Germany At A Crossroads

By Ulrike Malmendier , Thilo Kroeger, and Christopher Zuber, Project Syndiacate | February 14, 2025

The German economy is struggling with stagnating growth, a rapidly aging population, and declining competitiveness. Without decisive, coordinated action from both the public and private sectors, the country could once again find itself becoming known as the “sick man of Europe.”

BERLIN – Germany’s role as the motor of the European economy is at risk. Growth has been anemic since 2019 as the country grapples with profound structural challenges: an aging population, a tight labor market, declining productivity growth, and unprecedented levels of policy uncertainty.

Compounding these challenges, public investment in education and infrastructure has been inadequate even to maintain the existing capital stock. The German Council of Economic Experts (GCEE) projects that potential output growth will average just 0.3% annually for the rest of the decade – one-quarter of the average rate during the 2010s. Ahead of the country’s snap election on February 23, polls show that the economy is at the top of voters’ concerns.

While external and domestic shifts have contributed to Germany’s current malaise, the most important factor can be found in long-term trends weighing on its economy. Without bold, coordinated action from both the public and private sectors, Germany could face prolonged economic stagnation and a steady decline in competitiveness, once again becoming, as the Economist dubbed it a quarter century ago, “the sick man of Europe.”

How did economic conditions in Germany become so grim? Throughout the 2010s, the German economy was a beacon of stability and growth. Its strong industrial base and competitive exports provided a solid foundation of economic resilience, enabling the country to recover rapidly even from the COVID-19 shock.

So, what changed? At the root of Germany’s economic challenges is its heavy reliance on the manufacturing sector. Although manufacturing’s role has diminished worldwide over the past few decades, with many advanced economies shifting to service- and technology-driven growth, Germany has been slow to adapt to these shifts. As a result, Germany’s manufacturing sector, once a pillar of economic strength, has turned into a liability as rising geopolitical tensions, shifting trade patterns, and fragile supply chains have made the country’s export-driven growth model increasingly unsustainable.

Germany’s reluctance to overhaul an economic model that performed exceptionally well for so long is understandable. For much of the previous decade, manufacturing was the primary driver of growth, as mid-tech industries benefited enormously from globalization and rising import demand from emerging economies like China. But German firms now face intensifying competition in markets they once dominated. Meanwhile, Germany’s slowness to develop high-tech and service-oriented sectors has left it trailing its peers, and its standing in other knowledge-intensive industries has also suffered.

Impediments to Growth

A more recent cause for concern is heightened policy uncertainty, exacerbated by indecisiveness. Delayed reforms and unclear strategies have caused confusion among businesses and financial players, likely dampening private investment and impeding the country’s ability to adapt to new economic realities. A survey by the German Chamber of Commerce and Industry (DIHK) shows that policy uncertainty ranks among business leaders’ top concerns, alongside labor costs and energy and raw material prices (see chart 1).

The rising concerns of German business leaders over labor costs and worker shortages are understandable. Labor costs in Germany are among the world’s highest, driven largely by persistent shortages, which undermine the country’s ability to compete in labor-intensive and price-sensitive sectors. Sluggish productivity growth and rising wages have further driven up labor costs. Consequently, as Chart 2 shows, Germany’s unit labor costs have deteriorated relative to other major European economies such as France and Spain, eroding its competitive edge.

What is frustrating about these developments is that they were largely predictable, given demographic trends. The country’s labor shortage, driven by a rapidly aging population, has been well-known for decades, but little has been done to mitigate its impact.

To make matters worse, population aging is expected to accelerate over the next 15 years as more German baby boomers reach retirement age. Projections suggest that the old-age dependency ratio – the proportion of people aged 65 or older to the working-age population (aged 20-64) – will nearly double between 2000 and 2035. In 2022, Germany had roughly three working-age people for every person aged 65 or older. By 2040, that figure is expected to drop to just two, as consistently low birth rates and rising life expectancy reshape the country’s demographic profile.

Older workers have significantly lower labor-force participation rates and work fewer hours, further shrinking the available workforce. Germany trails behind even countries with a similar demographic structure, especially among workers over 50. Among individuals aged 50-74, Germany’s labor-force participation rate is 56.7%, compared to 58% in Norway, 59% in Sweden, and well over 60% in Japan and New Zealand. The disparity is largely due to Germany’s public pension system, which enables some citizens to retire at 63, creating strong incentives to leave the workforce early. Economic stagnation exacerbates the problem, because firms facing financial pressures often respond by laying off older workers.

