Germany’s Economic Downturn: A Challenging Transition or a Sign of Deindustrialization?

  Recently, Germany’s economic situation has attracted much attention. On October 10, the International Monetary Fund (IMF) released its latest forecast that Germany’s gross domestic product (GDP) will fall by 0.5% year-on-year this year. The IMF said Germany, once the economic engine of Europe, will be the only developed economy not to grow this year.
From “Sick Man of Europe” to “Economic Engine”

  Since the 19th century, Germany has formed an industrial and manufacturing system characterized by diversified and high-quality production, and gradually established four pillar industries: automobile manufacturing, machinery manufacturing, chemical medicine and electronic technology. The German manufacturing value chain system is highly vertically integrated, covering upstream raw material processing, intermediate product production, and final product production. It has constructed a strong industrial network with large multinational enterprises as the core and small and medium-sized enterprises clustered in the industrial chain.
  Since the second half of 2022, the German economy has shown a sluggish trend. In the fourth quarter of 2022, GDP fell by 0.4% quarter-on-quarter. In the first quarter of 2023, GDP fell by 0.1% quarter-on-quarter. In the second quarter of 2023, GDP increased by 0% quarter-on-quarter. A report in The Economist in August this year even asked, will Germany once again become the “sick man of Europe”? This article caused heated discussions in German society. The term “Sick Man of Europe” evokes an unmentionable memory in German history.
  After the reunification of the two Germanys in 1990, the Federal Republic of Germany faced the “sequelae of unification.” The huge economic and social gap between the two Germanys required the federal government to invest a lot of resources in integration. In 1993, the Federal Republic of Germany’s GDP shrank by 1%, the unemployment rate rose to 9.8%, and the unemployment rate in the east was as high as 15.4%. After a period of steady growth, Germany fell into recession for two consecutive years in 2002 and 2003, with GDP falling by 0.2% and 0.7% respectively, and the unemployment rate exceeding 10%. Merkel took office at the end of 2005 and adopted methods such as fiscal consolidation, social system reform, and investment budget increase to stabilize the economy, which achieved certain results and the economy stabilized and rebounded. But the good times did not last long, and Germany soon encountered the impact of the global financial crisis and the European debt crisis. However, compared to other European countries, Germany quickly recovered after the two crises with its strong industrial system. During Merkel’s 16 years in office, Germany’s GDP increased from 2.29 trillion euros in 2005 to 3.62 trillion euros in 2021, an increase of 58%, transforming it from the “sick man of Europe” to the engine of the European economy.
  In addition to its strong manufacturing industry, European integration has also boosted the growth of the German economy. In 1993, the European Community was officially transformed into the European Union. Subsequently, the number of member states continued to increase. Especially in 2004, ten Central and Eastern European countries joined the EU, and the European single market expanded significantly. The EU provides Germany with low-cost upstream product supplies and a huge downstream market, and the expansion of the Eurozone has further reduced transaction costs between Germany and its member states. About 60% of Germany’s imports and exports occur among EU member states, and the EU has become Germany’s most important trading partner.

Challenges facing the German economic model

  The Ukraine crisis and the energy crisis are the triggers for Germany’s economic downturn since 2022, but behind them they highlight the challenges facing the German economic model.
  First, the German economy is characterized by a high degree of external dependence, which makes it vulnerable to turbulence in the global political and economic situation. The German economy is highly dependent on international trade, especially cheap energy supplies and vast international markets. In the era of globalization, companies move production links overseas that do not have comparative advantages, and at the same time obtain resources at low costs from the international market. Relying on its strong competitiveness in the high-end manufacturing market, German products have achieved high profits in the global market, and Germany has become one of the important beneficiaries of the wave of globalization.
  However, as early as 2003, German economist Hans-Werner Zinn questioned this model. He called Germany’s economic model a “Bazaar Economy”. He pointed out that the risk of this model is that the added value of the supply chain will gradually be transferred to downstream production closer to consumers. For Germany, most of these links are abroad, resulting in Germany forming a “big market economy” with high added value abroad and low added value domestically.
  Second, the energy crisis affects the macroeconomy. Before the Ukraine crisis escalated, Germany mainly relied on Russian energy supplies, especially natural gas supplies. More than 55% of Germany’s natural gas imports come from Russia. In February 2022, after the Ukrainian crisis escalated, European countries followed the United States in imposing multiple rounds of sanctions on Russia, including energy sanctions. Germany cut off Russia’s energy supply, causing its domestic energy prices to skyrocket. From September to November 2022, German energy prices rose by more than 40% year-on-year. The impact of this energy crisis is not only within the energy field, but more importantly, it has a huge impact on the entire economy and society. In 2022, Germany’s inflation rate will reach 7.9%. The impact of rising energy prices on the manufacturing industry includes: First, cost surges inhibit private consumption, making business operations difficult and some companies go bankrupt; second, rising costs lead to a decline in Germany’s location advantage in attracting investment, and some local German companies are even considering moving their production lines. Move to areas with lower energy costs.
  Third, German trade exports face many challenges. Germany is a major exporting country, but inflation has triggered an increase in the export costs of German companies and reduced the international competitiveness of German products. To make matters worse, the demand side of the international market is still sluggish. After the COVID-19 epidemic, the global economy has recovered slowly, and Germany’s largest single trade markets, China and the United States, have been affected to varying degrees. The European Union is dragged down by inflation, and its GDP is expected to increase only slightly by 0.8% year-on-year in 2023. The export expectations index of the German ifo Economic Research Institute shows that German exports will continue to shrink starting in June 2023, and the index even fell by 11.3 in September (down by 6.6 in August). The agency believes that the current export situation between Germany and its major trading partners is not optimistic, and it affects all major manufacturing products.
  What is even more noteworthy is that the global industrial chain has undergone profound changes since the COVID-19 epidemic. In addition to cost, supply security has become a new constraint. The industrial chain that used to be too long and had fine division of labor began to transform into short, flat and regionalized. Downstream Companies seek to increase the number of suppliers to improve upstream supply security. Germany and the EU have repeatedly emphasized reducing dependence on the single market and increasing trade diversity, which to a large extent has strengthened the changing trend of the industrial chain and further increased the international trade costs of enterprises.
  Fourth, the long-term industrial transformation problem of the German economy. Although Germany remains globally competitive in traditional manufacturing areas, it has been slow to develop in emerging areas such as the digital economy for many years. Merkel has launched multiple rounds of “digital” strategies during her tenure, and announced the first federal artificial intelligence strategy in 2019, but the results are still limited. Among Germany’s traditional advantageous manufacturing industries, the chemical industry is an energy-intensive industry and is greatly affected by the energy crisis and inflation. The automobile industry is facing electrification and intelligent changes. Traditional German automobile manufacturers such as Daimler, BMW and Volkswagen no longer have their advantages in the field of fuel vehicles in the new energy market.
Will the economy fall into a long-term recession?

