Hamish McRae: Expect reform in Germany, but don't bet on it boosting performance

Things are getting worse in Germany and the onus will be on the European Central Bank to help by cutting interest rates at its meeting today.

The news yesterday was of yet another rise in unemployment, from 10.1 per cent to 10.3 per cent, and of the first-ever yearly loss (and 4,300 job cuts) at the country's third-largest bank, Commerzbank. This follows a cut in the federal government's growth forecast for this year to only 1 per cent, itself higher than most market forecasts. The only sliver of light comes from the latest Ifo survey of business confidence, which rose fractionally. This matters hugely to the UK, for not only is Germany our second-largest export market, after the US, butits slow growth is likely to pull down the performance of its neighbours, in particular France and Italy, both of which are also large markets for us. So we are damaged too.

This raises a string of questions of which, I suppose, the most obvious is whether this poor economic performance will lead to changes in policy. It has been suggested that the political position of the Chancellor, Gerhard Schröder, is now so weak that he really has nothing to lose by bringing forward a more radical set of structural reforms. On the other hand, his weakness could encourage him to lean more on his traditional supporters in the union movement, who by and large, resist significant reforms.

We don't know the answer to that question – maybe the Chancellor doesn't either – but it raises a more disturbing series. Suppose that there are indeed significant structural reforms in Germany, might the economy still not recover? Might the burdens of East German reconstruction, coupled with the rigidities of a single European exchange rate, be too great? And if so, what then?

German underperformance is quite deep-rooted. As you can see in the left-hand graph, it has consistently grown more slowly than the rest of the eurozone for almost a decade. Typically that growth has been one percentage point lower than the rest. That may not sound a lot but cumulatively the gap is enormous.

Visitors to Germany can feel this. I happened to be in Berlin a few days ago – a city with debts of some $50bn (£30.5bn). Two things strike the visitor. One is the enormous and impressive work that has been done on the fabric of the city: the fine 19th century buildings, mostly in the eastern sector, are steadily being renovated, bringing back some of the feel of the Prussians' great capital. The other is that, renovation apart, there is not much economic activity going on. Shops are empty, restaurants are empty, taxis are empty. This makes Berlin a wonderful city for the visitor and anyone living there with a good secure job. But a lot of residents are clearly watching their money very carefully.

That visit also gave me a clue to what, for outsiders, is something of a puzzle. Why, as in Japan, is there so little pressure for reform? The answer is that for people who are in secure jobs, things are rather nice. There is little sense of pressure, there is wonderful subsidised culture (though, unlike here, museums charge for entrance), and services are relatively cheap. The people who suffer are the under-qualified young and the outsiders, who find it hard to get jobs, but they are not politically important.

So it is perfectly possible that pressures for reform will remain muted for several years. What then?

Well, there will be some sort of cyclical recovery. Germany may well be moving into a new recession, but eventually it will struggle out. The business community's confidence is very low by historical standards, as the Ifo survey shows (middle graph), but it has been that low before. Some big German companies, such as Daimler-Chrysler, have just produced pretty good results, reminding everyone that there is still great strength in the best German companies. But note that even when business confidence was quite high, for example in 2000, the country was still underperforming.

Looking ahead, the burden of the former East Germany is not going to go away. Competition from the new EU members to the east and south will make it relatively less competitive, not more. By running lower inflation than the rest of the eurozone (right-hand graph), Germany will gradually narrow the cost gap. Core goods inflation has now gone negative in Germany, unlike the rest of the region. But it has to go on running lower inflation that its neighbours year after year to get its costs down to that of other eurozone countries: the process could take at least another decade, maybe longer. Meanwhile jobs and investment will continue to migrate abroad.

The world has had its first glimpse of the effects of deflation in Japan, which has put up with falling prices for some years without – yet – a self-sustaining collapse. But following the Japanese example may not be an option for Germany because it is a much more open economy. Exports of goods and services in Japan amount to only 12 per cent of GDP. In Germany they are 28 per cent. The muddle-through option chosen by Japan only works because it is a particularly closed society. In Germany, skilled workers have the option to move anywhere in the EU, while companies similarly have the option to base their production facilities abroad.

You could imagine Germany entering a spiral where more and more jobs are shipped overseas, thereby cutting the tax base and swelling the ranks of the unemployed, which in turn increases the cost of running the welfare system. The fiscal deficit, now exceeding the 3 per cent ceiling of the Stability and Growth Pact, could spiral out of control. We have seen that happen in Japan.

All this may be too alarmist. Other countries, including our own and the US, have serious imbalances too. The point about Germany, though, is that both ourselves and the Americans have growth. If you are growing you can afford to make mistakes. If you are not, and in addition you have no control over monetary policy, it is very hard to dig yourself out and get back on to a growth path.

It is not a popular view but actually it may not matter much what Chancellor Schröder does, at least in the short term. The lags between any structural reforms and a change in the economic performance are too long and too uncertain in their effect, particularly if they have to counter over-rigid fiscal and monetary policies. Yes, if you have to make unpopular changes – for example to labour laws and shopping hours – then it is better to get on with it because the earlier the start, the speedier the rewards. But don't expect a quick pay-off.

Expect the ECB to press on with cuts in interest rates, if not today then soon. Expect some easing of the fiscal plans following pressure to drop some of the more unpopular tax increases. And expect some sort of structural reform, including those that might free up the labour market. But do not expect, I am afraid, any significant improvement in Germany's relative performance.