News in Charts: Germany – seeking a new economic model

The latest estimate of euro area GDP confirmed that activity declined by 0.1% across the currency bloc in the third quarter. Headwinds include a global manufacturing downturn, as well as weak business and consumer confidence amid rising interest rates and a cost-of-living squeeze. Those looking to Germany, the euro area’s largest economy, as a potential source of growth will be disappointed.

Germany GDP is down 0.4% over the past four quarters and near-term prospects remain weak. Data released this week showed both exports and imports falling in October, pointing to weak demand at home and abroad. Industrial output was down 0.4% that month, against expectations for a 0.2% gain. The short-term outlook is not any better. November PMIs remained below 50, the threshold that separates contraction from expansion, with the composite reading 47.8.

Berlin’s export-led economic model has served it well over the past couple of decades, but looks increasingly perilous amid rising geopolitical tensions. Germany has been one of the main beneficiaries of the currency project. GDP per capita has increased by 28% since the euro was introduced, which compares favourably to the growth rates achieved in countries such as France (19%), Italy (5%) and Spain (21%).

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Part of Germany’s success was that it benefited from a weaker currency as part of the euro area than it would have warranted on its own. Domestic reforms that limited wage growth were also a big factor in driving exports. The result was large current account surpluses. Over the past ten to fifteen years Germany’s surpluses have been similar to China’s as shares of global GDP, albeit they have received less international blowback.

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The flipside of this reliance on exports was subdued domestic demand. Household consumption makes up 47.9% of Germany’s GDP – a large drop from the 60.7% figure when the euro was introduced. This has left the economy vulnerable to factors outside its borders. Two major developments mean that Germany’s economic model is looking increasingly shaky. The first shock came close to home. After Russia invaded Ukraine, European Union countries largely agreed to stop importing Russian natural gas. Germany’s manufacturing capacity was fueled in large part by cheap Russian natural gas. This sudden pivot has led to a sharp increase in energy prices, with European natural gas prices rising from being twice as expensive as those in the US to being more than four times as expensive. That ratio is not expected to unwind soon.

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A second pillar of the German model was rising Chinese demand. However, the Middle Kingdom has increasingly been turning from customer to competitor. German production of higher-end manufactured goods increasingly risks being supplanted by Chinese production in the long term. This means import substitution from China itself, and Germany’s exports there have been dwindling. But exports to third countries will face increasing competition too. The automotive sector is a key area to watch, with Germany’s crown jewel looking under increasing threat from China’s low-cost electric vehicles.

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With higher energy prices and a changing relationship with China, Germany will need to find a new economic model. In the short term, efforts to support domestic demand would improve the cyclical outlook. Public investment would help to support long-term growth and facilitate the green transition without exacerbating inflationary risks. However, constitutional limits on government borrowing have proven to be a legal headache. Further ahead, the country may have to reorient its economic model so that it is more focused on domestic demand. A higher share of income going to labour would support this adjustment and underpin rising household consumption. The end result would be a more balanced and more resilient economic growth model.

The views expressed in this article are the views of the author, not necessarily those of LSEG.

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