Friedrich Merz was confirmed as Germany’s new Chancellor on 6 May, despite losing an initial vote in the Bundestag. John Ryan argues Merz will face a formidable challenge in trying to revive the German economy.

The result of the German federal election in February reflected a complex and fragile social and political landscape. A crucial topic in the election campaign was the dire state of the German economy, which contracted in 2024 for the second year in a row. However, economic problems have been around for much longer. In fact, the economy is currently the same size as it was in early 2020, marking five years of de facto stagnation.

A combination of cyclical and structural headwinds has paralysed the economy. While cyclical headwinds like high inflation, high interest rates, high inventory levels, or even high policy uncertainty can fade away rather quickly, structural headwinds remain. Germany has started to realise that the old macro business model of cheap energy and easily accessible large export markets is no longer working. Twenty years of underinvestment, deteriorating competitiveness and China’s shift from an export destination to a fierce industrial competitor have taken – and will continue to take – their toll on the German economy.

Germany and China

In the early 2000s, China was the saviour of the German economy, but now it is one of the biggest threats. China’s fast growth, accelerated by joining the World Trade Organization in 2001, brought huge appetite for industrial goods “Made in Germany”. While German exports to the rest of the world doubled over the last twenty years, exports to China increased eight-fold.

But China’s role as an important growth driver for Germany has changed over recent years. First, Chinese demand dropped due to weak domestic demand, then it dropped as China increasingly became able to produce goods it normally imported from Germany, particularly cars.

In fact, in 2015, China launched its own “Made in China 2025” strategy, which aimed to secure China’s position as a global powerhouse in high-tech industries. The strategy was almost a direct copy of what Germany knew as its own “Industry 4.0” strategy. The biggest difference is that China put its money where its mouth was, while Germany did not. Consequently, China has become a massive competitor for many German industries.

Asleep at the wheel

While China executed its growth plans in the automotive sector and beyond, Germany fell asleep at the wheel. Germany’s international competitiveness was ranked in the top five in the early 2010s. Currently, it ranks between 20 and 25. The reasons for this loss in competitiveness include a rapid decline in physical infrastructure, education and digital infrastructure. Regarding physical infrastructure and education, Germany has been too complacent and simply forgot to reinvigorate itself. In relation to digital infrastructure, the country collectively neglected to invest and innovate.

As the German Council of Economic Experts has stated, the German economy has lost most of its competitiveness internationally, and Germany is at risk of losing ground in terms of innovation in major modern technologies. But it is not only conventional and digital infrastructure that is weighing on Germany’s growth performance. For a country that used to be famous for its skilled employees, Germany’s poor performance in the OECD’s Programme for International Student Assessment (PISA) tests are equally worrisome.

No easy way out

The drop in international competitiveness is closely linked to chronic underinvestment. Over the last twenty years, German public investment as a percentage share of GDP has been significantly below the EU average, and private sector investment has also been lower than in many other countries. While the holding back of public investment can be explained by increased public consumption and the constitutional debt brake, private investment has been held back by higher taxes and regulation.

Add to that an unfavourable demographic situation and the associated impact on healthcare and pension systems, and there is no easy way out of the current predicament. Not to mention that the security of Germany and Europe overall is under threat and Germany will probably need to invest some £300 billion in its defence industry and the armed forces.

In 2022, the German economist Hans-Werner Sinn succinctly summarised how Germany’s geo-economic policy had put the country in a precarious position: “We, Germans, have delegated our energy supply to the Russians, entrusted our security to the USA and our growth to the Chinese. Were we particularly enterprising or particularly stupid?”

The challenge for Merz

Can Friedrich Merz, the newly formed CDU/CSU/SPD coalition government and German industry dig the country out of this downward spiral? While the German economy is often portrayed as slow to adapt, it has in fact a proven track record of adapting quickly to large market and policy shifts.

Germany had been heavily reliant on Russian gas and since the Russian war on Ukraine has made the necessary investments and built infrastructure quickly and decisively to change its supply routes and sources. This has caused much disruption to industry, but it has happened. Another example is reforming the economy to support the historic unification of the East and the West. Germany was able to deal with both of those challenges dynamically.

The German economic downturn as we see it today though is not a regular market cycle adjustment. Germany must pursue an economic transition that can respond to the de-industrialisation brought on by Russian and Chinese dependencies as well as the fallout from the pandemic and climate change. Germany needs re-industrialising for a modern, electric vehicle, digitised, green economy. This restructuring effort will be based on more expensive energy, de-risking economic relations with China and eventually shifting to green energy.

Incoming Chancellor Merz enjoys little confidence from the German public. A poll in April suggested 60 percent of Germans think Merz is unsuitable as Chancellor. There is no comparable poll for his predecessor Olaf Scholz, but the impression is that Merz is starting with poll results for which Scholz needed three years to fall back to after his election victory. The fact that Merz required a second round of voting in the Bundestag to be confirmed as Chancellor on 6 May does not augur well.

Reforming the German economic model

One positive sign is the approval of a constitutional amendment in March reforming Germany’s “debt brake”. This will ensure the new government at least has the necessary basis to finance its plans. However, the German economy is projected to hardly grow for the next two or three years while inflation will be strong and a global trade war is looming.

An added complication is US President Donald Trump’s tariff offensive. The ZEW Indicator of Economic Sentiment for Germany, which is based on a survey of financial experts, plunged from a positive 51.6 points to minus 14 points in April after Trump announced his “Liberation Day” tariffs. This was the sharpest slump since Russia’s invasion of Ukraine.

In terms of solutions, there is a clear need for income tax reform and redistribution from unproductive capital to productive capital. This is especially true given the US is disappearing as an export market under Trump’s tariffs. Germany ultimately needs to pursue a fundamental reform of its economic model by strengthening domestic demand and hoping for growing demand in Europe.

Note: This article gives the views of the author, not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: EUS-Nachrichten / Shutterstock.com