Germany risks squandering a golden opportunity

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Welcome back. Germany risks squandering its chance to use a public investment splurge to raise productivity and growth potential unless it makes “significant improvements”. That was the damning assessment this week of the German Council of Economic Experts. It said under current plans half of the borrowing that is supposed to go on additional investment will instead be spent on government consumption.

The council’s report conveyed a widely shared appraisal among economists and business figures that the coalition government led by Chancellor Friedrich Merz is not doing enough — either through its €500bn special investment fund for infrastructure and decarbonisation or its reform plans — to revive long-term Germany’s flatlining economy.

The importance to Europe of Germany’s success in upgrading its growth model cannot be overstated. Only Germany has the fiscal firepower to invest its way out of trouble, with investment also buying political space for structural reforms. Failure would only further fuel the rise of the anti-EU far right. I’m at ben.hall@ft.com.

Strengths become vulnerabilities

The German economy is stuck in its longest period of stagnation since the second world war. Even with the government turning on the spending taps, the economy will only grow by 0.9 per cent, according to the council’s projection which is well below the consensus forecast. The recovery will be even weaker if the investment fund is slow to disburse or if it just pushes up inflation, especially in construction.

The economy is being weighed down by US protectionism and cheap Chinese competition. As my colleagues in the FT’s Frankfurt bureau reported in this excellent analysis, there is no end in sight to Germany’s industrial recession. The strengths that underpinned the German manufacturing powerhouse for decades have become vulnerabilities. The fact that Germany has since the beginning of this year run a trade deficit in capitals goods — a sector where German engineers once reigned supreme — with China for the first time is hugely telling. (For more on Germany’s “China shock” see this note from Deutsche Bank).

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Plenty of sugar

The council’s main beef with Merz’s government is that much of the special fund next year is earmarked for planned rather than additional investments, freeing up money in the budget for things like higher pension benefits for mothers or transport subsidies. It also worries about the lack of institutional checks to ensure the investment is additional, especially at regional level.

Conservatives dismayed at Merz’ post-election U-turn to relax Germany’s strict debt rules have condemned the government’s policy as an expensive mistake. In a commentary for the Frankfurter Allgemeine, Johannes Pennekamp argues it will only benefit the far-right Alternative for Germany (AfD).

The so-called special fund thus builds a bridge to the populists. Nothing is more beloved by the AfD and its ilk than promised investments that never materialise, crumbling roads, and a sluggish economy.

Not enough protein

Since the government took office in May, analysts have fretted that its plans for investment and reform would provide more of a short-term boost to demand than a long-term fix to underlying problems.

Economists at Deutsche Bank put it neatly in a note last month: so far there is plenty of “fiscal sugar” in the form of investment spending and more generous depreciation allowances for businesses, but not enough structural reform to “provide the protein” for more sustainable growth.

While the government moved swiftly to implement many of its short-term priority measures, some have become ensnared in coalition infighting. The coalition’s narrow parliamentary majority leaves it hostage to small revolts on either side. The so-called Young Group of newish Christian Democratic Union MPs is the latest faction to throw its weight around, rebelling against the coalition’s pension policy. The base of the Social Democratic party meanwhile is fighting against minimal changes to the Bürgergeld, a basic income paid to those outside the labour market; It doesn’t bode well for more ambitious, long-term reforms to welfare and tax that Germany needs.

Agreement was never going to be easy between a CDU that has swung to the right under Merz’s leadership and the SPD, which feels it paid a heavy political price for the pro-business reforms it agreed when heading the government in 2010. Still, it is surprising how querulous it has become in six short months.

Germany needs Europe

If Merz’s big borrowing gamble fails to pay off, it is hard to see how that would make Germans more favourable to a similar strategy of investment in innovation at EU level as recommended by former European Central Bank president Mario Draghi. But furthering integration of the EU’s single market is essential for Germany’s economic revival, the German Council of Economic Experts notes.

As a manufacturing giant, Germany for decades dragged its feet on EU liberalisation of services in which it historically lacked a comparative advantage, Sander Tordoir, chief economist of the Centre for European Reform, told me. But it too would benefit from deeper capital and services markets, especially with the US and China becoming less attractive export destinations.

It should be possible to offset some lost demand with internal demand, using Germany’s fiscal policy — and, hopefully, the fiscal space of the Netherlands and the Nordics,” Tordoir says. “Doing so while lowering barriers within the single market would supercharge these efforts by boosting intra-EU competition and the efficiency of spending.

Germany risks squandering a golden opportunity

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