Germany Amidst Shifts, Shocks, and Breaks
A new era is emerging, will Deutschland lose out?
The Jackson Hole Economic Policy Symposium—essentially Central Banking Coachella—played out last weekend. The annual meeting is always closely watched, perhaps especially so this year given the current economic climate, for the types of short-term policy signals that will move markets in the months ahead.
If there was an overall vibe up in Jackson Hole, it was one of marked humility (remember that the experts have almost uniformly got 2023 wrong, at least so far) and uncertainty. We currently find ourselves in a highly complex global environment and getting a solid read on the direction of travel regarding key economic indicators like job numbers, consumer sentiment, and inflation remains something of a guessing game.
I’m not a monetary policy or macroeconomic specialist so I’ll leave it at that. For more insight, you can read here, here, and here.
While most of the headlines coming out of the Mountain West focused—quite understandably—on the immediate term, the Jackson Hole meetings are relevant for another reason: they provide a forum for the world’s policymaking elite to work through some big new ideas and analytical frameworks. That is, in fact, a huge part of the allure for the participants. Because I fancy myself something of a geopolitical analyst, I want to focus here on a couple of tectonic shifts in the global order occurring right now; shifts that featured prominently during last weekend’s discussions.
The best example of this came from European Central Bank President Christine Lagarde. Her speech, “Policymaking in an age of shifts and breaks,” touched on three of them: the interplay between tight labor markets and the pandemic, digitization, and AI; climate change and the energy transition; and rising geopolitical tension and economic fragmentation.
Here’s Lagarde:
These shifts – especially those related to the post-pandemic environment and energy – have contributed to the steep rise in inflation over the last two years. They have restricted aggregate supply while also directing demand towards sectors with capacity constraints. And these mismatches arose, at least initially, against the backdrop of highly expansionary macroeconomic policies to offset the effects of the pandemic, requiring a rapid policy adjustment by central banks.
Whether all these various shifts will prove to be permanent is not clear at this stage. But it is already evident that, in many cases, their effects have been more persistent than we initially expected.
The speech is worth reading in full. Nor was Legarde expressing an isolated sentiment. IMF Chief Economist Pierre-Olivier Gourinchas and Bank of Japan Governor Kazuo Ueda also used the meeting to draw attention to the risks of an increasingly fractured, geopolitically-tinted trading system. As the FT notes, policymakers at Jackson Hole seemed to be casting about for a “new playbook” to better make sense of the current moment:
During the US Federal Reserve’s three-day symposium, current and former policymakers from around the world voiced worries that the well-established economic relationships that underpinned government authorities’ policy decisions were in jeopardy.
They issued an urgent call for a revised playbook to better understand and respond to a rapidly changing landscape that threatened to stoke more frequent supply shocks, higher prices and heightened volatility across financial markets.
The point to stress here is this: I don’t believe these aforementioned shifts are fleeting. The complexity, uncertainty, and volatility baked into the current environment aren’t going to abate. My best guess is that now and into the foreseeable future, technological, biological, geopolitical, and climate-related shocks will throw up all manner of interrelated and diabolically hard-to-predict challenges; disrupting established patterns of trade, investment, growth, and employment. Supply chains will be remade. New risks will sprout up. The old economic and geopolitical certitudes underpinning so much post-Cold War optimism—encompassing the period from roughly 1990 through the latter stages of the 2010s—have flown the coop for good.
My reasoning here is straightforward: none of the key meta-dynamics—including Sino-American great-power rivalry, the enthusiastic application of trade, investment, and technology controls, newfound fervor for industrial policy tools, the mobilization of anti-elite populist moments against the old globalization paradigm, the (still early-stage) AI revolution, the current electrification drive and our ongoing and escalating climate emergency, and Russian revanchism and alienation—are going away. Given the relative dearth of these types of shocks (aside from technological change) over the preceding 75-plus years, this unfamiliar terrain foretells a deeply uncomfortable “new normal” for governments, workers, markets, and central bankers alike.
This all brings me to Germany.
