Angela Merkel will be welcomed with full honours tomorrow, and for good reason: our two countries need each other

Germany exemplifies economic virtue and we exemplify economic vice

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We are putting on full fig tomorrow for Angela Merkel. Tea with the Queen, an address to both Houses of Parliament, as well, of course, as a bonding session with David Cameron. We are doing it because we need political help from Germany if we are to get reform in Europe – or at least that is what we feel we need. But we also need German economic growth because that is about the only thing driving the eurozone economy at the moment.

This year, Germany and the UK will supply about three-quarters of Europe’s additional demand – split roughly equally because, although they are a larger economy than we are, we look like growing a fair bit faster. They hope to get somewhere close to 2 per cent; we should be near to 3 per cent.

We are, however, expanding in quite different ways. We have domestic growth and not enough exports, whereas they have strong exports and hardly any domestic growth. The latest figures for Germany, out yesterday, show that in the final quarter of last year exports added 1.1 per cent to GDP, while domestic demand actually subtracted 0.7 per cent. The German government – adding together central, state and municipal spending – has been in surplus for the last two years. We still have the largest public-sector deficit of any major country in the world. You could say that Germany exemplifies economic virtue and we exemplify economic vice – or if not actual vice, at least an insouciant attitude to the basis for future prosperity.

Except that it is not quite as simple as that, which is why the relationship between our two countries is so interesting. Take unemployment. Currently, Germany is down to 6.8 per cent, just below ours at 7.2 per cent. But back in 2005 it was over 11 per cent, whereas we were below 5 per cent. Our public debt levels, despite our recent surge, are now roughly the same because at the start of the recession they started with much higher debts. Germany is the world’s third-largest exporter of goods, after China and the US, while we are only No 9 or 10. But we are the second largest exporter of services, after the US. And so on.

The basic point here is that we are good at different things. If our current position looks a little more precarious, that can largely be attributed to the way that we mismanaged our way through the financial crisis and its aftermath. On a forward view, Germany’s position is not that secure, with its ageing population and its dependence on manufacturing exports – a dependence that carries the danger of being undercut by China and other lower-cost producers as their competence rises. Remember, too, that on present projections the UK passes Germany to become the most populous European country in another 30 years’ time.

So we can, so to speak, look each other in the eye. If it is overwhelmingly in our mutual self-interest that the rest of Europe should be more successful than it is at the present; and it is in Germany’s narrower self-interest that we continue to be such an important export market. If you count the eurozone as a home market, we are No 2, behind the US but ahead of China.

Indeed, for the next three or four years, Germany and the UK look like being the main drivers of the EU economy. That is not a boast, it is an observation. It is hard to see much of an increase in demand from Italy and Spain, and France will remain hobbled for at least two years as it struggles with structural reform. The great unsaid fact is that both of us are gradually disengaging from Europe in an economic sense. The reason is not political at all but mathematical. Europe is growing more slowly than the rest of the world and the proportion of German exports to the rest of the EU is falling as fast as ours is.

That is the challenge to both countries. Unless Europe becomes more successful, our two economies will inevitably move away from it. The politics are totally different but the common ground is that both Germany and the UK need to foster structural reform in the rest of Europe. Remember Merkel’s comment that Europe has 8 per cent of the world’s population, 25 per cent of its GDP, and 50 per cent of its welfare spending. But the leverage that even Germany has over the rest of the EU, while vastly greater than ours, is limited. Its lever, its financial power, has helped underpin reform in Greece, Portugal and Ireland. But even Germany is not financially strong enough to bail out Italy and Spain.

And the relationship between us? Well, I suppose we need to be a little more like Germany – more cautious financially, less dependent on a housing splurge – while they need to be more like us – hitting the shops a bit harder and saving a bit less. But I am not sure either would find such a cultural transformation an easy task.

Are we fixed? Ask the markets

Financial markets have, over the past few days, exemplified the mixed moods of optimism and concern about the health of the world economy, and what they are trying to say deserves attention.

The starting point is that US shares are at their all-time high. They were off a bit yesterday but the S&P 500 hit a new peak on Monday. Meanwhile, our FTSE 100 index is within a couple of percentage points of the all-time high reached at the end of 1999 – gosh, a long time ago. German shares are also around their all‑time high, and while French shares are not, they are nonetheless up 23 per cent on a year ago.

True, the markets came off a bit yesterday. But the main reasons for this seems to have been concern about the slowdown in China, second thoughts about what is happening in Ukraine, and some decline in consumer confidence in the US – the usual noise of the global economy, that is. And actually, as the afternoon progressed, optimism in the US at least seemed to return.

So for the financial markets the crisis is over. We are back to normal. Except that we are not, because the legacy of the banking crisis is with us both in the debts accumulated and in the ultra-loose monetary policies that still support the major economies.

That leads to an uncomfortable possibility: that the world’s markets assume that the path back to fiscal and monetary normality is secure, and would therefore have no resilience were there to be another random shock.

If, on the other hand, UK shares break through their past high in the coming weeks, as US ones have done, that will powerfully reinforce UK business confidence. That past peak of house prices has, for good or bad, already been passed.

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