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By Hilary Schmidt, International Banker

In late May, confirmation came through of what many had feared. With gross domestic product (GDP) in Europe’s largest economy falling over two consecutive quarters—first by 0.5 percent in last year’s final quarter and then by 0.5 percent in the first quarter of 2023—Germany had officially fallen into a recession. And given its preeminent status as Europe’s leading economy, the implications for the region and the world cannot be underestimated. Is a prompt escape from this gloomy economic territory feasible, and if not, what does that mean for the world?

Germany’s GDP data showed “surprisingly negative signals”, Federal Minister of Finance Christian Lindner recently observed, also acknowledging that the economy was losing its growth potential compared with other highly developed nations. “I don’t want Germany to play in a league in which we have to relegate ourselves to the last positions,” Lindner said, referring to forecasts from the International Monetary Fund (IMF), which predicted 2023 recessions for only Germany and Britain among the European countries. A look at much of the data, however, suggests that Germany may have to undergo economic chastening this year.

“The optimism at the start of the year seems to have given way to more of a sense of reality,” ING Bank economist Carsten Brzeski told the Politico news publication shortly after the first-quarter (Q1) results were published. Brzeski cited key factors underpinning this “reality”, including soaring prices that significantly eroded domestic consumption, underwhelming industrial order books, the negativity surrounding further expected interest-rate hikes and the weak growth outlook now slated for the United States. “On top of these cyclical factors, the ongoing war in Ukraine, demographic change and the current energy transition will structurally weigh on the German economy in the coming years,” he added.

Indeed, consumption in Germany has been seriously rocked by the price shocks that have inflicted the country, the eurozone and much of the rest of the world. “The persistence of high price increases continued to be a burden on the German economy at the start of the year…. This was particularly reflected in household final consumption expenditure, which was down 1.2% in the first quarter of 2023,” Federal Statistical Office of Germany stated, having downgraded the Q1 figure from 0 percent to -0.3 percent, which meant that a recession, as defined by two consecutive quarters of negative output growth, was officially confirmed.

Energy prices have had an especially debilitating impact on German businesses and households, with the war in Ukraine, which began in late February 2022, creating a massively bullish environment for global fuel markets. With German industry hugely dependent on Russian gas, the conflict has resulted in several waves of economic sanctions being levied by the West—Germany included—against Moscow. In response, Russia has cut off supplies to Germany, sending gas prices soaring, while the mysterious sabotage attack that blew up the Nord Stream offshore gas pipelines running through the Baltic Sea from Russia to Germany to provide Western Europe with natural gas further restricted Germany’s fuel-source options.

With fuel and food prices skyrocketing as the Ukraine conflict persisted throughout last year, Germany battled sharply accelerating inflation that peaked at 8.8 percent in October and November, while the eurozone experienced annual price rises above 10 percent during the same months. By the start of 2023, hopes were renewed that Germany could weather the storm as a massive injection of public funding, growing consumption of liquefied natural gas (LNG) from alternative export locations, a sharp decline in gas prices and China’s reopening after strict COVID-19 lockdowns all improved the economic environment. But with inflation still far from being tamed and the European Central Bank’s (ECB’s) continued monetary tightening, the resulting impacts on domestic consumption were inevitable amidst a massive loss of purchasing power. As such, a recession was all but inevitable.

But the crucial question is whether Germany can quickly turn things around and escape a long recession. If recent economic data is anything to go by, a prolonged recession awaits the country. Perhaps most ominously, the inversion of the German yield curve, which saw the difference between 2-year and 10-year German bond yields hit a 31-year low of -87 basis points at the end of June, signals that not only Germany’s economy will fall deeper into recession but also that of the eurozone, which typically uses German bond yields as the region’s debt benchmark. With yield-curve inversions having predicted impending recessions with unerring accuracy on previous occasions, the signs do not look promising for either Germany or the eurozone. “The message that is coming is pretty clear. The market believes that the ECB will be determined to stick with higher rates and markedly slow the economy by doing so,” Lyn Graham-Taylor, a senior rates strategist at Rabobank, recently told the Financial Times.

Moreover, elevated inflation persists in both Germany and the eurozone, with the former seeing consumer prices increase annually by 6.4 percent in June and the latter facing a 5.5-percent rate for the same month. Even German unemployment, which had remained stable at 5.6 percent since March, snuck up by 0.1 percent in June, more than analysts’ expectations of another unchanged month. Germany was “feeling the effects of the more difficult economic conditions on the labor market”, acknowledged the chief of the Federal Employment Agency (BA), Andrea Nahles.

Perhaps most regrettable of all, however, is the waning of Germany as a global manufacturing powerhouse, with a growing number of firms now seeking an exit from the country amidst this environment of elevated inflation rates, sharp rises in borrowing costs, high energy costs and a lacklustre recovery in export demand from key trading partner China. “We currently see the country faced by a growing mountain of challenges,” Siegfried Russwurm, head of the German umbrella industry organisation representing 39 sector associations (BDI, or Federation of German Industries), recently noted, adding that more businesses, including small and mid-size enterprises, are working on “moving part of their activities out of Germany”.

And this downward spiral for German industry could well continue for the remainder of the year, with June figures for its manufacturing sector showing the fastest contraction in more than three years, with both output and new orders declining. The HCOB’s (Hamburg Commercial Bank’s) final Purchasing Managers’ Index (PMI) for manufacturing represents around one-fifth of Germany’s economy and fell from 43.2 in May to 40.6 in June, marking the fifth straight month of declines and remaining below the key level of 50, indicating a contraction since July 2022. The June report also noted that German manufacturing firms had implemented deeper cuts in production at the end of the second quarter due to consistently weakened demand.

“Conditions in the manufacturing sector have undoubtedly worsened, but this is not a crash,” Cyrus de la Rubia, chief economist at Hamburg Commercial Bank AG, told Reuters on July 3, adding that the decline in new orders commenced from very high levels and that manufacturers have not yet embarked upon any major rounds of job cuts. But the reality is that business confidence is dramatically weakened today, with the firms surveyed for the PMI identifying several challenges to growth. “Overall, the PMI data for manufacturing show that a recession in this sector, which was still expanding in the first quarter according to GDP statistics, has become much more likely,” de la Rubia added.

It is no surprise, then, that the German research organisation Ifo Institute for Economic Research anticipates Germany’s recession to become even more painful, with inflation remaining the culprit that will continue to drag down private consumption. As such, the Institute in June downgraded its GDP outlook for Germany this year to -0.4 percent from its earlier estimate of 0.1 percent in March. “The German economy is only very slowly working its way out of the recession,” Ifo’s head of economic forecasts, Timo Wollmershaeuser, told Reuters on June 21, noting that this contrasts sharply with Ifo’s more positive 2023 GDP outlooks it has recently posted for the eurozone and the United States at 0.6 percent and 0.9 percent, respectively. “When we compare Germany with our main trading partners, these countries are at least expected to post growth.” Ifo additionally trimmed its 2024 forecast for Germany to 1.5 percent from its previous 1.7 percent.

Somewhat more positively, however, it stated that it expects inflation to cool modestly this year to 5.8 percent from 6.9 percent in 2022 and markedly lower to 2.1 percent in 2024, but core inflation will rise this year from 4.9 percent to 6 percent before declining to 3 percent next year. The stickiness of ongoing inflation also means that private consumption will shrink by 1.7 percent this year, the Ifo Institute forecasted, before rising again next year by 2.2 percent.