The past half-decade or so has been particularly unforgiving for Deutschland. There are, of course, myriad factors at work but it’s clear that the country has been flat-footed by exactly the shifts and breaks outlined by Lagarde. Nor is the outlook in the years ahead terribly inspiring. To wit, last Fall, The Economist warned that Germany faces a growing risk of deindustrialization, and, just last month, provocatively asked if the country is reemerging as the “sick man of Europe,” writing:
Europe’s biggest economy has gone from a growth leader to a laggard. Between 2006 and 2017 it outperformed its large counterparts and kept pace with America. Yet today it has just experienced its third quarter of contraction or stagnation and may end up being the only big economy to shrink in 2023. The problems lie not only in the here and now. According to the IMF, Germany will grow more slowly than America, Britain, France and Spain over the next five years, too.
But before getting into more detail, I want to hold for a moment on what Germany got right over the preceding 70-plus years.
Wirtschaftswunder: The German Miracle
Simply put, few countries benefitted more fruitfully from the post-World War II liberal international order than Germany did. I’m currently working my way through The Global Age, historian Ian Kershaw’s excellent tome covering the European experience from 1950-2017. His writing makes clear how decisions taken by West German officials—particularly then-Chancellor Konrad Adenauer and then-Economics Minster Ludwig Erhard—tracing back to the earliest stages of the Cold War period laid the foundations for the country’s democratization, revitalization, and enduring prosperity.
Let’s remember that coming out of WWII, Germany’s place in Europe represented a major security challenge for a region deeply concerned about reunification and rearmament. Its status and sovereignty were a subject of extreme contention and concern—among the German people themselves and on both sides of the US-Soviet divide.
However, instead of pursuing past pathologies, the West Germans proved remarkably adaptive to this prior era of shifts and shocks. Adenauer eschewed reunification and neutrality in favor of state sovereignty; becoming first-ever chancellor of the newly-formed Federal Republic of Germany (FRG) in 1949. Under his leadership, Bonn (the then-capital) pursued unabashed alignment with the European democracies and embraced the US-led Western alliance system. European integration, first via the European Coal and Steel Community and later through the Common Market (EEC), was championed with vigor, as was broader trade liberalization when Germany signed onto the General Agreement on Tariffs and Trade (GATT) in 1951.
Action on the international stage was paired with a series of domestic reforms: the Reichsmark was swapped out for a new currency—the Deutsche Mark—in 1948; price controls were lifted; the scourage of inflation was eradicated; and a robust social market economy—melding a competitive free enterprise system with a generous welfare state—took root.
All of this paved the way for a rapid recovery in productivity and industrial output—led by German prowess in automobile manufacturing—as foreign trade volumes exploded, growth took off, and West German society quickly attained broad-based material prosperity. Pluralistic liberal democracy consolidated. By the 1960s, the FRG had firmly established itself as a re-industrialized, exporting powerhouse; serving as the primary economic engine for Continental Europe writ large. Despite moments of acute Cold War geostrategic tension and some unnerving acts of political violence on the homefront carried out by neo-fascist forces and Marxist radicals, the Federal Republic enjoyed internal stability and external security.
So to recap: Cold War imperatives prompted the West Germans to embed themselves into the emerging post-war European (and North Atlantic) trade and security architecture. The new German state benefited handsomely, in the form of both trade linkages and security patronage, from a relatively benign and open US-led international order. Growth and development—coupled with an overt fear of Soviet power and Marxist ideology—undergirded the consolidation of liberal democracy as a durable political system. This relatively virtuous and self-reinforcing cycle—prosperity, democratic consolidation, and European/North Atlantic alignment—worked extremely well throughout the latter half of the 20th Century.
Nor was Germany’s rise from the ashes of WWII a one-time trick. If we race ahead to the early 2000s, we see a freshly unified country able to revitalize itself anew. Facing another raft of challenges in the aftermath of the Cold War, ranging from the costly integration of East Germany to stubbornly high unemployment levels to rising competition from emerging markets, then-Chancellor Gerhard Schröder pushed through a series of highly controversial neoliberal reforms—cutting back on welfare benefits, altering the social security system, reducing taxation rates, and deregulating labor markets—under the aegis of his Agenda 2010 initiative.
