Our greatest worry should be Germany, not the smaller Eurozone economies

Although Italy is putting up a challenge to top the podium and displace France as the sick man of Europe, the country does at least have a functioning and relatively popular government. As with France, the brain drain of young Italians who are relied upon to fund pensions for an ageing population only exacerbates the problem, and of course, Italy’s debt to GDP ratio tops the podium at 140% of GDP. However, you might be surprised to consider that it is the plight of Germany that is more likely to prove the catalyst for the next Eurozone crisis.

Germany, by far the largest economy in the EU and Europe’s economic engine, has held the Continent together and provided the stability required for the success of the common currency. The German economy is now collapsing. Not a cyclical downturn, not a recession, but this is the structural disintegration of the economic model that made Germany the fourth largest economy in the world. For three decades Germany’s exports, trade surpluses and manufacturing dominance subsidised the entire European project. German economic strength made the euro work, made European integration possible and made the Continent relevant globally. German cars, machinery, and chemicals dominated global markets. That strength has gone, and European officials continue to pretend that everything is fine while the Eurozone’s foundations crumble.

Germany’s key advantages have evaporated. Cheap energy was German industry’s lifeblood. For decades, Germany had access to cheap Russian natural gas, offering manufacturers a massive cost advantage against international competitors. Factories could operate efficiently because energy was abundant and affordable. That era has ended. Russian gas is not coming back, the pipelines are cut, the political relationship is destroyed, and there is no alternative that provides energy at comparable prices. German industry now pays between two and three times what it paid for energy pre-2022. For energy intensive industries that formed the backbone of Germany’s economic strength, this is catastrophic.

German companies can no longer compete globally at these energy prices - they are being forced to shut facilities, move production to other countries or simply declare bankruptcy. BASF, the world’s largest chemical company, is downsizing domestic operations and relocating production to China because, to quote their CEO, ‘Europe is no longer a competitive location for energy intensive industries. The birthplace of the industrial revolution is no longer viable for industrial production’. ThyssenKrupp is closing steel plants, and VW, the symbol of German industrial might, has announced the closure of German factories for the first time in the company’s 87-year history. A company that survived Nazi Germany, the East/West split during the Cold War, and every economic crisis for nearly a century, is closing German factories and investing in China and the US, places with stable and affordable energy.

Germany’s export model is broken. The entire German economy was built on exporting manufactured goods to the world, particularly China, its largest trading partner. Having developed its own advance manufacturing capabilities, China no longer needs German imports and is taking market share. German exports to China are collapsing with no alternative market of sufficient scale to replace them. The US is protected by tariffs, the fast-growing Asian economies are dominated by China and Korea, and the rest of Europe is nearing recession. The numbers are devastating. Since 2022, German industrial production has fallen 8.5% - worse than during the 2008 crisis. Russian sanctions caused an immediate jump in energy prices from 15c per kWh to 65c and remain at two to three times pre-war levels. It is therefore mathematically impossible for German industry to compete internationally at these levels. 

Germany’s automotive industry, the crown jewel of German manufacturing, is in crisis. German car brands were once symbols of German industrial dominance, but the transition to electric vehicle is destroying this advantage, with German manufacturers too slow to adapt, investing in diesel technology while the world moved to electric. Chinese electric vehicles are cheaper, more technologically advanced and gaining market share rapidly. Globally Tesla and Chinese manufacturers are setting the standards. The massive investment in German diesel engine technology is a stranded asset with vast investment in EV technology required to catch up. Mercedes Benz is also shifting production, and the unmistakable trend is accelerating. The industry that employed millions of Germans is contracting sharply. 

The former Greek finance minister Yanis Varoufakis relates a conversation with the leader of one of Germany’s automotive unions whose members are terrified by talk of investment in Asia, America and anywhere but Germany. These are people whose grandfathers worked in these same factories, not mere statistics but communities, families and lives built around industries that are vanishing. Germany’s Energy Minister claims to have warned the government that this would be the outcome, but political pressure from Brussels and Washington was too intense, and now we are watching their industrial base evaporate. Estimates suggest that Germany could have lost 20-30% of its industrial base before the end of the decade. 

