Europe's economic locomotive is derailing

Germany - Europe's economic growth engine for decades, helping the region escape many crises - has just fallen into recession.

Decades of misguided energy policy, the decline of fossil fuel cars and a sluggish transition to new technology pose the biggest threat to Germany since reunification. But unlike in 1990, Germany today lacks a leader to address these structural problems.

“We were too complacent because everything looked good,” Martin Brudermüller, CEO of chemicals giant BASF, told Bloomberg. “The problems in Germany are accumulating. We have a period of change ahead of us. I don’t know if people realize that,” he added.

While Berlin has proven itself capable of weathering past crises, the question now is whether it can pursue a sustainable strategy. That prospect seems remote. Just as the threat of energy shortages has receded, Chancellor Olaf Scholz’s coalition government is back to grappling with a host of issues, from public debt to heat pump spending to speed limits on motorways.

But the warning signs are too strong to ignore. In January, Scholz told Bloomberg that Germany would survive this year’s energy shortages without falling into recession. But data released on May 25 showed that Europe’s largest economy contracted for two consecutive quarters, plunging it into recession.

Economists predict that German growth will lag behind the rest of the region in the coming years. The International Monetary Fund (IMF) also estimates that Germany will be the worst performing economy in the G7 this year.

Mr Scholz remains optimistic. "The outlook for the German economy is very good," he told reporters in Berlin after yesterday's figures were released. "By freeing up market participants and reducing bureaucracy, we will be able to overcome the challenges we face," he said.

People on a shopping street in Cologne (France). Photo: Reuters — People on a shopping street in Cologne (Germany). Photo: *Reuters*

The worrying thing, however, is that the recent figures are not just a blip. They are a sign of things to come.

Germany has yet to find a sustainable solution to the energy needs of its huge industrial sector. It is also too reliant on old production technologies and lacks the political will and commercial flexibility to move into fast-growing sectors. These are structural challenges that should be a wake-up call for Europe’s largest economy.

Industrial giants such as Volkswagen, Siemens and Bayer are under threat from thousands of smaller companies. While Germany’s conservative spending habits have put it in a better financial position than other countries to navigate the economic transition, it has little time to waste.

The most pressing issue is to get the energy transition on track. Cheap energy is a key prerequisite for the competitiveness of the country’s industry. Before the Russian gas supply disappeared, Germany had some of the highest electricity costs in Europe. If this situation is not stabilized, manufacturers will leave.

To address these concerns, Berlin has planned to cap electricity prices for some energy-intensive industries, such as chemicals. However, this is only a temporary solution, showing Germany's difficulty in supplying.

Germany closed its last nuclear reactor earlier this year, and is pushing ahead with plans to phase out coal-fired power by 2030. Last year, it added 10 gigawatts of wind and solar power capacity, but that’s still half the pace it needs to hit its climate goals.

The German government has set a target of installing 625 million solar panels and 19,000 wind turbines by 2030. But promises to accelerate that process have yet to materialize. Meanwhile, demand is forecast to skyrocket as electrification of everything from heating to transportation to steel production takes hold.

“We have to think about which industries can cope with rising fuel prices, which cannot, and focus on the future,” Siemens CEO Roland Busch said in an interview with Bloomberg.

Germany lacks the resources to generate much clean energy, given its small coastline and lack of sunshine. To address this, it has sought to build infrastructure to import hydrogen from countries like Australia, Canada and Saudi Arabia, betting on technology that has never been tested on such a large scale.

Germany also needs to accelerate the construction of high-voltage grids that connect power farms along the northern coast to factories and cities in the south. It also lacks storage capacity to ensure resilience to power disruptions.

“Germany needs unity among its parties to accelerate the expansion of its renewable energy infrastructure. However, after the 2025 elections, conflict between the parties could slow down the energy transition again. This is not good for Germany as a business location,” said Claudia Kemfert, professor of energy economics at the DIW research institute.

Europe’s economic powerhouse appears to be spending heavily and systematically on innovations to maintain its edge. Its spending on research and development is the fourth highest in the world, after the United States, China and Japan. About a third of patents filed in Europe are from Germany, according to data from the World Patent Office.

However, most of this activity is taking place at large companies such as Siemens or Volkswagen, or in established industries. The number of startups in Germany is falling, contrary to the trend in developed countries, according to the Organization for Economic Cooperation and Development (OECD).

There are many reasons for this, including a lot of red tape. Companies seeking to register often have to submit paper applications. Germany also has a risk-averse culture. Financing is also an issue. Venture capital investment in Germany last year totaled just $11.7 billion in 2022, a fraction of the $234.5 billion in the United States, according to data firm DealRoom.

At the same time, Germany’s technological edge is fading, especially in the auto industry. While brands like Porsche and BMW remain the leaders in internal combustion engines, Germany’s electric vehicle sector is struggling.

BYD overtook VW to become China’s best-selling car brand last quarter. The key to BYD is an electric car that costs a third of the VW, but has a longer range and the ability to connect to third-party apps.

Much of Germany’s wealth comes from its manufacturing sector, which provides many high-paying white-collar jobs. But that strength has created a dangerous dependence on foreign markets for orders and raw materials, especially China. After the Russia-Ukraine conflict, Berlin, like many other countries, is looking to reduce its reliance on China. But Germany’s biggest companies have yet to show any interest.

There are two main areas where Germany is underperforming and could use it to grow its economy: finance and technology.

The bulk of German money is held in a system of 360 small, locally-run banks known as Sparkassen. This increases the potential for conflicts of interest, as well as reducing the country's financial strength.

Germany’s two largest listed banks, Deutsche Bank and Commerzbank, have been mired in trouble for years. While they are in the process of changing, they remain small compared to Wall Street banks, with their combined market capitalization less than a tenth of JPMorgan Chase’s.

On the technology front, the biggest player in Germany is SAP, founded in 1970 and producing complex software that helps companies manage their operations. It is hard to find a replacement in this space. Electronic payments firm Wirecard came close to that position before collapsing in an accounting fraud scandal.

Germany also lacks investment in digital technology. Despite having the 51st-fastest fixed-line internet speed in the world, its investment in internet infrastructure is among the lowest in the OECD. “Years of underinvestment have left Germany behind,” says Jamie Rush, chief European economist at Bloomberg Economics. Berlin needs to spend more and make infrastructure projects easier to implement, he says.

Germany needs to tackle its problems with a long-term strategy. But that is difficult to do. Mr Scholz was elected with the lowest approval rating in decades. His current coalition government is also divided. German politics is in danger of falling into chaos.

This rift is all the more worrying as the population ages and young people worry about the future. German industry is feeling the impact of this demographic shift the most. Recent surveys show that 50% of companies have had to cut production due to labor shortages, costing the economy $85 billion a year.

In a recent report, the OECD commented on the German economy: "No major industrial country has seen its competitiveness threatened by systemic issues ranging from social, environmental to regulatory pressures like Germany."

Trouble in Germany will spread throughout the region, said Dana Allin, a professor at SAIS Europe. “The health of the German economy is important for the European economy as a whole, as well as for the harmony and unity of the bloc,” he said.

Ha Thu (according to Bloomberg)

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