A view from London

The challenges facing the world’s fourth-largest economy are partly a function of what, until now, have been strengths: its position as the world’s third-largest exporter, access to natural gas from Russia, and a large manufacturing and auto sector.

Relative to GDP, Germany’s manufacturing sector is about twice the size of the UK’s. Manufacturing is energy intensive, and, although Germany uses energy efficiently, its outsized industrial base means it uses about one-third more energy per head of population than the UK.

Having closed most of its coal-fired power stations and nuclear capacity, Germany became heavily reliant on natural gas. Before Russia’s invasion of Ukraine more than half of Germany’s gas came from Russia. It was also a significant user of Russian oil. Germany has successfully shifted away from Russian energy, but rising prices have hit manufacturing and led some energy-intensive businesses to move overseas.

Slower global demand has weighed on exports which account for over half of German GDP. As global demand snapped back from the pandemic in 2021 Germany posted a trade surplus equivalent to 5.3% of GDP. Last year the surplus shrank to 2.1% of GDP and this year, it is likely to be lower still.

German industry is more reliant on Chinese demand than other European countries, with exports to China accounting for 3.2% of GDP, more than twice France and Italy’s share. China’s lacklustre recovery this year has added to Germany’s export woes. So, too, has the threat posed by China’s own burgeoning auto sector.

In 2006 China and Germany each produced 5m vehicles. Today Germany produces 4m vehicles a year and China produces 28m, more than the US, Japan and Germany combined. In just seven years Chinese auto sales have risen fivefold, to 2.7m cars, 40% of which are hybrid or electric. Sixt, a German car rental company, last year ordered 100,000 electric vehicles from the Chinese carmaker BYD to be delivered by 2028. With its lead in EVs and huge volumes of production, China poses an even greater challenge to German and US carmakers than Japan did in the 1970s.

Germany’s consumer sector has fared no better than its industrial sector in the last year. Inflation, higher energy prices and rising interest rates have reduced spending power. Housing and construction activity has slumped, with house prices falling by almost 10% in the three months to June on a year earlier, the fastest decline since records began in 2000. This year consumption growth is likely to fall at an even faster rate than industrial output.

These headwinds mean Germany is likely to be the only G7 nation that posts a decline in GDP this year. Not until next spring is the German economy likely to return to growth.

Some of the problems Germany faces, such as high energy prices and weak export demand, are temporary. Others are longer term in nature: an ageing population, an energy-intensive economic model and growing competition, be it from Chinese automakers, the reshoring of supply chains or American firms benefitting from ‘green’ subsidies and tax breaks. It is these challenges that worry most policymakers and economists. They are not insurmountable, but to meet them Germany will need to reform and change.

Germany's future matters hugely for the Europe and the West more generally. Germany accounts for almost a quarter of EU GDP in 2022, is the region’s leading political power and, after the US, the second largest donor of aid to Ukraine.

While the risks are real, I think we have rather lost sight of Germany’s strengths.

German public and consumer debt is far lower, relative to GDP, than in most other European countries and the US. That balance sheet strength is a source of resilience, especially, as now, when interest rates are high. Germany’s manufacturing sector remains a world leader in autos, machine tools, chemicals, medical equipment, consumer goods, electronics and green energy. Its small and medium-sized business sector, the Mittelstand, has demonstrated an enviable capacity to adapt and succeed in overseas markets. Germany’s system of employee training, scientific education and its use of robots are among the best in the world.  

Perhaps most importantly, Germany has shown a capacity to adjust to major shocks and challenges, most recently in the rapid shift away from Russian gas and surge in energy efficiency. Industrial output per unit of gas used has risen by 16% since 2021.

Germany has overcome other challenges that many thought to be intractable. In the late 1990s, when I covered Germany as an economist at an investment bank, it was widely seen as a sclerotic, slow-growth laggard. This was the first time that Germany attracted the title of the sick man of Europe. Germany’s then chancellor, Gerhard Schroder, responded with wide ranging and politically contentious reforms to liberalise the labour market. Despite considerable opposition the so-called Hertz reforms passed into law. The measures helped change Germany from a high to a low unemployment country and were instrumental in rebooting German growth. One study (Uhlig and Krause) estimates the reforms led to a 2.8 percentage points reduction in Germany’s unemployment rate (this in an economy where unemployment has averaged 6.3% in the last 15 years).

Back to today. The good news is that German inflation is falling. This should help drive a recovery in growth next year. But to guarantee its long-term future Germany needs to reform. In doing so it needs to draw on the same determination and willingness to change that enabled it to bring down unemployment in the 2000s and to switch away from Russian energy over the last 18 months. Faced with the Europe’s migration crisis in 2015, Angela Merkel famously said, “we can do this”. It’s time to roll that phrase out again.