For the first time in more than two decades, Germany no longer has a cost advantage over its Eurozone counterparts. While Germany is suffering from this loss of competitiveness, it also has to contend with demographic changes. In recent years, an aging population has been offset by high emigration. But fewer immigrants are now coming, leaving companies without workers
Things may look better next year, but the relief will be short-lived. Germany’s Economy Minister, Robert Habeck, noted that economic conditions were “not satisfactory.” He said this on October 9, shortly after the official forecast for the year was revised from a 0.3% growth to a 0.2% contraction. This came after a 0.3% drop in output last year, meaning Germany is facing its first two-year recession in more than two decades. Europe’s largest economy has struggled to recover since the Covid-19 pandemic hit, lagging behind other rich nations. Isabel Schnabel, of the European Central Bank, noted that growth in the eurozone, excluding Germany, has been “extraordinarily resilient” since 2021 and faster than that of many other major economies.
But talking about the eurozone economy without Germany is like talking about the US economy without California and Texas. The country, once a driving force behind European growth, has now become a drag.
With the situation in place since 2021, it is hard to imagine a worse combination of circumstances for Germany’s economy, which is heavily dependent on exports and heavily reliant on manufacturing. After Russia invaded Ukraine, energy prices soared. Now, China’s industrial overcapacity is wreaking havoc in other countries. But while it is comforting to blame the world for its economic woes, in reality, Germany’s problems run deeper and many of them are domestically-generated. Moreover, a fractured three-party coalition in government is hampering the political response to this economic challenge. Industrial production has struggled in recent years. Energy-intensive industries such as chemicals, metalworking and papermaking have been hit particularly hard.
These sectors account for just 16% of Germany’s industrial output, but they consume almost 80% of the country’s industrial energy. Many firms responded to higher energy costs by cutting production.
Another problem for most German companies is changing global demand. As Pictet Wealth Management has noted, Germany’s economic relationship with China has changed. In the 2010s, the two countries’ growth complemented each other, with Germany selling cars, chemicals and machinery to China and buying consumer goods and intermediate inputs, such as batteries and electronic components, from China. Now, China is able to produce many of the goods it previously imported, and for some of them, it has become a serious competitor in the market, even for German cars. However, pessimism about German industry may be overblown. Although manufacturing output has fallen since 2020, its gross value added has been remarkably stable. Manufacturing companies have, in many cases, been able to change direction and produce higher-value goods, even as they have lost market share. And last year, while the overall economy shrank, trade continued to contribute to growth, something that looks set to repeat itself this year.
WEAK DEMAND
With inflation falling, higher real household incomes have not boosted demand much, but they should eventually be reflected in consumer spending. The worst of the energy crisis is also over. Most observers expect economic growth next year. The government has forecast growth of 1.1% in 2025 and 1.6% in 2026, based on the assumption that private consumption will start to recover. Ministers believe this will be partly due to their growth-enhancing policies. But a delayed economic recovery cannot fix the country’s long-term structural problems. Indeed, Germany’s economic weakness began even before the recent geopolitical and economic shocks.
As Ms. Schnabel pointed out this month, German GDP at the end of 2021 was just 1% higher than four years earlier, compared with a 5% increase in the rest of the eurozone and more than 10% in America.
Germany’s success in the 2010s came thanks to the country’s competitive advantage over the rest of Europe. At the turn of the century, Germany was still dealing with the shocks of reunification. Price levels were higher than in other eurozone countries (see chart 3). Then, in the early 2000s, the Hartz reforms, which included labor market liberalization, curbed costs, weakening labor’s bargaining power. At the same time, debt-fueled growth in southern Europe pushed up price levels in the eurozone as a whole. But over time, Germany’s competitive advantage has eroded. After the debt crisis in the early 2010s, peripheral European economies embarked on structural reforms.
Starting in 2015, after a decade of moderation, German wages began to grow faster. By 2019, the price gap between Germany and the rest of the eurozone had narrowed.
The energy crisis, which was made even more acute in Germany because of the country’s dependence on Russian gas, pushed up domestic prices even further. For the first time in more than two decades, Germany no longer has a cost advantage over its eurozone counterparts. While Germany is suffering from this loss of competitiveness, it also has to cope with demographic changes. In recent years, an aging population has been offset by high emigration. But fewer immigrants are now coming, leaving companies without workers. The IMF expects Germany’s working-age population to shrink by 0.5% a year over the next five years, the biggest decline of any major economy.
PRODUCTIVITY
IMF officials say that unless productivity improves, Germany’s economic growth will slow to 0.7% a year, half the pre-pandemic level. This could be boosted by government spending, but ministers are constrained by self-imposed fiscal rules. Annual net public investment has fallen from 1% of GDP in the early 1990s to zero. The “debt brake” rule limits the federal structural deficit to 0.35% of GDP a year, and although criticism of the policy has grown, few experts expect any change before next year’s federal elections.
Germany’s recession is painful for Germans as well as for the eurozone. An economic recovery next year, fueled by lower inflation and lower energy costs, will not alleviate the country’s structural problems. Germany’s economy was showing signs of strain long before the pandemic hit, before Russia invaded Ukraine, and before China began subsidizing struggling industries. The German economy will continue to show signs of strain for some time.