As the DIHK survey suggests, the high cost of energy and raw materials is another major barrier to doing business in Germany. Energy prices – particularly electricity and gas – are among the highest in Europe and significantly higher than in other regions, posing a serious challenge to energy-intensive industries such as chemicals and steel.

Although energy prices have eased since reaching record highs in 2022, electricity and natural-gas prices for industrial customers in Germany remain above the European and global averages. In the first half of 2024, energy-intensive German firms paid approximately €0.25 ($0.26) per kilowatt-hour of electricity – well above the EU average of €0.22 per kWh.

Natural-gas prices have followed a similar trajectory, as liquefied natural gas imports at global market prices have replaced cheaper Russian supplies. Rising costs have eroded the price competitiveness of German products, incentivizing companies to move production to more affordable regions.

In addition to hurting existing industries, high energy prices also hinder the development of emerging sectors. For example, demand for data centers is expected to surge as artificial intelligence technologies rapidly evolve. But as long as electricity prices in Germany remain above the EU average, AI companies and others will continue to seek more cost-effective solutions elsewhere.

Opportunities for Revitalization

How can Germany escape its current predicament? An obvious starting point is to close its productivity gap with the United States. This gap is not a recent development: over the past 20 years, US productivity growth has outpaced Germany’s by an average of one percentage point per year.

The productivity gap has widened in recent years as the US has made great strides in areas like AI, digital infrastructure, and high-value services. In 2024, only 20% of German firms used AI. Small and medium-size enterprises (SMEs, the fabled Mittelstand) – long regarded as the backbone of the German economy – are falling even further behind, owing to financial and technical barriers.

While government initiatives like the Agency for Innovation in Cybersecurity have sought to accelerate Germany’s technological transformation, the country still lags behind the EU average in most of the Digital Economy and Society Index’s digital infrastructure indicators. Broadband coverage remains limited, especially in rural areas, and investment in digitalization and training is insufficient.

Closing this gap represents a significant opportunity for Germany, as AI and digital infrastructure could help boost productivity and restore competitiveness. To promote future growth, German firms and policymakers must shift their focus from traditional industries like chemicals and auto manufacturing to emerging sectors such as biosciences. Beyond expanding broadband access, targeted support – particularly for SMEs – will be crucial to facilitate the adoption of AI and other advanced technologies.

The digitalization of public services should be a top priority as well. Establishing standardized government platforms, such as a unified business registration system across Germany’s 16 Länder (federal states), could streamline bureaucratic processes, benefiting both households and companies while strengthening investment incentives. This also applies to digitizing applications and planning procedures for renewable-energy projects. Without these measures, Germany risks losing ground in the global race for technological and economic leadership.

Ultimately, technological innovation and economic growth tend to be driven by younger companies. And this underscores a fundamental German shortcoming: while the country has significantly improved its startup ecosystem and is effective at nurturing companies in their infancy, it struggles to retain them as they scale.

To evolve into globally competitive companies, startups require substantial financial resources, access to international markets, and a supportive business environment. While early-stage financing has increased since 2007, later-stage funding remains a major hurdle. Only 4% of German startups successfully scale up, compared to 9% in the US. In 2022, the average deal size in Europe was approximately €8 million, whereas in the US, it was nearly €14 million, and, as of 2019, more than 40% of European companies’ financing rounds included at least one foreign investor. While capital inflows are vital – particularly for later-stage funding – overreliance on foreign venture capitalists increases the risk that companies will keep profits abroad or relocate to other markets, taking their innovations, jobs, and economic potential with them.

The Benefits of European Integration

To ensure that startups can scale without relying on foreign investors, Germany needs to foster a domestic venture-capital market for growth-stage funding, create incentives for private investment, and implement targeted policies aimed at retaining high-potential startups. Failing to act risks losing these businesses and undermining Germany’s position as an innovation hub in an increasingly competitive global market.

Building an EU-wide venture-capital market is equally critical, requiring concerted efforts at both the national and European levels, particularly when it comes to later-stage financing. The process should involve mobilizing resources through institutions like the European Investment Fund and the European Tech Champions Initiative. While public investment can help bolster later-stage financing, it should facilitate greater flexibility and better risk management by focusing on indirect investments through venture-capital funds. This would ensure that investments are guided by the expertise and market knowledge of experienced fund managers.

Collaboration between Germany and other EU member states is essential. Currently, the fragmentation of European capital markets restricts investment flows and constrains governments’ ability to support startups and scaleups. A major obstacle is the inconsistency in national insolvency regimes, which makes it difficult to assess the liquidation values of cross-border investments. These disparities lead to significant variations in recovery rates, deterring investors. Improving and harmonizing national insolvency regimes across Europe would reduce costs, channel more resources to innovative and efficient companies, promote cross-border investment, and strengthen financial stability.

