* Berlin's growth consistently outpaces Germany
* IT sector grows as Merkel targets innovation
* Unemployment and debt still high, output low
By Stephen Brown
BERLIN, July 13 (Reuters) - It has taken a quarter of a century longer than hoped but Berlin is now glimpsing the prosperity that was supposed to land in its lap after the Wall came down in 1989 and it was restored as the jubilant capital of Germany.
Twenty five years after reunification, Berlin remains a work in progress: with higher unemployment and lower income than the likes of Frankfurt and Hamburg, it will take years to catch up.
But its economy is growing faster than the German average and there are signs that Berlin is no longer a basket-case whose welfare dependency, lack of industry, poor infrastructure, high debts and pride at being "poor but sexy" - as the current mayor once said - make other Germans roll their eyes in despair.
Berlin does not dominate decentralised, federal Germany the way London or Paris do in their own countries. Generating just 4 percent of output, it cannot rival Bavaria or Baden-Wuerttemburg in manufacturing or Frankfurt for finance. Nor is Berlin's start-up scene likely to challenge Silicon Valley; but it can join the digital dots.
That chimes with Chancellor Angela Merkel's vision of the German economy keeping ahead of competitors in future by what she calls a "fusion of classic industry with the digital world".
"We won't be making cars like Stuttgart or Wolfsburg - but the bases of the technology," said the city's economy minister, Cornelia Yzer, referring to the headquarters of the German auto giants Daimler and Volkswagen.
Berlin is not devoid of manufacturing: Siemens makes gas turbines here and BMW makes motorbikes. But it has no DAX-30 blue-chip of its own and industry makes up just a tenth of economic activity - half the national level.
The real business buzz is around its universities, whose scientific alumni include Albert Einstein and Max Planck.
Deutsche Telekom's Innovation Laboratories set up at Berlin's Technical University in 2005 now have offshoots in Silicon Valley and Israel. CEO Tim Hoettges, visiting the labs, called them "sensors" keeping Telekom up with new developments.
Since Berlin began focusing on the digital economy in 2005 its information and communication sector has grown 58 percent in gross added value, said Hertmut Mertens, chief economist at the Investitionsbank Berlin (IBB), which finances local business.
In the pharmaceuticals sector, Berlin-Chemie which is owned by Italy's Menarini, cites the scientific talent for its latest expansion plans; General Electric, breaking ground on a new Berlin site last year, also cited the universities and R&D, plus the "proximity to the political decision-making".
There is optimism in the air: shopping centres are going up on the former 'no-mans land' by the Wall to cater to the boom in tourism, the public transport network has made its first profit and the population is growing fast, though at 3.4 million it is still less than in the city's early 20th century heyday.
"Berliners are benefiting from the persistently good economic situation, higher employment in the city and the rise in real wages," said Frank Bach at the Berliner Sparkasse savings bank, reporting a rise in summer-holiday spending plans.
"We are definitely not as poor as we were in the past," said Yzer, predicting 2 percent economic growth this year, after 1.7 percent in 2013 - when Germany overall grew 0.4 percent - and above-average growth repeatedly since 2005.
It has been a long road to recovery. Economic activity that survived Allied bombing or Soviet expropriation was subsidised during the Cold War on both sides of the Wall, to prop up the divided and isolated city for strategic reasons.
When the Wall fell, many companies collapsed in the face of competition or were bought out by westerners. "Half of the jobs in industry were destroyed," said Yzer. Unemployment in Berlin soared to 19 percent by 2005; at 11 percent, it is still way above the national rate of 6.7 percent.
IT and biotech are no quick fix, employing graduates rather than the long-term unemployed. But the boom in population and tourism may help some of the 200,000 unemployed find work.
Commercial real estate group CBRE's Alexander Torwegge says he expects to see "lots of jobs created" by new retail outlets like the Mall of Berlin, which is about to open on a former bomb site on Leipziger Platz.
Development does meet resistance. A referendum has defeated plans to build on the disused Tempelhof airfield, venerated for its role in the 1948 Berlin Airlift and now popular for skateboarding and picnics.
Paradoxically, Berlin's hipster chic and cheap rents are a big part of its appeal to young professionals working for start-ups, which feed talent into the R&D outfits of major companies.
Some people believe the city should focus on manufacturing instead to attract more sustainable sources of employment.
Stefan Hilscher, head of the local newspaper group Berliner Verlag, says it is essential to lure companies which are "firmly located in the Mittelstand" - the small to medium-sized firms central to the German economy.
Speaking at the Verlag's headquarters near Alexanderplatz with a revolving logo on the roof, he regretted that "the image has stuck" of Berlin as the work-shy capital.
Episodes like the attempt to build an airport more befitting Berlin's status than the ageing Tegel and Schoenefeld don't help - the "BER" project is running five years behind schedule, at twice the original budget, and has become a national joke.
"The city is growing economically, lots of international business people are coming to Berlin and they all have to go via Frankfurt," said Yzer. "It's a disaster, no doubt about that."
The city also finds it difficult to bring its debt below 60 billion euros, its debt per capita is twice the national average and GDP per capita and productivity are way under par. It has reined in spending but will remain a net recipient of inter-state transfers "for quite some time", city officials say.
For economist Karl Brenke at the DIW institute, Berlin has grown accustomed to receiving handouts "today and all the time since World War Two" and needs to change that mentality.
Nearly 17 percent of Berliners rely on welfare - more than twice the national average - which can make it hard to find youngsters who want to learn a trade, local businesses say.
"Young people nowadays are no longer interested in learning a trade," said Detlef Knop, who runs a small glazing firm. "It's difficult to convince them to do vocational training because of the pay levels compared with welfare."
But according to a study by Ernst & Young, R&D will be the growth driver in Europe in coming years, so Berlin may be wise to focus on this area. It has ranked Berlin as Europe's third most attractive city for investors after London and Paris.
But it also points out a lag in real investments, with just 34 foreign direct investment projects in Berlin in 2013 versus 84 in Duesseldorf and 81 in Stuttgart. Berlin's start-ups have only a 5 percent chance of creating "the next Google", it says.
On the other hand, consulting firm McKinsey estimates the start-up scene, centred around the brand-new "Factory" campus in the Mitte district, could generate up to 100,000 jobs by 2020.
Either way, economy minister Yzer says Berlin has to grow faster than the rest of Germany "for many years" to catch up.
How long is uncertain, but Brenke at DIW pours cold water on talk of anything but a very slow recovery, saying: "Berlin will be an economically weak region for the next 20 to 30 years." (Additional reporting by Christopher Alessi; Writing by Stephen Brown; Editing by Giles Elgood)