Mr. Merz’s whatever-it-takes move lifts Germany’s growth outlook, shows strong determination for the European cause and sends a strong signal to the US and Russia.
Fiscal “bazooka”
Relaxing Germany’s debt brake to enable higher defence spending and creating a shadow budget of EUR 500bn for infrastructure are game-changers, both politically and economically.
European cause
Mr. Merz’s announcement recalls former ECB President Mario Draghi’s pledge in 2012 to save the euro.
Growth impact
Our conservative estimate suggests that German GDP could be lifted by at least 0.5-0.7% but only gradually from 2026 on.
To say that these are unusual times in Germany would be a gross understatement, especially after yesterday evening’s announcement by CDU leader Friedrich Merz, who is widely expected to be Germany’s next chancellor. His intention to create a huge shadow budget for infrastructure and to relax the country’s debt brake for defence spending marks an unprecedented fiscal turning point (Zeitenwende). After all, these announcements come less than ten days after the general election on 23 February, and after policymakers from the CDU/CSU and the SPD only met for a third time for so-called “exploratory” talks. Needless to say, while many other policy topics still have to be discussed in the next few weeks, a new grand coalition has effectively been formed. In the following, we provide some orientation and our thoughts on this political process and its likely macroeconomic impact.
Yesterday evening, Mr. Merz vowed to do whatever it takes when it comes to defence “in the light of threats to our freedom and peace on our continent.” His remarks were a barely disguised reference to the latest signals and actions of US President Donald Trump and his administration, including the stopping of military aide to Ukraine.
More concretely, Mr. Merz announced that he will relax Germany’s debt brake to allow for higher defence spending. Accordingly, (specific) military expenditures exceeding 1% of GDP (which would amount to more than EUR 43bn in terms of German GDP in 2024) would be exempt from the debt brake. In less technical terms, this would result in unlimited defence spending, which could be ramped up to levels deemed necessary by the government. Last year, Germany’s military expenditures reached the NATO goal of 2% of GDP for the first time since 1992. However, these additional financial means largely came from a shadow budget (Sondervermögen) of EUR 100bn, which was passed in June 2022 after the start of the Russia-Ukraine war. In the meantime, these funds have already been budgeted, especially for the procurement of military equipment and in support of Ukraine.
The federal states should also get the opportunity of implementing a more-flexible debt brake. Currently, the federal states are obliged to run a balanced budget, in contrast to the central government in Berlin, which is allowed to run a small structural deficit of 0.35% of GDP.
Furthermore, an expert commission will work out proposals for a further reform of the debt brake. This could then be used to hammer out more-flexible provisions by end-2025. However, this would require a two-thirds majority in the Bundestag and Bundesrat (see also below).
Besides relaxing the debt brake, Mr. Merz announced that he would create a shadow budget of EUR 500bn, or of more than 11% of GDP, to modernize Germany’s infrastructure (roads, energy sector, digital infrastructure, education, hospitals, etc.). EUR 100bn of this EUR 500bn would be allocated to federal states and municipalities. For comparison, the regular federal budget in 2024 amounted to about EUR 480bn (see chart below). The additional funds are to be spent over the next ten years.
Mr. Merz also stated that he wants to swiftly support Ukraine with an emergency package of about EUR 3bn and that he will discuss this with outgoing Chancellor Olaf Scholz today.
Policymakers from the CDU/CSU and the SPD are now under great time pressure, as they will have to rush the legislation that will enable these two new financing tools through the pre-election Bundestag. According to German law, this is possible in the 30 days following a general election, i.e. by 25 March. This is the latest date by which the new Bundestag will have to be constituted. While the CDU/CSU, the SPD and the Greens have the two-thirds majority needed to achieve this in the pre-election Bundestag, they will fall slightly short of this in the new Bundestag (see chart below).
While policymakers from the Greens criticized Mr. Merz yesterday evening for not considering spending against climate change, we think that a two-thirds majority in the old Bundestag is likely. After all, the Greens can be regarded as staunch supporters of Ukraine and of higher infrastructure spending. Some policymakers from the Left could theoretically also vote in favour of the new shadow budget while rejecting higher military expenditure.
All in all, while Mr. Merz is likely to be further criticized for his flip-flopping on fiscal policy before and after the general election, an approval by the needed two-thirds majority in the (old) Bundestag and Bundesrat is likely in our view. The vote in the Bundestag will take place next week, although the concise date has still to be decided by the Council of Elders in the Bundestag. Filing a lawsuit before the Constitutional Court, as has seemingly been considered by some policymakers from the opposition, is unlikely to be successful. The above-described process with voting in the old Bundestag is explicitly allowed by German law.
One has to distinguish between the impact of higher spending on the demand side and the effect which comes through a higher efficiency on the supply side, i.e. thanks to better roads, education, etc.
We think that both effects will kick in with time lags and are unlikely to play a major role in 2025 for two reasons. First, after the formation of Germany’s new government, planning will be needed. In terms of military expenditure, a new law to set priorities and to speed up the procurement of crucial defence goods is envisaged by the new government. This may take time, possibly up to six months.
Second, the positive impact on the supply side from better infrastructure will probably take even more time to become apparent. In any case, given public underinvestment in this area over the last two decades, it seems reasonable to assume that the German economy would benefit markedly.
From 2026 onwards, the first positive demand effects may kick in. When it comes to infrastructure spending, and assuming a rather steady flow of higher expenditure, about EUR 50bn, or more than 1% of GDP, could additionally be spent per year. Besides the sheer size of spending, a fiscal multiplier decides how changes in fiscal policy amplify or dampen economic activity. For instance, higher public investment may also trigger a rise in private capex spending by companies and therefore amplify positive effects.
However, on a negative note, there could also be capacity constraints, as investment in public construction has recently amounted to less than EUR 70bn per year. Resources would then have to be reallocated from commercial real estate, and especially from construction in the housing sector, which is four times the size of the public construction sector. However, this will come about at a time when the first signs of stabilisation have emerged in the residential property market, with demand for condominiums and houses having picked up again. Hence, to avoid any crowding-out of activities in the private sector by the government, Germany would need additional construction resources, probably from other European countries. Otherwise, the positive GDP effect would decrease while construction costs might rise.
If one weighs these different effects and conservatively assumes a fiscal multiplier of (only) 0.5, GDP growth could be lifted by 0.5%, compared to a scenario in which no new shadow budget materializes.
When it comes to higher defence spending, a positive impact from this would also depend on where military goods are produced. For instance, if a large share of military goods has to be imported from the US or other countries, the GDP effect will be rather small. In this case, higher public spending would largely be matched by lower net exports. Recent research suggests that German companies have benefitted by up to 50% from the latest rise in German military spending. This also argues for an at-least-moderately-positive GDP effect. For instance, if Germany were to ramp up military spending by another 1% of GDP and if 50% of the military equipment it plans to procure is produced in Germany, alongside a fiscal multiplier of 0.5, this would result in additional GDP of 0.2-0.3%.
Mr. Merz has been pressing for a swift resolution on defence spending to be reached before a special EU summit on 6 March. His whatever-it-takes move can therefore also be seen as a game-changer for the European security architecture and regarding further support for Ukraine. In the same spirit, and also yesterday, EU Commission President Ursula von der Leyen suggested that the EU will need to spend an additional EUR 650bn on defence. Furthermore, she has proposed that the EU take out EUR 150bn in loans by activating an escape clause.
