The Man Who Rescued the German Economy

"Reform yourselves, and ye will grow out of your debt."

The last Social Democrat chancellor talks about how he cut   taxes and reformed labor markets—and how it cost him his job.

 By RAYMOND ZHONG

'Reform yourselves, and ye will grow out of your debt." So goes Germany's unwritten mantra for the European crisis. Chancellor Angela Merkel is urging Greece, Spain, Italy and the rest to shape up their economies and pay down their obligations—and withholding German money until they do.

The Berlin road to economic righteousness is no mere sermonizing. Germany itself has gone down it and grown stronger. Gerhard Schröder, a Social Democrat, was German chancellor from 1998 to 2005, and during his second term his government lowered taxes, revamped unemployment benefits and streamlined labor laws. Mr. Schröder's shakedown of the welfare state—dubbed Agenda 2010 when it was launched in 2003—has been credited with insulating Germany against the debt mess that would later befall Southern Europe.

I checked in with Mr. Schröder on a rainy morning last week at the chic offices of his Hannover law practice. "[Agenda 2010] was, if you will, a modernization concept for Germany," Mr. Schröder says. "Germany was known as being unreformable, and the Agenda proved that it was possible."

The former chancellor is stout and fit. He speaks quickly and confidently, sometimes pouncing to answer a question before I've quite finished asking it. Seven years after exiting German politics—"never again," he says when I ask if he'd ever get back into it—Mr. Schröder still seems suited to knock heads in the Bundestag.

Circumstance forced economic reform onto Gerhard Schröder's agenda as chancellor. When he took office in 1998, Germany's unemployment rate was 11% and economic growth was close to nil.

Mr. Schröder won the federal election that year by vowing to end the economic misery. But the Europe-wide recession during his first term left him having to explain to voters, when he sought re-election in 2002, why the jobless rate was still nearly 10%. Germans gave Mr. Schröder a second chance, and his government immediately set about making good on its mandate.

The result was a radical reshaping of the German welfare state. To reduce labor costs, Agenda 2010 merged social-welfare benefits with benefits for the long-term unemployed, paring down the total amount and availability of assistance. Employers' health-insurance costs were trimmed back. Planned income and corporate tax cuts were accelerated: The top personal income tax rate was lowered to 42% from 48.5% and the bottom rate went down to 15% from 19.9%. The corporate tax rate dropped to 19% from 25%.

In the labor market, Mr. Schröder made firing easier with the expectation that hiring would consequently become easier, too. Rules protecting employees against dismissals "for economic reasons" were loosened. Measures were introduced to help employers avoid lawsuits from laid-off workers seeking re-employment. To spur job-seeking among the unemployed, Agenda 2010 cut jobless benefits and strengthened financial sanctions against those who were able but unwilling to accept work.

"And now the results speak for themselves," Mr. Schröder says. "For a long time we were the sick man of Europe. Now we are the healthy Frau of Europe." With German unemployment at 6.8%, nearly the lowest level since reunification in 1990, it's hard to disagree. German GDP growth has so far kept the euro zone from falling into another recession this year.

Mr. Schröder does note that Germany's present economic vigor isn't solely the result of Agenda 2010. Work-sharing programs are common in Germany. During the financial crisis, this has allowed employers, with the help of government subsidies, to keep workers on reduced hours instead of laying them off. Mr. Schröder also notes that Germany's unique system of "co-determination," under which union representatives occupy permanent spots on corporate boards, ensures that labor and management are able to negotiate terms with both sides' long-term interests in mind. In Germany, workers' confidence that they have a say helps keep wages competitive while reducing the incidence of strikes compared to other European countries.

Co-determination doesn't get a fair shake in the Anglo-Saxon world, Mr. Schröder says.

Still, the chancellor suffered for his reforms. Agenda 2010 received committed support from Germany's main conservative parties: the center-right Christian Democrats and Christian Social Union, and the business-friendly Free Democrats. But it split Mr. Schröder's own party, the center-left Social Democrats, some of whom attacked the reforms as "scandalous" and "immoral." Unions revolted. In 2005, after a stinging defeat for the Social Democrats in a state election, Mr. Schröder called snap elections.

The Social Democrats failed to win a majority. The new chancellor was the leader of the Christian Democrats: a shy former chemist, raised in East Germany, named Angela Merkel. "I would like to thank Chancellor Schröder personally," Mrs. Merkel said in her first address to Parliament as chancellor, "for bravely and resolutely opening a door with Agenda 2010, so that our social systems could be adapted to a new era."

Mrs. Merkel may have kept the spirit of the Schröder reforms alive in Germany, but in most of Europe there has been little evidence, in seven years, that the reform wisdom Germany displayed has rubbed off. French President François Hollande has spent his first months in office raising the minimum wage, lowering the pension age, and standing by his notorious pledge to tax high earners at 75%. Adopting Mr. Hollande's policies would be "a real catastrophe" for Germany, Mr. Schröder says.

