Germany’s Economic Reckoning

Sudha David-Wilp and Jacob Kirkegaard

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When Russian forces invaded Ukraine two years ago, Germany braced for a painful reckoning. The German military was underfunded and unprepared to respond to a security threat on this scale. Roughly half of Germany’s coal and natural gas, plus a third of its oil, was imported from Russia—a dependence Moscow could weaponize if it chose. Berlin had enjoyed the savings that came from keeping its armed forces small and purchasing inexpensive Russian gas. But Germany could no longer afford to neglect its military capacity, nor could it allow its reliance on Russian energy to give the Kremlin the power to undermine the German economy and divide Europe.

Berlin has made progress on the military front. Just days after the Russian invasion, Chancellor Olaf Scholz announced a Zeitenwende, or turning point, to meet Germany’s new geopolitical challenges. The policy may not be perfectly executed—bureaucratic red tape and decision-making delays have slowed its implementation—but efforts to increase the German defense budget and modernize the country’s military are underway. With the help of a special allocation of 100 billion euros, Germany is on track to reach NATO’s defense spending target of two percent of GDP this year. Scholz has pledged to maintain this spending level over the long term, and his defense minister has suggested increasing the budget even further. Germany has come a long way from its paltry offer to send helmets to Ukraine at the start of the war—today, the country’s military assistance to Kyiv is second only to that of the United States.

When it comes to the German economy, however, recent trends are more concerning. The loss of cheap Russian gas has undermined Germany’s industrial model. Although the initial spike in energy prices after the 2022 invasion has abated, costs are not expected to return to prewar levels any time soon. In 2023, Germany’s economy shrank by 0.3 percent. Vice Chancellor and Economy Minister Robert Habeck, warning of “rough waters” ahead, has projected that the country’s 2024 growth will reach a mere 0.2 percent. New pressures account for the recent contraction, but Germany’s economic problems run deeper. Over the last decade, Berlin has avoided making critical investments and reforms to attract skilled workers and adapt to a data-driven world. And Berlin has often insisted that what is good, restrained fiscal policy for Germany is also right for the EU—a prevailing mindset that, by limiting public investment in many member states, has prevented European economies from adapting to new conditions.

Germany’s interests and the EU’s interests may not perfectly align, but Europe does need Germany to be an economic power. Germany is the third-largest economy in the world and the largest contributor to the EU budget. And although measures of the EU’s economic health, including its current account balance, productivity, and debt statistics, hardly give cause for alarm, if the German economy weakens, this picture may change. Europe could lose its ability to respond to crises, including the war in Ukraine or a second Trump presidency in the United States, and to advance ambitious policy programs, such as the expansion of the European defense industry or the acceleration of its green and digital transitions. The EU’s already waning influence on the world stage could degrade even further.

Germany therefore needs a new growth agenda. It must direct the country’s resources toward green industries that will accelerate decarbonization and emerging technologies that will shape the future of the global economy. Berlin has to muster the political will to back migration policies that support economic growth. And it must do all of this in close coordination with Brussels. If revitalization efforts succeed, a strong German economy can boost European competitiveness and set up the EU to face the challenges ahead.

BOOM TO BUST

Germany was thriving for most of the last decade. Under Chancellor Angela Merkel, who served from 2005 to 2021, the country’s economy grew by 34 percent. High exports and windfall tax revenues gave the German economy enough of a cushion that it even made it through the pandemic relatively unscathed.

But the boom times did not last. Today, in addition to high energy prices, Chinese competition in the automotive sector and an assertive U.S. industrial policy are causing economic harm. The subsidies and incentives included in the 2022 U.S. Inflation Reduction Act have German companies ready to transfer their production to the United States. The high-end automobile manufacturer Porsche, for example, is considering building a new battery factory across the Atlantic rather than in Baden-Württemberg, the state where the company was founded. As production components move out of Germany, supply chains become fragmented and crucial knowledge and skills are dispersed. Integrated environments are drivers of innovation; without them, Germany could lose this key advantage.

Europe needs Germany to be an economic power.

Offshoring is hardly Berlin’s only economic worry. Energy-intensive industries, including the chemical and steel sectors, have cut their output as energy prices rise, raising fears that Germany could lose control over end-to-end industrial supply chains. Rail and airport workers have organized frequent strikes, seeking higher wages amid a cost-of-living crisis. The disruption to transportation, not to mention the shrill whistles and rumbling of tractors that awakened Berliners as farmers protested planned subsidy cuts, have darkened the country’s already grim mood.

Weak spots in the German economy were apparent well before the current leadership assumed power in late 2021. The country decided to phase out nuclear energy in 2002 and accelerated its timeline after the Fukushima nuclear disaster in 2011, but the transition to renewable energy sources to fill the gap has still proceeded slowly. Merkel’s vow to embrace digital technologies, too, never translated into significant action. When Scholz and his coalition partners took office, they introduced an ambitious agenda to accelerate the green transition, invest in education, and usher in digitalization. But Russia invaded Ukraine just a few months later. Since then, Berlin has shown leadership in terms of its financial and military contributions to Ukraine, but the crisis has also siphoned Berlin’s attention away from addressing structural weaknesses in the economy.

