Germany faces stagnation after narrow election win

GERMANY faced the prospect of economic stagnation yesterday after Chancellor Gerhard Schroeder won Sunday's election with a reduced majority that narrowed his scope to implement painful reforms.

Schroeder said he would immediately start talks with the environmentalist Greens to resume the coalition that has ruled Germany for the past four years, as share prices across Europe fell amid disappointment about the election outcome.

After making criticism of the United States and its threat to attack Iraq a plank of his campaign, Schroeder made a first step toward mending fences by announcing the resignation of a minister who had been quoted as likening the methods of President Bush to Hitler's.

The controversy had distracted voters from Schroeder's failure significantly to cut Germany's four million unemployed.

But with his majority halved, analysts said there was little sense that Schroeder would now be able to overhaul the world's third largest economy, which many economists say is highly taxed, over-regulated and risks becoming as stagnant as Japan's.

His centre-left Social Democrats and the Greens got a majority of just nine over the combined opposition, down from 21, in one of the narrowest votes in post-war history.

SPD officials said they expected to strike a new coalition deal in the next three weeks and that its first task would be to drive forward planned labour market reforms. For now, Schroeder may continue to earn voter support from criticism of the United States, playing to the pacifist streak Germany has inherited from its violent history.

Even as he was announcing the departure of justice minister Herta Daeubler-Gmelin, whose reported comments outraged Washington, he insisted on his right to differences of opinion: "Between friends, there can be factual differences but they should not be personalised, particularly between close allies."

The United States showed no inclination to bury the hatchet. Defence Secretary Donald Rumsfeld said he would not be meeting German Defence Minister Peter Struck at a NATO meeting in Warsaw, reiterating Washington's line that German criticism of US foreign policy during the campaign had poisoned ties. Schroeder's Red-Green alliance secured 306 of the 603 seats in parliament.

While Schroeder's SPD fell 2.4 points from the previous election in 1998 to 38.5%, the coalition's majority was rescued by a best-ever performance from the Greens.

The ecologists scored 8.6%, boosted by the popularity of Joschka Fischer, their foreign minister, as well as environmental fears after devastating floods in east Germany.

Fischer said the Greens would not "flex their muscles" in coalition talks. But sticking points could emerge, such as SPD opposition to further so-called eco tax fuel tax increases, a pet project of the Greens and deeply unpopular with business.

The Green Party has also called for the re-introduction of capital gains tax on companies' sales of share stakes.

The SPD wants these to remain tax-free to help unravel Germany's complex web of cross-shareholdings among companies. Germany now faces a winter of weakening economic growth, seen below 0.75%, and of wrangling with Brussels over a budget deficit expected to exceed the European Union's ceiling.