Based on strong export growth, the German economy is recovering from three years of stagnation. Weak domestic demand is still weighing on activity although there are signs that investment is strengthening. The upswing should broaden in 2005, as consumer confidence gradually improves. In 2006 GDP is projected to grow by 2¼ per cent, above potential. The general government deficit is likely to remain between 3½ and 4 per cent of GDP this year and next, not falling below 3 per cent before 2006. Significant steps to reform labour and product markets are being phased in. While the short-run impacts on confidence and growth are ambiguous, it is clear that for economic performance to be raised in a durable way these reforms need to be continued and deepened within a coherent framework. Fiscal consolidation needs to be linked to more fundamental spending reform, requiring, inter alia, the untangling of responsibilities across different levels of government, more determined reductions in both subsidies and tax expenditures and continued reform of the social security system. ...