What’s Wrong with Germany’s Economy And Is There Hope?

Germany is going through a difficult phase right now. Among the seven G7 nations, it was the only economy to shrink in 2023. And for the first time in 30 years, major German carmaker Volkswagen is thinking of factory closures and layoffs. But the sad thing is, this may just be the tip of the iceberg.

Germany was once a world leader in exports, innovation, and patents. A true economic fairy tale. So, what happened? Where did things go wrong, and is there any hope? Knowing these answers is critical for anyone living in Germany or planning to move here. And that’s exactly what we are going to address in this.

1. Understanding the Problem: What’s Actually Wrong?

Earlier, I mentioned that the German economy is shrinking. But what does that actually mean? To understand this, we need to know what GDP (Gross Domestic Product) is. GDP measures the total value of all goods and services produced within a country over a specific period. Think of it as a quarterly report card for the economy that shows how much “stuff” the country produces and how well the economy is performing.

We don’t need to know the exact calculation of GDP; what really matters is whether it’s growing or falling. If GDP falls, it means the economy is shrinking. If this trend continues for two consecutive quarters, it is called a recession.

Now let's come back to Germany. In 2023, Germany’s GDP shrank by 0.3%. It is expected to drop by another 0.2% last year. But why does this matter? Why do we need GDP to always grow? Because everyone wants a better standard of living. Even though Germany has a very low birth rate, its population is still growing slightly due to immigration. If the economy doesn’t grow along with the population, the standard of living will decline. More GDP means more jobs, higher wages, and improved living standards for everyone.

Every economy goes through cycles of growth and decline. If Germany’s current problems were simply part of such a normal cyclical downturn, there would be less reason to worry. This is a country that has faced even tougher challenges in the past and emerged stronger. However, the current situation is different. If we take the last 5 years, we can see that Germany’s economic output has been almost stagnant. This is not normal for any economy. Germany is not dealing with a temporary recession—this is a structural crisis. And understanding the difference between the two is important.

Recessions are common and often triggered by specific factors like financial, political, or technological developments. Like the 2008 financial crisis. During a recession, companies reduce investment, people cut back on spending, and exports slow down. This leads to lower economic demand and output, along with rising unemployment. Fortunately, governments and central banks have various tools to deal with these short-term downturns, like cutting interest rates, launching government investment programs, and providing unemployment benefits. We saw this during the Covid crisis. So most recessions are usually short-lived, and the economy gradually recovers.

However, a structural crisis is different. This happens when the overall productive potential of the country itself stops increasing. In other words, the country is no longer improving its capacity to produce goods and services over the long term. Unlike a recession, a structural crisis does not have a single, identifiable root cause. So it cannot be easily resolved with short-term economic measures. In Germany’s case, a major factor contributing to this crisis is the decline in industrial production.

Industry struggles

Industrial production in Germany has been on the decline since 2018, and there are two major reasons behind this trend. One key factor is the end of rapid economic growth in emerging countries, especially in China. China was once a significant market for German goods. But the country is now capable of producing many of these products themselves. This has reduced global demand for German exports, especially in the automotive sector.

The German car industry faces another significant challenge: the shift to electromobility. German manufacturers like VW, BMW and Daimler have been slow to adapt to the growing demand for electric vehicles. And unlike traditional combustion engines, electric vehicles are less complicated to build and require fewer parts. This has led to a reduced demand for German expertise and components.

Other than the automotive sector, other industries that have been hit particularly hard are chemical and metal production. The main reason for this is the increasing energy costs.

High Energy Costs

For many years, Germany relied heavily on importing energy at very low prices, especially from Russia. This cheap energy was an important factor behind the country’s strong economic performance. However, with the start of the war in Ukraine, this dynamic changed and the prices shot up. Even though energy prices have reduced somewhat from the extreme highs last year, they are still significantly higher than they were before the war.

Additionally, the change to a climate-neutral economy has brought up further complexities and expenses. This shift demands an increase in the overall production costs, making the process both economically and operationally challenging for many businesses.

