By Eric Vandenbroeck and co-workers

 What Germany’s Economy Needs

Germany is in a prolonged economic crisis that has bred a subsequent crisis of democracy. The energy shock in the wake of the Russian attack on Ukraine in 2022 stalled the country’s recovery from the pandemic. After six years of stagnation, real GDP growth has plateaued and is almost ten percent below where it should be according to pre-pandemic trends. The energy crisis also fueled inflation and led to the largest one-year drop in real wages since World War II. Despite some gains in 2024, real wages are still eight percent lower than where they were trending before the pandemic.

This economic malaise has helped the extreme right Alternative für Germany party, or AfD, make startling and troubling gains. It managed a historic second-place finish in February’s federal election. With prominent neo-Nazi members and overt hostility to the liberal principles that Germany has sought to enshrine since World War II, the AfD poses a direct threat to the country’s democracy. Its success bodes ill not just for Germany but also for Europe writ large.

And yet Germany’s leaders have struggled to come to grips with the full dimensions of the crisis. The prior government, a three-party coalition helmed by the center-left Social Democratic Party of Germany (SPD), stuck to strict balanced budget rules even though a deficit-financed economic stimulus program would have been the right medicine for the ailing patient. It applied fiscal austerity in both 2023 and 2024. The result was two more years of economic stagnation and eventually the political deadlock that led to the downfall of Chancellor Olaf Scholz and the fresh federal elections this year. The incoming government, led by the center-right Christian Democratic Union of Germany (CDU), tried to avoid the fate of its predecessor by initiating a change of the constitutionally enshrined fiscal rules (known as the “debt brake”) in March to allow for unlimited deficit spending on the military and limited additional spending on infrastructure. Many analysts praised the change as a breakthrough. The markets soared. The new chancellor, Friedrich Merz, claimed: “Germany is back.”

To be sure, fiscal policy reform was long overdue. But the new exceptions will not be enough to put the German economy on a sustainable growth path that benefits workers. Although Merz wants to spend on the country’s rearmament and infrastructure, much of the rest of his economic agenda consists of social spending cuts, privatization, and deregulation. Such an agenda will not solve the problems caused by real wage losses and heightened economic insecurity. It is bound to produce constant tension with the center-left coalition partner. And it is unlikely to restore trust in democratic elites in a country where the frustration with the cost-of-living crisis drives growing support for the AfD.

Germany’s economic success in prior decades relied on demand for its exports; reliable energy imports from Russia; affordable housing and food that together helped prop up living standards at competitive wages; and global leadership in the form of major companies of the mechanical and fossil fuel age. All these key planks of German power have been falling away. The war in Ukraine has led to rising energy prices; Chinese manufacturing success has made it more difficult to hold a leadership position in key industries such as clean technology; U.S. President Donald Trump’s trade war is threatening export markets; and domestic policy mistakes have made this difficult situation worse. Beyond rearmament and infrastructure investments, Germany would benefit from a comprehensive fiscal reform that gives it greater latitude to advance policies that ensure the affordability of essentials and the creation of good jobs, speed up the green transition, and strengthen safety nets to encourage domestic consumption and less reliance on external demand. Such a program can generate shared prosperity and allow people to regain control of their lives. In so doing, it would weaken the appeal of extremists and help buttress the liberal democracy at the heart of Europe.

 

The Merz Agenda

Merz and his coalition government, comprising the center-right CDU and center-left SPD, were sworn in on May 7. The fiscal foundation of their agenda, however, was set in March, when the coalition amended the debt brake—with support from the Green party, whose votes were needed for the necessary two-thirds majority in parliament. Since the 2008–9 financial crisis, Germany has maintained strict limits on spending, capping its deficit at 0.35 percent of GDP. That bar remains intact, but the coalition added major exceptions. Most notably, defense spending is no longer subject to deficit limits, a development that the arms manufacturer Rheinmetall hailed in its earnings call in March. To get the SPD and Greens on board, the new fiscal rules also include exemptions for deficit spending on infrastructure investment of 0.8 percent of GDP (about $40 billion) and on climate protection of 0.2 percent (about $10 billion) annually until 2037.

The incoming coalition government decided to hike military spending to strengthen Germany’s defense capabilities and boost the economy. Once the German economy is back on track, Merz and his allies reasoned, social problems would presumably solve themselves; Merz is an advocate for free markets and espouses “trickle-down economics.” When it comes to the military sector, however, Merz has pushed Germany into a Keynesian world of industrial policy and unlimited government spending. For everything else, the government is taking a back seat. Public spending on infrastructure and climate change is capped, while spending on social benefits is in danger of being cut.

The prior government’s austerity did not do the country any favors. The scrapping, for instance, of electric vehicle subsidies in 2023 has slowed production in a key industry and threatened jobs. Merz is not planning to reverse rollbacks such as that cut. Pressure from his center-left coalition partner SPD will not likely change his mind. This laissez-faire approach could have a devastating effect on Germany’s industrial base: Volkswagen, for example, is planning to reduce its workforce in Germany by more than one-fourth until 2030 while freezing workers’ wages.

Merz’s far more generous approach to military spending will not boost domestic growth in the coming years as much as its advocates suggest. The defense sector is already operating near capacity, and in the short run, increasing government spending on weapons and tanks will have only a limited effect on production. Arms companies such as Rheinmetall have seen soaring profit margins, revealing their market power and the lack of competition they face even amid rising demand. Significant additional public spending may go into boosting their margins further. Rheinmetall’s 15-fold stock surge reflects expectations of continued windfall profits.

