Four months after taking office, Chancellor Angela Merkel has finally embarked on her promised reforms to boost growth and cut unemployment in Europe's largest economy.

Strengthened by the outcome of regional elections on Sunday, she announced her government had entered "Phase Two" consisting of an overhaul of the welfare system and labor market, and starting with the most contentious area, the costly and inefficient national health service.

Talks aimed at overcoming divisions on health in her right-left coalition began on Monday night when Merkel met with Health Minister Ulla Schmidt, a member of the center-left Social Democrats who share power with Merkel's conservative Christian Democrats.

Even though the two parties have almost diametrically opposite views on what to do about the health service, they aim to have draft reform legislation in place before the summer recess.

Analysts said health will be Merkel's first major test after she spent the first four months avoiding tough decisions on domestic policy and burnishing her image on diplomatic trips that, with the exception of some effective brokering during last December's European Union summit, yielded little more than photo opportunities.

The popularity of the shy and cautious leader has surged as a result, and her CDU avoided nasty surprises in Sunday's elections, the first voter test of her government.

"All that's happened so far is that the parties have been sizing each other up and avoiding trouble while they get used to being in government together," said Gero Neugebauer, political scientist at Berlin's Free University. "What's happening now isn't Phase Two, it's Phase One."

"Merkel has done a good job presenting herself, she's been well-mannered, she's done good public relations work. But where's the beef? I don't see any political achievements yet."

The beef will be hard to come by because both parties face the dilemma of needing to compromise to achieve results, yet having to stand their ground to appeal to their supporters.

Financial markets will be watching the reform negotiations closely in the coming months out of fear there could be messy compromises that will fail to get Germany's 5 million unemployed people back to work.

Shotgun Wedding

No one in the government regards the alliance between the CDU and SPD as anything more than a marriage of convenience. The two main parties linked up after last September's inconclusive general election outcome left them with no other option but to form their first "grand coalition" in almost four decades.

"We will put issues on the agenda. Tough working weeks lie ahead of us," Merkel said on Monday.

A closer look at the parties' different strategies for health shows just how tough those weeks are going to be. A new way of financing the system needs to be found to cope with rising costs, mounting unemployment and improving life expectancy.

At present the system is funded from levies on pay split between workers and their employers. Merkel wants to impose a flat monthly payment by all, regardless of income, arguing that this would help keep labor costs down and boost job creation.

The SPD regards that system as unfair and is proposing a "citizen's insurance" to broaden the financing base by bringing in currently exempt groups such as civil servants and the self-employed.

Once that divide has been bridged, assuming it ever is, the parties need to tackle further reform of the labor market, still regarded as too inflexible. Conservative demands for less job protection are bound to provoke a fight. The government also plans to reform corporate taxation, the pension system and energy policy, and to cut red tape.

"The SPD will need to demonstrate that it is protecting social justice," said Neugebauer. "If it doesn't, it will continue to lose support."

Both CDU and SPD claimed success in Sunday's state elections in Baden-Württemberg, Rhineland-Palatinate and Saxony-Anhalt.

The CDU won the most votes in the wealthy southwestern state of Baden-Württemberg and the poorer eastern region of Saxony-Anhalt. The SPD scored well in Rhineland-Palatinate, the last big western state it holds.

With the smaller parties failing to gain ground, the SPD and CDU's combined domination of the Bundesrat, the upper chamber of parliament, even increased as a result of Sunday's vote, which will make it even easier to pass legislation -- once they agree on it.

The SPD is currently in a weaker position than the CDU. Nationwide opinion polls put its support at around 30 percent, well below the CDU at around 40. Concern has been growing that SPD chairman Matthias Platzeck lacks the charisma and drive to mobilize supporters and put an SPD stamp on the government's policies.