Hamish McRae: Germany's economy is beginning to perk up (at last)

Frankfurt - the German economy is buzzing, as anyone making even the briefest visit will testify. Of course, Frankfurt is not Germany any more than the City of London is Britain and it always seems to be doing pretty well. But now it carries its cloak of prosperity with more style than before. Rocco Forte has opened a flash new spa hotel, symbolising that the place is not just about making money - it is also about spending it.

And that has been what is wrong with the German economy. It has been as brilliant as ever in making the goods the world wants to buy, passing the US as the world's largest goods exporter. But domestic consumption has lagged: it has hardly risen for five years. Despite the booming exports, overall growth has been minimal, averaging less than 1 per cent a year for the first part of this century ... until this year.

Suddenly things have changed. On Tuesday, Michael Glos, the economy minister, told a conference in Berlin that he expected growth to be around 2.5 per cent this year. He will present the formal new forecast tomorrow, following estimates by the main German economic institutes to be published today.

You may think growth of 2.5 per cent is nothing to write home about, but it would be the best performance from the German economy since 2000. This is also having a positive impact on the country's fiscal position by boosting tax revenues. The finance minister, Peer Steinbrueck, described the performance as "fantastic". As a result of the additional revenues, the fiscal deficit will go down to about 2.6 per cent of GDP this year compared with 3.5 per cent last year, and below the Maastricht ceiling of 3 per cent for the first time in five years.

As you might expect, the country's business community is cheerful about what is happening now. The latest survey from the ZEW Centre for European Economic Research in Mannheim, out this week, shows that investors are more optimistic about the current economic situation than they have been at any time since 2000, as the first graph shows.

But as you can see, they are also very pessimistic about the future, the other line on the graph. Indeed, the index tumbled this week, showing that the German investment community is less optimistic about that than at any time since March 1993. For investors the future is not "fantastic" at all.

How should these two views be reconciled?

First, a simple point. If people find present conditions are very positive it is reasonable for some of them to expect things may get worse. In other words, the negative expectation for the future is a function of the positive assessment of the present.

But it is not just that. There is hardly any doubt that growth will be slower next year. Mr Glos is expected to reveal a forecast for 2007 of 1.5 per cent growth, better than the 1 per cent the government was expecting in April but still a sharp slowing from this year. The private sector forecasts are also around the 1.5 per cent level.

There are two reasons for this. One is that because the German economy depends on exports to drive it, it is vulnerable to any slowdown in the growth of world trade. You can see in the second graph how German industrial production has outpaced that of France and Italy in the past couple of years. Suddenly it seems to have decoupled.

It is not quite clear why this should be so. Overall manufacturing exports from Germany have been doing well but not particularly so when compared with France and Italy. The big difference seems to be that German exports of capital goods have been very strong. The UK economic consultants Capital Economics argue that since the present eurozone recovery has been driven by investment, and German industry is skewed towards producing this equipment, it has benefited more than the rest of Europe from that.

The second reason for expecting a slowdown is domestic. In January, Germany plans to increase VAT from 16 per cent to 19 per cent. The reason is the country's determination to correct its fiscal deficit. You do not need to have an acute grasp of economics to figure out that if you pre-announce a tax increase of this magnitude people might alter their behaviour and buy big-ticket items this year rather than wait.

So domestic spending has been stimulated and will continue to run strongly until the end of the year. The obvious question is just how hard the drop will be then.

You might think that, given the strong fiscal performance this year, the government would drop its plans to increase VAT. That, after all, would be the response of a British Chancellor of the Exchequer.

But Germans do it differently and I have seen no suggestion that Angela Merkel's coalition government will revise its tax plans. On a long-term view, that may well be right, for Germany faces growing demographic pressures - much more marked than in the UK for example. The workforce may have started to decline this year and the German population is expected to start falling in about four years' time.

On a short-term view, however, it may not be a great idea to hike taxes on consumption at just the moment the economy has started to perk up. In any case, Germany's problem has been minimal growth in domestic consumption, precisely the thing that the VAT rise hits. Add in the prospect of higher eurozone interest rates and it is not hard to see why business is glum about prospects next year.

So what will happen? Maybe it is the warm, sunny prosperity of Frankfurt that is shaping my judgement but my instinct is that this is an important moment: that Germany will indeed do rather better in the next five years than it has in the past five, at least in relative terms.

It remains dependent on the world economic cycle and this cycle is now quite mature. But Germany has succeeded in holding down its costs, has exported lower-value-added jobs to eastern Europe, and is making a start in much-needed reforms to its labour market. That is real progress.

There is a bigger point here. The German economy has been carrying two burdens. One is the cost of rebuilding the former East Germany, a much larger task than the country realised 16 years ago when it took it on. That slog has years to run yet, but you can begin to see pockets of spontaneous growth there which were not evident five years ago. The other was entering the eurozone at what, with hindsight, was too high an exchange rate. That adjustment is now over and, within Europe, German prices are fully competitive again.

Germany will now continue to carry a third burden, the demographic one noted above. That requires further adjustment and adaptation.

The slog continues. Growth will remain pretty subdued. Let's face it, you would not have Gordon Brown declaring that 2.5 per cent growth was fantastic. But the modest success that Germany is experiencing should be celebrated and the achievement acknowledged. Things are a lot more encouraging than they looked even six months ago.