Cars are parked in a Volkswagen dealer in Milan, Italy, Sunday, Sept. 27, 2015. German media report that Volkswagen received warnings years ago about the use of illegal tricks to defeat emissions tests. The automaker admitted last week that it used special software to fool U.S. emissions tests for its diesel vehicles. (AP Photo/Luca Bruno)

Most scandals blow over. Some blow up. Volks­wagen will be of the latter kind. The penalties and damages resulting from VW’s manipulation of emissions tests could easily add up to more than €100bn. The total economic costs would be a multiple of that, more than what Germany would ever have faced from a Greek exit from the eurozone.

More importantly, the Volks­wagen scandal has the potential to unhinge the German economic model. It has been over-reliant on the car industry, just as the car industry has been over-reliant on diesel technology.

For its part, Berlin mollycoddles the industry and represents its interests abroad. The “VW law” in effect protects the company against a hostile takeover. And it was a former VW director, Peter Hartz, who wrote the labour reforms of the previous decade.

In return, the industry contributes to the stability of regional employment. And the voting rules in the supervisory board ensure that production could be shifted out of Germany only with the explicit consent of the trade unions. In other words, it cannot.

In terms of macroeconomic risk management, this is a silly strategy — similar to the UK’s over-reliance on the financial sector. Such strategies work well until they do not work at all.

To gauge the wider economic impact, one needs a sense of the size of the industry. It is much larger than official statistics suggest because they do not account for the interdependencies across industries. The car industry is by far the largest single buyer of goods and services from other sectors. According to a study published in 2008 by the University of Mannheim, the car industry accounted for 7.7 per cent of gross value-added for the whole of Germany in 2004 — the highest percentage of any country in the world. Second was South Korea with 5 per cent. Most other European countries were in the range of 2 to 4 per cent. The car industry, and German manufacturing at large, has since done well. I would not expect the numbers to be very different today.

There are various ways this can unravel. The best outcome for the industry would be a period of gradual adjustment. Life is not usually that kind. A little more likely would be an accelerated adjustment.

VW is missing out on the US boom in car sales. So there is already a loss. When accumulated, the commercial losses could easily outweigh the costs of any legal damages. To keep market share, VW would have to discount. A mix of lower prices and lower volumes augurs a period of falling profits.

A third, more abrupt, scenario would be a fire sale of assets in order to pay damages and fines. This would be difficult as the VW group works like a large, just-in-time network. Seat of Spain and Skoda of the Czech Republic, both VW subsidiaries, use common VW technology. Also, since the German political system invariably convulses at the thought of a foreign takeover, let alone an insolvency, my guess is that VW will be kept alive through some combination of hidden and overt state aid.

This would become progressively more costly over the years, and politically less popular. The motor car is a mature product. Global environmental attitudes are moving against the diesel technology; social attitudes are moving against the car itself.

I see some parallels between the transition from analogue to digital in the late 1970s, when the Germans were still developing and improving on analogue telephone exchanges. They worked. They worked better than the previous generation. They had a fan club of enthusiasts. Only the customers did not want them any more.

Countries that are less reliant for their economic output on individual sectors react more robustly when a shock comes. They can afford a policy of benign neglect towards specific sectors as long as the economy is flexible.

In Germany, however, there is not a lot of cross-sector flexibility. Car engineers will not retrain to work in the biotech industry, or — heaven forbid — in the services sector. Germany’s dependence on a few industries is one of the reasons why outside opinion of Germany has been so volatile.

It was very different 10 years ago. People spoke of Germany as the sick man of Europe. A few years later the same observers held up Germany as the example of a competitive economy. The baton of the sick man now rests somewhere to the west, in France, or the south, in Italy. There is as much volatility in those who do the observing as in the object they observe. But the object is clearly volatile.

This is why the scandal matters. It has the potential to trigger one of those shifts that could change the economic reality. And once Germany slows down, so will a eurozone that is refashioning itself on German terms.

munchau@eurointelligence.com

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