Tuning Up the Engine of Europe's Economy Long Sustained by Manufacturing, Germany's Ability to Halt Declining Competitiveness Will Require Adapting to a Service-Oriented Market Series: Chancellor Kohl Described His Country as the `Motor' of the European Union, but Germany May Lose Its Competitive Edge If It Does Not Deregulate Much of Its Economy. Part 4 of Five. * Part 1: A Penchant for the Status Quo * Part 2: Bridging the East-West `Mentality Gap' * Part 3: States Push for Greater Rights under Federalism * Part 4: Keeping the Economic Engine Competitive * Part 5: Wielding Foreign Clout without Inspiring Fear

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SINCE the Industrial Revolution, manufacturing strengths have propped up the German economic machine.

Industrial giants - names such as Daimler-Benz, Krupp, and Bayer - made Germany the economic powerhouse of present-day Europe and a crucial player in the effort to achieve lasting Continental prosperity.

But the economic rules are rapidly changing as Europe prepares for the 21st century. The service sector is coming to dominate heavy industry in the new age, and the cutting edge will involve developing computers and other information technology rather than heavy machinery.

That is prompting some economists to warn that Germany is dangerously underprepared for economic competition in the post-cold-war world.

"We need much more flexibility than we have right now," says Jurgen Dongas, an economist at the University of Cologne who served on the government's Deregulation Commission from 1989 to 1991.

"The future of the industrial state, that is the issue," says Arnulf Baring, a Berlin political scientist. "We cannot maintain the current social-welfare state if we don't change the way industry works."

Responsibility for guiding Germany through the transition will fall on Chancellor Helmut Kohl's coalition, which scored a narrow victory in the Oct. 16 elections. Mr. Kohl advocates deregulation, but it is unclear whether the chancellor - one of the last remaining world leaders from the cold-war era - retains the vigor and vision to implement dramatic change.

Germany's ability to adapt is critical to the success of the European Union's attempt to create a continentwide federation of states.

Forging closer EU cooperation will be difficult under any circumstances. But the experiment has virtually no prospects for success if Germany - a major force for integration - goes into a significant economic decline. And plenty of historical precedents highlight the danger to European stability when Germany is not firmly anchored in a Continental security system. No browsing at midnight

The German economy is governed by some of the stiffest regulations in Europe. While future prosperity may hinge on the retail and service sectors, they may be the most rigid areas of the economy.

Shopping hours, for example, are strictly regulated, with stores closed nationwide on Sundays and holidays. A cash-only attitude prevails, as many smaller shops still refuse to accept credit cards.

Expansive labor laws - covering everything from hiring to discounting - have left customer-service skills underdeveloped. Meanwhile, key service-sector businesses, such as the state-run telephone company, have received government regulation and protection.

"Many companies don't feel they need to provide service," says Volker Gorgen, a deregulation specialist at the German Industry and Trade Council (DIHT), a Bonn think tank. "When you operate like a monopoly, there isn't a need to attract customers." A short-term lift

Despite its rigidity, Germany still has the world's third- largest economy. Statistics indicate a strong economic recovery is under way after the country's worst recession since World War II. The government projects that gross domestic product for 1994 could rise more than 2.5 percent, far exceeding expectations at the start of the year.

The good economic news boosted Kohl's ratings in opinion polls leading up to the Oct. 16 vote, and was crucial to his coalition's slim win over the Social Democrats.

But if Germany wants to remain a leader in the next century, the post-October government must take quick action to rectify economic deficiencies concealed by the statistics, Mr. Dongas and others say.

Among the economic issues that require urgent attention are privatization, innovation, labor-cost reduction, and popular expectation about the welfare state.

The danger to the export-dependent German economy is perhaps best borne out by the fact that the nation's export share outside Europe has dropped steadily over the last two decades. …