In 2004, the world economy grew at a rate of 5.1%, the fastest pace in the last 28 years. While Ifo`s World Economic Climate indicator, generated from quarterly surveys of 1,200 experts in 90 countries, worsened slightly during the first three quarters of 2005, it rose again in the last quarter, indicating a continuation of the boom. In 2005, growth is estimated to have been about 4.3%, and a similar rate can be expected in 2006, marking a period of sustained rapid global growth unseen since the 1970’s.

But the boom is not uniform. In the United States, the number of experts giving a favorable assessment of the current situation declined; indeed, a majority believes that the economic situation will worsen during the next six months. However, in the Asian countries, including China, the optimism is unbroken. The same is true for Eastern Europe, the ex-Soviet states, and Latin America.

The big surprise is Europe, which, unlike in 2004 and the first half of 2005, now seems to be catching up with the rest of the world. Whereas growth was a miserable 1.5% in 2005 in the 15 “old” members of the European Union, Ifo expects EU-15 growth to accelerate to 2.1% in 2006.

To be sure, economic performance will vary widely among EU countries. While Italy will be the laggard, with only 1.1% growth, the Irish rocket will not lose its force, pushing real GDP up by about 4.8%. In general, the big EU countries are still performing badly, in contrast to the smaller members – hardly surprising, given that the EU is basically an institution to help the smaller countries overcome the drawback of their size by extending the agglomeration advantages that formerly were reserved to the bigger countries.

But even Germany, Europe’s biggest economy, is experiencing an upswing. The Ifo climate indicator for Germany, based on monthly surveys of 7,000 firms, jumped upwards in the second half of 2005, reaching its highest value since the boom year 2000, with businesses’ assessment of the current situation and expectations improving. After five years of stagnation, the economy is finally on the move.

The driving force is external demand, as Germany, the world’s second-largest exporter, profits from the global boom. Exports increased by 6.2% in 2005 and are expected to increase by 7.4% in 2006.

However, as we saw in 2004 and 2005, exports are not enough to create substantial growth if domestic demand does not follow. The good news for Germany is that investment demand is now growing, too. While the second half of 2005 was already quite good, Ifo expects investment in equipment to grow by a healthy 6% in 2006. After many years of contraction, investment in construction also will rise slightly.

Total investment growth is expected to reach 2.9% – weak by past standards, but nonetheless a promising salve for the wounded German mood. Moreover, any investment growth is vital for Germany, which, according to the latest OECD statistics, currently suffers from the world’s lowest share of net investment in national income. Even if Germany remains the world’s laggard, rising investment demand as such will contribute to GDP growth, which Ifo estimates at 1.7% in 2006.

That number looks small compared to most other countries. In fact, all EU countries except Italy and the Netherlands will grow faster. But everything is relative: Germany’s trend growth rate is just 1.1%, and the country has been the slowest growing EU country since 1995. Measured against a disappointing past, even Germany is currently experiencing an economic boom. Indeed, even German unemployment, which has been rising in cycles since 1970, will decline slightly in 2006, from 4.8 to 4.7 million.

The good economic data will reinforce initial favorable impressions of Angela Merkel’s new government, which got off to an excellent start at the EU Summit, where Merkel helped to broker a compromise between Britain and France on the Union’s 2007-2013 budget (by adding another €2 billion to Germany’s annual contribution).

In fact, the government may even have contributed a bit to the good economic data by announcing a serious effort to consolidate Germany’s own public finances – a prerequisite for investor confidence. According to the government, substantial tax increases will bring the fiscal deficit below the 3%-of-GDP limit set by the Stability and Growth Pact – a target missed for five consecutive years – by 2007.

The real test for the German government is the labor market. Most observers now agree that Germany needs something like the American earned-income tax credit. In Germany, it’s called “activating social aid” or “combi wages,” but the principle is the same: the state should reduce the money it pays for doing nothing and pay more for participating in the work force. That would widen the wage distribution, create jobs, and maintain the living standard of the poor.

Merkel announced in her inaugural speech in the Bundestag that her government will introduce such a system in 2006. If this is more than lip service, and if she really carries out a serious reform of the German welfare state’s incentive structure, the result could be higher employment and structural economic growth. In the long term, that would be more promising for the EU – and for the global economy – than the demand-driven performance that Germany is currently enjoying.

Hans-Werner Sinn is Professor of Economics and Public Finance, University of Munich and President of the Ifo Institute.

Copyright: Project Syndicate, 2005.