Germany Faces Prolonged Economic Stagnation Amid Industrial Decline and Demographic Pressures

Europe’s largest economy finds itself in a critical condition, with Germany’s economic performance stagnating since 2022 when Russia launched its invasion of Ukraine. The nation has managed to reduce its dependence on Russian energy supplies, yet now confronts unemployment approaching three million and significant losses across key manufacturing sectors, particularly in automotive production, as trade tensions with the United States intensify.

Friedrich Merz, the German chancellor, articulated the severity of the situation in a recent letter to coalition partners in the Bundestag. He characterised the state of German industry as critical in multiple areas, warning that industrial giants alongside numerous mid-sized and small businesses face substantial challenges, with job losses mounting across various companies.

The chancellor acknowledged that productivity growth has become insufficient, attributing this weakness to transformed global economic conditions, elevated labour costs, and excessive regulatory burdens. These structural impediments have constrained the nation’s economic potential despite historical advantages in manufacturing efficiency.

Recent economic forecasts underscore the persistence of this malaise. The Bundesbank has reduced its growth projection for 2026 to merely 0.6 per cent, whilst the Ifo institute anticipates a comparable expansion of 0.8 per cent. These projections come despite Berlin’s substantial spending commitments on defence and infrastructure.

Some analysts maintain a moderately more optimistic outlook. Holger Schmieding, chief economist at Berenberg Bank, observes that domestic orders have begun to recover even as export performance remains subdued. Berenberg forecasts economic expansion of 0.7 per cent for the current year, with government expenditure accounting for more than half of this modest growth. The bank projects stronger growth of 1.3 per cent in 2027 as the EUR 500 billion stimulus package reaches full implementation and consumer and business confidence improves.

Schmieding cautions, however, that Germany’s constitutional amendment permitting unlimited debt financing for defence spending above 1 per cent of GDP will not deliver the transformative growth impact that some advocates suggest. Supply-side constraints may limit the immediate economic multiplier effects, as manufacturers struggle to fulfil escalating orders for military equipment and infrastructure upgrades.

Demographic headwinds compound these challenges. The International Monetary Fund has warned that Germany’s working-age population is set to contract more sharply than any other G7 economy over the next five years, with nearly 30 per cent of the current workforce due to retire by 2036. This demographic shift not only threatens fiscal sustainability but exacerbates the existing shortage of skilled labour.

Peter Bofinger, a former member of Germany’s Council of Economic Experts, expresses concern that policymakers may over-emphasise support for declining industries rather than fostering innovation in emerging sectors. He highlights the nation’s relatively weak position in digital technology and financial services compared to manufacturing, noting that Germany’s prosperity remains heavily dependent on industrial output now under competitive pressure from Chinese producers offering comparable products at lower costs.

Bofinger warns against excessive reliance on energy subsidies at the expense of innovation funding, though he notes that research and development employment represents a positive trend within an otherwise challenging economic landscape. He identifies military spending as a potential catalyst for technological advancement, given the historical relationship between defence investment and innovation.

This perspective aligns with analysis from Paolo Surico of London Business School, whose research has influenced policy development across major economies. Surico argues that defence investment has historically generated significant technological spillovers, citing examples ranging from GPS and internet technology to the mass production of penicillin, which transformed Pfizer from a chemicals company into a pharmaceutical leader during the Second World War.

Surico advocates for prioritising research and development alongside traditional military procurement, suggesting that knowledge-intensive defence strategies generate superior economic returns compared to conventional military build-ups. He contrasts Ronald Reagan’s naval expansion programme of the 1980s with John F Kennedy’s space race initiative, arguing that the latter approach delivered substantially greater prosperity through technological advancement.

Bofinger expresses hope that Germany can move beyond its attachment to traditional industries. Whilst acknowledging that current demand-side Keynesian policies of increased infrastructure spending and tax reductions may deliver approximately 1 per cent growth and alleviate immediate stagnation, he cautions that this stimulus provides only temporary relief. The greater threat, in his assessment, lies in directing excessive resources towards supporting declining industries rather than facilitating their transformation.

The economist invokes Joseph Schumpeter’s concept of creative destruction, emphasising that innovation necessarily disrupts established businesses whilst simultaneously creating new opportunities. Bofinger suggests that Germany currently exhibits an imbalance, with excessive focus on Keynesian demand management and insufficient emphasis on Schumpeterian innovation. He stresses that genuine innovation requires substantial financial support, representing the pathway through which Germany can revitalise its economic model and secure long-term prosperity.