Making sense of Germany’s under-performing economy

Germany’s economy is slowing more sharply than in the rest of Europe, and may well be in recession. Can it recover anytime soon?The factors behind Germany’s under-performance are not difficult to discern. As in much of the developed world, productivity growth has been sluggish for some time. Moreover, since the Covid-19 pandemic, inflation – including a rise in energy prices – has taken a toll on growth. The Ukraine war compounded these headwinds, not least by forcing Europe to replace Russian fossil fuels with more expensive substitutes. Higher energy prices hit Germany’s heavily industrial economy particularly hard.Germany is also facing declining demand for its exports, owing to sluggish global growth, weakness in key markets (especially China), and rising foreign competition in autos and advanced industrial machinery. But exports are vital to Germany’s economic model: the country has long run trade (and current account) surpluses, in order to offset insufficient domestic aggregate demand.Then there are the economy’s labour shortages. As is true of most developed countries, as well as China, Germany’s population is ageing. At 1.35 births per woman, fertility is well below the replacement rate of 2.1. Add to that increasing longevity, and Germany’s dependency ratio – the proportion of dependents (old and young) to the working-age population – is on the rise, straining social security and healthcare systems. Already, the labour force has levelled off at around 44mn, and unless something substantial changes – say, workforce participation or net migration increases significantly – it will begin to shrink within the coming decade.The last time Germany faced such serious economic challenges, in the late 1990s, the government, in collaboration with industry and labour, carried out far-reaching reforms. This effort included a crucial structural shift: German industrial sectors moved to occupy the high-valued-added segments of supply chains, with other segments moving to lower-cost countries, including the emerging post-communist economies in Central and Eastern Europe. By 2006, Germany was outperforming other large European economies, and it continued to do so until 2017.Replicating this success today would require Germany to move to the forefront of the digital transformation. Fortunately, Germany does not lack talent, entrepreneurial activity, or innovative capacity. BioNTech, headquartered in Mainz, is a leading developer of vaccines and cancer treatments, with a growing global footprint. Berlin, Munich, and Hamburg boast entrepreneurial ecosystems and innovation hubs. Forty-six unicorns in Germany – mostly operating in digital-technology-enabled sectors – have received funding from domestic and international venture-capital and private-equity firms.But technological advances happen faster in very large, integrated markets, because the returns on costly upfront investments in innovation are higher when the total addressable market is bigger. This means that progress in Germany will depend significantly on European policy.Some might argue that the main problem here is that the world economy is becoming more fragmented, more complicated, and less open – perhaps permanently. And this does create serious challenges, especially for an export-oriented industrial economy like Germany.But an even bigger obstacle to digitally driven structural change in the economy, especially in Germany, is the growing digital-technology gap between the European Union and the other two global economic powerhouses, the United States and China. It might be tempting to downplay the importance of this gap, because divergences can appear in any sector over time and across countries. But digital technologies do not form just one sector; they are essential to the technological and structural transformation of every economic sector, including industrial manufacturing.In his September 2024 report on European competitiveness, Mario Draghi, a former head of the European Central Bank and prime minister of Italy, examined the main causes of the EU’s tech deficit. Perhaps inconveniently for Germany, some of them – for example, a dearth of basic research in science and technology – can be addressed only at the EU level, as they require centralised funding and administration. Similarly, services-sector and capital-market integration – vital to enable Europe’s innovators to reap the full benefits of its large economy – will require coordinated action across countries.EU-level regulatory approaches might also need to be reconsidered. As it stands, the mega-platforms that support the largest cloud-computing systems – which generate spin-offs, fund basic research (especially in quantum computing, artificial intelligence, and AI applications in science), and support AI development – are located mostly in the US and China.To be sure, major players – Microsoft Azure, Amazon Web Services, and Google – have established large data centres in Europe, including Germany, to serve local markets, leverage Europe’s deep pools of scientific talent, and comply with EU data-protection rules and AI regulations. But there are no comparable home-grown entities. This has contributed to a regulatory and policy bias toward risk mitigation and data security, with less attention being paid to leveraging tech’s upside potential and creating an enabling environment for digital structural transformation.A final imperative for Europe – and particularly for Germany – is progress on the digital transformation of industrial sectors, including automobiles, where China’s advances in electric-vehicle batteries and solar energy represent a huge competitive threat. This will require incumbent firms to overcome organisational inertia and let go of old mindsets and models. More important, it will require software engineering on a massive scale. But Europe does not currently have enough qualified people for these jobs. While an AI-fuelled surge in software-engineering productivity might help to ease this bottleneck, large amounts of engineering talent will still be essential. Changes to immigration policy can help here.But there is cause for cautious optimism. The Chinese startup DeepSeek has just stunned the AI world by demonstrating that a cutting-edge large language model can be trained more cheaply, and with less computing power, than previously thought. This discovery potentially reduces the EU’s deficit in the computing infrastructure required to support advanced AI development, thus creating an opportunity for Germany, and Europe more broadly, to close the gap with the world’s current tech leaders. But success will be possible only if EU leaders, national governments, and industry work together to mobilise the required human capital and deliver the necessary investment, not least in digital infrastructure. — Project Syndicate

• Michael Spence, a Nobel laureate in economics, is Emeritus Professor of Economics and a former dean of the Graduate School of Business at Stanford University and a co-author (with Mohamed A El-Erian, Gordon Brown, and Reid Lidow) of Permacrisis: A Plan to Fix a Fractured World.