Germany’s fiscal bazooka

Following on from last month’s German elections, Germany’s soon to be chancellor Friedrich Merz is attempting to implement the country’s most significant fiscal reform since reunification – before he even takes office.

Due to the difficulty the soon to be formed government faces in passing the required two-thirds parliamentary majority, Merz, leader of the recently elected CDU/CSU, is working with Germany’s other major political party, the SPD, to fast-track a major fiscal package. This will aim to utilise the outgoing parliament, which remains in power until the week of March 24, to form a two-thirds majority to accept a fiscal package thereby bypassing Germany’s “debt brake” (a constitutional rule limiting government borrowing to 0.35% of GDP).

Key points of the fiscal package:

• The CDU/CSU and SPD have agreed to a much larger fiscal package than anyone expected, which includes three main components:
  • Defence spending above 1% of GDP will be excluded from the debt brake limit, with no restrictions on the volume or duration of this exemption.
  • A €500 billion special fund for infrastructure spending over the next 10 years.
  • Additional borrowing capacity for German regions under the debt brake.

Potential impact:

If the package is approved by parliament:

• There’s potential for higher economic growth and improved investment sentiment as spending increases. Any shift away from German, or more broadly Europe’s, fiscal austerity measures would be considered a positive for growth and market performance in the short term.
• Spending is expected to begin midway through this year following the budget announcement, with economic benefits expected to start flowing in 2026.
• Global defence companies are a clear winner from an investment standpoint. The infrastructure proposal will also be a positive for German domestic stocks.

Timeline:

• Merz announced “Germany is back” after securing support from the Green Party last week by committing €100 billion of the infrastructure fund to cover climate protection initiatives.
• The deal now just needs to be pushed through the outgoing parliament before the 25^th of March with the following timeline of events:

Source: Goldman Sachs

Implications for the Eurozone:

• While these changes are positive for Germany, pressure will now be put on other Eurozone governments who have limited fiscal capacity to implement large spending plans. Germany has overdelivered in its fiscal prudence, leaving the country in a much stronger position to propose this significant stimulus.
• Other countries in the region have already announced increases in defence spending, like Denmark¹, Belgium², and the UK³, however, this will come at a significant cost, so further fiscal expansion is unlikely. Expected increased defence spending in these countries will likely require higher taxes and/or cuts to welfare.

Context on Germany’s debt brake:

• In response to breaching a 60% debt-to-GDP threshold in 2009, the German government introduced the ‘debt brake’ law to restrict structural budget deficits.
• The law limits government borrowing to no more than 0.35% of GDP, except in ‘extraordinary emergency situations’, with exemptions made from 2020 to 2022 in response to Coronavirus and the war in Ukraine.
• The debt brake is a controversial policy. Many economists argue it restricts Germany’s ability to invest in growth, while others support it for its fiscal prudence and protection of future generations.
• Reforms to the debt brake can only be made with a two-thirds majority in Germany’s federal parliament. However, this has been difficult to achieve due to recent parliamentary makeups and inter-party cooperation.
• Enter Friedrich Merz:
  • Merz campaigned with a willingness to reform the debt brake, but downplayed the idea, stating that “other solutions” would be prioritised, as reforming the debt brake would risk alienating parts of his voter base.
  • Although Merz’s CDU/CSU won the election, they did not secure a majority, forcing them to now try forming a coalition government. The far-right Alternative for Germany (AfD) party gained 21% of the vote, but Merz has ruled out negotiating with them.
• As a result, Merz is negotiating a coalition with Germany’s other major political party, the SPD, to form a functioning government starting March 25. He is also pushing to pass key reforms in agreement with the SPD under the outgoing parliament, as the new parliament’s makeup will make such reforms more difficult.

Sources:

1. https://www.euronews.com/2025/02/19/denmark-to-boost-defence-spending-by-67bn-over-next-two-years ↑

2. https://euro-sd.com/2025/02/major-news/42494/belgian-defence-spending-boost/ ↑

3. https://www.abc.net.au/news/2025-02-26/uk-to-boost-military-spending/104982430 ↑