German economy rebounds in 2026 but faces long-term headwinds from debt, demographics, and energy transition

After several difficult years, the German economy has regained its footing. Leading economic research institutes now expect the economy to grow by 1.3% in 2026 and by 1.1% next year. That is significantly more than was forecast back in the spring.

As to the reasons behind this, economists have pointed first and foremost to the global economy. Despite the war in the Persian Gulf, they say, the economy is proving surprisingly robust. "This is benefiting the German export sector, and underlying this is also the global boom in artificial intelligence," said Oliver Holtemöller of the Leibniz Institute for Economic Research in Halle during the presentation of the latest report in Berlin.

Because of the blockade of the Strait of Hormuz has cut off supplies from competitors, German companies have seen increased demand from abroad for petroleum and natural gas-based chemical products, for example.

In addition, the construction of AI data centers is driving demand for German companies. Some examples include machinery for energy production and services related to information and communication. Government spending on infrastructure and defense is also a significant driver of this upswing.

However, researchers believe it will not last. For 2028, the institutes expect growth of only 0.4%. "The drivers of growth will continue to dwindle," said Stefan Kooths of the Kiel-based research institute IfW. High energy prices, a shortage of skilled workers, an aging population and years of low investment by many companies are slowing growth. The institutes therefore warn against misinterpreting the latest positive figures as the beginning of a new economic boom.

Upturn fueled by debt

In this situation, the federal government is also playing a decisive role. The coalition of the conservative Christian Democratic Union (CDU)/Christian Social Union (CSU) and the center-left Social Democratic Party (SPD) has decided to invest heavily in modernizing infrastructure and the Bundeswehr.

In the short term, this additional spending is also helping generate business for companies and safeguard jobs. At the same time, investments in roads, railways, digital networks and military equipment should strengthen Germany's competitiveness.

Economic analysts agree that this spending has had a positive effect on the economy. Especially at a time when consumers are tightening their belts and many companies are postponing investments, the government has been an important engine of growth. But this is also where economists are raising concerns. That's because the spending is financed through debt.

According to forecasts, the government deficit will rise from 4.1% of GDP this year to 4.7% in 2028. At the same time, the government's interest burden will grow. Future budgets will have to allocate an ever-larger share of funds to servicing debt.

"We have two major challenges: one is demographics, and the second is energy security and energy prices," said Holtemöller. In this context, the economist from Halle sharply criticized what they see as a lack of clarity regarding "the measures, reforms and regulatory framework" that Germany aims to use to phase out fossil fuels. They note that a vision for how the energy transition could be carried out in accordance with the Climate Protection Act is "not even vaguely" outlined.

AfD's success is scaring off skilled workers

Germany's greatest challenge remains the declining labor force. As the baby boomers enter retirement, the economy is losing millions of workers. Many industries already complain of labor shortages. There needs to be greater openness "to the immigration of skilled workers," said Holtemöller.

Referring to the electoral successes of the anti-immigration Alternative for Germany (AfD) — a party that is, in part, right-wing extremist — Holtemöller cited studies indicating that "regions where populist parties are in power tend to have weaker economic growth than other regions." Openness, he emphasized, is the most important factor.

If immigration remains low, the average age of the population will only increase. This will drive up the cost of social security contributions, which in Germany are evenly split between employees and employers. On pension reform, economists are calling for doing away with the option to retire early after 45 years of contributions without any reduction in benefits. They argue that the debate about moving away from this policy is misguided.

The economy in transition

While the government is mobilizing billions, the private sector's momentum is lacking in many places. Investors are being deterred "because they don't know what to expect or what the business landscape looks like here," Kooths explained.

"What companies need now are not new debates but decisions on economic policy," demanded Helena Melnikov, chief executive of the German Chamber of Commerce and Industry. "This can only be achieved through a decisive course of reform: cutting costs, reducing bureaucracy, streamlining procedures and modernizing infrastructure."

For many decades, Germany was a country with a strong industrial sector. But that sector continues to shrink. About 15,000 industrial jobs are lost every month. Particularly hard-hit are industries such as automotive, mechanical engineering and metals. At the same time, the past two years have seen the emergence of many startups in the fields of digitalization and AI.

But according to economists, these new companies lack support, particularly when it comes to financing. As a result, many are relocating to the US. "We're very good at things like development, patent applications and so on, but the problem is that the ideas developed here end up creating value elsewhere," noted Timo Wollmershäuser of the ifo Institute in Munich.

When asked what could further improve growth prospects in Germany, the researchers pointed to a catalog of reforms that was presented last spring. The proposals include, among other things, a cap on social security contributions and stronger work incentives for older workers. As for the energy transition, the institutes place greater emphasis on price signals and advocate against taking national action on climate protection without other countries.

Notable criticism was directed at the fuel rebate scheduled to take effect on October 1. Researchers said it amounts to a blanket handout for which there is insufficient fiscal leeway.

The government cannot currently afford such expensive measures, and they are "also economically counterproductive," said Oliver Holtemöller. Cutting fuel taxes would "undermine efforts to reduce demand, which is precisely what is needed when energy supplies are tight."

This article was originally published in German.