Aware of the political and historical sensitivities, Mr. Schröder counsels that Germany and the European Union shouldn't be encouraging Agenda 2010-style reforms as a cure for Southern Europe without concurrent measures to promote domestic spending and forestall immediate collapse. He echoes the suggestions of Mr. Hollande and others that the EU should invest in wobbling economies via the EU's regional development funds and project bonds for infrastructure.

Too much pain without enough reward risks "destroying domestic demand," Mr. Schröder says. And even perfectly executed structural reforms will not yield results right away.

Mr. Schröder points out that he's made a habit of not commenting on his successor. But he says that Mrs. Merkel listened too closely to the German tabloids early on in the crisis, especially about Greece. "She knew, of course, that nobody likes to see German tax money used to stabilize Southern European countries."

His own attitude toward Greece is more sympathetic. "The rescue has bought time, but in any case, the government [in Athens] needs the opportunity—not to water down the reforms or to avoid them—but to be able to stretch them out over time, and to prove to the Greek people that the chosen path is helpful."

He points to his own experience with Agenda 2010. In 2003, just as his reforms were beginning to be implemented, the European Commission deemed Germany and France to be in violation of the EU's deficit and debt ceilings. Mr. Schröder's finance minister at the time, Hans Eichel, proposed €20 billion (around $24 billion then) of additional spending cuts to put Germany in compliance with EU law.

Mr. Schröder refused. "I said, 'Hans, that won't work. We can't push through these reforms, for which we need to devote all our power and take every risk, and also save €20 billion on top of that.'"

That Germany and France were never punished for their debt transgressions is still seen as evidence that no EU rule is so important that the Continent's largest members cannot get around it. Many blame Berlin and Paris's original sin for, in effect, licensing the Mediterranean governments' borrowing sprees. But Mr. Schröder says that fiscal rules ought to be negotiable "in countries where structural reform is really taking place—where, if you like, an Agenda 2020 is being implemented."

That's nice to promise, I suggest, but hard to practice. Mr. Schröder demurs when I ask whether political systems like Greece's are simply too dysfunctional to make certain changes, even if broad consensus within the country believes it's necessary. "I hope that the new [Greek] government understands—not only understands but takes to heart—that they have to take this road. That's a prerequisite for giving them more time."

Greater flexibility on the current rescue strategy is important now, he says, but he's still convinced that Europe's next step must involve deeper political union among member states. "That means the ability to control not just monetary policy but also economic, financial and social policy. The crisis has made this clear."

Mrs. Merkel and the Christian Democrats have taken the same line, supporting the installation of a "European finance minister" to control national spending and taxes directly. Chancellor Merkel has put forth a "budget commissar"—as the proposed office has been called, darkly—as a precondition for further EU assistance such as joint euro-zone bonds or direct purchases of periphery sovereign debt.

France's Mr. Hollande has protested the most loudly over the loss of sovereignty that such centralization would entail, though he's hardly alone: A poll published this week showed that just under three-quarters of Germans also oppose a "United States of Europe."

Mrs. Merkel's own ruling coalition is also divided on the issue. The Free Democrats demand that the chancellor impose EU-level budget controls without offering euro bonds in return. They see such bonds as a dangerous commitment of German tax money even if national governments' budgets were tightly controlled. Euroskeptic backbenchers from all three parties in the coalition grumble that the principles for European integration pursued by their forebears have been trashed; the idea of returning to the deutsche mark consistently polls well.

The Social Democrats, meanwhile, have criticized the conservative parties for compromising European solidarity by being too stingy with German aid. "For Europe, there is only a choice between a bad and a catastrophic situation," Mr. Schröder says. Choosing the former "means that Germany must stand behind what is developing in Europe, because we have benefited from it."

"But there must be limits," he adds. "Mrs. Merkel was right when she said that Germany's productivity isn't unlimited."

Those limits may not be so far off. Last month German manufacturing contracted at the fastest pace in three years. The cost of insuring against German government default has been ticking up. If Germany has to pitch in substantially more to rescue the Southern states, its own public debt—already more than 80% of GDP—could raise market hackles.

It could also put Mrs. Merkel at risk of losing her job in next year's federal election. A majority of Germans still view the chancellor as a responsible steward of Berlin's coffers; her approval ratings are at their highest since 2009. But the business of coalition-building will be complicated significantly by what unfolds in Europe. Even if Germany gets its way on political union, that is a 10- or 20-year project, not a quick fix in time for the election.

'This government will not remain after 2013," Mr. Schröder says with conviction. It's an "open question" whether that also means that Mrs. Merkel is out, he adds. But Mr. Schröder is certain that the current coalition will not win a majority the next time Germans vote.

Even before then, though, Germany's political class may find itself disabused of the hope that Europe's national governments can reform their way to solvency. The long record of disappointments that have come out of Athens, Madrid and Rome raises the scary thought that this is not just a crisis of European money or of European institutions, but of European-style social democracy itself.

Germany's example would seem to suggest that it isn't, or at least that it doesn't have to be. But how many recent European governments—left- or right-wing—have been like Mr. Schröder's?