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Can Germany fix its economy?

Gloom has replaced relief as the overriding sentiment about Germany among economists. Experts are warning of another downturn in Europe’s largest economy, despite it emerging from last winter’s energy crisis in better shape than initially feared.

The longstanding structural problems, from an ageing population to crumbling infrastructure, have been aggravated by the war in Ukraine, rising interest rates and faltering global trade.

The IMF and OECD both expect Germany to be the worst-performing leading economy in the world this year. The country’s top-selling tabloid newspaper Bild Zeitung recently raised the alarm, declaring: “Help, our economy is crashing” as it appealed for chancellor Olaf Scholz to take action.

Why is Germany doing so badly?

The world’s fourth-largest economy stagnated in the three months to June, after shrinking in the previous two quarters — underperforming all its large rivals. 

A big reason is the global downturn in manufacturing, which hits Germany disproportionately hard as the sector contributes a fifth of its overall output — a similar level to Japan, but almost double that of the US, France and the UK. 

Oliver Holtemöller, head of macroeconomics at the Halle Institute for Economic Research, said the higher energy prices and trade tensions triggered by Russia’s full-scale invasion have had an acute impact on the sector. The higher cost of capital and shortage of skilled workers has also put it “under severe pressure”, he added.

German gas and electricity prices have retreated since last year. But they remain higher than in many non-European countries and production in Germany’s energy-intensive industrial sectors, such as chemicals, glass and paper, is down 17 per cent since the start of last year, suggesting permanent losses.

Line chart of Official data measuring Germany's industrial output (index 2015 = 100) showing Energy-intensive parts of German industry have been hit hard

“The outlook for German industry is bleak,” said Franziska Palmas, senior economist at consultants Capital Economics.

Adding to the country’s worries, its traditional strength in carmaking is under threat, as its big brands are losing market share to cheaper Chinese rivals in the fast-growing electric vehicle sector. “The country’s major export goods — cars — are increasingly contested,” said Martin Wolburg, senior economist at Generali Investments Europe.

Analysts surveyed this month by Consensus Economics forecast German gross domestic product will shrink 0.35 per cent this year — a reversal from the slight growth they predicted three months ago. They also cut their 2024 growth forecast to 0.86 per cent, down from the 1.4 per cent they expected at the start of the year.

How long has it been underperforming?

Germany rebounded faster from the 2008 financial crisis than the rest of the eurozone, as global trade grew and southern members of the bloc grappled with banking and sovereign debt crises.

But the leader has since become the laggard. German GDP only snuck above pre-pandemic levels in June, while the eurozone was 2.6 per cent above that level.

Line chart of Gross domestic product (% change) showing Germany's economy has lagged the rest of the eurozone and the US

“If you take the coronavirus crisis out, the underperformance started in 2017, so the structural issues have been there for a while now,” said Jörg Krämer, chief economist at German lender Commerzbank.

The country’s competitiveness has been steadily eroded by rising labour costs, high taxes, stifling bureaucracy and lack of digitisation in public services, experts said. This is highlighted by Germany’s slide down the IMD business school’s competitiveness rankings to 22nd out of 64 major countries — from being in the top 10 a decade ago.

“The advantage Germany built in the first 10 years of the euro has largely eroded as German unit labour costs rose faster than in the rest of the euro area and labour costs in Germany’s eastern European supply chains have converged with the west,” said Christian Schulz, deputy chief European economist at US bank Citi.

The ZEW Institute recently branded Germany “a high-tax country for investment”, pointing out its effective tax rate on company profits of 28.8 per cent was well above the EU average of 18.8 per cent last year. 

What is the government doing about it?

When Scholz was asked this in a TV interview on ZDF earlier this month, the chancellor said the government was setting “an incredible pace” with lots of “concretely imminent” projects to accelerate the switch to renewable energy and boost labour supply.

He also hailed how chipmakers Intel and Taiwan Semiconductor Manufacturing Company plan to build vast plants in Germany — although these were only secured thanks to about €15bn of subsidies.

Most economists think Berlin is heading in the right direction by trying to tackle structural issues rather than provide a short-term fiscal stimulus.

“The government is already addressing some key issues,” said Holger Schmieding, chief economist at German bank Berenberg, citing planned laws to streamline planning approval for priority investments and to attract more skilled workers from overseas.

But Scholz’s three-way ruling coalition has also been hampered by infighting, most recently when the Green family minister this month vetoed a proposal by the liberal finance minister Christian Lindner that was intended to spur growth by giving companies several billion euros a year in tax relief.

Is there any hope of a rebound?

Despite all the gloom, some economists think Germany will not keep underperforming for long, betting its cyclical difficulties will ease as energy prices moderate and exports to China recover.

“I would say the pessimism is overdone,” said Florian Hense, senior economist at German fund manager Union Investment, forecasting the country’s growth will be back to the eurozone average of 1.5 per cent by 2025.

Consumer spending may rebound as German wages rise more than 5 per cent, while inflation is forecast to halve to 3 per cent next year. “Rising real wages is one of the main reasons why we think there will only be a shallow recession,” said Commerzbank’s Krämer.

Some believe the current economic woes will force the government to tackle difficult labour market and supply-side reforms that could unlock a new era of outperformance, as it did in the 1990s. “The bigger the problems, the more likely there is to be real change in policy,” said Stefan Kooths, director at the Kiel Institute for the World Economy.

Others are more pessimistic. “The country needs an all-encompassing reform and investment plan,” said Carsten Brzeski, global head of macro at Dutch bank ING. “But we are far from getting it.”

Additional reporting by Valentina Romei in London and Laura Pitel in Berlin

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