When Will the German Economy Bounce Back?

Economic

Summary:

Elections in February will provide an opportunity to tackle the country’s challenges.

Germany’s economy, which has lagged behind its peers in recent years, faces a series of headwinds in 2025, including trade uncertainty with the US, still-high energy prices, and growing competition from China. Elections in February will provide an opportunity to tackle the country’s challenges.

Europe’s largest economy is forecast to expand 0.3% in 2025, which is slower than the estimate for the euro area of 0.8% and for the UK of 1.2%, according to Goldman Sachs Research. The country’s real (inflation adjusted) GDP is unchanged since the fourth quarter of 2019.

When Will the German Economy Bounce Back?_1

For all the challenges, there are also signs of German industry finding ways to adapt. “Even though industrial production is down significantly over the last few years, the amount of value added has actually been much more stable,” says Goldman Sachs Research Chief European Economist Jari Stehn. “German companies have been able to respond by moving out of relatively low-margin production in chemicals or paper, and so on, into higher value production. I think the way forward essentially is for German companies to continue to do that.”

We spoke with Stehn and analyst Friedrich Schaper about Goldman Sachs Research’s forecast for GDP growth in Germany, competition from China, and the prospect for some easing of high energy prices.

Why has Germany’s economy underperformed other advanced economies in recent years?

Jari Stehn: Since the end of 2019, the statistics are quite striking. GDP in Germany has been flat over that period while the rest of the euro area has grown by 5%, and the US has grown 11%.

There are a few obvious reasons for that. One is the energy crisis that hit Germany particularly hard since it was so reliant on Russian pipeline gas. Germany has a lot of energy-intensive production, and its economy is quite heavily focused on manufacturing activity. So it’s natural that the increase in energy prices had a bigger effect on Germany than on other countries.

Second, Germany is highly exposed to China. This has been a big asset in the past because China has grown a lot. But over the last few years growth in China has slowed, so Germany has sold fewer goods into China. Also, China has become more of a competitor over time, particularly over the last two to three years. China now produces goods that are more like the goods that Germany produces. So essentially, China has transitioned from a key export destination to a key competitor, and it has gained market share, particularly in sectors where Germany has seen big cost increases.

Third, Germany has a number of broader structural issues, such as the degree of regulation that business startups face and public underinvestment. Cumulatively over the last few years, they have put Germany in a less competitive position.

When you take all of that together, it explains a good chunk of the of the underperformance.

Your GDP growth forecast of 0.3% for 2025 is below the consensus. What explains the difference?

Jari Stehn: First, we think that many of the structural headwinds that we just talked about will continue. But then, on top of that, we also expect significant trade tensions from the second Trump administration. Germany is likely to be particularly exposed to those tensions because it's a very open economy. It's heavily focused on industrial activity. When you look back at the first Trump term, we saw a very sharp growth slowdown in 2018 and 2019. The day after the US election we downgraded our forecast for all of Europe, but particularly for Germany.

Are you expecting most of the economic impact to come from tariffs or the mere possibility of them?

Jari Stehn: The takeaway from the first Trump term was you didn't actually see many tariffs implemented on Europe, but you saw a lot of discussions around tariffs that created a lot of uncertainty, a lot of trade tension. In the end, those had big effects on investment, on confidence, and on growth in Germany.

We have set out two scenarios. One, which is our base case, is that you get a sharp increase in trade tensions, but ultimately the actual tariffs that you see are relatively limited and targeted on the auto sector. The auto sector is obviously big in Germany, so you still see a significant hit. Our estimate is a 0.6% hit to the level of GDP. The downside scenario involves an across-the-board tariff on all European imports into the US. In that scenario, we think the negative effects would be significantly bigger — about twice as large.

Either way, we think there is going to be a pronounced period of uncertainty, and that uncertainty will weigh on confidence and investment.

What are the market implications, particularly for Bunds, of the February election in Germany?

Friedrich Schaper: The market is focused on the potential for a looser fiscal stance in Europe and for Germany in particular, and the elections could be a catalyst for such loosening. However, we argue that even at the upper end of our range of expectations about higher fiscal spending, the increase in duration supply of German Bunds is relatively modest compared to the notable increase in safe asset supply that we are already observing. That’s mainly because of a structural shift in the fiscal stance in Europe and the European Central Bank, which is reducing its balance sheet. That has made an impact already, and it’s showing up in higher Bund yields and higher interest rates for euro assets.

