Trade with Russia and China is gloomy, growth model is broken, what can Germany do to remove the label of 'sick man of Europe'?

Europe's No. 1 economy's ability to adjust and recover when faced with difficult circumstances should not be underestimated...

The German economy's constraints are structural and were evident even before the Covid-19 pandemic. (Source: allianz-trade)

Germany, Europe’s largest economy, has stagnated since the Covid-19 pandemic ended. Recent statistics show that pessimism about the short-term economic outlook and the stagnation have increased social unrest in the country, especially in the less developed regions. Evidence of this is the result of the September 1 elections in Thuringia and Saxony.

According to preliminary election results, the Alternative for Germany (AfD) party won the state of Thuringia with 32.8% to 33.4%. While the center-right Christian Democratic Union (CDU) is likely to take second place with 23.8%. This result marks the first time a far-right party has won a state election in Germany since World War II.

In the state of Saxony, the far-right AfD party also closely followed the CDU. The three parties in the ruling coalition, the Social Democrats (SPD), the Greens and the Free Democrats (FDP), suffered significant defeats in this election.

Debates are ongoing over whether the current ruling coalition can remain intact throughout its term.

But analysts say the economic headwinds are more than cyclical. They are deep-seated, structural, and were evident even before the Covid-19 pandemic. Will Germany once again become the “sick man of Europe”?

Global demand declines

For decades, Germany’s economy has thrived, reflecting the country’s stability-oriented policies. Small and medium-sized enterprises (the so-called mittelstand) thrived on the production of high-quality goods, especially cars, while exports played a large role in growth. However, this long-standing successful growth model for Europe’s leading economy has now largely broken down.

Exporting goods is difficult when global demand is weak. Global GDP growth has been around 5% for the past decades. However, the International Monetary Fund (IMF) recently predicted that global growth will remain around 3% in 2024-2028, due to slowing growth in advanced economies, emerging markets, and developing countries and a slowdown in China.

Germany's auto industry accounts for about 5% of GDP and employs more than 800,000 people, but the sector is reportedly under increasing pressure from China, which is seen as a world leader in electric vehicles. The Asian powerhouse is currently the German auto industry's main export market, but China's slowing growth could slow the Western European nation's exports.

Meanwhile, Germany's trade with Russia has also decreased significantly since Moscow launched a special military operation in Ukraine (February 2022), and the prospects for trade cooperation between Berlin and the birch country have also become bleak.

German manufacturing accounts for nearly 20% of the country's GDP, compared to nearly 30% in China, and receives significant subsidies. US manufacturing accounts for nearly 10% of GDP, as do other European countries such as the UK, France and Spain. The German economy's heavy reliance on manufacturing could weigh on growth in the coming years.

After the Russia-Ukraine conflict and soaring energy prices, Germany’s dependence on cheap Russian energy was seen as making its manufacturing costs less competitive. When the conflict first broke out, this seemed to be the case. However, Berlin has responded to its energy needs through significant efforts to shift its import focus, and energy prices have now fallen.

The big challenges

Demographic trends and an ageing population top the list of challenges facing Germany today. The number of pensioners is growing rapidly and this group will live longer, putting a strain on public finances. Meanwhile, the share of young workers in the population structure will decline without net migration.

In addition, the country also lacks investment in public infrastructure, along with cumbersome administrative procedures that are reducing productivity and investment. In addition, Germany still lags behind its peers in digitalization.

Germany has approved a comprehensive reform of its immigration policy framework in November 2023. In this photo: People walk in front of the European Central Bank (ECB) building in Main, Germany, June 2024. (Source: AFP)

The good news, though, is that Berlin has the policy space to address these structural problems.

First , the immigration of skilled workers could significantly boost Germany's growth prospects. Given public concerns about immigration and the current political situation, the Western European country is changing its stance on immigration policy.

Berlin is shifting from a largely humanitarian model to an immigration policy driven more by “economics”. The current governing coalition has approved a comprehensive reform of the immigration policy framework by November 2023.

Accordingly, the new “Skilled Immigration for Qualified Professionals Act” framework aims to attract skilled and semi-skilled workers from third countries to fill the gap in the workforce for domestic manufacturing. However, it is still unclear whether this policy is strong enough to address labor shortages in key sectors.

The results of the state elections on September 1 will certainly deal a blow to the current governing coalition, especially since immigration appears to have been a strong driver of the far-right AfD’s gains. But this should not be overstated. Moreover, these states represent only 7% of Germany’s population, so the results are unlikely to be repeated at the federal level in the fall elections next year.

Berlin can change the nature of its immigration policy, but it cannot completely stop the flow of immigrants.

Second , a more expansionary fiscal policy could address underinvestment in infrastructure and defense while also adhering to net-zero emissions ambitions. While fiscal space has shrunk for governments around the world in the wake of the pandemic and conflict-related energy shocks, Berlin has huge fiscal space.

However, the country has locked itself into the Schuldenbremse (Germany's constitutional debt brake). Political will on the issue may also change, as evidenced by the calls for reform by several prominent CDU state politicians, despite the party's leader, Friedrich Merz, supporting adherence to the Schuldenbremse.

The German economy continues to face structural stagnation. Given the presence of the FDP in the current governing coalition, the Constitutional Court rulings and the CDU’s stance on debt and deficits, Berlin seems to have little prospect of changing its position in the “Schuldenbremse straitjacket”.

Immigration policy, despite major changes, will take time to fill the labor gap. Meanwhile, the external environment is increasingly challenging for the country’s manufacturing sector. The slump seems to be entrenched regardless of which party is in power.

With domestic constraints and a changing international environment, it will be a long and difficult road to implementing the political and economic measures needed to address Germany’s structural challenges. However, after being called the “sick man of Europe,” the country has changed. Europe’s No. 1 economy’s ability to adjust and recover should it face difficult circumstances should not be underestimated.

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