What’s the Matter With Germany?

ROME – Italy may be the “sick man of Europe” today, but it is not the only country in need of medicine. On the contrary, even the mighty Germany seems to be coming down with something.

Italy is, to be sure, in dire straits. Over the last two decades, annual GDP growth has averaged just 0.46%, and government debt has risen steadily, totaling more than 130% of GDP today. Unemployment has remained persistently high, investment is plummeting, and the banking sector is deeply troubled.

Equally concerning, the number of women of child-bearing age has fallen by nearly two million since the fall of the Berlin Wall in 1989. And the share of active workers with a university education remains at levels barely comparable with other advanced economies.

Given all of this, it should come as no shock that Italy and crisis-plagued Greece are the eurozone’s weakest performers in terms of per capita GDP growth over the last three years. What is surprising is that Germany is the third-weakest performer. Germany is fiscally sound, with a large accumulation of surplus savings. It is also highly competitive in unit-labor-cost terms, enjoys its highest-ever labor participation rates, and benefits from a steady inflow of skilled labor from other parts of Europe.

But the fact is that Germany’s average annual per capita GDP growth of 0.51% since 2014 puts it far behind other core eurozone countries – namely, Austria, Belgium, Finland, and the Netherlands. Even France, where per capita growth barely exceeds that of Italy, slightly outperforms Germany.

How is it possible that economies as different as Germany and Italy have such similar per capita growth performance? To some extent, the explanation might seem obvious. Germany is much closer to potential growth than Italy and even the United States, which struggled more than Germany to escape the Great Recession. But the more recent recovery in other advanced countries should, if anything, have boosted potential growth in export-driven Germany.

Likewise, migration could affect per capita GDP growth. Germany has received 2.7 million new residents, net of outflows, over the last five years, nearly a million of whom are refugees. The latter provide an obvious Keynesian boost, but don’t add much to potential output.

Yet the migrant flows into Germany are not exactly anomalous. The country had experienced similarly strong net inflows at other times in the last three decades, without such adverse effects on per capita GDP growth. On the contrary, in many cases, migrants into Germany, particularly the young and skilled among them, have contributed to potential output.

The real culprit behind Germany’s low per capita GDP growth must be sought elsewhere. According to the Bank for International Settlements, German banks’ claims on other eurozone countries – including Austria, France, Ireland, Italy, the Netherlands, Portugal, and Spain – have fallen by over $200 billion, in aggregate, since the peak of the debt crisis in mid-2012. Claims on Italy are down to pre-euro levels, and claims on Spain are nearing that benchmark. Germany has even been disinvesting from core eurozone economies.

German banks’ quiet move toward disintegration contrasts sharply with the behavior of banks based in France, Italy, Spain, and the Netherlands, all of which have resumed European financial integration by stabilizing and often increasing their exposure in other countries. These divergent trends, rather than generic capital flight, explain part of the growing imbalances in the Target 2 eurozone payment system.

Why are German banks the only ones backtracking on integration? One possible reason is that domestic financial authorities, skeptical about the euro’s future, have instructed banks to cut their exposure to the rest of the eurozone. Another is that German banks are experiencing a slow-burn malaise that European regulators have yet to recognize fully. Their cost-base is, after all, the highest in the advanced world, yet their profitability is among the lowest, despite their negligible burden of bad loans.

Nonetheless, such skittishness is puzzling. Around half of the German banking system is publicly owned, and thus enjoys an implicit government guarantee. In fact, German banks received €239 billion ($253 billion) in state aid between 2009 and 2015.

In any case, German banks’ withdrawal from Europe cannot possibly be good for confidence, investment, or a dynamic service sector. And, indeed, investment in Germany last year was more than five percentage points below its 1999 levels as a share of GDP, even though gross national savings have climbed to the highest levels since the International Monetary Fund data series began in 1980.

German officials usually explain away this huge drop by citing the parsimony of an aging society. But demographic challenges – which are tomorrow’s constraints on potential output – should inspire reforms in entitlements and education, not suppression of today’s demand. And that is where the real issue lies: no EU country, with the possible exception of France, has implemented so few reforms over the last decade as Germany.

That lack of reform is starting to show. Wary banks and low investment must have played a role since 2012 in what looks like Germany’s slowest stretch of growth in total factor productivity in three decades. Relying largely on exports – that is, other countries’ demand – may have distracted the German government from some of its own domestic responsibilities. But it is in the interest of all of Europe – and Italy, in particular – that the continent’s largest economy become even stronger.

To be sure, the productivity slowdown is far from unique to Germany. But unless Germany addresses the roots of that slowdown at home, it risks taking a huge hit, in the event that its currency is sharply revalued, in the form of lower exports and damage to its already-weak banking sector, resulting from deflation and negative long-term interest rates.

Italy’s illness is far more acute than Germany’s, but both are potentially serious. Both are in need of immediate treatment.

Federico Fubini is a financial columnist and the author of Noi siamo la rivoluzione (We are the revolution).