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Is Germany Europe’s new weak link?

The contraction in private sector activity in Germany deepened in February. This is another sign of the weaknesses of the German economy, in line with last year’s recession. Patrick Artus explains why this situation was foreseeable

Germany’s economic growth was negative in 2023 (GDP shrank by 0.3%) and the German Ministry of Economy forecasts only 0.2% growth in 2024. For comparison, France had 0.9% growth (annual average) in 2023, and the growth forecast for 2024 is between 0.5 and 1%, according to different forecasters.

German industry explains this decline in attractiveness in 2023: manufacturing output, which accounts for 20% of Gross Domestic Product, fell by 2%, exports by 1.8%, industrial production is 9% below its pre-Covid crisis level.

On the contrary, services are resilient, particularly information and communication services. Consistently, business investment is growing negatively, but so is household consumption due to their growing pessimism, which has led to a further rise in their savings rate.

A largely predictable situation

In reality, this unfavourable situation of the German economy was largely foreseeable. In the early 2000s, Germany opted for a mercantilist model of development, based on the growth of exports and not on the growth of domestic demand. This choice has led to restrictive economic policies (debt brake, limiting the public deficit to 0.35% of GDP, low wages in services, deregulation of the labour market), with a single objective: to improve the cost competitiveness of industry and allow the continuation of strong export growth.

But this mercantilist model has become ineffective today. On the one hand, the geopolitical crisis (protectionism, barriers to trade in goods, etc.) and China’s economic difficulties have led to a decline in China’s imports and Germany’s exports to China (which fell by 15% in 2023). On the other hand, the turnover of German industrial companies in China is considerable (in total, the Chinese market accounts for 20% of the world sales of German manufacturers), and German companies face strong competition from Chinese companies, for example in electric cars and other capital goods.

In addition, Germany’s cost competitiveness deteriorated sharply in 2023. Strikes multiplied, and German companies had to raise wages by 5.5%, while labour productivity fell by 1%. The model of wage moderation to improve competitiveness has therefore come to an end.

Finally, Germany’s excess savings are massive: Germany’s current account surplus reached 7% of Gross Domestic Product at the end of 2023. But this excess savings, as the current account figures show, is lent to the Rest of the World, not invested in Germany. In particular, German industrial companies were attracted to the United States with its tax advantages (Inflation Reduction Act), the price of natural gas four times lower in the United States than in Europe. A total of CHF 125 billion in investments by German companies were made abroad.

An irreversible decline?

Is Germany’s industrial decline irreversible? Germany has comparative advantages for the production of industrial goods: an industrial culture, a highly developed training of technicians and engineers, the presence of 15,000 medium-sized companies (the Mittelstand) with a culture hostile to relocations. But the challenges are numerous, as we have seen: loss of competitiveness, delay in the development of certain products (electric cars, electric batteries, semiconductors, etc.), an ageing population, and a decline in labour productivity.

The German government is aware of its handicaps and was preparing a plan to support the modernisation of industry, with more than 60 billion euros. But a ruling by the Constitutional Court in Karlsruhe has banned the use of “special funds” that make it possible to circumvent the “debt brake” rule limiting the public deficit to 0.35% of GDP.

Most German economists are in favor of revising this rule, but more than 60% of Germans support keeping the debt brake on. The outcome of the debate on the debt brake will be central to whether to become optimistic about Germany again. If the effort to modernize companies is not supported by the state, large German companies will remain attracted to the United States and Germany will not become competitive again.

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