Germany's moment of truth: can the largest economy in Europe remain competitive?

Ulrich Schumacher was the man German trade unions loved to hate. As chief executive of the world's sixth-largest chip maker Infineon Technologies--and an avid Porsche racer--he pushed hard for performance-based pay on the shop floor. He also moved several R & D and manufacturing operations out of Germany to cheaper locations in Europe, the United States and Asia. Boosted by the success of his restructuring, Schumacher was even planning to transplant key chip operations to Austria and to move the company's headquarters from Bavaria to Switzerland. By U.S. standards, he was making a lot of the right moves.

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But no longer. In late March, after a stormy six-hour meeting of Infineon's supervisory board, Schumacher, 45, quit his job over unidentified disagreements on strategy.

Germany's largest union, IG Metall, which has a representative on the Infineon board, threw a party after hearing the news. "This is our revenge," gloated one top union official, for whom Schumacher's demise sounded like evidence that corporate profits aren't the only thing that makes this country tick.

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The unions should listen harder. Germany hasn't been ticking for years in its famously precise, Black Forest cuckoo-clock way. It is no longer a country whose work habits and skills stand out in international rankings, its education standards have plummeted, and its much-vaunted social consensus has made radical change all but impossible.

As a result, Germany's erstwhile model society--aging, mostly well-off and lulled to sleep by the hum of its economic engine--has gradually been surrendering economic leadership, while clinging to the illusion that it remains on top. Granted, Germany is still the world's largest exporter and Europe's biggest economy. But it has been consistently falling behind in economic growth, innovation and job creation.

This is a moment of truth for Germany, and for both German and non-German CEOs who operate here. Will this country of 82 million pull itself together and reverse the inexorable slide into irrelevance and mediocrity? Can it break the cycle of ever-rising social costs?

The alternatives are dire. "If Germany fails to radically reform its pensions, health care, education, social welfare, taxes and the labor market, this could lead to fundamental shifts in political and economic power constellations in Europe and beyond its borders," warns Norbert Walter, chief economist of Deutsche Bank.

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If his statement sounds almost like panic, it's because it very nearly is. "Our impact on the rest of the world keeps dwindling," says Lutz Raettig, CEO of Morgan Stanley in Frankfurt. "It's process of slow erosion."

Such decline, however sluggish, quickly translates into a change in the business environment, warns Deutsche Bank CEO Josef Ackermann. In international transactions, he says, German companies "are playing now, at best, a role of junior partner."

One reason, of course, is that Germany has been bogged down by reunification with its ex-Communist eastern part. Launched in 1990, reunification boosted the country's population by one-quarter but saddled it with an inefficient economy and an unproductive labor force. To bring the east up to speed fast, the German government has pumped more than 1.2 trillion euros into the five new regional states, more than matching their own economic output.

Most of it has been wasted. Although highways, railroads and phone networks in the east of Germany are now often better than those in the west, a sum of more than 1 trillion euros has ended up as handouts in the pockets of pensioners, white- and blue-collar workers, the unemployed or, in some cases, swindlers. Instead of fueling consumption and construction booms to jump-start the east's economic engine, the west's subsidies, tax breaks and outright payouts have created masses of unemployed people, streets of boarded-up shops and empty apartment blocks. The former industrial hub of East Germany around Halle in Saxony-Anhalt now holds the dubious record of having the European Union's highest unemployment rate, 27 percent.

As a result, the German economy has been growing at an average of 1.5 percent a year, about the same as Japan but at less than half the speed of the U.S. and Britain. Last year, it shrank by 0.1 percent. This year, the prospects aren't much better. Equally disturbing, unemployment climbed from 7.7 percent in 1992 to 11.4 percent in 1997 and has been languishing recently at 10.5 percent, with nearly 4.5 million people out of work.

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But despite such dire joblessness, unions have been pushing for--and often winning--pay and benefit hikes. So now, total labor costs in German manufacturing, the mainstay of the country's economy, are the highest in the world, says the Cologne-based Institut der deutschen Wirtschaft (German Economic Institute), a research center. Not only are costs and productivity out of whack with the U.S. and Japan. When eight Central and Eastern European countries join the European Union on May 1, Germany's costs will seem even more extreme. (See table, far right.)

Little wonder that German makers of everything from cars and machine tools to consumer goods and computers are shifting as many labor-intensive operations as they can into Central and Eastern Europe. Service industries are following suit with software developing and testing, call and logistics centers and back-office operations.

