Expert View: Germany needs more than Claudia draped in a flag

"A haircut? What, on a Monday?" I knew that the German town I was in fully respected the tradition both of half-day closing on a Wednesday and the tendency to slope off at lunchtime on a Saturday, but Mondays? Just when did anyone work around here?

My haircut came to mind when markets were sent into a tailspin last week by a shockingly bad German statistic. The ZEW index of economic expectations fell to minus 5.6 per cent (economists had been looking for 12.2 per cent), sending the bulls of Frankfurt clambering for the Ausgang. Suddenly the new dawn in Germany seemed over before sunrise.

It had all been going so well. The World Cup had been cleverly exploited to showcase a new-found optimism: Claudia Schiffer draped in the flag of "the country of ideas". Business confidence had surged to a 15-year high, GDP growth estimates were being revised upwards and even unemployment - Germany's Achilles heel - seemed to be improving. It fell from a peak of five million in March 2005 to 4.44 million in July.

Then came the ZEW number. Markets reacted ferociously, especially the euro, as a slowdown in the eurozone's largest economy would make further rate rises near impossible. As ever, the bears found plenty to chew on, not least the thorny question of whether Germany's notoriously inflexible labour markets had really changed that much at all - haircuts included.

What's going on? The reality would seem to be that we are at one of those crucial economic turning points where Germany could go either way (as confirmed by Thursday's Ifo business confidence numbers, which refused to follow the ZEW down). Investors are forced to look in two directions because of the underlying weaknesses in the economic infrastructure, and the coalition government's attempts to address them. Both are strong forces.

The budgetary issues have crystallised the problems. Caught in the machinery of the EU stability and growth pact - what finance minister Peer Steinbrück refers to as "the instrument of torture" - Germany struggles to keep within the rules without the wholesale dismantling of its generous welfare system. Next year's plan to raise VAT by 3 per cent in one swipe is a dramatic way to close this gap, but one which endangers snuffing out economic recovery. The bears have economic growth slowing to close to zero in 2007.

There are no quick solutions - Thomas de Mazière, minister to the Chancellor's office, predicts "fiscal consolidation will remain a priority of all German governments for the next 30 years" - not least because of the unspoken elephant in the room, the former East Germany. Integration has worked politically, but a truly phenomenal sum of money (€1.2 trillion, or £811bn) has been poured in by the German taxpayer with far too little to show for it. East Germany's 18 per cent unemployment contrasts sharply with the vibrancy of other ex-Soviet bloc economies.

On the other hand, Chancellor Angela Merkel demonstrates a quiet determination that is admirable. Despite leading a government weakened by the necessities of coalition, she has achieved much in the first half of 2006. A crucial reform of Germany's deadlocked federal system was passed on 30 June, cutting the proportion of laws that will in future require Bundesrat approval. Likewise, the various measures to improve public finance have been passed with remarkably little opposition.

The real danger is that things could get increasingly fractious as the coalition discusses thornier issues: healthcare spending, corporation tax and wage reforms. S&P, the credit ratings agency, is monitoring developments: "If structural impediments are not addressed, then the next cyclical downturn could reverse the current modest improvement."

Ms Merkel's success is vital not just for Germany but for all of us in Europe. If this continent is to have a future in an increasingly globalised economy, it needs at its heart an economic engine that is firing on all cylinders. Germany needs a haircut.

Christopher.walker@tiscali.co.uk