a triple crisis looms large at the heart of the economy

Ahead of the election on February 23, many German voters are deeply concerned about the economy – and for good reason. The German economy is in a recession^[1] and has been shrinking for two consecutive years. In fact, it is now about the same size^[2] as it was in 2019, even as some of its peers among the world’s advanced economies have experienced solid growth (on the left of the chart below).

This matters for voters, who have experienced stagnating real incomes and remain pessimistic^[3] – expecting real incomes to decline further.

GDP and productivity growth of Germany, UK and US:

There could be several reasons for Germany’s economic malaise. First, fiscal policy in Germany is tighter than in other countries, meaning higher taxes and lower public spending. Due to the “debt brake”^[4] enshrined in its constitution, Germany is severely restricted in running budget deficits, except when the government declares an emergency^[5], as it did due to COVID.

The last coalition government collapsed^[6] over a dispute about whether to declare another emergency over the war in Ukraine in order to increase borrowing capacity. This did not happen, and as a result Germany’s fiscal deficit^[7] has remained relatively moderate. The argument goes that a larger deficit might have boosted economic growth.

Second, for decades, Germany has relied on foreign demand to sustain economic growth at home. During the first two decades of the 21st century, it benefited greatly from China’s integration into the world economy.

To build up its productive capacity, China relied heavily on machinery produced in Germany and it purchased a significant number of German cars^[8]. However, this is no longer the case. As China has moved to the technology frontier, it no longer depends as much on German cars or machinery.

However, both factors only go so far in accounting for the stagnating German economy. For if demand – domestic or foreign – is too weak to sustain growth, this should be reflected in falling prices.

Yet prices have been rising strongly. Inflation in Germany has been running high^[9] over the last couple of years.

And it has not been systematically lower than in, say, the US^[10] or the rest of the euro area^[11]. Over the next 12 months, households expect inflation to be above 3% – well above the European Central Bank’s 2% target^[12].

Another relevant indicator also suggests that lack of demand is unlikely to be the main reason for Germany’s stagnation. Unemployment^[13] is low in Germany, lower than in most European countries and hardly higher than in 2019.

Instead, adverse supply conditions are key, as reflected in households’ expectations of falling incomes and higher inflation.

Overall, supply is simply the combination of labour and capital inputs (for example, the size of the workforce and the machinery or premises available to them) along with productivity or technology, which tells us how much output we get from the labour and capital inputs. Germany is facing a triple crisis in this regard – expensive energy, weak labour supply and low productivity growth.

First, there are energy prices, which have been pushed up everywhere by the Russian invasion of Ukraine. However, the effect has been particularly strong in Germany due to its direct dependency on Russian gas^[14].

The outgoing government, in which the Greens^[15] have been a key player, is widely credited with trying to accelerate Germany’s green transition. This raised the costs of the transition above those caused by the European Emissions Trading System^[16], whereby polluters pay for their emissions.

While it is difficult to determine the exact contributions of the war and the green transition to the rise in energy prices, both clearly act as a drag on growth, particularly on the supply side (that is to say, production potential).

But Germany faces more fundamental supply-side challenges. The second issue becomes apparent when comparing GDP per hour worked (a measure of a country’s productivity, as seen on the right of the chart above).

Here, the trends in Germany and the UK are quite similar, implying that Germany’s lower economic growth relative to the UK is primarily due to people working fewer hours. This, in turn, may reflect demographic changes, migration that does not contribute to the labour force or shifting preferences in the wake of COVID.

The third issue is productivity growth. Consider the increase in GDP per hour worked in the US, which has risen by more than 10% as shown in the chart above, dwarfing the developments in both Germany and the UK. Common causes of weak productivity growth include ageing infrastructure, low private sector investment, a lack of start-ups and fewer new companies growing into multinational leaders.

A turnaround requires far-reaching improvements in supply conditions. In terms of energy, Germany should avoid measures such as introducing more regulation on the heating or insulation of new and existing homes, and instead rely on the EU-wide emissions trading scheme to curb emissions.

In the labour market, increased participation or skilled migration is needed, supported by policies that encourage people to retire later and entice more women into the workforce.