Poor Demographic Outlook

According to the UN, Germany’s working-age population is expected to drop by an average of 0.6% per year from 2024 to 2050. This is making it increasingly challenging for industries to find skilled employees. And the consequences don't stop there. An aging population means a need for higher social security contributions, increased demand for healthcare services, and other related economic pressures.

A potential solution to address these challenges is immigration. Even though Germany has started campaigns to attract skilled foreign workers, there are significant challenges. On one hand, there is confusion and division within the country about immigration, and on the other, issues such as a slow bureaucratic process and language barriers make attracting skilled workers more difficult.

Low Public Spending

Debts are often seen as a negative thing, but from a macroeconomic perspective, debt plays a critical role in driving growth. Governments can use the borrowed money to invest in projects today that generate higher returns in the future. As long as the economy grows faster than the debt and interest payments remain manageable, borrowing can be an effective strategy for long-term economic development.

However, due to a fiscal rule embedded in its constitution, there is a limit on how much debt Germany can accumulate . This is known as the “debt brake” (Schuldenbremse), and this limits the debt to 0.35% of GDP. While this rule is designed to ensure fiscal responsibility, borrowing less means the government has less money to invest in public goods and essential infrastructure. This can in turn lead to slower economic growth.

Inflation

Another factor that can harm the economy is high inflation, which is simply the rise in prices over time. Most countries incuding Germany saw a surge in Inflation after the COVID-19 pandemic.

Other than making all goods and services expensive for the common man, high inflation can also lead to slow economic growth. Directly and Indirectly. An increase in the price of goods and services directly leads to a decrease in consumption, which can slow the economy.

The indirect problem comes from the measures used to fight inflation. To address the rise in prices, the Central Banks normally raise interest rates. After Covid, the European Central Bank raised interest rates up to 4.5 percent, the highest level since the 2007–2008 global financial crisis. When the rates are high, borrowing becomes more expensive. As we discussed earlier, borrowing is critical for investment and growth, so higher interest rates harm economic activity.

Taxes and bureaucracy

Germany has one of the highest corporate tax rates compared to other Western countries like France, the USA, or the UK. This makes it less attractive for businesses to expand or invest in Germany. Along with high taxes, another challenge is the complicated bureaucracy. In Germany, the paperwork can be so overwhelming that you might need to fill out a form just to apply for another form. For example, it takes about eight days to start a business in Germany, while it only takes four days in countries like France, the USA, or the UK. These could discourage entrepreneurs and investors and make it harder for businesses to operate in Germany.

Political Uncertainty

Germany’s government was led by a coalition of the Social Democratic Party (SPD), the Green Party, and the Free Democrats (FDP). However, each party has its own economic ideology, and this led to political infighting over key issues. One big disagreement was over the debt ceiling that we discussed earlier. The SPD and Greens wanted to relax Germany’s strict debt ceiling to allow for more public investment. On the other hand, the FDP insisted on keeping debt low, saying it’s important for the country’s long-term economic stability. Now that the FDP has left the coalition, we will see early Bundestag elections in February, creating more uncertainty for Germany’s future.

There are also major external risks alongside its domestic challenges. One major concern is the potential economic impact of a Trump presidency. The USA is Germany’s second-largest trading partner. And Trump has threatened to impose tariffs of 10-20% on EU imports. If these tariffs are implemented, they could cost Germany up to €137 billion, severely impacting its export-driven economy.

What Next?

But its not all sad and gloom. There have seen some promising signs. In mid-July, the German government approved a detailed growth plan consisting of 49 measures to boost the country’s economy. It focuses on addressing these structural challenges, promoting innovation, and building a more sustainable and resilient economy. Inflation rates are declining, unemployment remains low, and energy costs have decreased. All this has led to a positive growth rate in the third quarter of 2024.

Germany is a nation that has faced some of history’s toughest challenges and has consistently emerged stronger. Germany does have the tools and strength to overcome these challenging times and build a stronger, more prosperous future. Whether it can achieve this is something we will have to wait and see.

Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal or other advice. It is important to do your own analysis before making any decision.