While Germany is relatively prosperous, it faces an array of challenges that include internal demographics and external trade disputes. Working with its European partners is key to keeping its edge, writes Clemens Fuest, economist and president of the IFO Institute.

Clemens Fuest

In recent years Germany has enjoyed a phase of strong economic performance. The short-term economic outlook remains positive, but there are various medium- to long-term challenges. To meet those challenges, Germany needs domestic policy reforms and a successful EU.

In the years since the financial crisis, the German economy has been growing faster than that of most other European countries. From 2010 to 2018, Germany's gross domestic product (GDP) has increased by more than 16%, compared to an average of 11% for the eurozone and 15% for the G7.

Labour market performance is even more impressive. Between 2010 and 2018, employment grew by 10% – twice as much as the eurozone average (including Germany) of 5%. Government debt, which peaked at 81% of GDP in 2010, will fall below 60% in 2018. Among the other large eurozone countries, the country with the lowest level of public debt is France, with 96% of its GDP.

The short-term outlook continues to be positive. In 2018 and 2019, most forecasters expect the German economy to grow at a rate of about 2%, driven by strong domestic demand and supported by dynamic wage growth.

The danger of protectionism

However, such an impressive performance should not divert attention from the fact that Germany faces significant economic challenges. Currently, the most visible challenge is the threat to free trade posed by both Brexit and Donald Trump’s protectionist policies. Individual measures such as the US steel and aluminium tariffs have very limited impact; even US car tariffs could be coped with.

According to research by IFO Institute’s foreign trade specialist, Gabriel Felbermayr, the car tariffs announced by Mr Trump would reduce German output by €5bn, just 0.15% of GDP. The real danger is that protectionism spreads and undermines the existing international trading system.

The trade war between the US and China may cause the EU to take measures against growing import pressure from China. Brexit will reduce the size of the European internal market by one-sixth. The combined impact of these new barriers will dampen growth worldwide. Germany’s exports are more diversified and less price-sensitive than those of most other countries, but German export dependency is also much larger.

The issue of protectionism is related to the debate about the German current account surplus. This surplus is often portrayed as being primarily caused by too little domestic investment in Germany. This misses the key point: 2001 was the last year where the German current account was balanced. In that year, overall investment and savings were both equal to 22% of GDP.

A nation saves

Today, investment is equal to 20% of GDP, while savings have grown to 28% of GDP. It is true that investment growth was weak, but the big change is the massive increase in domestic savings. These are primarily corporate savings and the reduced public sector budget deficit.

The reduction in the public sector deficit is not a result of efforts to cut spending. It is driven by other factors: the decline in unemployment has reduced public spending on transfers to the unemployed and boosted tax revenue, and the decline in interest rates has also helped.

Why does Germany save so much? Higher savings are necessary because the German population is ageing more rapidly than that of most other developed countries. The pension system and most of the health insurance system is financed on a pay-as-you-go basis. Public sector deficits in Germany will surge when the baby boomer generation retires in the 2020s. While this justifies the public sector surplus, it is less clear that the massive savings in the corporate sector are healthy. These savings are mostly used for investment abroad, rather than in Germany.

A country with an ageing population is less attractive as an investment location than the booming economies of east Asia. At the same time, from a policy perspective, maintaining economic growth in the presence of a shrinking labour force requires more investment. Economic policy should not encourage investment at home if investment abroad is more productive.

Removing barriers

But economic policy should remove undesirable barriers to investment at home if they exist. In Germany, the tax burden on investment is today one of the highest in the Organisation for Economic Co-operation and Development, in particular after the US tax reform along with corporate tax cuts in many European countries. In the area of public investment, there are bottlenecks in the transport infrastructure. The digitisation of the public administration is underdeveloped and investment in e-government should be increased.

Then there are sectoral regulations that hamper investment. The regulation of the energy sector is highly inefficient, distorting investment in renewable energies and holding up spending on complementary fossil energy provision. Moreover, the German service sector continues to be plagued by over-regulation and barriers to entry. Railway and postal services are well-known examples where reforms are overdue.

Demographic change also requires efforts to mobilise and educate the available workforce. In the German welfare state, taxes and transfers reduce incentives to work more than necessary – for some people, working more even reduces disposable income. The German system of professional education is generally good; its system of dual vocational training is world class. But German schools should perform better with children from disadvantaged backgrounds.

Finally, boosting the labour force requires immigration. Germany lacks a rational immigration policy, which should aim to attract young, well-educated people from all over the world. Among the refugees who came to Germany in 2015, there are many who do not qualify for asylum. But if they are young enough and succeed in education or in finding a job, they should be allowed to stay.

Encouraging innovation

Future economic growth and prosperity in Germany will also depend on the ability to innovate and embrace technological change, in particular digitisation. German companies are both innovative and competitive, and many of them are investing heavily to grasp the opportunities offered by new technologies and digitisation, a trend summarised under the buzzword ‘Industry 4.0’. Nevertheless, the need for change is significant.

In particular, the German economy relies heavily on the car industry. One out of 10 jobs in the entire German manufacturing sector is involved in producing vehicles with combustion engines. The transition to other technologies, including electric cars, may take more time than many people think, but it will come, and the German car industry needs to invest heavily if it wants to lead this change.

Innovation is also an area where population ageing does not help. The impact is already visible. The establishment of new firms is a key driver of innovation and growth. Between 2000 and 2015, the number of new firms started in the hi-tech sector in Germany declined by roughly 40%. Generally, people set up companies at an age between 25 and 40 years. In the same time span, the number of 25- to 40-year-olds in Germany fell by 25%, explaining a large part of the decline in new business launches.

There is little that economic policy can do to influence demographic change, but it should make sure the available potential for innovation and growth is used effectively. For instance, the German tax system discriminates risky investments by heavily restricting loss offset. This needs to be changed to encourage entrepreneurship.

Eurozone integration

Finally, a key issue for Germany’s economic future is a positive development of the EU. The most important and complex issue is the reform of the eurozone. Currently the eurozone member states are deeply divided in their views regarding the future of the common currency. The Italian government is even playing with the idea of leaving the euro. These differences need to be overcome.

To be sustainable, the euro needs a combination of more solidarity and more discipline and accountability in economic and fiscal policy. Europe needs to surmount the current disputes among its members including Brexit, and tap the huge potential of European integration. Moreover, the EU should deepen its internal market to boost domestic growth and use its weight to support open markets globally. Fostering economic growth and competitiveness will help to solve many of the European policy challenges, including the problems of the eurozone.

If Germany tackles domestic reforms and succeeds – jointly with its partners – to use the potential of EU integration, it has no reason to fear the future.

Clemens Fuest is professor of economics and president of the Ifo Institute – Leibniz Institute for Economic Research at the University of Munich.


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