German Growth Engine Could Be Running Out of Gas

Dissecting the Issues

Over the last 20 or so years, Germany was the admired industrial juggernaut. Now, Germans are growing dissatisfied with the economy and the government’s performance. Confidence in the economy has dramatically deteriorated, which could partially explain the sudden growth in popularity of the far-right Alternative for Germany (AfD), with its Euroskeptic and anti-immigrant platform. So, why has growth stalled? What are the economy’s issues that make it different from the rest of Europe? For one, the government’s tight grip on fiscal policy and the “debt brake” have constricted government spending on infrastructure, sapping potential growth.

The German Model

The Schroeder reforms ushered in a period of German exceptionalism. Germany’s manufacturing and engineering prowess were touted the world over. The economy would become an export machine that benefited from cheap Russian gas. Then the war in Ukraine started and prices of natural gas surged, raising the prospect of energy shortages and rationing. While the worst outcome never occurred as Germany built up storage capacity from non-Russian sources and accelerated its efforts to shift electricity generation to renewable sources of energy, the war in Ukraine pulled back the curtain on the risks to German economic growth.

The energy crisis hit energy-intensive sectors hard, sectors like chemicals, paper and paper products, and basic metals, for example. These sectors make Germany a sizeable consumer of natural gas and electricity, particularly when compared to other European countries. Its energy consumption remains larger than France, Spain, and Italy. Furthermore, its CO2 emissions per person suggest a still-large carbon footprint, also larger than France, Spain, and Italy, and its renewable energy investment is lagging.¹ Germany’s energy consumption could raise the costs of production, potentially pushing companies out of business or forcing companies to move production to a lower-cost geography. Energy security remains a high risk even as Germany transitions toward 100% usage of renewable energy sources.

Sizeable Exposure to Global Growth

Germany’s economic model is trade-driven. As the world goes, so goes the German economy. Any shock to global growth shocks Germany’s economy via trade. A simple way to look at this exposure is to calculate a measure of economic openness. This measure is derived by taking the sum of imports and exports and dividing that sum by GDP. Exhibit 2 shows the calculation for Germany and compares it to the U.S.

The higher the percentage for a county, the more exposed a country is to global growth, trade, and the global economy. Germany’s openness percentage is a sizeable 70%, while the U.S.’s is a relatively low 25% by comparison. Global growth is expected to slow in 2024, driven by the fledgling, tepid recovery in China and the global growth slowdown attributable to tighter monetary policy around the globe. The U.S., whose economic resiliency in 2023 has been well-chronicled, is less driven by global growth and more by internal demand. But, even in the U.S., that resiliency will likely ebb.

Germany’s important export markets are depicted in Exhibit 3. Most of the markets to which Germany exports recorded weaker economic growth and, hence, lower demand for German exports. One important trading partner has been exceptionally weak. That partner—China—has struggled to emerge from its restrictive COVID policy, but its recovery also continues to be hampered by weak consumer confidence and the challenges in its property market. Additionally, China is no longer seeking the cars and industrial products that Germany produced. Now, Chinese consumers are buying more domestically produced automobiles. Lastly, Chinese consumers are more likely to purchase electric vehicles (EVs) made in China, as Chinese EV manufacturers are much further advanced than German automobile manufacturers. Geopolitically, China is increasingly viewed as a less reliable trading partner. Many countries, including Germany, are rethinking their economic relationships with China. However, Germany will have to adjust its supply chain, including from whom it gets the minerals and processing necessary for its planned energy transition away from fossil fuels.

Labor Force Shrinkage

Demographics are a drag on the economy, both cyclically and structurally. At first glance, the labor market is healthy. Unlike in the post-unification period, high unemployment is not a current problem for Germany. The Schroeder reforms were initiated to address high unemployment, which helped drive the unemployment rate down. However, this “strength” masks an unsettling population trend.

What is happening are reports of companies complaining of a labor shortage, as seen in Exhibit 4. That chart attempts to measure the difference between labor demand and labor supply. A negative difference indicates labor supply is greater than labor demand. That is the environment that necessitated the Schroeder reforms. Now, with the demand-supply difference positive, there is a scarcity of labor—a sizeable one. Such scarcities raise the cost of labor, as Exhibit 5 shows, making the German economy less competitive.

Surveys of businesses indicate companies are facing labor shortages. One such survey, the KfW-ifo Skilled Labour Barometer, reported that at the beginning of the second quarter of 2023, over 40% of firms surveyed experienced a scarcity of skilled workers. This reading marked an improvement, but the percent of firms reporting shortages is still historically high and broad across sectors. Given the slowdown in the German economy, a tight labor supply appears counterintuitive, until one scratches below the surface a bit more.

First, Germany operates a so-called Kurzarbeit program. This program permits employers to avoid laying off workers by reducing the hours these employees work. Under certain conditions, employees receive a portion of the net pay lost through the reduction of hours worked. The employers pay wages and salaries in advance, with the short-time working allowance being a reimbursement benefit. The government pays the benefit retroactively to the employer. While such a program smoothes out the business cycle, it appears to create a less dynamic labor market. This scheme would make a prospective recession less severe, but it could reduce incentives to lay off workers. It is even possible that workers, too, may be disincentivized to find employment in other industries.

