Germany Is Having a Very Weird Recession. It Could Happen Here.
A worker on a production line in Bad Laer, Germany. The country has low unemployment and recession.
Ben Kilb/Bloomberg
Germany is a long way from the U.S., with a different geopolitics and economy. But Germany’s recent economic plight might offer some clues to what may lie ahead for the U.S.
Germany, Europe’s economic powerhouse, went into recession after its gross domestic product fell over the past two quarters. Much of the blame for the recession has been laid on weakness in Germany’s key manufacturing sector, which has been crippled by energy costs from the Ukraine war and the withdrawal of government spending after the Covid pandemic. Germany’s downturn has dragged down the entire 20-nation euro area, pulling it into recession as well.
It’s an atypical recession. The reason: German unemployment has remained near historically low levels. In April, Germany’s jobless rate was running just below 3%, even lower than the U.S. level of 3.4%.
The anomaly of a recession with low unemployment has implications for everyone from investors to workers to central bankers. On the one hand, it may mean that interest rates have to go higher than previously thought to bring down inflation. On the other hand, the downturn caused by higher rates could turn out to be less painful than past experience would imply—that is, the rebound can start off on a strong foot.
European Central Bank President Christine Lagarde described the labor market as an “enigma” on June 15, as she raised interest rates again and promised more hikes to come. She noted that labor and wage growth are “major drivers” of inflation, implying that rates may have to stay higher for longer to control cost pressures.
Like Germany, the U.S. labor market has remained strong despite the Federal Reserve’s interest-rate increases. The U.S. economy cooled in June, according to the S&P Global purchasing managers index released on Friday, with both services and manufacturing falling. Still, services continue to expand while manufacturing is shrinking, the report showed.
Even if the U.S. follows Germany into recession, unemployment might remain relatively low, making the downturn shallower than it might otherwise have been—but also requiring higher rates to corral inflation.
A stubbornly low jobless rate is a problem for central bankers on both sides of the Atlantic. They aren’t eager to admit it, but one of the main ways higher interest rates quell inflation is by prodding companies to cut costs. As companies downsize and let staff go, it’s harder for workers to bid up pay. Muted wage growth, in turn, makes it harder for companies to raise prices, slowing inflation.
On the flip side, if unemployment doesn’t rise, workers have more leverage to seek higher pay, particularly if inflation has been strong. That reinforces inflationary tendencies.
Unemployment is also a lagging indicator. Joblessness usually rises after economic growth cools, and increases the longer recessions go on.
What’s behind this low unemployment? “The labor market is still in good shape. It’s not a typical recession,” says Stefan Schneider, Deutsche Bank ’s chief Germany economist in Frankfurt. It’s possible that companies are “worried that if they let people go, they won’t be able to hire them again later.”
Schneider believes the lack of layoffs has a lot to do with skills shortages and demographics of an aging workforce. Companies are reluctant to cut staff, especially when vacancy rates remain high. With baby boomers hitting retirement age, workers that companies let go may choose to retire rather than remain in the workforce.
It’s another indication of how aging populations are becoming an inflationary force, adding to powerful pressures pushing up consumer prices that have surprised policy makers over the past few years. Forecasts from both the Fed and the European Central Bank have underestimated inflation, even before the surge in energy costs following Russia’s invasion of Ukraine in February 2022.
Deepening the problem is that Germany is still seeing its services sector bounce back after Covid shut things down. That’s a problem, since services create jobs in parts of the economy that haven’t been hit as badly as manufacturing in the economic downturn.
Indeed, inflation in services is one of the main reasons the ECB will probably continue raising interest rates even though economic growth has ground to a halt. Core inflation, which excludes volatile components such as food and energy, has also remained surprisingly strong.
Again, the similarity with the U.S. situation is stark. The Fed, which began its tightening campaign last year, has raised rates further and faster than the ECB. The Fed is undoubtedly hoping it can thread the needle by cutting the number of jobs available—listed as vacancies in unemployment statistics—to keep a lid on wages without actually driving up the jobless rate enough to trigger a recession.
So far, the U.S. labor market remains resilient. The latest U.S. Job Openings and Labor Turnover Survey showed 1.8 job openings for every unemployed person. Traditionally, economists reckon that ratio needs to be lower, say 1 to 1.2, to be consistent with a labor market that isn’t adding to inflation pressures.
“It’s very possible for the Fed to slow the economy and bring down the vacancy rate materially without necessarily inducing a hard landing,” says Nomura economist Andrzej Szczepaniak. “The unemployment rate could stay much more subdued and not rise as you would expect under normal tightening cycles.”
Meanwhile, Germany’s outlook still doesn’t look great. Deutsche Bank predicts modest expansion in the second, third, and fourth quarters. But if the contraction is as bad as it gets, Germany, and by extension the euro area, can count itself lucky. “We’re looking at quite a bleak, muted outlook for growth,” says Szczepaniak. “But the worst is behind us in some sense.”