For the past 20 years, Germany has experienced huge economic growth thanks to its highly demanded exports and unique brand of Rhine capitalism[i]. This has allowed Germans to enjoy the best of both worlds. However more recently, many are sounding the alarm over Germany’s heavy stagnation. The IMF has predicted its GDP to fall 0.5% which makes it the worst performing advanced economy in the world. Both the manufacturing sector and exports are in decline.
What are the problems facing the German Economy?
The fallout from the war in Ukraine crippled many firms. Much of Germany’s industrial base was heavily dependent on cheap Russian gas. As the supply of Russian gas was cut off, energy prices soared creating unprecedented inflation. Many firms were forced to close or scale back production on energy-intensive products such as chemicals, putting thousands of jobs at risk.
BASF, the world's largest chemicals producer, has been forced to close several of its most energy-intensive operations affecting some 700 jobs.
The green energy transition means energy-intensive and polluting industries such as steelmaking are facing more agony. The consequences of the COVID-19 pandemic are still being felt. Lockdowns critically disrupted global supply chains. Many German manufacturers are losing competitiveness and facing lower demand. Demand from China, which is one of Germany’s biggest trading partners, has waned due to its strict zero Covid Policy.
Even Vice Chancellor Robert Habeck admitted earlier this month that Germany was emerging from the energy crisis “more slowly than we expected”.
The automobile industry has always been a pillar of the German economy. However nowadays, inflation, slower demand and high taxes are damaging the industry. The transition to electric vehicles and fiercer competition from China is also creating a headache for German automakers as they lose market share. Domestic troubles and lucrative subsidies from countries such as China and the USA are also incentivising automakers to relocate away from Germany. German firms such as Volkswagen and BMW are shifting production overseas. Volkswagen is building a new electric car battery factory in Canada.
The CEO of Volkswagen cited the reasons for relocation was due to the enticing incentives from the Canadian government, coupled with electricity costs about a third of those in Germany.
Even before the war in Ukraine, Germany was facing numerous structural problems. The country had long enjoyed a trade surplus thanks to its export-led growth model. Its exports were worth almost 44% of GDP in 2022.
One of the reasons why Germany became a manufacturing powerhouse was due to weak wage growth. From the 1990s until last year real wage growth rarely surpassed 2% a year. This makes German exporters more competitive. Nevertheless, Germany experienced record wage growth in 2023. Although good news for workers, this could reduce the comparative advantage[ii] of German exporters by creating a wage-price spiral[iii] and diminishing profit margins.
According to a survey by the Federation of German Industries, one in three German companies is thinking of relocating production abroad. This could lead to huge structural unemployment and worsen regional inequalities. The exodus is due to a myriad of factors including higher labour and energy costs, stringent environmental regulations, and excessive red tape. Slowing productivity is also proving to be a problem.
For example, in 2022 Ford announced plans to phase out the Ford Focus and sell its large factory in Saarlouis putting 4600 jobs at risk. Ford is the town’s biggest employer so this move could create huge unemployment and social issues such as deprivation.
Germany’s inbuilt current account surplus results in a financial account deficit. This means private investment is very low. Even German firms often prefer to invest overseas as they want to lower costs and generate higher returns.
BASF is downsizing many of its European operations and relocating much of its production to China. It recently opened a €10 billion petrochemicals plant in China. More than half of BASF’s current 111,000 workforce work in Europe.
Even public investment in Germany is notoriously low. Public services such as hospitals and schools suffer from underinvestment, staffing shortages, bureaucracy, and lack of digitalisation. German infrastructure is also crumbling. In 2006, Germany ranked third in the World Economic Forum’s Global Competitiveness Report for the overall quality of its transport infrastructure. Ten years later, it dropped to 11th place.
Another issue is changing demographics. Germany has an ageing population and a low birth rate. This means that a large chunk of the population is saving for retirement which further decreases consumer spending. This will also put a severe strain on the labour market. The government estimates the labour shortage could reach 7 million workers by 2035. An LFO survey in August 2023 found that 43.1% of German companies lack skilled workers.
Inflation is also denting consumer demand. Consumer spending has fallen to just 54% of GDP. This means many domestic businesses are facing lower revenues and profits. To tackle inflation, the European Central Bank has raised interest rates to record highs.
This is severely hurting the German construction industry. Germany has Europe’s largest housing market and construction is a major driver of economic growth employing 2.5 million people. Rising interest rates make the cost of borrowing more expensive dampening the demand for mortgages and new builds. Subsequently, house prices have fallen at record rates. The European Construction Industry Federation reported that orders for building contractors fell 9.7% from 2021 to 2022. Construction firms are also suffering from rising costs and dire labour shortages. Germany is already facing an acute housing shortage of 700,000 homes.