A new development--which worries German politicians and unions alike--is that off-shoring is now no longer limited to low- or medium-skill jobs. Siemens CEO Heinrich von Pierer recently asked the company's German production facilities to take a hard look at their costs and calculate how much lower they would be if their labor costs were the same as those in Hungary. There, the workweek spans almost 43 hours and monthly wages are around 500 euros.

Siemens's mobile phone factories in Bocholt and Kamp-Lintfort, where weekly shifts run just under 38 hours and monthly wages reach about 2,500 euros, came back with a shocking answer: possible savings of 30 percent.

'Homeless Merchants'

The upshot of this exercise was clear to everyone: Either these factories would have to cut their costs drastically, or almost 2,500 high-skilled jobs would move eastward. A further 7,000 to 8,000 jobs from other parts of the company might follow.

The unions were enraged: IG Metall Vice Chairman Berthold Huber complained that Siemens wanted to profit from EU subsidies in Hungary and planned to cut its tax bill by writing off the expense of the move as an operating cost. He was backed by heavy artillery: Chancellor Gerhard Schroeder. Through a spokesman, he hinted that companies exporting jobs out of Germany were being "unpatriotic." And the new secretary-general of Schroeder's ruling Social Democratic Party (known by its German acronym, SPD), Klaus Uwe Benneter, branded such businesses "homeless merchants."

Siemens shot back, insisting it had to cut costs or lose business, but said it was looking for a compromise. "We believe it will be possible to reach an agreement with German employees to bring relatively higher costs in Germany under control to remain competitive," explained Klaus Kleinfeld, who runs Siemens's networks and mobile phone divisions and heads its corporate strategies unit.

And to make the company's intentions crystal clear, Kleinfeld added: "It will be necessary to increase German working hours at existing salary levels and to add flexibility." Period.

This is just another twist in the downward spiral that Germany's manufacturing sector is locked into. Both German and non-German CEOs know that, for political reasons--and to preserve the country's consensus model--they are being forced to lug a bigger payroll in Germany than they need or can afford. Thus, although it follows a strategy to produce where its market is, Siemens employs 40 percent of its global work force in Germany, although its sales there are only 23 percent of the total. A similar proportion can be found at Deutsche Bank: 44 percent of its staff is in Germany, but only 28 percent of revenues are generated in this country. This is one reason why Deutsche Bank's Ackermann says: "The situation here has gotten to the point that German companies are practically forced to explain to their shareholders why they haven't moved their business operations out of Germany."

Cherry-Picking by American CEOs

So it's little surprise that few fresh dollars--or euros--are going into German manufacturing. The Bundesbank has calculated that industrial investment fell by almost 5 percent in 2001, plummeted by 9 percent a year later, and declined by a further 3 percent last year.

The U.S. CEOs who are placing bets on Germany despite the dismal picture are doing so only on a very selective basis, trying to target opportunities but not wanting to get saddled with high production costs.

One target is technology. Thomas Limberger, CEO of General Electric Deutschland, said in an interview with the newsweekly Der Spiegel that when GE was looking for a European site for its high-tech operations, Germany won by offering "by far the best location for GE's R & D activities" in renewable energies, medical and sensor technology and automotive materials science.

Limberger's boss, Jeffrey Immelt, agrees: "I'm impressed by German technology." Last year, GE added 1,600 jobs to the 5,400-strong payroll it already keeps in Germany, with several hundred of them in Munich.

A second target for U.S. companies is access to the affluent consumer market. Take Procter & Gamble. Despite declining sales and profits at the German cosmetics and hair-care firm Wella, P & G plunked down $6.9 billion for it last September. The lure was pocketing a leader in the German hair-care market, with over 60,000 loyal hairdresser salons, gaining a foothold in the European salon hair-care market and adding key product lines that Wella had previously acquired.

In addition to the P & G deal, major U.S. private-equity firms are sniffing around for bargains: Blackstone's 3.6 billion-euro buying spree has netted it the chemical company Celanese and the waste-management firm Sulo; KKR spent 1.45 billion euros for engine-maker MTU; and Bain Capital took over chemicals logistics firm Brenntag for 1.3 billion euros.

