On March 4th, CDU/CSU and SPD, the two parties that are planning to form Germany’s next government, agreed to overhaul borrowing rules and create a 500€ billion infrastructure fund to revamp the military and boost the economy.1
To highlight the sense of urgency and determination, Friedrich Merz, the leader of the CDU and likely next chancellor, said they are prepared to do “whatever it takes,” following a similar line that former ECB President Mario Draghi used in July 2012 when he said that “the ECB is ready to do whatever it takes to preserve the euro.”2
We leave it open whether the German government has the same resources as the ECB to do “whatever it takes,” but there is no question to us that this plan is a two-dimensional paradigm shift: first, Germany and its European allies taking defense matters into their own hands independent of the United States and, second, a radical overhaul of the constitutional borrowing rules to boost military and infrastructure spending.
Whether the plan will pass parliament and become a real game-changer is less clear. In our view, money alone is not the solution for Germany’s and Europe’s problems. Broader reforms are needed to avoid that the outcome will only boost public debt and inflation.
The plan by CDU/CSU and SPD aims to boost both defense and infrastructure spending. For defense, spending in excess of 1% of GDP is to be exempted from the constitutional debt brake.3 That would allow theoretically unlimited defense spending without having to cut outlays elsewhere or hike taxes.
For infrastructure, a special off-budget fund that bypasses the debt brake is to be set up to spend 500€ billion over ten years on transportation, energy, digital and environmental infrastructure as well as on education and research.4 Twenty percent of the infrastructure fund is to be directly allocated to the 16 Federal States.5
Finally, the States, which are required by law to balance their budget, are to be allowed to run a fiscal deficit of 0.35% of GDP.6
These proposals require changes to the basic law, which have to be approved in both houses of parliament (Bundestag and Bundesrat) with two-thirds majorities.7
CDU/CSU and SPD plan to push the constitutional changes through the outgoing Bundestag before the end of March, as it is unlikely that they will get a two-third majority in the incoming Bundestag. That requires support from the Green party, which demands amendments.
If the Greens can be brought on board, which currently appears difficult, we think the chances are good that the constitutional changes will pass in the Bundesrat (assembly of the States) as well. The States controlled by CDU/CSU, SPD and Greens have a two-thirds majority and the changes give the States more fiscal resources and flexibility.
Germany is not the only country in Europe that has recognized the need to boost defense spending. EU leaders have agreed on an 800€ billion defense package that allows member states to either borrow directly for defense spending or provide member states with special loans for defense programs.8
In our view, providing the funding is a necessary, but not sufficient, condition to build an independent and forceful European defense system. Much will depend on how European countries cooperate, including the UK, especially in areas like nuclear deterrence, air defense and intelligence and build up an efficient defense industry. Furthermore, it will be critical to work closely with the US for some time until Europe has built sufficient military capabilities.
In the case of Germany, we think it will take at least five years to push defense spending from currently around 2% of GDP to 3.5% of GDP9 due to practical constraints, and it will probably take a few more years at that level, before Germany is in a position to play a critical role in the European defense system.
If the constitutional changes are passed, we expect that the funding mix for defense will already shift in 2025, but the total is unlikely to make a huge jump. Under the old fiscal plan, 53€ billion were meant to come from the budget and an additional 22€ from a 100€ billion special fund that was set up in 2022.10
Under the new plan, on-budget defense spending would decline to 44€ billion plus the 22€ billion from the special fund and another 21€ billion from off-budget borrowing.11 Chart 1 shows the compositional change of defense funding until 2028. By 2028, when the 100€ billion special fund is expected to run out, 63% of defense spending would be funded off budget and total spending would exceed the prior plan by 60%.
Source: Deutscher Bundestag und ZAIS estimates12
Part of the reason why Germany will need time to build up its military capabilities is the relatively small size of its own defense industry (see Table 1). That implies that Germany will have to import a fair amount of new defense equipment and that the economic multiplier effect of defense spending will initially be moderate.
*France and Netherlands
Source: Defense News13
Easing the debt brake is a clever way to fund the defense buildup but it is not sustainable if the economy stagnates and the debt burden becomes unsupportable. Unfortunately, Germany’s economy is in trouble. The economy was already slowing before COVID and has gone nowhere since then, falling way behind the US and most other European countries (see Chart 2).
Source: EUROSTAT, US Bureau of Economic Analysis14
The aim of the 500€ billion infrastructure fund is to fix and modernize the infrastructure itself and stimulate the economy through additional spending. Germany had already lifted government investment by nearly 1% of GDP from the lows in the mid-2000s, but that was not enough to maintain and modernize the infrastructure (see Chart 3).
Source: Bundesbank and ZAIS estimates15
We do not expect that the entire 500€ billion will be spent on physical infrastructure and we think the spending will not be equally spread over the next 10 years. Still, we believe the total spending size and pattern will be similar to what we saw in the early 1990s during German unification (see Chart 2 again).
