Germany is still facing a difficult dilemma

Berlin encapsulates both the strengths and weaknesses. It looks stunning, but it is in recession

Here in Berlin the re-election of Gerhard Schröder as Germany's Chancellor was met almost with a sense of relief – except at the CDU headquarters where there was only an hour or so of elation when they shouted Jawohl! and knocked back the Bavarian beer before it became clear they had lost rather than won. But then Berlin is not CDU territory: it returned not a single CDU candidate at the weekend's election. It is also a city where the business community is hardly evident and that lives off subsidies from taxpayers in the rest of Germany.

Here in Berlin the re-election of Gerhard Schröder as Germany's Chancellor was met almost with a sense of relief – except at the CDU headquarters where there was only an hour or so of elation when they shouted Jawohl! and knocked back the Bavarian beer before it became clear they had lost rather than won. But then Berlin is not CDU territory: it returned not a single CDU candidate at the weekend's election. It is also a city where the business community is hardly evident and that lives off subsidies from taxpayers in the rest of Germany.

Berlin is in its way a wonderful place and becoming better as funds are poured into it. But it has huge debts and is not, on its own, really a viable economic entity; it looks great and, apart from its high unemployment, provides an enviable way of life for most of its residents. Without reform, it really cannot go on. But, Berliners ask, why reform when things still seem pretty good?

That is Germany's dilemma. The voters ducked the issue last weekend. The markets, in their usual brutal way, duly cast their vote on the decision, marking German shares down. But in a sense the voters' indecisiveness is understandable, for the campaign of both candidates downplayed the specifics of economic reform. Still, had the centre-right coalition won, Germany would feel a different place. It didn't and it doesn't.

Of course, there will be reforms of sorts. Just before the election, the Hartz Commission reported on possible changes to the labour market: for example, making it harder for unemployed people to refuse job offers. But that is not really getting to the heart of the problem; it is not so much that people refuse jobs but that there are not enough jobs being created. The economy, inching forward at half a per cent a year, isn't growing fast enough to do so.

Germany is quite close to one of those vicious spirals where slow growth cuts tax revenue and increases welfare spending, which in turn forces tax increases, which in turn chokes off growth in consumption, which slows growth still further. Yet to many Germans – or, indeed, to the casual foreign visitor – things don't look like this, which is precisely why making the case for reform is so difficult.

Berlin encapsulates both the strengths and weaknesses of Germany. It looks stunning. Every year another swathe of renovation is completed; the new offices shine; transport is swift and cheap; and the streets of the centre are so spotless that you could eat your breakfast off them. But it is in recession. I have not seen GDP figures for Berlin itself, but I know recession when I see it. Hundreds of taxis wait at the airport for the handful of customers. Those spotless streets are void of people. The shops and restaurants are two-thirds empty.

This is a country where retail sales are falling on average by 5 per cent a year, and I would guess by more in Berlin. Population is falling; rents are falling; the new offices built to house the businesses that were expected to transfer their headquarters are often empty. Yes, firms do open offices in Berlin, but they are for show – high-level meetings with politicos. The real work is still done back in the former West Germany, which has to pay the bills.

It is impossible not to be in awe of the effort that the western part of the country has made to lift the standards of the east: the order, the discipline, the thoroughness and of course the money. The 2.5 per cent solidarity tax on incomes that people have to pay isn't the half of it. But the effort has failed. That is not to say that the money has been completely wasted. Rebuilding infrastructure that had suffered 40 years of neglect and worse was always going to be hugely expensive. But the effort has failed in the sense that it has not created a self-sustaining competitive economy.

It is quite tough for voters to accept this, for it means saying to people that they have done things too well. The post-war economic miracle was based on quality: producing better goods than anyone else. Germany remains the world's second largest exporter, after the US, thanks to that drive for quality.

As anyone who visited the old East Berlin will see, the city has been rebuilt to extraordinarily high standards. But standards can be too high. Cut corners on transport and other infrastructure and you have the sort of problems that Britain has, particularly in the South-east. But at least ordinary Britons have money to spend in the shops and that keeps the economy growing.

Do the opposite, spend too much centrally, and no one has any spare money for themselves. For a while the money spent on infrastructure boosts the economy. But when you have done most of the work, you are left with a shining city with very little activity in it – and a load of debts.

Berlin is not Germany. Rather, it is an extreme example of a more general problem – the transfers made through the public sector are too large for the private sector to bear without serious damage. Small businesses close; large businesses shed staff and shift operations across the border to Poland or to the Czech Republic and Hungary. There is no sudden catastrophe; just a gradual slippage down the European wealth league. If the trends of the past 10 years continue, Germany will become one of the poorer European nations, something that Germans would not like at all.

So what will happen? Here are three predictions, and one thing to look for. Prediction one is that the economy will experience a second leg to its recession this winter. Export demand will remain low and domestic demand will fall. That will put great pressure on the budget deficit, which will be held below the 3 per cent limit of Europe's stability and growth pact only by fancy accounting and deferment of spending programmes.

Renewed recession will jolt the country into a series of modest reforms to pensions, labour laws and taxation. Expect, too, some further easing of restrictions on shopping hours. So, prediction two: there will be two years of patching but no change of direction.

Then, depending on the performance of the rest of the European economy, one of two things will happen. If Europe as a whole manages a slow recovery in 2003 and 2004, there will be just enough growth in Germany for it to claw its way out. It will be able to stabilise its unemployment at not much above its present level of 4 million, manage something close to 2 per cent growth and be able to postpone further serious reform. Gradualism will not have succeeded, but the country will have avoided disaster.

If, on the other hand, the continental European economy continues to disappoint, then things do become quite serious. I don't know where the break point is – 5 million unemployed? – but the time would be ripe for some discontinuity in the way Germany runs its economy. The country would be looking for a change of direction, which presumably would have to come from the CDU. My third prediction is that gradualism is more likely, but some radical shift in the way Germany runs itself should not be ruled out.

And the thing to look for? It's the young. Will they march in the streets or (those of them in jobs) pay their taxes and grumble? It is the young who will decide whether to keep the German economic model because they will have to pay for it. Maybe the politicians can keep this sad truth from them a bit longer, as they did in this last campaign. But if not, I fear there will be a lot of very angry young people wondering why their parents have had a much more prosperous life than they can hope to have.