Senior Fellow
University of Helsinki
Finland
The German economy has been stagnant since 2019, performing worse than the EU or the euro area on average. Per capita GDP was 0.9 % smaller in 2023 than in 2019, while it was 2.1 and 3.3 per cent higher in the euro area and the EU, respectively.
This stagnation represents a remarkable change from the almost 15 years of star performance until 2019. Between 2005 and 2019, the German economy grew faster than any other major developed economy. Per capita GDP growth was 20 %, which is double of that of France or the UK and surpasses substantially also the US rate of 16 %.
The sea change at around 2020 did not stem from the Covid-19 shock that put a heavy pressure on all economies. The German GDP declined substantially less in 2020 than in the aforementioned countries or the euro area on average. The slowing down had in fact started already prior to Covid. This suggests that longer-term structural issues rather than cyclical factors are behind the change.
In terms of labour productivity and labour input, the recent stagnation is due to fewer hours per capita. GDP per hour grew consistently until 2022 to decline only in 2023. The lower labour input reflects a stagnation of the share of employed in the total population at a very high level and a continued decline of hours per employed. Unemployment has remained low.
On the demand side, manufacturing exports were the key driver of growth prior to the recent stagnation, showing up in the exceptionally high current account surplus. Since 2018 export performance has weakened significantly. Several factors have contributed to this. Unfortunately, many of them are likely to be long-lasting if not permanent.
The rise of energy costs since the Russian war of aggression in Ukraine weakened the profitability of energy intensive production, particularly in the chemical industry. While the prices have come down, relative energy costs are and will most likely remain higher than in the past. Therefore, investment decisions are also affected. In particular, the US will be a significantly more profitable place for energy-intensive production than Europe.
Simultaneously the demand for combustion engine cars has weakened while the German car industry has been slow to develop electric vehicles (EV). Given the importance of the car industry in German manufacturing, this has already had a major impact on industrial production. This impact is also unlikely to disappear soon. The Chinese EV production is technologically well-advanced and enjoys a significant cost advantage as well. The industry has already started to respond to the weakened prospects; for example Volkswagen was recently reported to plan shutting down three plants. Also the weakening of Chinese growth has impacted on German exports, for which China has become a major market.
The re-election of Donald Trump will almost certainly lead to higher tariffs on European exports to the US thus weakening the demand for export production directly. The tariffs on Chinese exports on the other hand are likely to put pressure on the Chinese exporters to redirect some of the supply to the European markets. The combined negative impact could be significant on all EU exports and import competing production, and particularly so for the export-oriented German manufacturing. How high and durable the tariffs will be is difficult to foresee, but one cannot trust that the new barriers to trade would disappear soon.
Two supply side factors are also contributing to slow down growth in Germany. Ever since the collapse of the Iron curtain, the integration of the Central European economies – Poland, Hungary, Czech Republic, Slovakia – to the Western economic system has benefitted Germany greatly. German companies could locate significant parts of their supply chain in these near-by, low-cost countries with well-educated labour force. This potential has been largely exhausted, as the cost levels have converged and the weak demographics of these countries is having an increasing impact on their labour supply.
Secondly, labour supply is becoming an increasing constraint for growth in Germany itself. The employment rate has already stabilised at a very high level by European standards. While the average annual working hours per employee are low, hours per total population are around the European average, and can hardly increase substantially. As the share of the working age population in the total population is set to decline fast, even keeping labour input stable would require substantial work-related immigration. Its availability is an open question.
Given this outlook for labour supply, growth will be determined by productivity, not only in the long run but also in the coming few years. German productivity is high by European standards, but the gap vis-à-vis the US has widened since the global financial crisis. This difference stems essentially from the high-tech companies (software, ICT, pharma) which have lifted US productivity rapidly, while Germany and the rest of Europe lack large technology companies.
The outlook depends very much on how fast Germany can transition from production relying on mid-level technologies to high-technology production. The jury is out on that. Like most other European economies, the spearhead of high productivity production, start-up companies, comprise only a small fraction of the German economy. Unlike in the US, the scaling-up of start-ups has been held back by weak supply of risk capital and more fragmented near-by markets. On the other hand, spending on R&D has steadily increased surpassing 3 % of GDP since 2017. This is well above the EU average of slightly over 2 % and provides a solid basis for innovation. Furthermore, Germany has a versatile and competent engineering ecosystem, which should be in a good position to expand into new lines of production when new opportunities arise.
Germany has ambitious climate policy targets aiming at climate neutrality by 2045, five years prior to the EU deadline. While demand for fossil energy has declined and the installation of new energy production has proceeded, Germany is not yet on track to achieve its target. The transition is constrained not only by an insufficient overall supply of green energy but also by an inadequate electric grid to transfer green power from where it can be produced to the locations of consumption. As in other countries, the transition will be a burden on the economy in the medium run: the existing capital stock gets replaced by climate-friendly capital without addition to the net stock.
Germany has made extensive use of state subsidies allowed by the relaxation of EU state aid rules since the pandemic. The question nevertheless remains whether the subsidy policy has contributed in the hoped-for degree to green and digital transition. For example, in September 2024 Intel’s plans to build a “mega factory” for chip production in Magdeburg was put on hold despite the promise of € 10 billion of subsidies.
A topical policy question in Germany indeed is to what extent and way government expenditure should be used to promote growth. Typically, the public sector is responsible for a substantial part of infrastructure, as private incentives for its provision tend to be weak. However, in Germany public investment in infrastructure has remained low for a long period of time; the ratio of all German public investment to GDP was 2.3 % on average in 2008-2023, while the EU average was 3.3 % and for example Sweden and Finland posted figures over 4 %. There are in fact many indications that for example transport and communication infrastructures have not developed in line of those of many countries of similar GDP per capita levels.
Low spending on infrastructure is at least in part caused by the tight constitutional deficit rule, in place since 2011; according to the “debt brake” the so-called structural deficit shall not exceed 0.35 % of GDP. Pressures to increase spending on defense will further reduce scope for increasing expenditure on infrastructure and other items likely to support long-term growth. Some relaxation of the debt brake would seem necessary to allow policies needed for better economic performance.
It is hard to avoid the conclusion that the short-term growth prospects remain subdued in Germany. This is obviously bad news for the Baltic Sea region, which is tightly linked to the German economy. On the other hand, the predicament of low growth has been recognised both in Germany and the EU. For example, the report by Mario Draghi lays out extensive policy reforms that could improve prospects for sustainable growth in the EU and in its largest economy, Germany. Should policies change along the proposed lines, substantial improvement in economic performance could be expected.