Germany's economic strategy is dependent on the consumer, writes Derek Scally, in Berlin.

Gerhard Schröder has earned his summer break this year. The German leader is relaxing at home in Hanover these days - a year after he gave up his holiday to fight an election few thought he could win.

Mr Schröder got back into office but the subsequent months have been filled with false starts. Now his back is to the wall.

After three years of negligible economic growth and with unemployment likely to hit five million this winter, the government has thrown its rule book out the window and turned to a drastic, high-risk strategy.

The strategy, to stimulate the economy with debt-financed tax cuts, could save the day and kick-start the German economy. Or it could backfire with dramatic consequences for Germany and the rest of the euro zone.

The tax-cut plan is dramatic enough, cutting the top tax rate from 48.5 per cent to 42 per cent. But even more dramatic is how it marks a complete turn-around from Mr Schröder's policy as recently as last March.

Mr Schröder's self-styled "steady hand" approach favoured economic growth through a balanced budget and deficit reduction. He was determined to wait out the economic slump for the upswing he was sure would follow, dismissing talk of debt-financed tax cuts to stimulate the economy as "irresponsible" and "economic madness".

Now the German leader has changed his mind.

"It would only have been economic madness if we had decided on the tax cuts without simultaneous structural reforms," he told the Süddeutsche Zeitung newspaper before his holiday. "We are cutting taxes in tandem with far-reaching reforms and that's why it is responsible and economically correct."

The government plans to introduce two years' worth of tax cuts at once next year in an attempt to stimulate the economy. The move will be one-third financed by cutting state subsidies and selling off holdings in former semi-state companies. The other two-thirds, around €5 billion, will have to be borrowed.

Germany was already going to have a deficit of 3.2 per cent of gross domestic product (GDP) next year, according to the Ifo Economic Institute in Munich. The extra borrowing will swell the deficit to 4.1 per cent.

The tax-cut proposals follow other reform proposals for the employment market that would make it easier for small firms to hire and fire workers, cut the duration and value of unemployment benefit and trim of the cost of the state health and pension insurance systems.

Leading economists in Germany have complained that the reforms are superficial and that the government has missed the opportunity to push through even more dramatic reforms. But the same economists are anxious to back any measures that would breathe life into the economy and reject calls to fine Berlin next year if it breaches the terms of the Stability and Growth Pact for the third year running.

"What would punishing Germany achieve?" asks Mr Gernot Nerb, chief economist at the Ifo. "What should Germany do in the current situation? Raising taxes isn't something anyone in the EU would recommend. We don't want just financial stability but growth. There's no point having stability in a recession."

His comments reflect those of the government, which has been telling anyone who will listen that focusing on the 3 per cent deficit ceiling ignores the room for manoeuvre afforded by the pact in a bad economic situation.

"Everybody only ever refers to it as a stability pact but the pact, for very good reason, is called the Stability and Growth Pact," said Mr Schröder recently. "On the basis of the pact, it's possible and necessary to stimulate economic growth."

In other words, Berlin believes that to make a growth omelette, you need to break a few stability pact eggs.

Economic growth will only take place, however, if German consumers take the extra 10 per cent in their pay packet from the tax cut and go shopping. The government is tight-lipped about what it will do if hard-pressed consumers decide to save the extra money, leaving Berlin with no extra revenue to pay back its newly acquired debt. There is no plan B.

"There is a plan A on the table and it is up to the government, working with the opposition, to push that through," said Mr Stefan Giffeler, spokesman for the finance ministry. "It's very important that the psychological impulse for growth is not flogged to death."

Politicians and economists agree that psychology is the key to dragging Germany out of its slump. But surveys of consumer mood present a confusing picture: more than three-quarters of consumers said they planned to save the extra money from a tax cut and not spend it, according to a survey by polling agency Polis.

However, consumer confidence is clearly improving, according to the monthly survey conducted by the Consumption Research Society (GfK) for the European Commission.

"The trough of the valley has been reached. Now we are witnessing an improvement in mood as a result of the tax cuts being brought forward," said Mr Rolf Bürkl of the GfK.

"First the mood improves and there's always a delay before that's transferred into actual behaviour. But I am quietly optimistic."

That's a feeling shared by Mr Nerb of the Ifo.

"People just need to feel that the worst is over and that things are moving on the reform front even if it hurts," he says. "Then they are prepared to spend. I've never experienced a case where people save 100 per cent of a tax cut, it's always more like 50 per cent."

Political and business leaders are hopeful that growing consumer confidence will be matched with growing business confidence in tomorrow's eagerly awaited Ifo business survey.

It would add momentum to Mr Schröder's reform politics just days after the government reached a landmark deal to reform the public healthcare system, with cost savings of €9.9 billion next year and an estimated €23 billion by 2007.

Mr Schröder has a battle ahead to convince Brussels and the rest of the euro zone that his 11th hour change of direction will save the day.

For inspiration, Mr Schröder turns to German poet Heinrich Heine and his poem Junges Leiden (Young Suffering). "At first I almost wanted to lose heart, and I believed I'd never endure it. Yet I managed to endure it, but just don't ask me how."