But increased European integration offers significant benefits for the German economy beyond capital inflows. Access to a single market of more than 500 million consumers enables German businesses to expand without facing trade barriers – an enormous competitive advantage for an export-driven economy and for emerging companies deciding whether to scale in the US or the EU.

Moreover, greater European integration would enable industries – even traditional sectors like auto manufacturing, machinery, and chemicals – to achieve economies of scale, reduce costs, and boost competitiveness. Seamless cross-border trade would also reinforce Germany’s highly integrated supply chains, enhancing manufacturing efficiency and addressing regulatory inconsistencies that impede cross-border operations. If there was ever a time to pursue full economic integration of the single market, it is now.

Investing in Long-Term Growth

As Germany opens its economy to future-oriented investments, it must commit to public spending that enhances long-term growth. Too often, policymakers have neglected projects whose returns would materialize only after the next election cycle, with lasting economic consequences.

Germany’s chronic underinvestment in education and infrastructure is a prime example. Public spending on education stands at 4.5% of GDP, below the European average of 4.8%. The country’s latest scores from the OECD’s Program for International Student Assessment and Program for the International Assessment of Adult Competencies highlight deficiencies in core skills like literacy, numeracy, and problem-solving. Such shortcomings undermine the workforce’s ability to adapt to the demands of a rapidly changing global economy.

Similarly, Germany’s outdated transport, energy, and digital infrastructures hamper connectivity and slow productivity growth. Nearly half of the bridges on federal roads are in “adequate” condition or worse, while the rail network requires extensive upgrades. As a result, Germany’s roads are congested and its railways are unreliable, disrupting freight transport and economic activity.

To advance stable, future-oriented spending, policymakers must take three key steps. First, they should implement systematic cost-benefit analyses to streamline public planning processes.

Second, Germany must reform its debt brake, which limits deficit spending to 0.35% of GDP. While intended to enforce fiscal discipline, its inflexibility risks stifling investment. A pragmatic reform could enhance fiscal flexibility without jeopardizing long-term debt reduction. This should include a transition phase following periods when the debt brake is lifted for emergencies, such as natural disasters and other crises beyond the government’s control. A gradual phaseout of the debt brake could help ensure that short-term relief does not come at the expense of long-term stability, and it might mitigate the effects of external economic shocks.

Furthermore, the structural deficit limit should be adjusted based on the debt-to-GDP ratio. When the debt ratio is below 90%, the deficit limit could be increased to 0.5% of GDP. If the ratio falls below 60%, the limit could be raised to 1%. The current 0.35% brake would still apply if the debt-to-GDP ratio exceeds 90%. According to the GCEE’s simulations, such an approach would keep Germany’s debt ratio on a downward trajectory.

Lastly, and perhaps most critically, Germany needs new institutional arrangements to ensure that public funds are directed toward spending on education and infrastructure. One solution is a statutory mandate that sets a minimum investment level in education – such as a per-student spending benchmark – to guarantee stable and sufficient funding. Given that local governments shoulder most education-related expenditures, such a measure would have to be implemented at the state level.

When it comes to transportation infrastructure, a permanent investment fund could stabilize spending on roads and rail networks by securing dedicated revenue sources. Switzerland’s experience shows that reliable funding streams, such as truck and passenger vehicle tolls, could provide long-term financial support for infrastructure maintenance and modernization.

Redirecting revenue from energy and motor-vehicle taxes into the transportation fund could provide a stable financial foundation. If limited to federal transportation projects, Germany’s Federal Ministry for Digital and Transport could oversee it, keeping administrative costs low by incorporating the fund into existing structures instead of creating a separate legal entity. To align expenditures with broader government goals, the fund should adopt an intermodal approach, coordinating strategic investments in road, rail, and water transport.

To be sure, Germany’s outlook is far from hopeless. There are ample opportunities for the country to restore its growth momentum. But it must meet the demands of the twenty-first century by diversifying its economy and developing new growth engines, responding decisively to adverse demographic trends, and closing the investment gap plaguing Germany’s education system and infrastructure. Clinging to what worked in the past is a surefire recipe for continued economic stagnation.

Ulrike Malmendier, a member of the German Council of Economic Experts, is Professor of Finance and Economics at the University of California, Berkeley.

Thilo Kroeger, Senior Economist at the German Council of Economic Experts, is a postdoctoral researcher at the University of Copenhagen.

Christopher Zuber is Senior Economist at the German Council of Economic Experts.

Christian Ochsner and Milena Schwarz contributed to this commentary.

Copyright Project Syndicate

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