According to Financial Times News, Germany’s economy has continued to stagnate since the COVID-19 pandemic despite Chancellor Friedrich Merz taking office earlier this year with growth revitalization as a key objective. A July Bundesbank report identified that the bottleneck in Germany’s industrial sector lies firmly on the supply side, with issues including high taxes, burdensome regulations, high energy prices, labor costs, and intense Chinese competition weighing heavily on the Mittelstand. Merz’s policies have instead emphasized fiscally expansionary measures including removing the debt brake on defense spending and creating special infrastructure funds, while doing little to address the core supply-side constraints. This approach risks creating a structural imbalance similar to the post-pandemic inflation surge by stimulating demand while supply remains constrained. This fundamental policy mismatch represents a critical test for Europe’s largest economy.
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Germany’s Industrial Model Under Stress
What makes Germany’s current predicament particularly concerning is how it strikes at the heart of the country’s economic identity. The German manufacturing sector, particularly the Mittelstand of small and medium-sized enterprises, has long been the engine of European industrial competitiveness. These companies thrived on a formula of specialized engineering excellence, reliable supply chains, and access to affordable energy. The convergence of multiple supply-side pressures—from the energy transition’s costs to global competition—represents an existential challenge to this model. Unlike cyclical downturns, these structural issues cannot be solved through traditional demand-side stimulus alone.
The Dangerous Timing of Expansionary Policies
The timing of Merz’s expansionary measures creates a particularly risky scenario. When an economy faces supply constraints, injecting additional demand through fiscal stimulus typically leads to price increases rather than increased output. We saw this dynamic play out globally following the COVID-19 pandemic, when supply chain disruptions combined with massive stimulus packages created the worst inflationary surge in decades. Germany now risks repeating this mistake at a moment when its industrial base is already struggling with competitiveness. The defense spending increases, while geopolitically necessary given regional security concerns, function as particularly inefficient economic stimulus in this context.
What Real Supply-Side Reform Would Require
True supply-side economics reform for Germany would need to address several politically challenging areas simultaneously. Energy policy represents the most immediate pressure point—Germany’s transition away from Russian gas and nuclear power has created some of the highest industrial energy costs in Europe. Regulatory reform would need to tackle Germany’s famous bureaucracy, which while ensuring quality standards also creates significant barriers to innovation and scaling. Tax reform would need to address both corporate rates and the complex system that burdens small businesses. Most controversially, trade policy would need to balance legitimate concerns about Chinese dumping with maintaining access to global markets.
The Political Economy of Reform
The challenge for Chancellor Merz reflects a broader tension in democratic governance. Supply-side reforms typically involve short-term pain for long-term gain—reducing regulations or changing tax structures creates uncertainty and political opposition. Demand-side stimulus, by contrast, provides immediate economic activity and visible government action. This dynamic explains why politicians across the political spectrum often default to stimulus measures even when structural reforms are needed. The test for Merz’s government will be whether it can withstand the political pressure to pursue quick fixes and instead implement the more difficult but necessary supply-side adjustments.
Broader Implications for the European Economy
Germany’s policy direction carries significance far beyond its borders. As Europe’s largest economy and manufacturing hub, Germany’s economic health directly impacts the entire Eurozone. A German economy struggling with structural imbalances would weaken the euro, reduce demand for exports from neighboring countries, and potentially trigger another European sovereign debt crisis if German growth falters significantly. The European Central Bank would face an impossible trilemma—managing inflation from German stimulus while supporting growth across a struggling continent. Germany’s choices in the coming months will therefore determine not just its own economic future but that of the European project itself.
