Germany's economy is in worse shape than expected. Will the hoped-for recovery fail to materialize?

It's a popular strategy among politicians to announce things but not keep them. Chancellor Friedrich Merz is no exception. During his election campaign, he announced that he would defend the debt brake and quickly return the German economy to growth rates of at least 2 percent. Neither of these efforts has come to fruition. Merz had already undermined the debt brake with a majority in the old Bundestag before he took office. And economic output in Germany is shrinking instead of growing.

The Federal Statistical Office has just reported that real gross domestic product fell more sharply in the second quarter than initially projected. Instead of shrinking by 0.1 percent, it shrank by 0.3 percent compared to the previous quarter. This decline wiped out the 0.3 percent growth from the first quarter – and with it, hopes for a rapid recovery.

Now, politicians and economists are pinning their hopes on the German government's debt package to rehabilitate infrastructure and restore the Bundeswehr's defense capability. But can this achieve sustainably higher growth?

The decisive factor for the slump in economic output in the second quarter was the weakness in the construction and manufacturing sectors. Gross value added in these two sectors shrank by 3.7 and 0.3 percent, respectively, compared to the previous quarter. Value added also declined by 0.6 percent in the trade, transport, and hospitality sectors.

Companies held back on investments in light of weak domestic demand, high costs, and uncertain geopolitical developments. Spending on new machinery and equipment fell by 1.9 percent, continuing its downward trend. Private households also held on to their spending in light of rising unemployment, despite recent strong wage increases. Consumer spending increased by a barely noticeable 0.1 percent.

Foreign trade, which had boosted the German economy in the first three months, slowed the economy in the second quarter. Many American customers of German companies had ordered more goods from Germany at the beginning of the year to anticipate the tariff increase announced by US President Donald Trump. This boosted exports. However, after the tariff increase, demand from the US declined, and German exports declined by 0.1 percent.

However, analysts at financial institutions have not yet given up hope for a revival of the German economy. They are counting on the effects of lower interest rates and higher government spending.

In Europe, the European Central Bank (ECB) has halved its key interest rate by 200 basis points since the middle of last year, to 2.0 percent. Because it takes time for the lower borrowing costs to fully filter through to companies and households, prompting them to invest and consume more, analysts believe the monetary policy stimulus will only really give the economy a boost in the coming quarters. If the economy in the euro zone picks up, companies and households there will again buy more products made in Germany.

On Friday, Federal Reserve Chairman Jerome Powell also opened the door to interest rate cuts in the United States in a speech at the Jackson Hole Central Bankers' Meeting. A fall in interest rates there is likely to bring additional orders to German exporters due to the economic stimulus.

However, this is offset by the fact that American tariffs on imports from Europe are rising to 15 percent. At the same time, there is a risk that the dollar will continue to lose value in the wake of falling key interest rates in the US, making German products more expensive from the American perspective.

It is therefore all the more important for the economy that the credit-financed infrastructure package announced by the federal government and the defense spending fill companies' order books as quickly as possible. The additional demand from the government could boost economic growth by 0.3 percent per year in the coming years, says Holger Schmieding, Chief Economist at Berenberg Bank.

Commerzbank economists have calculated that the additional government demand, combined with the ECB's lower interest rates, will stimulate the economy more than the American tariffs slow it. While the tariffs could push price-adjusted German exports down by 20 to 25 percent over the next two years, reducing real gross domestic product by up to 0.4 percent, the Commerzbank economists write in a study, this is offset by the fact that the government's demand, financed by additional loans, will give GDP a growth boost of around 3 percent this year and next.

Even taking into account that part of government demand will fizzle out in rising prices due to companies' short-term capacity constraints, there will be a positive net effect on the economy, says Commerzbank economist Ralph Solveen. He expects a net boost for the German economy of at least half a percent next year. He forecasts that real GDP will grow by 1.4 percent in 2026. After an expected mini-growth of 0.2 percent this year and the setbacks in 2023 (minus 0.9 percent) and 2024 (minus 0.5 percent), 2026 would thus be the first year in which the German economy would experience noticeable growth again.

The question remains whether the growth is sustainable . Solveen fears that it could remain a credit-financed flash in the pan, "from which only one thing will remain in the end: massively higher debt." Because there is no evidence that the federal government's additional spending will noticeably improve the medium- to long-term growth prospects of the German economy.

While higher defense spending boosts production in defense industries, the economy's capital stock does not grow through additional tanks, rifles, and combat aircraft. "Defense spending is an insurance premium," says Stefan Kooths, head of economics at the Kiel Institute for the World Economy. It provides protection against foreign aggressors, but does not increase the economy's production potential.

The situation is similar with infrastructure spending. The repair and maintenance of roads, bridges, and the rail network maintains the capital stock but does not expand it.

In order to put the economy on a sustainably steeper growth path, the federal government would have to change the framework conditions so that hard-working workers, companies willing to invest, and brilliant innovators feel at home in Germany again.

"Germany urgently needs structural reforms to increase its long-term growth potential," says Schmieding. Otherwise, he fears, rising social security spending will drive up non-wage labor costs and further reduce work incentives.

Chancellor Merz seems to share a similar view. On Saturday, at a party conference of the CDU in Lower Saxony, he announced that he would soon hold a tough reform debate with his coalition partner, the SPD. Germany needs a realignment of social policy. "The welfare state as we have it today is no longer financially viable with what we are achieving economically," Merz said.

It remains to be seen whether he will follow up on his announcement this time.