Germany’s economy will be Europe’s problem

The imminent end of German Chancellor Angela Merkel’s final term presents a great challenge for both her country and the entire European project. If her successor can’t pull the German economy out of its slide towards second-tier status, the union could lose its most important financial supporter.
Since Merkel’s announcement that she will not seek another term in 2021, the focus has been on whether her successor will be more willing to engage in the kind of risk-sharing needed to make the euro a viable currency — meaning a more complete banking union and more fiscal support for struggling member countries. Friedrich Merz, a leading contender to replace Merkel, has implied he might try, though he remains skeptical of “old French ideas” for financing deeper integration.
Yet even if Germany’s next leader can summon the political will, there’s another obstacle: a diminishing economy, which threatens to undermine the confidence Germans need to play a more proactive role. Besieged on multiple fronts, the country is struggling to deliver higher standards of living. For nearly half the population, incomes haven’t risen in a generation.
The warning signs flashed in Merkel’s first term. German companies, for example, had long excelled in innovation, as measured by the number of patents registered in the US. But by 2007, Korean firms had caught up. They now register nearly double the number that their German counterparts do, thanks to huge investments in education and research.
Merkel understood the challenge. In 2010, she promised a big push on
investment in education and research. She invoked Europe’s Age of Enlightenment in 17th century, when dazzling intellectual progress placed Europeans at the frontier of human knowledge. She recognised that Chinese leaders were making a concerted bid to return to the heyday that Chinese science enjoyed in the 10th century.
But Germany fell short. As of 2015, Korean and Chinese high-school students were outperforming their German counterparts in science and, especially, in mathematics. While Korean universities have not securely established themselves in the
top echelons, the two best
Chinese universities rank higher than the best German universities. Indeed, measured by how often their
science and technology research is cited, Chinese universities occupy the top two spots globally and four more of the top 15. No European institution is even on that elite list.
The automotive industry exemplifies how Germany is losing its edge. The country has long enjoyed a formidable reputation for quality, performance and style. But that might be changing. In
an ever-enlarging scandal, American and European regulators have caught German companies cheating on emission standards in their diesel cars. As they scramble to meet the standards, the country’s automakers are facing a broader regulatory transformation, with municipal authorities banning cars in city centers.
Meanwhile, as electric replaces internal combustion, German manufacturers
remain deeply rooted in the old diesel technology. Merkel and her government have sought to ease their pain by delaying tougher emission standards and deferring bans on car use, but this is a losing battle.
There’s more. Germany’s fabled banks have served
the country’s small and medium-size firms well. But the banks suffer from chronically low profitability — particularly in the network of quasi-public institutions, the Sparkassen and Landesbanken, typically owned or controlled by municipalities and state governments.
Perhaps Germany’s greatest weakness is Deutsche Bank, whose stock price is still less than a tenth of where in stood in May 2007, ahead of the subprime crisis. In recent years, US and British regulators have fined the bank hundreds of millions of dollars for improper representations and possible money laundering.
Ideas propel a modern economy. Yet Germany’s farthest-reaching economic policy of the past generation, the labor reforms of Gerhard Schroder, reduced incentives to invest in human capital by making it easier to fire
employees. Workers became expendable, inequality increased and the sense of insecurity spread. Climbing the economic ladder became harder. Many discouraged Germans turned to the euroskeptic, anti-immigration Alternative für Deutschland party. A growing rebellion within Merkel’s Christian Democrats eroded her authority. These deepening political fault lines delivered a fragmented German Bundestag in 2017 federal polls, placing Germany’s vaunted political stability at risk.
Germany must shed its narrow reliance on engineering excellence and bank funding, and move towards a more flexible structure where emergent technologies can flourish.
The government must consolidate Sparkassen and Landesbanken into two or three banks, while severing their subsidies. And if Deutsche is not cleaned up and downsised, it will surely become a public liability.
Germany is in the last phase of its global prominence, a nation unwittingly sliding into the ranks of also-rans. The question is whether it’s too set in its ways, with too many vested interests, to change course.
The task for the next chancellor is clear: Reinvigorate the economy. Only then will Germans show a willingness to do more for Europe.
—Bloomberg

Ashoka Mody is a visiting professor in international economic policy at Princeton University
. Previously, he was a deputy director at the International Monetary Fund’s research and European departments