecks. Barely five years later it is Europe's leading volume car maker, making record profits with revitalised brands and appealing models. And it is continuing its global expansion.

Professor Chris Voss of London Business School has compared UK and German industrial methods in detail. He sees design quality rather than productivity behind VW's success and thinks this typifies German manufacturing. "Our research shows a clear superiority in German design, rather than in manufacturing efficiency," he said.

Skilful, creative design at VW has cut production costs, enabled part- sharing and raised product quality. The new Golf is said to contain 25 per cent more features than its predecessor and take half the time to make. VW can sell a significantly better car at a similar price and earn far more.

While VW's revival is spectacular, the same trick is being repeated across Germany. Mr Voss says Mercedes and Porsche have gone further than VW in rethinking their entire production methods, making them truly world-class manufacturers.

The British experience has informed the response of German business to their sluggish economy. It, too, is becoming mean and lean through restructuring and rationalisation. Its products were always good: now they are made more cheaply. New giants are emerging. Thyssen and Krupp are merging to create Europe's largest steel maker. There are rumours that Hoechst, the pharmaceuticals giant, may be bought by Bayer. A wave of banking and insurance mergers is just starting.

Apart from the oil majors and the pharmaceutical giants Glaxo Wellcome and SmithKline Beecham, Britain has relatively few global companies. We have withdrawn from, or sold out of, many areas of manufacturing. Bernd Pischetsrieder, the Anglophile chairman of BMW, recently said that the one big difference between Germany and Britain was that all business sectors were still represented in Germany. There is, at the very least, a loss of national expertise.

There are no British equivalents of VW, Mercedes, Bosch, Siemens, Bertelsmann or SAP, the business software giant. European integration of defence and aerospace will see British Aerospace and GEC disappear inside companies dominated by the French and the Germans.

Economic orthodoxy says ownership does not matter: that we are all part of a global market where capital efficiency rules. Generate the conditions for wealth creation and it will somehow happen. This is current Government orthodoxy, too.

Maybe, but it helps to have a few world-class companies around town. The south German cities of Stuttgart and Munich, where Mercedes, BMW, Siemens and Allianz are based, enjoy high personal incomes and low unemployment because of these companies and their commitment to the local economy. Only Mercedes and Siemens cut their workforces during the 1990s: now they are creating jobs again.

While Germany has learned from Britain, we have failed to learn from Germany. This will cost dear in the coming months with a full recession looming.British manufacturing has neither raised productivity nor controlled costs. Roger Bootle, economist at HSBC Securities, said: "The five years from the 1992 devaluation saw sterling significantly undervalued and export margins artificially boosted. Productivity growth since 1992 has been negligible."

While we were supposedly enjoying an enviable miracle, we were in fact standing still. The surge in sterling took manufacturing into recession because it was unable to compensate, and now we are pricing ourselves out of the market. "In the last year, relative labour costs have risen by 20 per cent in Britain and fallen by 20 per cent in Germany. Manufacturing is being squeezed by high costs and high sterling. The only way out is through higher productivity," said Mr Beedell at Paribas.

Without higher productivity, we will probably see a new round of heavy job losses in manufacturing. Mr Beedell adds: "I find it amazing that people talk of restructuring the UK's downsized manufacturing base. But people are going to get laid off."

The search for the reasons for Britain's poor relative productivity is a favourite economic parlour game. Nick Oulton, senior research fellow at the National Institute of Economic and Social Research, said: "We grew less fast than the French and Germans between 1950 and the first oil shock in 1972. We have been trying to catch up ever since and the productivity gap remains substantial. We have low levels of physical and human capital."

In other words, the British are badly educated and British businesses do not invest enough. This has resulted in a shrinking manufacturing sector. Unlike Germany, which has lived with a strong mark for decades, we cannot cope with an appreciating currency. Our manufacturers lack the design excellence that allows the Germans to charge premium prices or enable VW to build world-beating cars like the Golf. We continue to compete on price.

Nothing in this analysis is exactly new. And, of course, there have been improvements in British manufacturing in recent years. Mr Voss said: "With Honda, Rover made unbelievable strides forward. And Rolls-Royce Motor Cars is not backward in manufacturing." He adds that the weakness of British manufacturing is not so much to be found in the leading companies "but in the long tail of underperformers".

While it is a grand British tradition to bemoan the state of manufacturing, this sector now accounts for only 26 per cent of the economy compared with 36 per cent in Germany. While the service sector has flourished recently, there are few world-class British service companies, according to Mr Voss.

There are no British investment houses of note in the City of London, Europe's largest financial centre. Two of the biggest, Morgan Grenfell and Kleinwort Benson, were bought by German banks.

A recession in manufacturing could now be spreading to the services sector. Once again we may be forced to think how the British economy could be made competitive. Higher investment and better education, features of the German system, seem to be the answers, but they are answers that British governments have heard before.

In his first Budget, Mr Brown tried to enhance the climate for business investment, building on the work of his Conservative predecessors. Like them, he may be disappointed by the reaction of industry. He found relatively little money to fulfil Tony Blair's election pledge of "Education, education, education!"

That is certainly part of the answer, but it will take money, money, money and much more before British industry can think of bestriding the globe.

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