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Unravelling Germany's Deindustrialisation: Challenges and Prospects

By Alberto Mantovan

Edited by Sara Campeti

For much of the 21st century, Germany stood as the model of European economic prowess, boasting a robust industrial base that propelled it to the forefront of European manufacturing. However, recent years have witnessed a stark reversal of fortunes, with Germany wobbling on the brink of recession and grappling with some of the lowest post-pandemic growth rates in Europe. The OECD even predicts Germany to be the worst-performing economy among the G7 nations. What has happened to the once mighty German economy and can it reverse the current negative trend?

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Germany's underwhelming performance

Germany's economy has faced significant challenges and a notable industrial decline since 2023. Economic activity contracted by 0.3 per cent in 2023, with private consumption suffering from a loss in purchasing power. High building and borrowing costs depressed investment in construction and energy-intensive sectors. This downward trend in industrial output has persisted, with production falling for six consecutive months by November 2023. The Bundesbank further cautioned that real gross domestic product will likely decline again slightly in the first quarter of 2024, thus risking to slip into a recession as the German economy continues to face headwinds in various directions.

German Model of Growth

To understand how Germany got itself into this precarious position, we first need to take a step back and understand the nature of its economic growth model. Germany's economic engine has long been fuelled by its prowess in manufacturing, solidifying its position as the world's third-largest exporter.  A significant portion of these exports originates from its manufacturing sector, which contributes approximately a fifth of the country's GDP, a notably higher share compared to other advanced European economies. Celebrated for its efficiency and innovation, the nation's manufacturing has historically been indeed the engine driving economic prosperity.

Shifts in Global Trade

However, the reliance on the export of manufactured goods makes the economy sensitive to shifts in global trade policies, particularly from key partners like the United States and China. The United States' move towards protectionism under the 'America First' doctrine during Trump’s Administration led to trade tensions, the imposition of tariffs and disruptions of global supply chains that German manufacturers were deeply reliant on. President Biden's continuation and expansion of protectionist policies with the Inflation Reduction Act has placed German exporters at a further disadvantage, particularly in sectors targeted by substantial subsidies for domestic industries.

In 2015, China launched the ‘Made in China 2025', aiming to upgrade its manufacturing capabilities and reduce dependence on foreign technology. This also adversely influenced German exporters, causing a shift away from German imports in favour of local production. Germany is highly dependent on these two countries for its exports and due to these policies their market share has been gradually eroded.

Diminished Demand and Energy Dependency

High energy costs, weak domestic and external demand have more recently been cited as key factors contributing to the ongoing decline in German industrial output. Germany's already struggling manufacturing sector suffered from declining global demand during the Covid-19 pandemic. Subsequent economic slowdown in China since 2021 only exacerbated the situation and reduced demand for German goods, further straining the country's export-oriented model.

Moreover, the war in Ukraine compounded economic pressures, particularly in energy supplies. Germany's reliance on Russian gas for its energy-intensive industries left it exposed to rising energy prices which fed into production costs, further stifling industrial output and therefore undermining its industrial competitiveness.

In December 2023, production in energy-intensive industries fell by 5.8 per cent month-on-month, despite a decrease in gas prices. The chemical industry and construction sector were particularly hard hit, with output dropping by 7.6 per cent and 3.4 per cent, respectively.

Labour Shortages and Structural Inefficiencies

In addition to the industrial challenges, Germany is grappling with labour shortages, particularly in skilled high-growth sectors. Contributing factors are diverse: they include demographic trends such as an aging population, which not only shrinks the workforce but also shifts consumption patterns, and a historical underinvestment in integration policies that could mobilise underrepresented groups and migrants effectively into the labour market.

Furthermore, the specific demand for high-skilled workers in a technologically advancing world has created a mismatch in the labour market, as the educational and vocational training systems struggle to keep pace with changing industry demands.

Finally, a significant long-term concern for the German economy is the stagnation of productivity due to a surprising lack of digitalisation and aging infrastructure. German firms have been slower to adopt new technologies and innovative practices compared to their global counterparts, curbing efficiency gains.

The famously robust Mittelstand — the small to midsized enterprises that form the backbone of the German economy — have been particularly resistant to abandoning paperwork in favour of digital tools and platforms which explains why card payments are especially low compared to its European neighbours.

This resistance is born out of a complex fabric of cultural attitudes towards risk and change, availability of financing for innovation, and the infrastructural lag in digital transformation. Lack of investments in infrastructure such as the now infamously late Deutsche Bahn (DB) trains lead to increased inefficiency and costs for businesses. All these internal factors compounded contribute to stagnating productivity which reduces the competitiveness of German businesses.

Looking for a path forward

The downturn in Germany's economic fortunes did not emerge overnight, but rather unfolded gradually, with its origins predating the global pandemic. Signs of trouble surfaced as early as 2019 when German economy contracted, primarily driven by a slump in manufacturing and industrial production stemming from endemic labour shortages and lack of modernisation, compounded by progressively more protectionist policies by the USA and China. This decline was only exacerbated with the onset of the pandemic and Russian invasion of Ukraine.

As Germany grapples with the its deindustrialization, a multi-sided approach is imperative to navigate the turbulent waters ahead. Renewed investment in innovation and technology, coupled with efforts to bolster domestic industries and diversify export markets, could mitigate vulnerabilities stemming from over-reliance on exports. Moreover, fostering sustainable energy transitions and reinforcing strategic partnerships with like-minded nations could enhance Germany's resilience in the face of geopolitical uncertainties.

Sources: Brookings, CleanEnergyWire, DeStatis, Deutsche Welle, OECD Libary, Reuters, WSJ.

Written by Alberto Mantovan

May 2024

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