Germany’s economic model is broken, and no one has a plan B

Carmaker Audi, headquartered here near the Danube river, used to pump over €100 million a year in municipal tax into Ingolstadt’s coffers through its parent, Volkswagen, but those flows dried up over a year ago. Audi in November reported a 91% decline in operating profit for the three months through September and has been cutting thousands of jobs in Germany.

Audi’s business in China, where Germany’s flagship car industry used to make a big chunk of its sales and an even bigger chunk of profits, shrank by a quarter in the nine months through September from a year earlier. Chinese carmakers, once mocked by Western auto executives as primitive, have turned into formidable rivals, gobbling up market share in and outside China.

Slowing economic growth in China and growing competition from companies there have undercut German industry as a whole. Combined with exploding energy costs and the threat of new trade tariffs, the forecast is grim.

German carmakers and their suppliers have announced tens of thousands of job cuts. Germany’s manufacturing industry, the world’s third largest, has shrunk steadily for seven years. And Germany’s economy as a whole has contracted for the past two years, marking only the second back-to-back annual contraction in records dating back to 1951, according to Germany’s federal statistics agency.

Gross domestic product has roughly flatlined since 2019, before the start of the Covid-19 pandemic—the longest period of stagnation since the end of World War II. Most economists expect it will stagnate again this year.

America, recently a relief valve, likely won’t come to the rescue: President Trump is threatening to disrupt global trade with a slew of tariffs that would raise barriers in the U.S., Germany’s biggest export market.

For Germans, who will elect a new parliament next month, this is a scarier version of the mid-2000s, when the unemployment rate reached 12%, double today’s rate.

At that time Berlin enacted unpopular overhauls of its labor market and welfare system that encouraged more people to find work, while holding down business costs and boosting exporters’ international competitiveness, paving the way for two decades of solid growth.

Economists say the current crisis is worse, because it questions the very foundation of Germany’s export-reliant economic model. In the earlier downturn, China’s economy was growing at around 10% or more a year, absorbing goods and powering global trade and the global economy. Today, China’s economy is growing at half that rate, and global trade volumes have stalled, according to the World Trade Organization.

Without fast-growing export markets, Germany’s model “is dead," said Jacob Kirkegaard, a Brussels-based senior fellow at the Peterson Institute for International Economics in Washington, D.C.

A Volkswagen factory in Shanghai in October.New cars at a logistics terminal in Essen, Germany, in November.

Yet few politicians are focusing on the major changes economists say are required. Germans “don’t want to look at the problem in the face. They still think it’s a blip, and it can be addressed the way they usually do things," incrementally, said Ludovic Subran, chief economist at Allianz, the German insurance group. “I don’t think this will suffice."

The country, with 83 million inhabitants, grew into the world’s third largest economy by making and exporting the engineering products—cars, robots, trains, factory machinery—others wanted to buy. Now, the world is turning its back on made-in-Germany, and Germany has no plan B.

‘Spoiled over many years’

Until recently, the fallout from this slow-motion economic crash has been confined to newspaper editorials and economic data releases, with little tangible impact on voters’ lives.

This year, the crisis has turned political. Most polls show the economy has upstaged immigration, security and climate change as voters’ top concern. The outgoing government of Chancellor Olaf Scholz is the most unpopular since 1949.

Most politicians are focusing on how to tweak and improve the current export-reliant, manufacturing-heavy economic model. New ideas to encourage investment and consumption, boost trade inside Europe or open up to fast-growing tech or services sectors are virtually absent.

Scholz, whose coalition collapsed in November because of internal tensions over economic policy, has pushed for the European Union to sign new trade deals. The center-right Friedrich Merz, now front-runner to replace Scholz, wants lower taxes and fewer regulations for manufacturers.

“I see no serious initiative to try and develop a new economic model," said Jens Südekum, an economist and professor at Heinrich-Heine-Universität Düsseldorf. “In the short term, it’s all about how to tactically deal with the situation along the lines of: ‘If Trump imposes tariffs, then we’ll go and manufacture there.’"

Germany’s industrial output has fallen by 15% since 2018, and the total number of people employed in the manufacturing sector is down 3%. Manufacturers in Germany’s metal and electrical industry, weighed down by costs, could lay off as many as 300,000 workers over the next five years, said Stefan Wolf, president of a lobby group for the sector. “Deindustrialization is in full swing," said Wolf, adding that over €300 billion in investment capital has flowed out of Germany since 2021.