Of course, the government has insisted that this military spending will create well-paid manufacturing jobs. Yet Merz’s cabinet is full of business executives and lacks a strong voice for labor issues, an absence that has drawn criticism from the CDU itself. Moreover, the defense build-out will not likely compensate for the impending loss of jobs in ailing industries such as the automotive sector. Rheinmetall’s profits almost doubled between 2020 and 2024, but the number of its employees based in Germany rose just 25 percent in that period. The conversion of civilian plants to military use does not offer much more hope. In the East German town of Görlitz, a former Alstom train factory was taken over by the German-French defense company KNDS and now produces tanks, but the factory’s workforce has been slashed in half. The arrival of KNDS was clearly better than nothing, but it is unlikely to turn things around in a place such as Görlitz with a high unemployment rate of 7.7 percent. In this year’s federal election, the far-right AfD candidate Tino Chrupalla won nearly 49 percent of the vote in the town.

Given stagnant growth and precarious external demand, the government would be well advised to stimulate consumer spending and inspire greater confidence among consumers. Instead, Merz and his party have advocated for social spending cuts, partly to offset rising defense costs. It is unlikely that large cuts will materialize since no party, so far, wants to touch the two biggest spending pots—public retirement benefits and public health care. But the rhetoric alone can dampen consumer sentiment and affect spending habits. In addition, such messaging amid prolonged economic strain may further alienate voters. If citizens believe that their government is spending freely on defense while forcing them to shoulder the burden of a six-year economic crisis, Germany’s mainstream parties may hemorrhage more support to far-right populists.

Public confidence in Merz’s leadership is already at stunning lows, even at the outset of his time in office. Only 30 percent of Germans believe the new government will bring positive change. Merz holds the lowest favorability rating of any incoming postwar chancellor and is the first to fail to secure a parliamentary majority in the initial confirmation vote. The AfD now has a narrow lead in some polls. For the first time since World War II, a right-wing extremist party (it was classified as such by German intelligence this year) has a realistic chance of winning federal power.

 

A Plan for Renewal

To escape stagnation - and thus slow the rise of the far right - Germany needs a policy approach that renews the economic model and generates broadly shared economic gains. Instead of the one-sided approach of the Merz government, Germany should be embarking on a real and balanced reform of the debt brake and European fiscal rules. The reform should allow for deficit financing of public investment spending - not just in the military and a few other sectors. The U.S. bond market is currently experiencing historic turbulence. Trump’s tariff rollout in April triggered a major bond selloff and shook the trust in what used to be one of the world’s most important safe haven assets. This volatility has spooked leaders in Washington, but it presents an enormous opportunity for Europe, Germany in particular. Germany has massive public spending needs, and many countries and financial investors are keen to buy German government debt. Loosening the fiscal rules to allow Germany to sell more of its debt would consequently grant the government greater fiscal firepower.

That firepower should be used efficiently. Investments that create public ownership of critical infrastructure come at a lower cost than investments owned by private equity since public infrastructure does not have to generate profits. Enhanced European coordination can increase the effectiveness of military spending and enable some rebalancing of fiscal resources away from defense spending toward needed areas of investment such as clean technology and elder- and childcare. Investment in these areas has a far greater economic effect than it does in defense; compared with military spending, every euro spent in nonmilitary sectors generates four times as much growth.

Germany urgently needs an ambitious industrial policy that delivers sustainable economic growth and good jobs. Key industries such as the car sector must regain competitiveness, in part by pioneering clean production techniques. Merz hopes the free market will facilitate this positive transformation, but the evidence suggests it will not. Leaving German companies to their own devices has led to them lagging in the green transition. Targeted green industrial policy with the right mix of incentives and conditions is needed to steer firms toward catching up with the technological frontier in clean tech. To ensure that workers benefit, firms should receive subsidies only if they pay decent wages and maintain domestic production sites. For large companies coming from China and other countries outside the European Union, joint venture agreements that require strong labor standards can be made a requirement for market access in key sectors - much as China requires joint ventures for foreign firms to access critical areas of the Chinese market. This could help secure jobs and technology transfers where Germany has fallen behind.

The German economy also needs to become more resilient to global demand shocks. To this end, Germany should strengthen domestic demand for goods and services. High labor standards, including minimum-wage laws and broad union coverage of all sectors of the economy, are key to boosting the incomes of the majority of households. The government should raise the minimum wage from its current level of around 13 euros to 15 euros and give preferential treatment in procurement to companies that pay union-level wages. The government must also help keep down the price of essentials, such as housing, food, and energy, so that they do not eat up people’s purchasing power. Authorities should craft an ambitious program to address the cost-of-living crisis through effective national rent control, energy price stabilization, and strict antitrust enforcement in the food processing and grocery sectors to reduce food prices.

Both Trump and the AfD have capitalized on economic problems that mainstream politicians have ignored or downplayed for too long. Of course, neither of the so-called populists offers a credible solution, but the problems they identify are real. So far, the new German government has no convincing plan to solve the economic problems tearing society apart. To be sure, its coalition agreement includes several useful ideas for a pro-worker growth model, but it is unlikely that Merz, an unreconstructed free-marketeer, and his conservative ministers will advance these ideas into workable policy programs. If mainstream parties can’t offer an alternative playbook for economic policy that really addresses the current crisis, they will end up ceding even more ground to the extreme right—with terrible consequences for Germany’s democracy.

 

 

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