In common with France and Italy, Germany’s demographic crisis is accelerating the economic decline. Germany has one of the world’s oldest populations. The workforce is shrinking and the number of retirees is exploding as a proportion of the population, leading to fast growth in healthcare and pension costs, declining tax revenues and labour shortages in critical sectors. Germany needs millions of additional working age immigrants to bolster the workforce and maintain current economic output, but political resistance is intensifying. The result is slower growth, higher costs and declining competitiveness. Germany needs massive investment to restructure the economy and to invest in energy infrastructure and digital technology, but fiscal rules and constitutional limits on borrowing strangle any meaningful response.

Germany’s political system is paralysed. The coalition government is fractured, with the traditional parties losing support to the extremes. As a result, effective political leadership has fallen prey to infighting and internal conflicts, with no political consensus on how to respond to economic collapse. Some advocate greater European integration, others are pushing for national solutions; some free market policies, others centralised industrial solutions, but the official narrative is that this is a ‘temporary problem and we will build LNG terminals, we will transfer to renewables fast’. However, LNG costs far more than pipeline gas, and renewables cannot power industry 24/7 - the technology does not yet exist. Germany is trapped, and with Russian energy gone, alternatives are expensive.

GDP is contracting, and the IMF projected that Germany would be the worst performing developed economy in the world in 2025 - worse than sanctioned Russia. It is a cruel irony that while German industry implodes due to anti-Russian sanctions, Russia has adapted quite successfully, with energy exports to India and China filling much of the gap, while German factories are shutting down because they cannot afford the energy they need. The sanctions aimed at crippling Russia are instead crippling Germany, demonstrating strategic incompetence on an epic scale. So, who benefits? The US sells LNG to Germany at premium prices and attracts fleeing German companies, China absorbs market share and welcomes German factories, capital, technology and jobs. Germany is hollowed out as competitors feast on the remains.

Without the German anchor and surpluses that lent credibility to the euro, Southern Europe faces deteriorating economic conditions and Eastern Europe is losing their largest export market. The European project was always reliant on German economic strength and prosperity which allowed it to subsidise weaker economies and provide financial stability. Absent these abilities, European fragmentation is more likely, and countries such as Italy and Hungary are already pursuing national economic strategies. Fiscal solidarity will be threatened, and the euro might not survive in its current form because no other European nation is large or strong enough to hold Europe together. A German collapse leads to inevitable European decline and global realignment. It is likely that German industrial output will continue to fall, more companies will relocate production, more factories will close, unemployment will rise and living standards will decline.

To add insult to injury, America is cutting Europe adrift, compelling Germany to vastly increase borrowing to double defence spending from 86 billion euros in 2025, to 160 billion euros by 2029. Other massively over-indebted European nations are also required to ramp up defence spending from a current average of below 2% towards a target of 3.5% of GDP. It is easy to see the spread between France and Italy’s borrowing costs against Germany’s widening from the current 0.5%, as overseas investors in French and Italian bonds demand larger risk premiums. And of course, French banks are particularly exposed to their government’s bonds, with an estimated 500 billion euros held as assets classified as ‘zero risk’ on French bank balance sheets. Substantial further increases in long-term bond yields will therefore cause serious losses and further weaken France’s banking sector.

Despite politicians’ outward complacency, there is panic that German competitiveness is not coming back. Hundreds of millions in subsidies cannot address actual disadvantages. If energy costs remain at two to three times pre-war levels, subsidies just delay the inevitable while bankrupting the Treasury. Projections suggesting that Germany will de-industrialise and lose 20-30% of its industrial base begs the question of what happens to the EU in the wake of Europe’s self-inflicted decline as an economic power with a misconceived sanctions strategy. You cannot weaponise energy on which you yourself depend.