What we see here, yet again, is how the Germans successfully reformed their political economy in the face of a changing world order; adeptly taking advantage of a relatively benign post-Cold War moment defined by globalization and free trade, European stability, explosive growth across emerging markets (namely in East Asia), and the absence of a serious challenger to US hegemony.
That Was Then
Despite a (mostly) illustrious 70-plus-year run, Germany confronts a new spate of challenges. A similar reckoning may be on the cards.
Now to be clear, there are a bunch of things going on that help account for struggles over the past 18 months. Here’s Reuters outlining some of the key dynamics behind the current recession:
Quarter on quarter, economic activity had fallen by 0.4% in the fourth quarter of 2022 and by 0.1% in the first quarter of 2023. Two consecutive quarters of contraction fulfills the technical definition of a recession.
"Both the short-term and the longer-term outlook for Germany looks anything but rosy," said Carsten Brzeski, global head of macro at ING.
Weak purchasing power, thinned-out industrial order books, a slowdown in the Chinese economy and the impact of the most aggressive monetary policy tightening in decades all point to weak economic activity in Germany going forward, Brzeski said.
Household consumption showed zero growth in the second quarter from the first and government spending rose by 0.1%. Capital investment also grew modestly while exports fell 1.1%, Friday's data showed.
Delving a bit deeper though, we can see how much Germany’s current travails sync up with the shifts and breaks flagged by Legarde. Let’s unpack what that looks like in greater detail.
The obvious starting point is energy supply. The geopolitical shock unleashed by Putin’s invasion of Ukraine, and subsequent throttling of European gas markets, hit the Germans especially hard, driving “an extreme wedge between prices in Europe and some other regions, as European wholesale energy prices have reached unprecedented levels in 2022,” notes CEPR.
This energy shock has raised probing—perhaps existential—questions about German industrial competitiveness, especially in critical sectors like petrochemicals. While prices have come down a bit since last Winter, they still rate among the highest in Europe and overall business confidence remains low following a period of extended manufacturing weakness. Bloomberg recently noted that still-elevated price levels, coupled with frustrations over Germany’s energy transition process, are prompting businesses to scale back investments at home and look abroad for production alternatives:
Over half of surveyed companies say the energy transition is having negative or very negative effects on their competitiveness, according to a report by the German Chamber of Commerce and Industry. Among manufacturers, almost a third are considering or already executing a production shift abroad — twice as much as during last year’s energy crisis.
None of this was preordained. Let’s recall that up until 2022, Berlin largely discounted the risks emanating from Moscow while building up a high degree of reliance on Russian energy to power its industrial economy. As the WSJ recently wrote on the subject: “German politicians dismissed warnings that Russian President Vladimir Putin used gas for geopolitical leverage, saying Moscow had always been a reliable supplier.” It’s worth pointing out here that Berlin’s confidence in Russian reliability was despite the fact that Putin and his subordinates had, by the late 2010s, a multi-decade track record of weaponizing energy flows and deploying cyber-attacks, election interference tactics, extrajudicial assassinations, and other sharp power tools—to say nothing of overt military interventions in Georgia (2008) and (Ukraine 2014)—as a means of bolstering Russia’s geopolitical leverage.
It goes past an inability to manage energy costs amidst the fallout from the Russia-Ukraine geopolitical shock. Declining demographics, creaky infrastructure, excess red tape, and skilled labor shortages have also drawn criticism. Despite its high-tech industrial image, Germany appears to be falling behind when it comes to the rollout of cutting-edge digital technologies across both the public and private spheres, leaving it potentially vulnerable to the vicissitudes of a still-nascent AI Age.
Perhaps more damningly still, as the Journal piece points out, is the failure of Germany’s iconic automakers (and their multi-tier supplier networks) to adequately anticipate the generational EV shift:
Successful exporters became reluctant to change. German suppliers of automotive components were so confident of their strength that many dismissed warnings that electric vehicles would soon challenge the internal combustion engine. After failing to invest in batteries and other technology for new-generation cars, many now find themselves overtaken by Chinese upstarts.
A recent study by PwC found that German auto suppliers, partly through reluctance to change, have suffered a loss of global market share since 2019 as big as their gains in the previous two decades.
