German Chancellor Olaf Scholz
German Chancellor Olaf Scholz (R) talks with an employee of Eavor New Technologies on a drilling tower during his visit of a "green energy" geothermal power station in Geretsried, southern Germany, on August 24, 2023. Image Credit: AFP

Berlin: Stagnant growth, high inflation and manufacturing weakness - the challenges facing the German economy will be top of Chancellor Olaf Scholz's agenda when political life resumes in earnest following the summer break.

The outlook for a country long lauded as Europe's industrial powerhouse is deteriorating, with the IMF forecasting it will be the only major advanced economy to shrink this year. But the remedies needed to get the country's stuttering motor running again are a matter of fierce debate within the country's uneasy, three-party ruling coalition.

What is the current picture?

The final figure for second quarter growth will be released on Friday. According to the initial estimate, the German economy stagnated from April to June. This followed two straight quarters of contraction - the technical definition of a recession.

Problems include weakness in the vast industrial sector and a lacklustre performance by exports, both of which have major impacts for the whole of the economy. These two key pillars are particularly sensitive to surging inflation, rising eurozone interest rates and the struggling economy in China, Germany's top trading partner.

As a result of rising prices as well as the cost of credit in Europe and the United States, companies' order books are suffering, in a country where industry represents more than 25 per cent of GDP. "Exports have created our wealth... but as the global economy weakens, Germany takes it harder than others," Economy Minister Robert Habeck told weekly Die Zeit.

On top of that, German firms had to contend with the energy shock triggered by Russia throttling crucial gas supplies after its invasion of Ukraine. Although prices have fallen since peaking last year after the German government rushed to find new suppliers, they remain above their levels before the war started.

Is the government getting to grips with it?

The current government is the first ruling coalition to consist of three parties in Germany's post-war history, comprised of Scholz's Social Democrats, the Greens - in charge of the economy ministry - and the pro-business FDP, who head the finance ministry.

But the coalition, which took power in late 2021, has been beset by disputes and squabbling, and economic policy is no exception. One area of tension has been over Habeck's plan to cap the price of electricity used by energy-intensive industries until 2030 to insulate them against sharp cost increases.

The measure is aimed at keeping sectors such as the chemical industry competitive while the country boosts its capacity to produce renewable energy from sources like wind and solar, which are cheaper.

But it has provoked opposition from Habeck's coalition partners - Finance Minister Christian Lindner of FDP has said it is 'out of the question to intervene directly in the market by distributing subsidies'. Scholz is also against the plan, although some lawmakers from his own party has spoken in favour of it.

For his part, Lindner wants tax cuts for businesses - but the six-billion-euro package that the government was supposed to adopt last week was blocked by a Green minister.

Are things really that bad?

Marcel Fratzscher, head of the Berlin-based DIW institute, says Germany's problems are structural. The country needs a 'long-term transformation programme, with an investment drive, a broad (reduction of its bureaucracy) and strengthening of social systems', he said in an analysis.

Several concerns on the economic front are widely shared - uncertainty about energy costs in the medium term, cumbersome regulations, a lack of skilled labour, and a slow shift to a digital economy. The media have seized on the gloomy economic data as evidence things are going seriously wrong, an Economist cover story asking: 'Is Germany once again the sick man of Europe?'

But some experts have struck a less alarmist tone.

"Germany is like a man in his 40s who has long been successful, but now has to reorient himself professionally," said Clemens Fuest, from the Ifo institute. Berenberg Bank economist Holger Schmieding said the 'current wave of pessimism is far overdone', and the situation was different from a previous period of economic trouble, from 1995-2004.

"The government is already addressing some key issues, such as the shortage of labour and the long approval procedures that hold back public and private investment," he wrote in an analysis.