Kick-starting the German economy on a grant

Europe’s largest economy, Germany, is back in the limelight. In between the parliamentary election and the new government, the EUR 500 billion (USD 540 billion) infrastructure economic package got approved. At the same time, a defence investment package of probably the same size was also approved. The amount is impressive and will naturally generate economic growth in Germany. However, we argue that Germany badly needs a wide range of long-term reforms to fundamentally improve the economy.

Amid the current political coalition negotiations, we recommend investors to focus on this very important issue in deciding on their long-term investment allocation to Germany.

A 25-year buildup

To give an impression about the magnitude of the reform needed in the German economy, it is worth to revisit the extraordinary tailwinds Germany has benefited from during the past 25 years.

January 1999 saw the introduction of the common European currency, wherein 11 eurozone members initially converted to the euro. Germany represented the strong bloc among the members versus the traditional weaker economies in Southern Europe. To smoothen out economic trade frictions among upcoming members, currency adjustments had been the most used solution, meaning economically weaker countries devalued their currencies against the stronger countries within EU, although this did not happen during the lead up to the euro creation.

Consequentially, the economically strong Germany entered the EU with an undervalued currency while weaker Southern European countries joined with overvalued currencies. Thus, the German economy and domestic companies heavily profited from this imparity for years, at least until the 2007-2009 Global Financial Crisis.

Germany has relied on Russian gas for decades; the premature German decision in 2010 to close down the nuclear power was based on access to this. The gas was available in unlimited quantities, and cheap. For the German industrial sector, this gave a competitive advantage against international peers which also meant that the need to implement economic and labour market reforms did not surface.

A clear sign that Germany needed economic reform became almost clear in the first quarter of 2020, but then the Covid-19 pandemic broke out. At the time, unemployment in Germany was at its historical low, and the GDP growth rate was sliding lower towards zero. It should have alarmed everybody, though only a few economists tried to raise the flag.

The pandemic took over the world and governments completely changed focus. In some countries, particularly in Europe, the crisis was used to give all kinds of economic support which, maybe coincidentally, covered up an emerging economic slump. Huge public spending led to an inflation crisis that was also countered with public intervention, predominately liquidity support from central banks but also via government credits.

When Russia attacked Ukraine on 24 February 2024, access to cheap gas for Germany became history and the country’s constitution made it difficult to hand out more government support. Obviously, the German economy had a harder time absorbing the energy price shock than other economies. Since then, Germany has suffered from negative economic GDP growth.

Grant vs. reform

This 25-year review of Germany’s economy covers some of the biggest macroeconomic events in modern history, wherein Germany managed to come out with the upper hand. The economic magnitude of these events is enormous, but because Germany managed to come out on the sunny side, its government was “saved” from the need to reform the economy. Instead, popular themes and European policy took centre stage, including a clear political leadership, and “powership”, in EU. This magnitude also describes the giant mountain of missing economic reform work that must be done in Germany.

The two famous economic support packages for infrastructure and defence each worth EUR 500 million are huge, but it has nothing to do with economic reforms. We fully see that it will end the negative GDP growth period with an expected GDP growth next year of around 1.5 per cent, albeit only briefly.

There are a number of German economists who are celebrating the new spending spree and argue that it will kick-start the economy. We fully understand that the German stock market is reacting positively to the news, but it is solely growth based on a grant.

The economic package might be huge, but it is not the reform that Germany so badly needs now – one that addresses the mountain that has grown for 25 years. Therefore, it is extremely important for investors to stay sharply focused on the coalition negotiations currently taking place between the conservative CDU/CSU group and the social democratic party SPD. So far, the reality is that they cannot agree on a lot. Should the two groups decide to create a grand coalition, we expect little to be done with the outstanding reforms.

In coalition negotiations, we are on the lookout for anything concerning Germany’s labour market as it is the root of many of the problems that its economy is facing.

For instance, the reason why the country is increasingly missing funding just to keep its roads in order is that the total economic pie is simply not growing enough fulfil all its promises and obligations.

Graph 1 shows a couple of things worth considering. The average labour hours per workweek in Germany for both full-time and part-time employees is 34.6 hours, which is among the lowest within EU. Netherlands is lower with 32.4 and Denmark is tied with Germany, though usually these countries have the highest labour productivity per person. Comparing the countries against the EU index of 103.8, the Netherlands is at 108.6 and Denmark is at 113.3. Germany lags behind at 101.6.

Germany is losing its global competitiveness, which is worrisome. Even more concerning is the speed at which productivity declined, as shown in Graph 2. The conclusion is straightforward – currently, German workers are working less hours per week and they are also getting less productive.

Such a development can simply dissuade companies and investors. Our current outlook towards Germany will not change unless the incoming government forces big reforms.