Second, the labor market is further complicated by the aging of the labor force and the country’s attempts to make up for a labor shortfall. Baby boomers are exiting the labor force in Germany. Meanwhile, the birth rate is just too low to maintain a stable population. Hence, the working-age population falls, and potential output slows. Exhibit 6 shows Germany’s working age population is shrinking at the same pace as Japan’s. Germany’s birth rate is 1.53 births per female, compared to Japan’s 1.34 and France’s 1.83. A fertility rate of 2.1 births is necessary to maintain a stable population. Germany’s 65-years and older population will continue to grow, and its working age population will decline, creating potential budget issues over pensions and healthcare. By 2050, the UN Population Division predicts that the 65-years and older population will grow 41% and comprise over 30% of the total population.

Third, Germany can create policies, for example, which encourage older workers to remain on the job longer. The labor force participation rate of 55–66-year-olds has been rising, according to the Federal Statistics Office. Raising the retirement age is one such policy that would allow Germany to retain older workers longer. However, the increased labor force participation of older workers appears to be insufficient to offset the expected shortfall of skilled workers. Where will Germany find skilled workers to fill the void created by demographics? Immigration is the answer. The Federal Employment Agency estimates Germany needs 400,000 immigrants per year to address the skills shortages.

The government realizes that it must encourage immigration, but immigration has become a politically charged issue and has fed the growth of anti-immigrant sentiment. Support for far-right anti-immigration political groups is rising. Regardless, immigration is the answer. Still, the immigration solution needs policy solutions, too. Such policy changes include: dual citizenship; allowing those with “tolerated” status for five years to apply for a one-year “opportunity residency;” vocational and language training for all new arrivals to Germany; and programs for skilled workers to bring families to Germany. At the same time, deportations will be rigorously enforced.

Conclusions

• This article identifies three possible causes of Germany’s slowdown: A flawed economic model, a sizeable dependency on exports, and a shrinking (aging) labor force. This brief commentary only scratches the surface of Germany’s economic issues, which include a developing financial crisis and its slow energy transition.
• The days of cheap Russian energy to fuel Germany’s growth engine are past, and the country must now aggressively step up its efforts to shift from fossil fuels to renewable sources of energy. Germany’s dominance in manufacturing and energy-intensive sectors, which for years delivered strong growth, now puts the country behind its peers in terms of energy use and the transition to greener alternatives. The country must address its energy security, but a policy like refusing to extend the lives of its remaining nuclear plans seems ill advised.
• Global trade helped drive Germany’s economic juggernaut, but this dependence leaves the country exposed to slowing global growth. That same drive that built Germany’s industrial power also made the country sensitive to the whims of the global economy and trade. Today, that focus on trade also carries with it geopolitical risk. Germany was a beneficiary of globalization but deglobalization could foster more of a regional focus, leaving the German economy exposed. Germany must focus on creating the 21st century production that the world wants.
• Demographics are probably the biggest risk to the economy’s medium- and long-term growth perspectives. Germany faces an aging population and a falling working age population, an economic feature shared by all developed economies. Immigration is an answer, but there is a political price to pay as anti-immigrant sentiment grows with the influence of far-right political parties, like AfD in Germany. Also, German companies could address the demographic constraint by stepping up capital deepening, whereby technology is increasingly substituted for labor. The capital-to-labor ratio would rise, which could make for a more productive economy.

While there are several factors driving the economic decline, overall, Germany’s lethargy is a product of its fiscal restraint, which has negatively impacted government investment and, hence, growth. Germany's woes are structural and will only be reversed over a longer period of time. However, cyclical woes have been aggravated by these long-unfolding structural issues. Policy changes are necessary, including stepping up infrastructure investment, which suffered from a government focused on deficits and debt.

Many of the issues that Germany faces are shared by other European countries, which dampens the broad outlook for the region’s economic recovery. However, Germany’s economic woes are most pronounced, putting it closest to recession. Additionally, the country’s structural challenges are not easily or quickly reversed, making the timeline for Germany’s recovery questionable.

More broadly, Germany remains a driving force in the overall European economic outlook. It is both a source of demand for European producers and a supplier of goods and services to those countries. As the largest economy in Europe, Germany’s economic health contributes to the well-being of Europe as a whole. Lastly, Germany’s influence on the policies of the European Union is significant. To some extent, as Germany goes, so goes Europe.

This article is only the opening chapter. Subsequent articles will explore further the outlook for the eurozone, assessing both shared and country-specific dynamics impacting the currency bloc and some of its major economies.

¹Office for National Statistics, “Greenhouse gas emissions and other environment measures, UK and European countries: 2020”, Alexandra Christenson, November, 14, 2022

Definitions

The KfW-ifo Skilled Labour Barometer reports on the share of German enterprises that are indicating adverse impacts on business operations from a shortage of skilled workers. Each quarter, about 9,000 enterprises representing trade and industry, construction, wholesale, retail, and services and excluding banking, insurance, and the state, are polled on their business situation. The barometer provides an overall indicator for the skills shortage in the German economy along with indicators for various sectors and regions, and company size-specific data.