* Merkel's conservatives on track to win re-election
* Budget consolidation main priority of next government
* Investors worry about tax hikes, labour reform tweaks
By Noah Barkin
BERLIN, June 17 (Reuters) - From Britain to the Baltics, governments across Europe have taken a battering in the credit crisis, blamed by their citizens for policies that led to the downturn or faulted for failing to cushion the blow.
But in Germany, which faces the deepest recession of any major economy, the crisis seems to be having the opposite effect on voters and their faith in the political establishment.
As layoffs, insolvencies and state rescues of companies pile up, appetite for the steady, consensus-first approach of Chancellor Angela Merkel and her "grand coalition" government has only grown.
Stability is in. Change is out. And despite criticism from abroad for what other countries saw as a slow, timid response to the crisis, Merkel is cruising towards re-election in September.
In contrast to the last time she ran, however, no one is expecting a German version of Britain's tough, reformist Prime Minister Margaret Thatcher should Merkel win.
After selling herself as "Maggie Merkel" four years ago and barely scraping into office, Germany's first woman chancellor has softened her image and her policy prescriptions.
With job losses mounting and Germany's deficit lurching above European Union limits, it will be difficult to get the economy back on track while tackling longer-term challenges, from bank consolidation to the ageing of the workforce.
So the "small steps" approach that Merkel has advocated as head of her right-left coalition, and Berlin's tendency towards state intervention to limit the impact of the recession, is likely to continue.
This will remain true even if, as many expect, Merkel's conservative Christian Democrats use the election results to ditch the Social Democrats (SPD) and form a centre-right government with the liberal Free Democrats (FDP).
"I think the election result of 2005 made clear the majority of Germans don't want radical reforms," said Bert Ruerup, former head of the "wise men" council of government economic advisers.
"Merkel has learned this lesson and even if she were to form a coalition with the FDP, I would not expect her to push for far-reaching economic policy changes. The image of Merkel as a German Margaret Thatcher was always wrong."
LOWER SPENDING OR HIGHER TAXES
Regardless of what the next government in Berlin looks like, its main focus is likely to be budget consolidation -- the area where Merkel's coalition was most successful in its first years in office.
Berlin is already pressing its European partners to think hard about how they will rein in their surging debt levels once a recovery takes hold.
During the crisis, Germany has introduced two economic stimulus packages worth a total of 81 billion euros ($112.5 billion). It has introduced car-scrapping subsidies and extended "Kurzarbeit", or short-term work, measures to limit factory layoffs.
These steps, a drop in tax revenues and a rise in jobless payouts are expected to expand the budget deficit next year to 6 percent of gross domestic product, double the European Union ceiling.
How the new government in Berlin will unwind the stimulus is already a source of concern.
"To get public finances back in order, the next government will have a choice: lower spending or higher taxes," said Klaus Wiener, head of research at Generali Investments in Cologne.
"What I fear is a new debate about raising value-added tax, particularly with another grand coalition. Germany needs policies that give a bigger role to private consumption."
Merkel's coalition pushed up VAT by three percentage points at the start of 2007 in a drive to rein in the deficit, a move Wiener says is still hurting consumers.
Her conservatives are preparing an election programme which stresses the need for tax cuts, not hikes.
But the plans foresee only minor adjustments to tax brackets and no serious relief for years, far less ambitious than the tax overhaul being advocated by the FDP, and more modest than the flat-tax idea that Merkel considered four years ago.
Labour market reform has also lost its appeal, and some experts fear the next government, under pressure from rising unemployment, could dismantle changes to welfare and jobless benefits put in place by Merkel's predecessor Gerhard Schroeder.
"Germany's brief period of reform, between 2002 and 2004, is over," said Josef Joffe, publisher-editor of leading German weekly Die Zeit.
"We are back in the arms of the 'Vater-Staat', or all-providing state, that protects its citizens against all the vagaries of life."
DEMOGRAPHIC CHALLENGE
The crisis also risks clouding Berlin's efforts to get a grip on longer-term challenges such as its ageing population.
With a birth rate that is one of the lowest in Europe and millions of baby-boomers gearing up for retirement, Germany faces a daunting pensions and healthcare crunch which could cripple its economy in the decades to come.
Merkel's government has taken some steps to alleviate the burden, introducing parental subsidies to encourage more babies and pushing legislation to expand the provision of child care.
But for the past two years, it has ignored caps on state pensions that were designed to reduce the strain on a creaking social security system, and it has resisted steps to bolster Germany's labour force with foreign workers.
Along with Austria, Germany is the only EU country to have kept labour market restrictions in place for workers from eastern countries that joined the bloc in 2004.
Reiner Klingholz, director of the Berlin Institute for Population and Development, fears the crisis and the deficits it spawned will cause a new government to continue in this vein, ignoring demographic imperatives until it is too late.
"In the future Germany will need more qualified immigrants, but right now conditions simply aren't good enough and they are heading to other countries like Canada," he said.
"The steps we've seen have been too small and too slow. As with climate change, the problems become bigger the longer you wait." ($1=.7197 Euro) (Editing by Janet McBride and Andrew Torchia)