No resolution appears imminent for Germany’s ongoing economic downturn

Germany’s Economic Struggles: A Nation at a Crossroads

Germany, often referred to as the “sick man of Europe,” is facing a period of significant economic hardship. Since Russia’s invasion of Ukraine in 2022, the German economy has experienced minimal growth. Although the country has made progress in reducing its reliance on Russian energy supplies, it now contends with rising unemployment—approaching three million—and major setbacks in crucial sectors like automotive manufacturing. The ongoing trade tensions initiated by Donald Trump have further destabilized Germany’s industrial backbone, leaving the nation in search of a new economic identity.

Chancellor Merz Sounds the Alarm

German Chancellor Friedrich Merz recently addressed his coalition partners in the Bundestag, highlighting the urgent challenges facing the country. He cautioned that many areas of German industry are in a precarious state, with both large corporations and numerous small to mid-sized enterprises struggling. Job losses are mounting across various sectors.

Merz also pointed out that Germany’s once-envied productivity is faltering. He attributed this decline to shifting global economic dynamics, high labor costs, and excessive bureaucracy, all of which are stifling growth.

Bleak Growth Prospects

Recent economic indicators suggest that Germany’s sluggish performance is likely to persist. Despite significant government investment in defense and infrastructure, the central bank has revised its 2026 growth forecast down to just 0.6%. The Ifo Institute projects a similarly modest increase of 0.8%.

Some analysts remain hopeful, noting early signs that the government’s €500 billion stimulus package is starting to have an effect. Holger Schmieding, chief economist at Berenberg Bank, observes that while exports remain weak, domestic demand is beginning to recover. Nonetheless, Berenberg anticipates only a slight 0.7% economic expansion this year, with government spending driving much of that growth. Schmieding expects a more robust 1.3% growth rate by 2027 as the stimulus fully takes hold and consumer and business spending rises.

However, Schmieding cautions that Germany’s constitutional amendment allowing unlimited debt for defense expenditures above 1% of GDP is unlikely to be the transformative solution some hope for. He notes that many companies may struggle to fulfill new defense contracts and infrastructure upgrades due to existing backlogs.

Demographic Challenges and Labor Shortages

Germany faces another pressing issue: a rapidly aging workforce. The International Monetary Fund warns that the country’s working-age population is set to decline more sharply than any other G7 nation over the next five years, with nearly 30% of current workers expected to retire by 2036. This demographic shift not only strains public finances but also intensifies the shortage of skilled labor.

Innovation Versus Tradition

Economist Peter Bofinger, a former member of Germany’s Council of Economic Experts, expresses concern that policymakers may focus too heavily on subsidizing traditional industries rather than fostering new sectors. He points out that Germany lacks a dynamic digital industry and a strong financial services sector, making its prosperity heavily reliant on manufacturing—a sector now under pressure from more cost-effective Chinese competitors.

Bofinger warns that prioritizing energy subsidies over innovation could hinder progress. Nevertheless, he sees promise in the country’s growing investment in research and development, with official data indicating an increase in R&D-related jobs.

Defense Spending as a Catalyst for Innovation

Bofinger believes that Germany’s substantial boost in military spending, aimed at meeting NATO’s 3.5% of GDP target, could drive technological advancement. This perspective is echoed by Paolo Surico of the London Business School, who notes that many groundbreaking innovations—such as GPS and the internet—originated from defense investments. Surico cites the development of penicillin during World War II as an example of how government support for research can yield transformative results.

Surico advocates for channeling government funds into research and development alongside defense, arguing that investing in innovation offers greater long-term benefits than simply expanding military hardware. He contrasts the “Reagan deterrent” of building ships with the “Kennedy deterrent” of leading in technological achievement, suggesting the latter brings more prosperity.

Looking to the Future: Embracing Change

Bofinger urges Germany to move beyond its reliance on traditional Keynesian policies of increased spending and tax cuts, which may provide only temporary relief. He warns that excessive support for declining industries could ultimately harm the economy.

He recommends drawing inspiration from economist Joseph Schumpeter’s concept of “creative destruction,” which highlights how innovation can dismantle established businesses while creating new opportunities. Bofinger concludes that Germany needs to shift its focus from short-term stimulus to fostering innovation through adequate financial support, paving the way for sustainable economic growth.