Trade in goods is more critical to Germany’s economy than oil is to Texas or tech to California—an overdependence that is the result of decades of government policy that supported export manufacturing while creating hurdles to investment in new sectors such as IT or in the country’s infrastructure. Exports support roughly one in four German jobs. More than two-thirds of cars produced in Germany are exported. Since the mid-1990s, exports’ share of Germany’s GDP doubled, reaching 43% of GDP, four times the share in the U.S. and twice as high as China.

Now that the heart of the German economy—its sprawling automotive sector—is struggling, the pain is spreading. In Schweinfurt, a former American garrison town north of Ingolstadt, workers at auto supplier Schaeffler went on strike late last year to protest plans to cut up to 700 jobs. ZF Friedrichshafen, another supplier, agreed in November to reduce local employees’ working hours by 7% to save jobs, as it starts to cut 14,000 jobs across the country. The IG Metall trade union has warned of thousands of possible job cuts in the central German industrial region.

To try to cover the shortfall in Ingolstadt, Scharpf, the mayor, has jacked up fees for museums, parking spaces and buses, and ordered that public lawns be mowed less frequently. He is considering raising property taxes and cutting spending further.

“You can’t simply replace a company with 40,000 employees," Scharpf said.

Audi declined to comment.

The company is everywhere in the city: It sponsors the local ice hockey team, football arena and plenty of cultural events.

At the boutique Block Hotel, a couple of miles from Audi’s headquarters, owner Carolin Block said revenues have declined by about 10% since 2019 as conventions dried up and business guests stayed away. Room rates are down about 15%, and the length of stays has shortened.

“We were spoiled over many years. We didn’t have to do much to attract tourists because business guests had to come to Ingolstadt because of Audi," said Block.

Jürgen Seissler, a master carpenter with 16 employees, said order books are shrinking and inexperienced carpenters are finding it harder to find work. Many of his clients are engineers at Audi or its suppliers. Businesses are becoming more cautious about hiring new employees and investing, he said. Seissler himself is rethinking plans to renovate his own house.

In the medieval city center, restaurateurs complain of being squeezed after Audi canceled Christmas dinners. Local businesses, including Block, stepped in to finance a free ice rink overlooking the New Castle after Audi pulled out. City authorities are considering whether to cancel next summer’s Bürgerfest, a two-day street festival in the old town with music, food and drink, that costs about €350,000.

Audi boom

No other city in Bavaria grew as quickly as Ingolstadt in past decades, fed by the auto industry. Its population has increased by about 50% since the mid-1980s. It built a regional court, a police headquarters, a conference center and a large university.

Today, nearly half of the jobs in Ingolstadt are in the auto industry. Many of the rest provide services to those auto workers. Fewer than 2% of Ingolstadt’s employees work in IT.

“Ten years ago, it was said that Ingolstadt had to reduce its dependence on Audi," said Stefan König, a former newspaper editor who is running for mayor in local elections next month. Little has happened since then, König said.

Block’s family fortunes mirrored those of Audi. Her grandparents fled Soviet occupation in the Sudetenland after World War II with few possessions. They settled in Ingolstadt and soon started to cater to local auto workers, who had arrived from Saxony after Soviet authorities expropriated the Auto Union factory there.

In the early 1960s, Block’s grandfather built a hotel 2 miles from the Audi factory, close to the autobahn. The Audi boom took off in earnest in the 1980s with the introduction of the Quattro, a popular sports coupe. The company adopted the slogan Vorsprung durch Technik—Leadership Through Technology.

With Ingolstadt’s fortunes soaring, Block decided eight years ago to build a new hotel, its spiral structure inspired by Manhattan’s Guggenheim museum. She increased the number of rooms from 38 to 50. She now blames city authorities for focusing too much on auto exports at the expense of other business sectors. “There are signs of a Detroit effect. We fixated only on this one area," she said.

In the early 2000s, amid the economic upheaval after the unification of East and West Germany and the end of the Cold War, politicians revitalized the export model by cutting taxes and loosening wage policies, amid other reforms, which made German companies more competitive on manufacturing costs. The country became the largest exporter of goods in the world from 2003 to 2008, ahead of the U.S. and China.

Since then, successive crises have thrown sand into the gears of Germany’s export machine. A political backlash against globalization brought a protectionist President Trump into power in 2016 for his first term. The pandemic disrupted supply chains. Russia’s war on Ukraine, China’s saber-rattling in the South China Sea and Hamas’s attack on Israel all weighed on international trade.

Inside China, a critical German export market, growth has slowed. And Chinese companies gorged with state subsidies have been producing more than China can absorb, stoking exports that in turn pressure German firms, including carmakers.

