More than a quarter century after The Economist first dubbed Germany the “sick man of Europe,” the label applies again.
And this time, the illness is a chronic condition, requiring a long-term treatment plan. The new government’s fiscal plan to fund infrastructure investment and increased defense spending is a start. But Germany must also open its economy to future-oriented technologies, push for greater market integration in Europe, and build stronger capital markets at home.
For the past five years, Germany’s economy has been stagnant, growing by just 0.1 percent since 2019. Over the same period, the US economy has grown by 12 percent and the euro area as a whole by 4 percent. The forecast does not look any brighter. The German Council of Economic Experts, an independent panel that advises the federal government, expects growth to remain sluggish for the next two years, with potential output increasing by only 0.4 percent per year.
When The Economist first called Germany a sick man in 1999, the country was plagued by high unemployment and low economic growth. Then Germany made a recovery. Major labor market reforms in 2003–05 helped reduce unemployment significantly. Wage restraint in the 2000s lowered relative unit labor costs and increased price competitiveness.
But Germany’s challenges are different now. The economy does not lack jobs; it lacks workers. In the next 10 years the situation will worsen as 20 million workers are expected to retire while only 12.5 million enter the labor market. Older workers are less likely to work, and those who do, will work fewer hours. The aging population will worsen the labor crunch the country is experiencing today, further driving up labor costs.
Labor costs are in fact the main driver of the decline in German price competitiveness, even more so than rising energy costs. Sluggish productivity growth, combined with rising wages, has led to a deterioration in unit labor costs, also compared with other major European economies such as France and Spain.
Also holding Germany back is a high degree of employment stability, reinforced by measures such as “short-time work,” which keeps people on payrolls at reduced hours. While this may sound like a positive for the working population, it has in fact slowed structural change and reallocation to more productive sectors, as there is less pressure on companies and employees to adapt to a changing economy.
Manufacturing decline
We see these adverse factors at work in particular in the manufacturing sector, once the motor of German economic growth but now in continuous decline since 2018. Even when foreign demand, especially from China, picked up again after COVID, manufacturing and other core industries did not benefit, and exports failed to rise accordingly. The loss of competitiveness, combined with rising trade fragmentation, the threat of US tariffs, and increasing competition from China in global markets, will make it more difficult for Germany to regain its footing.
High energy costs matter, too. Although Germany weathered the spike in natural gas and electricity prices following the Russian invasion of Ukraine, output in energy-intensive industries has been declining almost continuously since the start of 2022. Energy prices remain elevated, not only historically and relative to the US, but also relative to many neighboring European countries. This has made Germany less attractive for new energy-intensive industries, such as artificial intelligence, which relies on data centers that consume vast quantities of power. Estimates by the International Energy Agency point to a potential doubling of global electricity demand from data centers between 2022 and 2026, which Germany is not ready to provide at low cost.
In addition to labor shortages and energy costs, Germany’s low growth can be linked to two additional factors.
Legacy technologies
First, the country’s legacy of leadership in the automotive, mechanical engineering, and chemical sectors has left it focused on, and reliant on, existing technologies. Existing infrastructure, specialized skills, and established markets in these traditional sectors have made it difficult for Germany’s economy to diversify into high-tech sectors like IT and biotechnology. While private R&D spending remains relatively strong by international standards, it is concentrated in these “mid-tech” sectors, which can no longer deliver the desired growth.
Second, under the traditional German financial system, too much capital is allocated by the banking sector and too little flows to innovative and higher-risk businesses.
Deep and liquid capital markets foster long-term growth by channeling financial capital to the most productive and innovative companies. This is especially true for young and innovative firms such as start-ups. But German companies have traditionally relied on bank financing rather than the broader capital markets. Although the volume of venture capital grew from an average of 0.02 percent of GDP in 2011–13 to almost 0.09 percent in 2021–23, the volume is still insufficient, particularly for late-stage financing of growing companies. There are fewer and smaller venture capital funds in Europe than in the US or Asia, which makes it hard for start-ups to obtain funding through multiple large financing rounds.
One important reason is a lack of large institutional investors willing to invest in European venture capital. They either prefer to invest in less risky assets or they favor larger and established US funds. This poses a challenge, particularly for larger European scale-ups that frequently move to the US, where deeper capital markets and better exit options, especially as initial public offerings (IPOs), await.
What are the solutions to German stagnation? We think the country must address its economic development from two perspectives: It must look outside and drive European market integration, and it needs to look inside and foster long-term, future-oriented investment.