The financial services industry is also attractive. German banks are sitting on 1.3 trillion euros in deposits, on which they pay a measly 0.5 to 1.5 percent interest. They can be bought relatively cheaply. Deutsche Bank, for instance, is valued currently at around 40 billion euros, less than one-fifth of Citigroup's 212 billion-euro market cap. The two banks could be a good fit, because Citi already runs a small, fast-growing and profitable retail bank, Citibank Privatkunden, based in Dusseldorf. Deutsche Bank CEO Ackermann apparently met recently with Citigroup Chairman Sandy Weill. And Citi reportedly checked with the Chancellor's Office in Berlin for objections to a hypothetical merger; none came. An agreement between the two also failed to develop, but the talks could still be resumed with Citi or with another major international bank, once Deutsche sees a merger as its best option. "I don't expect a hostile takeover and we are not ready for a friendly one," says Ackermann.

Deutsche Bank could do with some of Citi's savvy. According to a 2003 study by the American Chamber of Commerce and management consultants Droege & Comp., American CEOs who stress innovation and service as top differentiators can be very successful in Germany. "The typical U.S. business culture provides for action-oriented management, aggressive marketing, innovative offerings along with high levels of customer orientation, informal yet 'to-the-point' communication, and focus on facts rather than assumptions," the study's authors wrote. "'I'he unique competitive mind-set of U.S. businesses is hard to find in traditional German businesses."

But does it mean foreign CEOs should rush to invest in German factories? That wouldn't be smart unless they get an absolute bargain in cars, banks, chemicals, materials science or investment goods--all areas where Germany is leading, says a recent study from the American Chamber and the Boston Consulting Group. It asked the 100 biggest German subsidiaries of U.S. companies what kinds of investments would work best in Germany and whether now is the right time to make them. A majority saw Germany as the best place in Europe for setting up a regional center or a management center. But not now. In fact, as a current investment destination, Germany earned only 14 percent of survey respondent votes, compared with Britain's 24 percent and Central and Eastern Europe's whopping 46 percent.

This isn't what Jurgen Weber wants to hear. As Lufthansa's supervisory board chairman and one of the three "Invest-in-Germany" volunteer commissioners who travel around the world on behalf of the German government, his message is that Germany is a good place to be right now.

Speaking at a recent presentation in New York, Weber launched into a bravura recital of Chancellor Schroeder's achievements in pulling Germany out of its maze of social, economic and demographic problems. True, Schroeder managed to cobble together a package of reforms called Agenda 2010, which lowered top tax rates, restructured the Labor Agency and cut some social welfare, health care and pension costs.

But it took Schroeder almost a full year to bludgeon those changes through. He paid a hefty price, too, having to step down in March as party chairman to avoid the revolt among left-wing SPD members who saw his program as an attempt to replace their social and political values with capitalist ones.

Franz Munterfering, the new SPD chairman and Schroeder-loyalist, confesses: "We've botched up the job of explaining ourselves to the party." And Rudolf Scharping, who headed the SPD in the 1990s, agrees. "The need for change was very, very badly communicated. The reforms were presented to the nation in a way that they sounded more like a threat than an opportunity." He adds: "If you get so much ahead of your party and of a large part of your society that they cannot follow you, you will get badly bruised."

It's not the first time, of course, that Germany has to pull itself out of an economic mire. But the signs of economic and social decay have never been clearer. The question is whether Schroeder will be able to push through the reforms as fast and far as he has to. "These moves are all pointing in the right direction, but I have strong doubts whether they'll all be implemented," says John Martin, director of the Paris-based Organization for Economic Cooperation and Development. "After all, we suggested similar measures to Germany several years ago, but they fell on deaf ears."

Schroeder has two more years to set the country on the right path. It seems safe to say, however, that his present reform plan is too timid and has come too late. The radical and unpopular measures needed may cost him the election. But whoever wins will have a hard time ahead.

RELATED ARTICLE: The Cost of German Labor

1 Fringe costs have pushed up total costs.

* The average German worker is paid 26.36 euros per hour, of which 44% is fringe benefits.

* A Japanese worker makes 20.18 euros an hour, with more than 40% in fringe benefits.

* A U.S. worker is paid 22.44 euros an hour, with fringe benefits accounting for 28%.

SOURCE: Institut der deutschen Wirtschaft, Cologne

2 Productivity isn't what it should be.

* While Japan's productivity is almost equal to Germany's, its labor unit costs are 25% lower.

* Manufacturing productivity in the U.S. is 23% higher than in Germany, while U.S. labor unit costs are 15% below Germany's.

SOURCE: IW

3 And the entry of eight countries to the EU will widen the gap.

* Total industrial labor costs in Germany: 21.31 (euros per hour)

* Same costs across the EU: 17.77 per hour

* Same costs in new EU countries: 3.31 per hour

SOURCE: Federation of European Employers