Europe

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THE FINANCE ministry of the southern German state of Baden-Württemberg, home to giants like Bosch, Mercedes and zf Friedrichshafen, is not a bad spot from which to probe Germany’s anxieties. The country is gripped by fears of deindustrialisation as it heads into an election that seems certain to throw its chancellor, Olaf Scholz, out of his job if his party does not dump him first. That ministry’s occupant, Danyal Bayaz, frets that Germany has squandered the “globalisation dividend” of the past 15 years, underfunding the public realm in an era of low interest rates. Now, facing an energy squeeze, growing competition from China and the prospect of Donald Trump’s America slapping 10-20% tariffs on imports, the country’s business model, fears the minister, is “collapsing”.

Mr Bayaz laments Germany’s inability to get to grips with new tech, despite its strengths in basic research and engineering. He notes that Germany’s last successful big startup was sap, a software firm, founded just as an intensely sideburned Franz Beckenbauer led the West German football team to victory in the 1972 European championships. Germany has over 60 times as many people as Estonia, but only 15 times as many “unicorns” (privately owned startups worth over $1bn).

It is a familiar litany. German industry, especially its small and medium-sized Mittelstand firms, has focused on incremental innovation, leaving it unprepared for technological shocks like the advent of electric vehicles. Cosy links between business, banks and politicians bred complacency and resistance to reform. Dogmatic adherence to fiscal rules led to rusting bridges, decaying schools and delayed trains. Growth in foreign markets fattened Deutschland ag’s profits (and treasury revenues) for a while, but that export-led model left Germany exposed when the winds of globalisation turned chill.

Now Germany, which last year replaced Japan as the world’s third-largest economy, is reaping the harvest. It is difficult to discern any net growth in real gdp since before the pandemic. Forecasts are little better, and do not account for the risks of a Trumpian trade war. Volkswagen, Europe’s biggest carmaker, is mooting the first factory closures in its 87-year history; up to 30,000 jobs could be lost. Unemployment is ticking up, albeit from a low base. Chart: The Economist

High energy prices, especially after Germany had to divest from Russian gas following Vladimir Putin’s invasion of Ukraine in 2022, are a common grumble among firms in a country where manufacturing still accounts for 20% of gross value added. That remains almost twice the figure for France, even though industrial production peaked in 2018 and has since sagged more quickly than elsewhere in the eu (see chart 1), especially in energy-intensive sectors such as steelmaking. Order books are down, and planned investments have been postponed or shifted abroad. The ceo of Thyssenkrupp, a lossmaking steelmaker, has said Germany is “in the midst of deindustrialisation”. Even retailers have been hit. After Russia’s invasion Raoul Rossmann, who runs a pharmacy chain headquartered near Hanover that bears his family name, toured its branches to work out how to save on energy bills.

Other laments include a lack of skilled workers as Germany ages, and layers of red tape, much of it emanating from Brussels, that the Ifo Institute in Munich reckons cost the economy €146bn ($154bn) a year. One crucial development, according to Sander Tordoir of the Centre for European Reform (cer), a think-tank, is the changing relationship with China. In the 2000s and 2010s Germany was perfectly placed to satisfy Chinese appetites for its cars, chemicals and precision-engineered widgets: goods exports to China rose by 34% between 2015 and 2020, even as those to other countries fell. As recently as 2020 China was a net importer of cars, but last year it became the world’s largest exporter. Chinese firms are morphing from customers to competitors, coming to eat the lunch not only of the German auto industry but also of the Mittelstand. “The car story is emblematic, but it’s also about machines and chemicals,” says Mr Tordoir.