Infrastructure spending that parallels the boom during German unification could be a game changer, but implementation success and economic multiplier effects will depend on far-reaching reforms.
Table 2 shows the changes in German real GDP by its main expenditure components and economic sectors over the last five years.
Source: Bundesbank16
On the expenditure side, private consumption is depressed, investment and exports are contracting and only government consumption contributes to growth. The manufacturing sector, the hallmark of the German economy,17 is contracting, and so is construction. The only private-sector bright spot is information and communication services, but that is not sufficient to revive the overall economy.
In our view, the problems of Germany’s manufacturing and export-based growth model and its failure to strengthen the transition into new growth sectors are based on several factors:
It would be wrong to blame the government for all these problems, and new challenges like tariffs could make matters worse, but we believe that success of the infrastructure program will depend critically on labor market and social security reforms, the reduction of bureaucratic obstacles and a restructuring of the energy system to reduce inefficiencies that raise energy costs.
The next weeks will show whether CDU/CSU and SPD, who are currently negotiating the policy agenda for the new government, will recognize the need for broader change and not just rely on wasteful deficit spending.
If they succeed, we expect not only that businesses will invest again but that consumer sentiment will recover from its five-year depression and boost private consumption (see Chart 4).
Source: GfK18
Whether the next government is able to engineer broad economic change will also determine the fiscal implications of the proposed policy changes.
Despite all the talk of restrictive borrowing rules, Germany’s general government, which includes the federal, state and local governments and social security and other government institutions, currently already runs a deficit of 2.8% of GDP, which is just shy of the EU 3% of GDP deficit limit (see Chart 5).
We estimate that the already sizeable deficit reflects several factors: a large cyclical component of over 1% of GDP and deficits attributable to special funds (defense and climate change) as well as deficits outside the core government institutions.19
Under current borrowing rules, the deficit is projected to shrink gradually towards zero over the next 10 years (see Chart 5 again).
Source: Bundesbank and ZAIS estimates20
Under changed borrowing rules, we expect the fiscal deficit to rise over the next five years to around 5% of GDP. We think the deficit will decline subsequently but may not fall back inside the 3% of GDP EU deficit limit. If the new government succeeds with reforms and lifts growth sustainably, we think the deficit will widen less and subsequently decline to a permanent range between 1% and 2% of GDP.
The risk is that the economy remains stagnant, which would mean that the fiscal deterioration is worse and unlikely to recover at all with all the extra government spending only boosting inflation.
Correspondingly, we expect general government debt to rise if the borrowing rules are changed. If the new government succeeds in improving broad growth conditions, however, we anticipate that the debt-GDP ratio will initially rise from currently 63% of GDP to around 73% but subsequently will start to gradually decline (see Chart 6). Here again, the risk is that growth conditions remain unfavorable. In that scenario, we expect the debt-GDP ratio to rise to 80% within five years and remain on an upward trajectory afterward.
Source: Bundesbank and ZAIS estimates21
Financial markets’ first reaction to the announcement was positive. The DAX rose 5% in the 48 hours after the news22 and the EUR gained 2.5% versus the USD.23 However, 10-year German Bund yields jumped from 2.50% to 2.88% within the first 48 hours after the news.24
Market reaction is likely to change, taking in more news from the coalition talks between CDU/CSU and SPD as well as discussions with the Greens to secure the two-thirds majority needed to change the basic law. Furthermore, markets will respond to other developments, such as global growth, monetary and financial market developments and the possibility of new tariffs or a cease-fire in Ukraine.
It is interesting to compare this impact to the market reaction during German reunification. Back then, 10-year Bund yields rose by more than 200 bps and the DM rallied 24% versus the USD.25 In our view, a market reaction of this magnitude is unlikely.
First, the geopolitical background was very different then. The fall of the Berlin Wall marked the end of the Cold War. Now, Germany and its European neighbors find themselves beleaguered again. Second, reunification triggered a massive spending boom in Germany, which fueled inflation, forced the Bundesbank to slam the breaks and shifted the current account from a large surplus into a deficit.26 Third, the fiscal deficit back then was larger (see Chart 5 again).
We think the proposed policy changes will increase inflationary pressures, restrain the ECB and reduce Germany’s still massive current account surplus,27 but the magnitudes are likely to be more moderate and will depend on how well the new government implements its broader reform agenda.
If the overall outcome is favorable, we think the equilibrium for 10-year Bund yields is around 3% (see Chart 7). In a less favorable scenario, we think 10-year Bund yields could rise to 4%.
For the EUR, much probably depends on the success of the policy changes, both in terms of the economy as well as the buildup of credible defense capabilities in Europe. In a positive scenario, we think a return of EURUSD to 1.20 is quite possible.
Source:Bundesbank and ZAIS scenario estimates28
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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