The geopolitical shifts and shocks push out beyond Europe. For the first time in over a generation, great-power competition—this time pitting the United States and its allies against China—is back in the foreground. With trade, technology, and capital flows at the epicenter of the Sino-American rivalry, major new strains in the global trading system have washed away many of the old certainties the German export model has long relied on; reflecting a chaotic new reality being driven, in no small part, by political decision-making in DC and Beijing. Here’s Lagarde again:
We are facing a deepening geopolitical divide and a global economy that is fragmenting into competing blocs. This is being accompanied by rising levels of protectionism as countries reconfigure their supply chains to align with new strategic goals.
Over the past decade, the number of trade restrictions in place has increased tenfold, while industrial policies aimed at reshoring and friend-shoring strategic industries are now multiplying. And while this has not yet led to de-globalisation, evidence of changing trade patterns is mounting. The fragility of global supply chains highlighted by the pandemic has also accelerated this process.
Let’s bear in mind that, much as with Russia, for decades German officials enthusiastically championed intimate economic coupling with China to the point where, today, the People’s Republic serves as Germany’s largest trading partner. China’s rapidly expanding middle class proved enthusiastic buyers of German automobiles. Its firms snapped up high-value-added exports, like Germany’s world-beating machine tools, to power their own industrial ambitions. To generalize a bit: from the vantage point of Germany’s political and business elite, China’s rise to the status of an economic superpower was primarily seen as a growth opportunity rather than a potentially knotty geostrategic challenge.
Now, in relatively short order, that assumption has badly frayed. For one, China-EU relations are currently going through a rough patch. Here’s Liana Fix and Zongyuan Zoe Liu unpacking that dynamic in a recent Foreign Affairs piece:
The European bloc has grown disenchanted with Beijing’s opaque handling of the COVID-19 pandemic, its implicit support for Russia’s invasion of Ukraine, and its increasingly assertive foreign policy. The EU-China Comprehensive Agreement on Investment, hastily inked in December 2020 before U.S. President Joe Biden took office, was put on hold after China imposed sanctions on EU lawmakers and is now on indefinite hiatus. The “Russia shock” has jolted leaders to attention, exposing the unsettling reality that Europe’s biggest problem is not a pushy ally across the Atlantic but rather deep vulnerabilities to potential Chinese coercion.
Over the past six months, European Commission President Ursula von der Leyen has led the charge to reorient the EU’s stance toward China. In a speech in March, she championed a plan to safeguard Europe’s economic security by “de-risking” its relationship with China—that is, reducing critical vulnerabilities resulting from overdependence, especially in the health, digital, and clean-technology sectors, and deterring economic coercion, while seeking to cooperate on broader challenges such as climate change.
That analysis dovetails with Berlin’s own growing set of concerns: over the lopsided bilateral trade imbalance (which rose to an all-time high last year); over PRC investment into strategically critical German tech and manufacturing businesses; over Bejing’s ability to coerce and threaten German multinationals with a large operational footprint in the PRC market; over the Chinese Communist Party’s dismal human rights record and threats to Xinjiang, HK, and Taiwan; and over China’s highly negative approval rating among the German general public.
In appraising the German government’s new China Strategy earlier this summer, CSIS noted: “the publication of such a document signals an important change in Berlin and aligns the German government more clearly with the European Commission, which has emerged as a more critical voice on China in recent years,” and that “it suggests that Germany now firmly views China as capable of impinging on its security as well as its economic interests—the traditional ballast of the relationship.”
In the past, Sino-German frictions could be largely offset by bigger-picture commercial imperatives. Going forward, it’s less clear how well that case will land as a) Chinese demand for German exports sags amidst a broader (likely long-term) growth slowdown arising from severe structural deficiencies in China’s exhausted-looking growth and development model, and b) Chinese businesses operating in key sectors like EVs and sophisticated industrial manufacturing continually build up their competitive position, eating into market share (both internally and globally) across industries that form the backbone of Germany’s export economy.
This all puts Berlin in something of a bind, as Fix and Liu write: “Germany’s three-party coalition must thread a difficult policy needle: tread cautiously with its most important economic partner but heed the growing economic risks of integration.”