As Clemens Fuest of Ifo notes, China now accounts for just 6% of total German exports, around the same share as the neighbouring Netherlands. But the China story is not just about export dependence. In a forthcoming paper for the cer, Mr Tordoir and Brad Setser, an economist at the Council on Foreign Relations, an American think-tank, describe how the “second China shock” could worsen Germany’s industrial woes. China’s domestic market cannot soak up the excess production of its state-subsidised manufacturers, and as they seek customers abroad the country’s trade surplus has exploded. This presents difficulties for German firms at home and in markets abroad. “China’s state-directed markets could provide irrational levels of financing for Chinese investment in new capacity for longer than swathes of German manufacturing can remain solvent,” write the pair. Chart: The Economist

As German exports to China have declined, America has partly stepped into the breach (see chart 2). Some firms have been able to exploit opportunities opened by America’s decoupling from Chinese tech; others have grown fat on the subsidy bonanza triggered by the Inflation Reduction Act. But Mr Trump threatens all that. Not only do tariffs loom—the Bundesbank thinks they could lop a percentage point off German gdp—but new American restrictions could hit German manufacturers that use Chinese inputs. They will also accelerate Chinese exporters’ hunt for alternative markets, including Europe.

German industry is split on China, notes a diplomat: although many Mittelstand companies, especially machinery firms, back the policy of “de-risking”, carmakers and conglomerates like basf are doubling down. Volkswagen and bmw are planning big new investments in Chinese production, as are car-parts firms like Continental. Lobbying by the car sector helped ensure Germany was one of only five countries to vote against eu tariffs on Chinese ev imports in October. Inside Germany’s government there are tensions between diplomats and spooks, who want to punish China with trade restrictions for propping up Russia’s military effort, and industry-minded types who fear that is a measure low-growth Germany cannot afford. Ending the fetish

The deindustrialisation story can be more complicated than it looks. Losing manufacturing jobs cuts into Germany’s already sagging productivity. But gross value added in manufacturing has remained stable even as production has slumped. Some German manufacturers, in other words, may be making more valuable stuff while selling less of it. This “quality over quantity”, as Deutsche Bank puts it, suggests a future for German firms in high-end tech, including fancy cars. Germany retains an edge in green technology, including wind turbines and electrolysers.

But this can hardly compensate for losses elsewhere. Germany must get over its “industry fetish”, reckons Moritz Schularick of the Kiel Institute for the World Economy. Energy-intensive industries have not grown for two decades. The car sector has been shedding jobs for six years, and a reversal seems unlikely. “For years they had this belief that ‘We are the best’, and suddenly it’s over,” says an eu official.

Deep structural forces are driving changes to Germany’s industrial model. Convincing Germans that there is an alternative to being an Exportweltmeister is the work of years, not months. Even compensating for declining trade elsewhere is a marathon: despite Germany’s best efforts the eu’s free-trade negotiations with Mercosur, a big South American trading bloc, have dragged on for 25 years. (France, among others, remains opposed.)

For some, a handier tool for juicing the economy would be to reform another piece of the German model that no longer seems fit for purpose: the debt brake, a peculiarity of the constitution that limits the federal government’s annual structural budget deficit to 0.35% of output. The debt brake is an artefact of a bygone age, says Max Krahé of Dezernat Zukunft, a Berlin-based research outfit, when Germany relied on other countries running deficits to stoke its economy. In a world where globalisation has stalled, that model no longer works. Chart: The Economist

Meanwhile Germany’s public-investment requirements—one widely cited estimate puts them at €600bn over ten years—have become too big to ignore (see chart 3). Moreover, fresh funds will have to be found for defence. This year Germany at last reached the nato target of 2% of gdp, but only thanks to a special fund that will soon expire. Even more is likely to be needed to appease the new Trump administration.

For these reasons, there is a growing sense that the next coalition, probably led by Friedrich Merz, leader of the centre-right Christian Democrats, will be open to a modest reform of the debt brake. (Germany will hold an election in February, following the collapse of the three-party coalition this month.) If so, says Mr Tordoir, an investment boom could help compensate for export losses in the short term; done well, investments in education, where Germany lags its peers, and infrastructure could lift Germany’s long-term growth rate. There are plenty of ideas for reform around, including raising the permitted deficit (or replacing it with broader guidelines), exempting public investment from borrowing limits, or establishing off-books funds for infrastructure or defence.

Yet as changes to the constitution, all these would require a two-thirds majority in both houses of parliament. And there is every chance that spoiler parties on the extremes might command a one-third blocking minority in the Bundestag after the next election. The governing Social Democrats have therefore asked Mr Merz to consider lending his support to reform now, as that would give pro-reform parties the numbers they need. H