So the additional impulse of higher spending after the elections is already well reflected in pricing, in our view. Coupled with the outlook for slowing economic growth, which we expect will lead to a sustained cycle of interest rate cuts from the ECB, Bunds remain our favorite long position among G-10 bonds.

Going back to the energy situation in Germany, are you expecting any relief on the cost front next year?

Jari Stehn: Energy prices have come down significantly from the peak days of the summer of 2022. So we've seen a lot of relief and there's probably some more relief in the pipeline in the sense that contracts in Germany are relatively long and don't reset very frequently. We do think there's some drag on the energy-intensive sectors that is still likely to lift.

We also think that ultimately a lot of liquid gas will flow into Europe and into Germany. Germany has built many liquid gas terminals, and from the end of 2025 onwards, a huge amount of liquid gas will be coming from the US and from Qatar. That should be helpful in normalizing prices.

The caveat is that, on a relative basis, energy costs are likely to stay high. They are still notably higher than before the energy crisis — about twice as high. And they are three to four times higher than in the US.

Do you see competition with China remaining a growth obstacle for the foreseeable future?

Jari Stehn: Yes, I think it will continue to be a headwind. China has moved up in the value chain in terms of the goods that it produces. It used to be more that China would produce lower-value manufactured goods that Germany would import and use as an input for creating high-value manufactured goods that they could sell and capture a big margin in the process. Cars are an obvious example. China is now producing a lot of cars itself that are in direct competition with German-made cars. I don't really see a good reason why that should change anytime soon.

I would also say, though, that Germany has managed to adapt. So even though industrial production is down significantly over the last few years, the amount of value added has actually been much more stable. In other words, German companies have been able to respond by moving out of relatively low-margin production in chemicals or paper, and so on, into higher-value production. I think the way forward essentially is for German companies to continue to do that.

You also write that Germany has by far the most fiscal space amongst major advanced economies. Is it likely to use some of that capacity for additional spending in the next year?

Jari Stehn: In terms of the debt levels, government debt accounts for 64% of Germany’s GDP, almost half of what you're seeing in the US. And the trajectory is very different because that figure is falling in Germany while it’s rising in the US. So there clearly is space.

That said, Germany is constrained by the constitutional debt brake, which allows only for a small bit of borrowing when you adjust the deficit for the cycle. This has led to very tight policy over the last few years, particularly now that you have significant costs related to defense, to Ukraine, and then also to all of these challenges that we talked about, which all need investment to be addressed.

The outgoing government was not able to find a compromise around changing the debt break rule. The issue is that you need a two-thirds majority to do that because it's a constitutional amendment. But we do think that there's a good chance under the new government that you could get agreement on a modification of the rule that would open up some fiscal space.

The economic boost would probably be relatively modest — about half a percent of GDP, or about 20 billion euros a year. We would not expect this amount of investment to immediately turn around the growth picture or affect our 0.3% GDP forecast for next year. It’s probably more of a 2026 or 2027 story.

What else do you expect in terms of new policies once the February elections take place?

Friedrich Schaper: Much of the focus has been on what a government led by the CDU (Christian Democratic Union), which is currently leading in the polls, might prioritize. First, we think a CDU-led government would focus on passing some reforms to improve the competitiveness of the economy. That could include rolling back some of the most recent legislation, including climate-related regulations, to lower taxes for businesses, and especially to focus on lowering energy prices for industry.

Second, we think there will be a push to increase labor market participation. On the one hand, there has been some talk about limiting immigration. But, on the other hand, we think a CDU-led government would focus on improving work incentives, for example, by toughening eligibility criteria for welfare recipients, reducing welfare spending overall, and potentially also raising the retirement age.

Third, we would expect the incoming government to continue to fulfil the 2% NATO target on military spending. We would expect strong support for close transatlantic relations.

Lastly, we would expect some further European integration given the very pro-European agenda of the CDU as a party. However, we would note that the CDU is very skeptical of any further integration that involves some joint liabilities, such as a common deposit insurance scheme or any improvements of the capital markets that would imply joint borrowing.

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