Germany's economy is facing a period of extreme testing

The coronavirus pandemic has taken its toll, and now the effects of the war in Ukraine are pushing the economy to the brink of collapse. Inflation, rising energy prices and supply bottlenecks have combined to create a perfect economic storm.

GDP is the value of all services and goods produced in a given period. If GDP shrinks for two consecutive quarters, this is called a "technical recession," which is already looming after a 0.3% contraction in the last quarter of last year due to the coronavirus pandemic at the end of 2021.

In the first three months of 2022, economic output grew by 0.2%. However, the situation now looks very different. In both the last quarter of 2022 and the first quarter of 2023, the German economy contracted.

If the recession continues for some time, it could evolve into a tangible economic crisis. Rising unemployment and bankruptcies, goods piling up in warehouses, financial crises, stock market crashes and bank failures round out the nightmare scenario.

Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics, said, "The German economy is still deep in the mud at the beginning of 2023, barely avoiding recession."

German economic forecast

"We are working our way out of this crisis," Economy Minister Robert Habeck said at an event in Berlin.

Industrial production and construction have rebounded, while the decline in private consumption is expected to be contained. Nevertheless, investment volumes and private consumption are still below pre-pandemic levels.

Adjustments in the supply chain for energy and other intermediate goods and a full order book should set the stage for a return to growth in equipment investment in 2023. This is further supported by cost pressures.

Producer and energy prices, by historical standards, are expected to spur investment in equipment aimed at improving energy efficiency. Easing supply bottlenecks should help lift production backlogs and support exports. The rebound in the current account surplus is expected to remain subdued as energy-intensive industries shrink in size, the import content of production and domestic demand is expected to increase, and the cost of energy imports will remain higher than outside the EU. Higher construction and borrowing costs are expected to put pressure on the construction sector, but high housing demand and plans to address infrastructure needs should continue to support the sector.

The Bundesbank brings another sense of optimism. In its latest monthly report, it predicted that growth will accelerate in the second quarter and said the outlook is based on improved supply chain issues and the fact that companies are therefore now better able to fill orders that were backlogged during the pandemic beyond.

Economists warn Germany not out of the woods yet

Economists warn that the eurozone's largest economy is not yet out of the risk of recession.

"The recent recovery in industrial production is likely to drive the economy through the second quarter," said Carsten Brzeski, head of global macro at ING. "However, we are concerned that looking ahead to the second half of the year, the German economy will continue to fall into recession."

In the second half of the year, industrial backlogs of orders will decline if no new strong demand emerges, the full impact of the most aggressive monetary policy tightening in decades will be felt, and a slowdown in the U.S. economy will hit German exports, Brzeski said. "Looking beyond the first quarter, the optimism of the beginning of the year seems to have given way to a greater sense of reality."

Falling purchasing power, lower industrial orders, aggressive monetary policy tightening and an expected slowdown in the U.S. economy all point to weaker economic activity.

With Wednesday's decline in the Ifo business climate index, all major leading indicators of manufacturing are now falling, Kraemer said.

A technical recession in the winter half of the year is off the table for now," said Joerg Kraemer, senior economist at Commerzbank. However, we recommend caution for the second half of the year."

Kraemer is concerned about the ECB's sharp interest rate hikes. "In the past, such rate hikes have always been accompanied by a recession in Germany," Kraemer said.

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