Can Germany do structural reform?

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 funda­mental 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 will 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, German participants assess the current economic situation as worse than even 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 only being realised 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 labour shortages, high energy costs due to past policy misjudgments, high regulatory and tax burdens, a slow process of digitalisation 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” or mid-sized companies, which form the country’s economic backbone.

To stop this trend, Germany needs lower energy prices. These must be achieved primarily through an expansion of domestic energy production. The government thus has to do more than prioritising faster planning and approval procedures.

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 prioritise laying the groundwork for productive private-sector investment.

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

Expanding the service sector offers another route to boost the German economy over the long run. Coincidentally, this is a demand that had 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 utilise 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 an increased demand for high-quality services by German consumers.

To succeed, German policymakers will need to create an environment that allows the German 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. These initiatives will enhance the service sector in particular. Special depreciation rights as well as tax credits are required in order to incentivise such investments.

Such reforms are necessary not only to incentivise the domestic labour pool for higher as well as longer levels of participation. They are also critical to attracting highly skilled immigrants who are an important component of Germany’s economic transformation.

The government should act with great determination on this front to ensure that recently legislated immigration reform efforts, a useful first step, lead to real changes.

During the eurozone crisis, it was the German government that criticised 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.

The writer is chief economist of Allianz