Germany’s economic foundations are collapsing

Which is the sick man of Europe? There can be no doubt that Britain is suffering significant economic difficulties at the moment. But it’s an interesting thought experiment to ponder whether you would swap them for Germany’s woes.

The UK’s problems can broadly be put down to incompetent governance and counterproductive policies. Yes, it has laboured under poor productivity and stagnant wage growth for the best part of two decades. But this should be solvable when and if the country is led by a government that can walk and chew gum at the same time.

Germany’s issues, on the other hand, are more structural. Having been masked for decades by the euro – which, compared to the traditional strength of the Deutsche Mark, made German goods more competitive abroad – hidden flaws are now bursting into the open. The question is whether the country's economic model can survive and, if not, what that might mean for the eurozone.

If the global financial crisis ended the era of hyper-globalisation, it now seems like Covid might have put the process into reverse. The hope was this would be a temporary phenomenon but, for the time being at least, Putin’s war is accelerating the trend. Few economies are more vulnerable to the coming squeeze than Germany.

There was a glimpse of the pain this might inflict yesterday when Germany reported its first monthly trade deficit in three decades after the value of the country’s exports unexpectedly fell in May.

The shortfall of €1bn was minuscule compared to those of many other developed nations – not least the UK’s own £51.7bn balance of payments deficit in the first three months of the year. But whereas the UK is accustomed to depending on the “kindness of strangers”, this was Germany’s first such shortfall since 1991.

Since reunification, Germany has fashioned itself into an open, trade-integrated, export-driven powerhouse. It sucked in Russian energy to power its factories. These churned out vehicles, machinery and equipment that were then sold to China.

That strategy worked for decades; now, it’s a massive problem. Olaf Scholz’s government faces the unenviable task of dialling back Germany’s dependence on both countries and finding an alternative to globalisation.

Dalia Marin, professor of international economics at the University of Munich, says: “The German economic model is not dead yet. But its high dependence on international trade implies that today’s changing economic and geopolitical environment will confront Germany with greater challenges compared to most other developed countries.”

Lots of European countries are net importers of energy and their trade balances have been skewed by energy prices going through the roof. But Germany is particularly reliant on energy to power its industrial sector, which accounted for 37pc of gas consumption in 2021. In the UK, the figure was 23pc.

Germany imports around 60pc of the energy it uses. Of this, half of all gas and hard coal imports and a third of all oil imports originates in Russia. In total, Germany depends on the Kremlin for about one third of its total energy consumption, according to the London School of Economics.

Berlin is now having to wean itself off Russian hydrocarbons at speed, not least because Putin is threatening to close the taps. The government has provided €15bn in credit lines to buy gas for storage facilities ahead of the winter. However, the head of the country’s energy regulators has warned that this may not be sufficient.

At the same time, Germany is adopting a more circumspect attitude towards its second largest export market. For decades, Berlin pursued a “change through trade” policy towards China. But Beijing’s studied ambivalence towards Russia's invasion of Ukraine, disastrous zero-Covid strategy and persecution of the Uygur people has altered the calculus.

China has recently given indications that it is prepared to follow Russia’s lead in weaponising trade. Beijing recently sanctioned Lithuania after the Baltic state hosted a Taiwanese Representative Office and imposed tariffs on Australia imports after officials criticised Chinese efforts to thwart an investigation into the origins of the Covid pandemic. Speaking at the World Economic Forum in Davos earlier this year, Scholz expressed concern over China's growing power.

And yet, Berlin’s geopolitical pragmatism has been met by something approaching dismay from German industrialists. In an interview with the newspaper Bild am Sonntag over the weekend, Yasmin Fahimi, the head of the German Federation of Trade Unions, said: “Because of the gas bottlenecks, entire industries are in danger of permanently collapsing: aluminium, glass, the chemical industry.”

And last week, Herbert Diess, the chief executive of Volkswagen, said inflation would spiral even further if Germany reduces the amount of business it does with China. Diess told Der Spiegel that "Germany would look completely different" if it turned away from China, warning that such a move would harm growth, wealth and employment.

In truth, there may be little alternative. Germany has reinvented its economy in the past and could do so again. According to a survey by the Ifo Institute, 50pc of German companies with supply chains in China are now rethinking their operations. But this process will undoubtedly take time.

The trouble is, Germany is the only major eurozone country that has consistently run a current account surplus. The longer it continues to post deficits, the greater the strain on the currency, which is already approaching parity with the dollar.

The UK and German economies might both be unwell. But the British malaise appears easier to cure. What’s more, the eurozone’s shared currency means Germany’s sickness could be contagious.