The German government faces impossible choices. Abandon the debt brake and spend massively - politically difficult and probably too late; accept a politically suicidal industrial decline; or seek closer ties with China. Incremental policy adjustments will not address Germany’s fundamental problems and the decline is therefore likely to continue, political extremism will intensify, and, as with France, the traditional political centre parties will be further marginalised. Having provided the stable centre that balanced European politics, a politically unstable Germany means an unstable Europe. The euro will face severe stress, because without a stable German backing, the currency loses credibility and investors will question whether the Eurozone can hold together. Interest rate spreads between Eurozone borrowers will widen further, capital will flow out of European assets and European unity will fracture. 

The grand experiment of European integration is unravelling, not through political choice, but through the economic collapse of its foundations. Germany, the lynchpin of European stability, is failing. Germany was Europe’s success story and the proof that the European model worked, and the economy that demonstrated a social democracy’s ability to export its way to prosperity. This success story is ending, and with it the credibility of the entire European project. The energy is gone, the markets are lost and the industries have become obsolete. The demographics are terrible, politics are paralysed and a collapsing Germany necessarily leads to the collapse of a continent that relied on its strength and of a world order that relied upon European stability. The question is how long it takes for policy makers to acknowledge this reality. Europe’s future looks very dark indeed and should be dominating headlines, but is being downplayed and hidden by European officials because it is too late to fix. 

There is no way back. Closed factories will not reopen and relocated supply chains will not return, and industrial decline tends to be permanent. Britain deindustrialised in the 1980s, the US in the 1990s and neither have recovered. Germany is on that same path, but unlike Britain and America, Germany has no finance sector or technology sector to fall back on. The tragedy is that the maths doesn’t work anymore. Germany has a skilled workforce and excellent technologies, but this is what happens when political posturing overrides economic reality. 

Germany will have to choose between supporting others and its own survival. The structural disintegration of the economic model that made Germany the fourth largest economy in the world and the cornerstone for the euro is all but ignored by the international media. Absent a dramatic change of direction, the next euro crisis is a ‘when’ and not an ‘if,' and it is beyond irony that this is the very moment when pretenders to Keir Starmer’s job as UK Prime Minister see re-entry into the EU as a popular vote winner with Labour’s internal voting colleges.

About the author 

Jo Welman had a career in the City spanning 45 years and worked in a wide variety of financial sectors. After graduating from Exeter University in 1979 with a degree in economics, Jo spent ten years at Baring Asset Management where he managed a range of UK and US pension funds and unit trusts, investing across multiple sectors including bonds, international equities, commercial and residential property and private equity.

In 1989 Jo became Managing Director of merchant bank Rea Brothers’ institutional and private wealth investment management division. Over the following decade Jo launched a series of specialist investment trusts and funds in a variety of industry and property sectors, before forming a joint venture with reinsurance broker Benfields (now Aon Benfield) and raising one of the first limited liability corporate capital vehicles for the Lloyds insurance market in 1993. As part of his long-standing involvement in the insurance industry, Jo co-founded the Benfield Re-Insurance Investment Trust plc (Brit) in 1995. Following the sale of Rea to Close Brothers in 1999 Jo became Chairman of Brit Insurance Holdings Plc and in 2001, in partnership with Brit and Benfields, he co- founded specialist asset management firm, EPIC Investment Partners (EPIC).

Jo continues to provide corporate finance and investment advice to entrepreneurs and private investors. He sits on the board as a non- executive director of ARK Syndicate Underwriting

“Feet up by the pool”

Jo does not receive any remuneration for his EPIC commentary. Instead, EPIC is pleased to promote the latest edition of his book “Feet up by the pool”.

Profits from sales of the book go to The Money Charity, a charity that shares Jo’s objective to help fill in some of the worrying gaps in the school curriculum. These omissions leave many young adults lacking in the financial awareness that they need to survive in a world where they will rely on their own savings if they are ever to stop working. Even if they earn the right to a full State Pension, today this amount hardly covers council tax and utility bills, and so they need to save and build up a sum of capital amounting to around twenty times their desired retirement income. A frightening number.

As Jo eloquently says, “If we can do our bit to raise awareness of the impending UK saving and pensions crisis, the exercise will have been worthwhile.