Germany: Curing Europe’s Sick Man?

15 October 2023

Once admired as Europe’s growth engine, Germany is now being identified as the region’s “sick economy”. Indeed, Germany’s post-Covid recovery has lagged far behind the world’s other advanced countries (Chart below). And, the nation’s underperformance pre-dates the pandemic.

What lies behind Germany’s growth malaise, and can Europe’s “Sick Man” be cured? To be sure, it’s easy to overstate the problem. Germany enjoys a highly productive economy, and has relatively strong private and public sector balance sheets. However, as a result of overly cautious fiscal policies, poor demographic trends, and supply-side disincentives, Germany’s long-term GDP growth potential now has sunk below 1%.

Therefore, a combination of stimulative macroeconomic policies and significant supply-side reform is needed to boost the nation’s long-term growth prospects. Unfortunately, this appears unlikely in the near term. To the contrary, fighting inflation rightly remains top priority, and the ECB is likely to keep interest rates high until late next year. And, reducing Germany’s reliance on Russian energy supplies will remain a headwind for another year. Therefore, even after the current recession ends, German GDP growth is likely to remain below 1% annually in both 2024 and 2025 as well.

What’s the Problem: Diagnosis is the Easy Part?

It’s pretty easy to identify the key elements of Germany’s growth conundrum. Long-term growth potential results from the supply of inputs (labour and capital), and the efficiency of their usage, e.g. productivity. Europe’s aging population will lead to a contraction of the native-born labour supply in coming decades. Moreover, the Chart above illustrates the growth headwind will be especially acute in Germany.

In addition, German private sector business investment lags behind Asia, the USA, and much of Europe (Chart above). Similarly, public sector capital spending lags well behind neighbouring countries (next Chart).

These headwinds can only be offset by robust productivity growth. And, while Germany enjoys a highly efficient workforce, output per hour has slowed sharply in recent decades (next Chart), especially after the Global Financial and Euro Crises (as has occurred in other advanced economies a well).

Demand Side: Enjoy Life a Bit More!

A striking feature of Germany’s economic performance is it’s current account surplus of 6% of GDP, despite being dependent on costly energy imports. Typically, one would expect this from a country with booming exports or a wildy undervalued currency: Germany enjoys neither (though the Euro does appear a bit cheap).

Rather, Germany’s external surplus stems from chronically weak domestic spending. And, all economic sectors contribute to the problem (Chart above). In particular, household savings appear especially excessive. German consumers should try to enjoy life more! You’re highly productive and affluent — spend, have some fun!! Likewise, German corporations enjoy good profitability, but tepid investment leads to excess savings in this sector as well. The following Chart illustrates that German private sector balance sheets are healthy relative to other countries (lower debt); providing ample scope for more robust spending.

Likewise, German government finances are far healthier than elsewhere (Chart above); providing leeway for more stimulative policies. However, cautious German fiscal plans remain focused on the long-term budgetary consequences of the aging population. In addition, ECB monetary policy rightly will prioritise reducing inflation. To be sure, Eurozone price growth has peaked. However, continued wage pressures in the region — pay advanced 4.8% in H1 2023 (compared to 3.9% last year) — indicates that inflation will not return to the 2% target until the end of 2024, or later. Indeed, while German unemployment is now rising, Eurozone joblessness is still declining.

Supply Side: Deep Reform Needed Now

With demand stimulus unlikely near term, lifting both near and medium-term growth prospects will depend greatly on deepening supply-side reforms (the OECD surveys provides numerous great recommendations). Attention must focus on all three fronts: expanding labour supply, improving the business investment climate, and boosting productivity.

Labour Supply:

As policymakers can do little to change near-term population trends, efforts need to concentrate on boosting labour force participation. Germany imposes high direct and indirect taxes on workers (Chart above). High social insurance taxes, in particular, provide a strong disincentive both to working and hiring. Taxes are especially onerous for households with two earners, which reduces female participation.

Liberalising immigration also would help mitigate the impact of Germany’s declining domestic workforce. The Chart above illustrates Germany’s foreign-born population is amongst Europe’s highest. And, Germany tends to respond generously during crises, e.g. during the Ukraine war and the 2015 immigration crisis. In recent years, net immigration into Germany has averaged 300,000-400,000 annually. To meaningfully offset upcoming adverse demographic patterns, this should increase to 600,000-700,000.

Business Investment Climate

A complete discussion of improving Germany’s business climate, of course, is beyond the scope of this short essay, but I offer a few observations for both the manufacturing and service sectors. First of all, the high marginal corporate tax rate is an investment disincentive (Chart above).

Germany’s heavily regulated service sector is meaningfully less developed than in the USA and other European economies (Chart above). Service businesses are typically labour-intensive; creating large numbers of often high-paying jobs.

Despite its high level of efficiency, Germany’s large industrial sector leaves the nation relatively vulnerable to automation and artificial intelligence: another important motivation to expand the service sector.

Improving Productivity

Again, many factors could potentially contribute to boosting productivity, and helping Germany respond to a changing global economic landscape. However, education and training are critical ingredients. To be sure, Germany’s educational system has many strong points, including emphasising vocational training. However, the overall level of spending on primary education is lower than in many competitors (Chart above). In addition, the achievement gap between more and less socio-economically advantaged students is wider in Germany than elsewhere. This could worsen income inequality over time.

Climate Change and the Energy Transition

The European Union continues its successful efforts to reduce its reliance on Russian energy imports. Indeed, Russia now accounts for 7% of overall EU energy imports, compared to over one-third a year ago. Coal imports have vanished, and oil purchases will soon be eliminated. Natural gas purchased from Russia have also declined sharply: representing 15% of overall EU NG imports compared to over 50% in recent years. Germany is doing its part: imports from Russia are down 88%, while exports to Russia have declined 45%. This transition will remain a headwind during the next year, but the worst part appears over.

Meanwhile, Germany has established aggressive targets to cut carbon emissions. Since 1990, Germany has reduced emissions nearly 40% compared to the EU’s 30% and the USA at 2%. Indeed, the left panel above indicates Germany is a relatively efficient user of energy. Nevertheless, Germany’s emissions per capita remain above the European average. Germany continues to rely heavily on coal in electricity generation: 30% compared to 15% in the rest of the European Union (20% in the USA). Despite its achievements, currently adopted policies will not be sufficient to meets its climate goals (next Chart). The decision to eliminate nuclear power will slow progress.

China: Repeating the Mistakes of the Past?

In recent years, Europe has extended its trading ties with China. Moreover, Germany has led the way: the following Chart indicates bilateral commercial ties have risen six-fold during the past 20 years. China is now Germany’s largest single trading partner. Germany represents nearly 50% of all EU exports to China. And, China now accounts for 15% of German sales to non-EU nations: compared to 9% and 6% for France and Italy respectively (Ireland, Denmark, Finland, and Slovakia are above 10%). Meanwhile, German imports from China are the second highest in the EU (behind the Netherlands), representing 22% of Germany’s purchases from non-EU countries. (Likewise, Germany accounts for 21% of all EU imports from China).

After becoming overly dependent on Russian energy, one might question the wisdom of Germany’s deepening bilateral trade ties with China at present. If global trade fragmentation continues or if geopolitical tensions over Taiwan escalate, Germany could be vulnerable. At present, the risks are manageable, as German-China trade represents only 3% of German GDP. However, this situation warrants close scrutiny. At the least, China’s current economic difficulties represent yet another GDP growth headwind for Germany.