Germany has the third largest economy in the world after the US and Japan. And its economy has been underperforming not only the US, but Europe as a whole for at least a decade. Japan's economy is already in a deflationary slump, and now Germany is in danger of following in its footsteps. On the one hand, monetary union has forced inappropriately high interest rates on Germany, while on the other hand it suffers from deep-seated the structural problems. The ECB is not going to help out on the former, while German politicians have no clue about the latter.

The German economy's underperformance is a result of an economic structure built on social consensus rather than market forces. The Weimar republic and the following Nazi era led to Germans attaching a very high premium on domestic stability. As the economic boom of reconstruction after the war produced great wealth, the predominant socialist ideology of the welfare state spread ever further. Labor unions demanded shorter work weeks without proportionate falls in pay, while the captains of industry built a cozy network of cross-shareholdings with their banks. This system worked for a while, but the ever-increasing amounts of legislation under the banner of "social protection" shackled the economy down one by one. The road to serfdom is paved with good intentions. to protect workers from getting fired, laws were passed making firing people expensive. Now the risk of hiring workers in Germany is high, because you may not be able to fire them again. The great fundamental flaw in building this system was the belief that you could legislate your way to social cohesion and prosperity. One particularly egregious example are the "Arbeitsbeschaffungsmassnahmen." This word translates into "measures to provide employment." All kinds of retraining programs fall into this category, and over the years the unemployment statistics have been massaged downward by sending people off on these projects. If the government could indeed wave its magic wand and provide employment like that, Germany would have no unemployed. Instead, the unemployment rate is around 10%.

The structural rigidity of the German economy has meant that it could not react quickly and nimbly to changing circumstances. Germany has not yet made the wholesale transition from a manufacturing to a service economy. It is not able to climb the value-added ladder, and competing in manufacturing with much cheaper labor in Poland or the Czech Republic is futile. Yet there are no politicians in Germany who really get this. Occasionally the FDP might mumble something that would be a step in the right direction, but aside from their self-inflicted implosion, they would in any case not be a major force.

Unification provided a brief boost to the German economy at the beginning of the 1990's, but that proved ephemeral. The monetary union between East and West Germany shows the dangers of joining two disparate economies. What's even worse, the worthless Eastern Marks were exchange at a one-to-one rate for Western Marks. This was a political necessity, but the long-term economic consequences are still being felt. Despite a truly gargantuan transfusion of money from West to East, the eastern part of the country is still very far behind economically. It's quickly becoming the German mezzogiorno, the name given to the destitute south of Italy, which gets huge handouts from the prosperous north.

Ever since unification, the German economy has not been doing well. Retail sales have been flat for ten years now. The only growth Germany has seen has been export-driven as it has been unable to generate self-sustaining domestic growth. While growing a little less every year may not sound like a catastrophe, the cumulative effects do add up (or rather, they multiply up). Since 1981, the German economy has grown in real terms by 54%. However, in the same period the EU economy grew by 61%, the British economy by 69% and the US economy almost doubled in size with growth of 92%. The comparison since unification 1991 is even more shocking. The Germany economy grew just 15%, beating Japanese growth by about 5% over the period. But the performance of the Anglo-Saxon economies was in a different league altogether: the US economy increased by 41% and the British economy grew by 31%. In terms of virtually every macroeconomic indicator, the US and British economies have done better than Germany.

What Germany needs is exactly what Schröder promised not to do: a strong dose of Anglo-Saxon economic medicine. The German economy needs to be unshackled, taxes need to be cut, the labor market needs to be liberalized. Without radical change, the German banking sector is heading towards a systemic crisis like the one in Japan right now.

How much pain is necessary before the changes can be made? It took Britain a winter of discontent to get serious about breaking the unions and restoring economic sanity. With the German premium on stability, the gut instinct will be to try to muddle through as long as possible, all the while making the problem worse and the eventual cure more painful. And if Germans have an economic pain tolerance like the Japanese, Europe's biggest economy will be in for a very long period of misery.