Germany’s economic health check shows further signs of weakness

Weak growth, worsening sentiment, and pessimistic forecasts have brought back headlines and public discussion over one key theme over the last few months: whether Germany is once again the ‘sick man of Europe’. The Economist reintroduced the debate this summer more than two decades after its groundbreaking front page. The infamous headline certainly seems justified when looking at the current state of the German economy.

More than 10 years ago, Germany was celebrating its Wirtschaftswunder 2.0 and grew by 2.1% on average per year between 2010 and 2015. The eurozone – excluding the German economy – grew by only 0.8% on average per year over the same period. Between 2016 and 2022, however, other eurozone economies picked up speed and Germany lost momentum. GDP growth in the monetary union (excluding Germany) was 1.7% on average per year between 2016 and 2022, compared with an average GDP growth per year of 1.1% in Germany.

Currently, cyclical headwinds like the still-unfolding impact of the European Central Bank’s monetary policy tightening and high inflation – plus the stuttering Chinese economy – are being met by structural challenges like the energy transition and shifts in the global economy, alongside a lack of investment in digitalisation, infrastructure and education. To be clear, Germany’s international competitiveness had already deteriorated before the Covid-19 pandemic and the war in Ukraine.

To a large extent, Germany's issues are homemade. Supply chain frictions in the wake of the pandemic, the war in Ukraine and the energy crisis have only exposed these structural weaknesses. These deficiencies are the flipside of fiscal austerity and wrong policy preferences over the last decade.

Germany's low level of investment activity in recent years is evidence of the fact that the country has long rested on its functioning business model of importing cheap energy and exporting goods. While fixed capital investment in Germany grew by an average of 4.4% per year between 2010 and 2015, growth was only 3.1% between 2016 and 2022.

Just like the economic growth story, the picture elsewhere in the eurozone looks quite the opposite. Excluding Germany, the eurozone's fixed capital investments grew by an average of 1.9% per year between 2010 and 2015. In the years 2016-2022, average investment growth per year was 4.9%.

The structural transitions the economy is facing will come at a cost. Just think of energy-intensive production. In the production of food, beverages and tobacco, for example, more than half of the total energy consumption is covered by natural gas. Such a large share of consumption is met by renewable energy sources only in the manufacturing of wood and wood products. The shift from natural gas production to greener forms of production will initially come with productivity losses and, as a result, cause products to become more expensive.

The good old growth driver, exports, is also stuttering. On the one hand, China's economic weakness and the expected economic downturn in the US are a burden on German exports. If both of its main trading partners are not doing well economically, this automatically does not bode well for German trade. Secondly, the globalised world as we know it will change. This does not necessarily mean deglobalisation, but rather that trade flows will change. Be it supply chain disruptions in recent years or geopolitical tension, there is certainly a case for diversifying trading partners more and, if possible, bringing production closer to home. However, this development will also be accompanied by efficiency losses and higher prices.

The general lack of investment is reflected in crumbling infrastructure. The quality of German roads has been rated worse and worse by various indices since 2010, and digital infrastructure in Germany remains in need of improvement as well. Fibre connections, or high-speed Internet, only accounted for some 8% of total German broadband connections in 2022. The OECD average in the same year was 36%.

Demographic change will also structurally weigh on the German economy in the coming years. By 2060, the German working population could shrink up to around 25% compared with 2019. Assuming high labour market participation and high net migration, the loss would still be 5%.

Particularly over the next 12 years as the baby boomer generation retires from the German labour market, the shortage of skilled workers in Germany will become much more severe. However, in addition to labour market migration, another factor which could help to fill the gap in the German jobs market is automation. Nearly 80% of baby boomers currently employed in humanities and social sciences could be replaced by fellow robots. In the cleaning profession, more than 60% of employees aged over 55 could be replaced by automation.

They say a real crisis only shows in the labour market. With a seasonally adjusted unemployment rate of just 5.7%, the German labour market is holding up very robustly. Beneath the surface, however, the first effects of the tense economic situation are beginning to show. For roughly a year now, the number of job postings has been declining, and companies' employment expectations are also slowly becoming much more gloomy. For the time being, it is therefore likely that labour unions will increasingly argue for job security rather than strong wage increases.

Taking all the above findings into account, it is clear that the German economy – like a patient that has not taken good care of itself over the last decade – is now paying the price for too little maintenance work. As a result, the country has lost international competitiveness in almost every single ranking. In the European Commission’s latest industrial survey, for example, more companies than ever before stated that they expect Germany's competitive position to deteriorate – both within and outside of the EU.

Germany has shown regularly in the past that it can master crises. At the current juncture, however, the remedy for the country's current economic problems is not a simple one. It requires a long list of policy measures, structural reforms and investments to bring the economy back to full speed. More than twenty years ago, it took around five years between the first diagnosis and the beginning of serious structural reforms. Let’s hope that it will be less this time around.