Nor is it all about China. In a post-Trump world, America’s reliability as a trading partner and security patron is also in greater doubt than at any point in decades. Let’s remember that the former POTUS had a notoriously hostile relationship with then-Chancellor Merkel, repeatedly threatened the German auto industry with crippling tariffs, and proved to be overtly hostile towards both NATO and the European Union during his time in office.
Back in 2017, shortly after Trump’s election, Merkel cryptically warned that Europe may have to take its fate into its own hands given the collapsing level of trust between DC and Brussels. Not to be outdone, her French counterpart, President Emmanuel Macron spoke of the need for European “strategic autonomy” to reduce the continent’s risk exposure to American protectionism and Trumpian capriciousness.
Fast forward to 2023 and the MAGA specter still looms large over the North Atlantic. Despite an ocean of legal woes and high unfavorability numbers with the American general electorate, Trump remains the overwhelming favorite to secure the Republican nomination. It would be folly to dismiss his chances of returning to the White House come January 2025. Trump 2.0 would likely be, in the words of a recent Economist feature, “more resentful, more organised and less constrained than in his first term.”
That contingency poses immediate risks to Germany in its own backyard. Were Trump to spring a comeback, confidence in the NATO alliance would likely hit rock bottom regardless of whether or not he acted on long-standing threats to withdraw American support. The transatlantic consensus on Ukraine would possibly shatter, with the conflict being eventually settled on terms broadly acceptable to the Kremlin. Putin would feel vindicated and empowered to continue pushing the envelope across the region. The US government would likely resume a policy of verbally undermining EU cohesion—with Trump openly badmouthing the European project. Transatlantic trade could once again emerge as a major flashpoint between DC and Brussels.
The reverberations would go beyond Euro-centric policy issues, however. Here’s Chatham House Director Browen Maddox:
Dealing with Trump in the White House again would present problems on a different scale. In a second term, he would be a president who had denied the result of one election and rejected the legal process of being held to account for that. He would have an utterly different conception of America’s role in the world and the nature of its democracy at home, of the rule of law at home and abroad. And so would the US voters who elected him.
At that point, the US becomes, for its allies, a different country altogether. The implications for global institutions, for international law and order, for predictability of a world superpower are stark.
Beyond Europe, a potential Trump second act plays out during a moment in world history when volatility around AI, climate change, Ukraine, Taiwan, and US-China relations more broadly will likely reach a fever pitch. In those circumstances, Berlin may be forced to confront an American government that—rather than playing the role of global stabilizer and democratic agenda setter—will act as a powerful political risk catalyst in key areas of climate, trade, and geopolitics.
It would be reductive and somewhat misleading to pin all of Germany’s US-related headaches on Trumpian psychodrama. While the Biden administration, to its (considerable) credit, has taken steps to repair frayed alliances across both Europe and East Asia, the White House’s underlying approach to trade and economic security—informed in no small part by the anti-globalization populism of Trump and Bernie Sanders—reflects a sea-change from the pre-2016 era.
To summarize where things stand: 31 months into the Biden presidency, Trump’s China tariffs remain in place; new investment and export controls hitting the PRC’s high-tech sector have been rolled out; WTO reform is going nowhere fast; and, via big-ticket legislation like the Inflation Reduction Act and the CHIPS Act, DC is plowing massive amounts of state resources into building out localized supply chains in key areas like batteries, EVs, and computer chips.
That last point is critical. The combination of lower energy prices and generous policy inducements has helped America gain a massive edge over its allies in attracting cleantech investment, and “European leaders have been dismayed by how protectionist the Biden administration has turned out to be in its economic policy, putting ‘Buy American’ provisions in many of its spending bills and showering subsidies on green technology produced in the United States,” notes Fareed Zakaria. US clean energy startups are running circles around their European counterparts when it comes to fundraising.
So anyway, that’s my take on the perils that Germany’s political and corporate leadership must now confront. Massive shifts are afoot—in trade, supply chains, geopolitics, climate, and energy—and, for the time being, they appear to have caught the German machine off guard. For now, the onus will be upon the country’s increasingly fragmented political class—led by a makeshift, ideologically heterogeneous “traffic light” coalition government composed of the Social Democrats, Free Democrats, and Greens—to navigate the path forward.