A constitutional debt brake further complicates Berlin’s ability to restore the country’s economic fitness. By law, the federal government’s borrowing is capped at an amount corresponding to 0.35 percent of the country’s GDP. The measure is intended to ensure stability, but it has become a hindrance to the kinds of investment that Germany needs to transform its economy. Reform is sorely needed but unlikely to happen before Germany holds federal elections next year. In the meantime, Berlin can focus on addressing labor shortages, improving cooperation with EU partners, and streamlining bureaucratic processes.

SHAPING UP

Germany has turned its economy around before, and it can do so again. After a period of economic stagnation in the late 1990s, Chancellor Gerhard Schröder—a Social Democrat, like Scholz—introduced Agenda 2010, a set of hard-to-swallow labor reforms. Under Schröder’s successor, Merkel, the reforms bore fruit, and Germany’s growing economic strength made it possible for the country to serve as Europe’s creditor of last resort during the euro crisis. Germany played an outsize role in EU decision-making during this period, as Merkel used the country’s economic weight to steer Brussels’s policies on austerity measures, data privacy, and migration.

Merkel’s efforts to wield influence in Brussels in service of German interests did not always win friends. The EU is still facing the consequences: Germany’s decision to wean itself off nuclear power and use natural gas as a bridge to renewable energy left not just Germany but much of Europe vulnerable to Russian threats to shut down gas pipelines in 2022. Now, with fossil fuel prices notably higher than those in the United States and EU-mandated carbon pricing putting pressure on the continent’s economies, Europe needs to complete its green transition as fast as possible. But the current German government is still following an old pattern. Although Berlin is a proud advocate for Europe’s net-zero emissions target, in practice it has tried to block the EU’s classification of nuclear power as a climate-friendly energy source, watered down a European Parliament–approved ban on internal combustion engines in a bid to protect the German car industry, and opposed an EU directive that would require large companies to conduct due diligence reports on the environmental harms of their supply chains. The German government is facing down a right-wing populist challenge at home, so its preference for limiting economic disruption is not entirely surprising. But erratic decision-making in Berlin introduces uncertainty to the EU’s regulatory environment, jeopardizing the bloc’s long-term plans for a green transition.

Germany can still play a productive role in Brussels. It can identify industries that will help the European economy decarbonize and take steps to ramp up renewable energy production as quickly as possible, including by easing the German permit process for new grid transmission lines and for solar panel and wind power production. Not only will this effort alleviate Europe’s soaring energy costs; it will also leave Germany and the EU well positioned to compete with clean energy production in places such as China and the United States.

Germany has turned its economy around before, and it can do so again.

In addition to pursuing green energy, Germany—along with the rest of Europe—should build its capacity in biotechnology, quantum computing, and other emerging fields. Traditional sectors, such as chemicals and automobiles, still dominate German industry. German companies have been slow to adopt digital technologies, and sensitivity about data privacy makes it more difficult for German researchers to make breakthroughs in AI and machine learning.

But with its wealth of engineering talent, Germany has the potential to be at the forefront of emerging technologies. Together with fellow EU member states, it should pool capital, research, and human resources to create the next generation of companies. Rather than have each country back its own AI champion—as Germany and France are now doing with the firms Aleph Alpha and Mistral AI, respectively—Berlin should encourage European capitals to consider joint ventures that can replicate the success of the aircraft manufacturer Airbus, which developed as a cooperative effort among France, Germany, Spain, and the United Kingdom. A pan-European AI unicorn is not guaranteed, but further work with artificial intelligence can bring other benefits. Germany, with its vast manufacturing knowledge, can help European companies use AI to increase efficiency. And Brussels can build on its first-mover advantage in AI regulation, ensuring that its values-driven approach (shaped, in part, by Germany) allows enough flexibility and adaptation to encourage the development of new European businesses.

Germany will need to expand its skilled workforce if it is to take full advantage of new technologies. Yet the country’s population, like that of most of Europe, is aging. The obvious answer to this demographic problem is immigration, but the rise of right-wing populism across the continent makes it difficult for policymakers to advocate for legal avenues for skilled migration. Berlin, along with EU leaders in Brussels, must emphasize the economic case for attracting skilled knowledge workers from countries such as Egypt and India. A series of large weekend demonstrations across Germany, condemning the far right and calling for tolerance, has shown that such a change in political momentum is possible.

Given that Germany’s traditional economic strengths lie in energy-intensive, fossil fuel–based industries, the upcoming transition will require large public and private investments. Right now, strict fiscal rules and divisions within the coalition government in Berlin are holding up reform on the scale that Germany needs. For now, though, there are steps that Germany can take to make its own economy—and Europe’s—more competitive. By advancing the green transition, attracting skilled immigrants, and eliminating bureaucratic chokepoints, Germany can remain a global leader in manufacturing and trade and an anchor for the European single market in the decades to come.