Upon entering office, Chancellor Olaf Scholz promised to alleviate the housing crisis by building an extra 400,000 homes a year. However, in 2022 only 295,300 homes were built well short of the target. This number is expected to shrink even lower this year. Many building firms blame the government for the slowdown citing excessive red tape and environmental regulations.
This means the cost of renting is exploding in Germany’s cities exacerbating the cost of living. Investment in residential construction fell by 8.5% to € 9 billion from 2021 to 2022.
What is the government doing to help the German Economy?
The government has not remained idle. Chancellor Scholz has vowed to boost economic growth by removing the “mildew of bureaucracy”.
For starters, he has promised to speed up the digitalisation of online government services. This is expected to make business easier and more efficient cutting costs and attracting investment. Moreover, it makes it easier to found and grow startups strengthening the Mittelstand[iv] which is the heart of the German economy.
To help the ailing construction sector, a €45 billion relief package was unveiled. Burdensome regulations were dropped, and the government announced €18 billion in funding to build affordable housing. A €7 billion corporate tax relief package was also passed to help building firms.
To improve transport infrastructure, the Chancellor promised to increase investment into the state-owned Deutsche Bahn rail network which is infamous for delays. Energy infrastructure is also being boosted with new LNG terminals being opened and the development of renewable energy being accelerated. The government is also addressing labour market problems by loosening immigration laws and increasing the minimum wage.
Vice Chancellor Habeck himself is calling for optimism. He expects the German economy to return to growth by 2024 and inflation to halve in the same period. Habeck also said his ministry is overseeing €80 billion in planned investment.
Although industries such as chemicals and cars have taken a hit, Germany is building new industries to replace them. The government provided €15 billion in subsidies for Intel and TSMC to build new semiconductor plants in Germany. The German defence industry is also booming. As a result of the war in Ukraine, many countries including Germany have swelled their defence budget. In 2022, Germany was ranked the 6th largest arms exporter in the world.
Shortly after the war in Ukraine began, the Chancellor pledged to increase defence spending by €100 billion. German arms manufacturers are enjoying high demand and can now even produce products without pre-orders. Companies such as Hensoldt and Rheinmetall have enjoyed record-high revenues and orders. Hensoldt shares are up nearly 90% since the war in Ukraine began and Rheinmetall shares have risen 140% in the past year. Many outside firms are switching production lines to enter the defence industry and take advantage of the boom.
What does the future hold for Germany?
Germany, for years, was the envy of Europe. It was lauded by many economists for having a great brand of capitalism with its efficiency and innovation coupled with a generous welfare state. However, its export-led model has come under intense pressure in recent times. To ensure continued growth and avoid previous mistakes, the German government must look at ways to boost energy security and remove dependency on imports. This makes the country more resilient to economic shocks. Measures to regain export competitiveness and demographic shifts must also be tackled to make economic growth sustainable.
However, efforts to decarbonise and digitalise the economy have so far been too slow. The current 3 party coalition has also been troubled with political infighting making the government less decisive. This means necessary reforms may not be delivered.
Footnotes:
[i] Rhine Capitalism - associated with business practices centred on providing goods and services efficiently in a free market economy, while aiming to distribute income and benefits equitably at the societal level.
[ii] Comparative Advantage - an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners.
[iii] Wage Price Spiral - this theory suggests that rising wages increase disposable income raising the demand for goods and causing prices to rise. Rising prices increase demand for higher wages, which leads to higher production costs and further upward pressure on prices creating a conceptual spiral.
[iv] Mittelstand - commonly refers to a group of stable business enterprises in Germany that have proved successful in enduring economic change and turbulence.
Bibliography:
German homebuilding collapse threatens wider economic damage - FT
Economic Key Facts Germany - KPMG
German Economy Shrank in Third Quarter Amid Recession Threat - Bloomberg
Ford says potential investor in Saarlouis plant pulls out | Reuters
Rhine Capitalism: the Economic Policies of the German Social Market Economy — Rohan Gopal
War in Ukraine has triggered a boom in Europe’s defence industry - The Economist
Defence industry’s business model transformed by war, says German contractor - FT
How a year of Olaf Scholz has changed and shaped Germany | Euronews
Olaf Scholz' economic 'Germany pact': Substance or spin? – DW – 09/10/2023
German hospitals protest lack of funds, warn of looming crisis - AA
German builders warn of crisis as they scrap record number of projects - FT
The region at the heart of Germany’s economic stagnation - FT