  The competitiveness of the manufacturing industry has declined, the inflation rate has remained high, and companies have withdrawn. Will Germany face the risk of “deindustrialization”? Will the German economy fall into a long-term recession? Despite the current difficulties, this economic downturn will not fundamentally weaken the competitiveness of Germany’s manufacturing industry. The reasons are as follows:
  First, the energy crisis will have the greatest impact on high energy-consuming industries, such as the chemical industry, metal manufacturing and processing, building materials, papermaking, etc. In recent years, Germany’s energy transition has significantly reduced the share of fossil fuels in the national economy, with energy costs accounting for only 2% to 5% of the total costs of most economic sectors in Germany. Industrial transfers are happening all the time, and energy-intensive industries are not Germany’s comparative advantage. Short-term industrial transfer does not mean long-term “deindustrialization.”
  Secondly, the competitiveness of German manufacturing has never come from cost advantages. The competitiveness of Germany’s manufacturing industry comes from its efficient innovation system, which includes powerful industrial enterprises, universities, scientific research institutions, and a government that attaches great importance to setting framework conditions. The foundation of German manufacturing companies is still strong, universities and scientific research institutions still maintain strong scientific research output and industry-university-research collaboration, and the federal government has continued to increase investment in innovation in recent years. These factors have not been weakened by the energy crisis and can support the German economy to gradually get out of trouble after a short-term downturn.
  However, the German economy also faces some problems. In 2022, German Chancellor Scholz proposed the concept of “turn of the times”, pointing out that the domestic and international environment, geopolitical relations, and national security environment faced by Germany have all undergone tremendous changes. In fact, Germany’s domestic and external economic orientation is also changing. During the COVID-19 epidemic, the German government took resolute and powerful measures to stabilize the fundamentals of the domestic economy on the one hand, and on the other hand, strengthened economic security, economic sovereignty, and trade diversification. Since the Scholz government took office in 2021, it has vigorously promoted energy transformation and green economy internally, and implemented values-oriented trade policies externally. Overall, the role of the state in the German economic system has increased, and political intervention in the economy has become more frequent.
  The Ukraine crisis has had a profound impact on Europe. It has broken the geopolitical balance between Europe and Russia, destroyed the Russian-European energy supply system, and exposed a major shortcoming of the German economy, which is that energy supply is highly dependent on outside the EU. regions and countries. While energy shortage is just a symptom, the long-standing problem in the German economic system is the problem of industrial transformation. Currently, in terms of energy, the German federal government is accelerating energy transformation by decentralizing energy supply, revising the Renewable Energy Law, and vigorously promoting the construction of wind energy, hydrogen energy, and solar energy. In terms of technology investment, the German government is actively attracting high-quality foreign investment. In 2023, it announced that it would invest 9.9 billion euros and 5 billion euros to subsidize Intel and TSMC to set up factories in Germany and develop chip technology. In terms of technological innovation, in 2023 the German government announced a new innovation policy – the draft “Future Strategy for Research and Innovation” to strengthen cutting-edge technological innovation and strengthen cross-departmental coordination. This is a critical period for Germany’s economic development and reform. Whether traditional industries can transform into digital and green industries, and whether emerging industries can grow as quickly as possible, are practical issues that urgently need to be solved.
  In addition, the current Scholz government is experiencing constant internal discord and the implementation of many policies is slow. In the future, in the context of accelerating changes in global industries and increasingly fierce industrial competition, it is worth observing whether the federal government’s industrial promotion policies and innovation policies can effectively promote the transformation of German industries and accelerate the development of emerging industries.

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