Energy costs are another problem. The end of natural gas deliveries from Russia because of the Ukraine war, the shuttering of Germany’s last nuclear plants and a costly transition to renewable energy have made costs in Germany spike to 10 times the costs in Texas, said Peter Huntsman, chairman and CEO of Huntsman Corp., a Texas-based chemicals manufacturer with $6 billion in revenue that supplies auto manufacturers in Germany, including Audi.

In Ingolstadt, energy-hungry manufacturers are suffering badly. MT Technologies, a local auto supplier founded in 1869, filed for insolvency in November.

Franz Schabmüller, CEO of Framos Holding, another auto supplier with around 1,200 employees, said he had become used to annual revenue growth of 10%-15% in the 2010s. Recently, growth has flattened, and it could stall this year as the automakers he supplies, including Audi, Volkswagen and Daimler, sell fewer cars.

The second Trump administration, he said, was adding to uncertainties by threatening German auto manufacturers with tariffs. “The visibility is lower than ever," Schabmüller said.

Lagging investment

Executives say Germany is missing out on the investments that could lay the foundations for new industries. Over a third of industrial companies in Germany are cutting investments in core processes due to high energy costs, according to Allianz. Two-thirds report that their competitiveness is at risk.

The country lags behind in sectors such as software and AI. Investment in research and development stood at 3.1% of GDP in 2022, compared with 3.6% in the U.S. and 5.2% in South Korea, according to Allianz.

Decades of government underinvestment have left Germany with a depleted transportation infrastructure, including trains that no longer run on time and a military that is a shadow of what it was during the Cold War. In May, the business-affiliated IW economic institute and the trade union-owned IMK think tank estimated Germany would need €600 billion in spending over the next 10 years to offset its investment gap, modernize the country’s education system, fix its transport networks, upgrade its power grid and digitize its public administration.

Germany also needs tens of billions of euros every year just to maintain defense spending at 2% of GDP or more—one of its obligations as a member of NATO. Trump has demanded that the country raise defense spending to 5% of GDP.

German consumers, meanwhile, are among the most highly taxed in the world. Last year, a German employee with no children was paying 47.9% of gross pay in taxes and social security contributions on average. Germans are also saving 20% of their income as of the second quarter of 2024, more than the eurozone average and a near two-percentage-point rise since just before the pandemic.

“This is a problem because every one-point increase in the saving rate takes €25 billion in demand out of the economy," said Rolf Bürkl, head of consumer climate at the Nuremberg Institute for Market Decisions, which compiles Germany’s main consumer confidence index. A big chunk of these savings is languishing in bank accounts and, given the right incentives, could be tapped to fund productive investments.

Another hurdle, constitutional restrictions on government spending and public debt would have to be overcome in parliament.

The current electoral campaign has mostly ignored these ideas. Unpopular measures, such as welfare-state cuts that might be needed to free up funds needed for urgent investments, also are hardly being discussed.

Instead, most politicians are defending the status quo. “I think the top priority for Germany and for Europe is to try and keep trade channels open as much as possible," said Yannick Bury, an economist and a lawmaker for Merz’s center-right CDU party. “We will lose market share in China but the market is still growing so I wouldn’t write it off," he said, adding that strong growth in the U.S. might offset Trump’s tariffs.

Even the upstart antiestablishment parties that have thrived on challenging old consensus positions are sticking to traditional economic policies.

“If you ask about plan B, my opinion is that we should go back to plan A," said Leif-Erik Holm, a lawmaker and economy expert for the right-wing AfD, which is expected to emerge as the second-biggest party in the next German parliament.

“Our business model worked very well, when we had lower energy costs," Holm said. The next government should focus on lowering these and cut environmental regulations for business, he said.

In Ingolstadt, Scharpf, the mayor, opened a 150-acre technology park south of town on the site of a former refinery in late 2023, hoping to seed a Bavarian Silicon Valley. The park’s only significant tenants so far: Audi and Cariad, Volkswagen’s struggling software arm.

The city council said in December it would no longer try to promote startups at a business center it owns but instead concentrate on renting out the space. It blamed the city’s strained finances for the decision.

City officials are in talks with a Chinese engineering company to build its German headquarters in Ingolstadt, and are seeking to attract more Chinese businesses, said Scharpf. In Schweinfurt, the city to the north, local officials are working to lure XPeng, a Chinese EV manufacturer, to build a factory on the site of a former U.S. Army barracks.

“I don’t think it’s possible to replace the auto industry…It will remain the biggest economic sector here," said Christian Lösel, a former Ingolstadt mayor.

Write to Tom Fairless at tom.fairless@wsj.com and Bertrand Benoit at bertrand.benoit@wsj.com