Two Years (Almost) Without Russian Gas: German Economy, "Frozen" Europe, and Expectations for the Future
What does bureaucracy, green transition, and retired baby boomers have to do with it?
In the two years since the beginning of russia's full-scale invasion of Ukraine, Germany has successfully overcome the consequences of the energy crisis that followed the severance of ties with moscow. The country has diversified its energy import and is building infrastructure to increase the security of its energy supply. These fundamental policy changes and their early results have disproved the widespread premise that the success of the EU's largest economy is based on the supply of cheap pipeline gas from Gazprom fueling highly competitive export industries and essential to avoid deindustrialization.
Yet some experts keep claiming the German economic model is damaged beyond repair. But is this really the case?
What is happening to the German economy after forgoing russian gas?
The situation appears to be more interesting upon deeper examination: Germany is still a prosperous country, but russian aggression has led to a redistribution of local elites: manufacturers who relied on friendship with gazprom are losing ground, while the defense industry, car manufacturers who have relied on electric cars, and other green and energy-efficient companies are gaining influence in the economy. These are the conclusions reached by economists at the International Monetary Fund upon analyzing the relevant statistics.
They also pointed out that Germany's current problems, which pose serious economic challenges to the country, are caused mainly by internal systemic factors rather than geopolitical shocks. Among them, the IMF identifies an aging population and, as a result, slow labor productivity growth exacerbated by a lack of infrastructure investment, low levels of digitalization, and "analog" bureaucracy. In other words, they can be characterized by the low quality of public administration in the country. As a result, Germany's GDP growth forecast for 2024 is 0.1%, which is the lowest among the G7 countries.
These problems rarely get the public attention they deserve. However, it is their solution via ambitious reforms that can avert a systemic economic crisis in the country.
"Last year, Germany was the only economy among the most advanced industrialized countries to shrink, and according to the IMF's latest forecasts, this year it will again be the country with the slowest growth in this 'elite' group," the fund said.
The shutdown of pipeline gas from gazprom in 2022 certainly led to a sharp rise in inflation and the cost of living in the country. Yet the rise in energy prices proved to be temporary. Now wholesale gas prices in the eurozone have recovered to the 2018 level.
What about the industrial sector?
Other indicators of Germany's international competitiveness also show a significant recovery: the export price index has returned to the same level as before the energy shock, and the trade surplus last year reached 4.3% of GDP, which is lower than the excessively high levels in the pre-pandemic years but above the average for the last two decades. The trade surplus is likely to increase further through 2024.
Concerns about widespread deindustrialization have also been exaggerated. Although energy-intensive industries (chemicals, metals, and paper) have declined, they account for only 4% of the economy.
Meanwhile, car production in Germany grew by 11% last year. One of the reasons was the growing demand for electric cars and the car industry's support for the green transition. In 2023, German exports of electric cars increased by 60%. Just two German manufacturers, Volkswagen and BMW, account for more than 10% of global electric car sales.
The German industrial sector has also adapted to the energy crisis and supply chain disruptions by refocusing on higher value-added products and using less raw materials.
According to analysts at J.P. Morgan, this shows that the value added in production remained stable, even if industrial production fell. To put it another way, industrial production has become a less useful indicator of the economy's overall performance.
Why does the German economy appear so weak?
This reflects a combination of temporary and some structural factors. On the one hand, when inflation soared, consumers cut back on spending. The European Central Bank also raised interest rates to prevent high inflation. This in turn weighed on housing construction and other interest rate sensitive sectors. The post-pandemic redistribution of consumer demand from manufactured goods to services has also proved unfavorable for the German production-centered economy.
The good news is that these obstacles should gradually disappear over the next year or two. The bad news is related to fundamental factors: The IMF predicts the country's productivity growth will fall and the population ageing will speed up sharply. These are the main obstacles that Germany faces on the way to improving its economic situation.
Over the past decade, the number of working-age people in the country has been increasing due to migrants fleeing regional conflicts. When this wave ends and baby boomers retire over the next five years, Germany's labor force growth rate will be the lowest among the G7 countries.
Therefore, the country will have fewer workers for every retiree. This will also result in the need to raise social security taxes and cut pensions in the absence of structural economic reforms. At the same time, the growth of the elderly population will increase demand for healthcare services, drawing workers from other sectors.
What can be done about this?
Greater immigration could be a powerful force to counteract these factors. However, the prospects for this are uncertain.
Another solution is to increase labor productivity that has declined due to underinvestment in public infrastructure. The German paradox is that there is enough budget for such purposes. However, these funds are regularly underspent due to staff shortages in municipalities.
Productivity can also be increased by reducing bureaucratic red tape, which is a barrier to both investment and start-ups. For example, it takes approximately five to six years to obtain a building permit for an onshore wind farm in Germany. And getting a license to set up a company takes as much as 120 days. This is more than twice the OECD average.
Digitalization of public services also remains an unresolved problem. Germany lags behind other EU countries in providing online services for businesses, including registration and filing tax returns. For example, only 43% of public services offer the option to pre-fill personal data online, while the EU average is 68%.
"Germany is facing important economic challenges, but it also has the political leverage to overcome them and secure a bright economic future. It is time to use them," IMF economists conclude.
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