The German economy is less of a juggernaut these days, with a full-blow drop into a recession a strong possibility. What should policymakers be focusing on? Image Credit: Shutterstock

Germany is the only major country in the world whose economy is set to contract in 2023. But there is a real risk that the downturn is not a temporary phenomenon. Instead, it points to an altered funda-mental long-term outlook for the country.

For Germany’s own sake, as well as for the sake of the rest of Europe, one can only hope that decision-makers act with resolve now. They should view this crisis as an opportunity to address, at long last, the long list of structural challenges that have piled up over the past two decades.

As the Allianz Pulse 2023 survey indicates, Germans assess the current economic situation as worse even than during the height of the COVID-19 pandemic in 2020 or following Russia’s invasion of Ukraine in 2022. The fact that the geo-economic framework is currently shifting to Germany’s disadvantage is thus only being realized with some delay.

A very long to-do list

While recent policy initiatives by the government may lead to a small boost in growth, they are not substantial enough to restructure an economy of Germany’s size to the degree necessary. Germany must quickly shift from managing past suboptimal policy choices towards deep reforms.

In restructuring its economy, Germany faces a steep uphill climb. It has a laundry list of tasks to address, including labor shortages, high energy costs due to past policy misjudgments, high regulatory and tax burdens, a slow process of digitalization and, perhaps most concerning, policy uncertainty.

One key area of reform is in energy policy. Companies are starting to flee Germany for locations with cheaper energy. This trend significantly includes 'Mittelstand' companies, which form the country’s economic backbone.

For all the talk about expanding green energy solutions, including updating the electricity grid network, as well as the Hydrogen Acceleration Law and other solutions, there are significant questions about the prices, the timeliness and the sufficient volumes of renewables. All of this translates into a great deal of uncertainty for companies.

Beyond energy policy, Germany urgently needs to take concrete steps to establish itself as a place to innovate, invest and create high value-added jobs. Instead of relying on subsidies as the preferred – but very suboptimal – method to support the transformation of the German economy, policymakers need to take the long overdue leap of faith to prioritize laying the groundwork for productive private sector investment.

A 'lean' economic model

A leaner state entails simplifying regulations, reducing bureaucracy and strengthening administrative capacity in necessary functions as well as much more reliance on the productive power of digitization.

Expanding the service sector offers another route to boost the German economy over the long run. Coincidentally, this is a demand that has been raised by prominent German economists at least two decades ago. Little has changed since...

Germany ought to enhance its strong manufacturing base by expanding into areas that are not traditionally associated with its strengths, including software, big data and entertainment. One lever to do so would be for corporates to utilize their excess savings to make investments into service sector activities beyond those directly associated with manufacturing activities.

This strategy would of course need to be matched by increased demand for high-quality services by German consumers.

To succeed, German policymakers will need to create an environment that allows the economy to be sufficiently flexible to adjust to the needed shifts. Doing so also requires concrete steps in fiscal policy such as reducing corporate and personal tax burdens as well as enacting pension reforms.

This applies in particular to enhancing Germany’s service sector. Special depreciation rights as well as tax credits are required in order to incentivize such investments.

During the eurozone crisis, it was the German government that criticized a number of European countries for having left structural reforms unaddressed for too long. It is far more than irony to state that it is now high time for Germany to rise to that same challenge. It is an existential question for Germany’s economic model.