Well, that's a long-standing law, so it doesn't support a "collaps[e] into a dictatorship", but I agree that such a law isn't generally compatible with freedom of speech. Freedom of speech most certainly does include the freedom to be an arse, Anttech.
This is a similar issue to the one on Holocaust denial being a crime, so I won't go into it much, but IMO, I'd let the Germans (and near-by Europeans) slide on free speech when it comes to skeletons from their closet. Perhaps in 75 years when all Holocaust victims and perpetrators and their children are dead, they will reevaluate such laws. Such pendulum-swings in laws as reactions to skeletons-from-the-closet can temporarily help calm things down.