Germany & Europe step up with much-needed fiscal gear shift

Germany is poised to deliver a significant fiscal reform that would reshape its economic landscape while bolstering its economy and Europe’s response to the US’s ‘America first’ foreign policy. Proposed changes include a reform of the country’s ‘debt brake’ to exempt defence spending, increase leeway at the state level, and a substantial half-trillion euro package focused on infrastructure development. This ambitious plan would mark a pivotal moment in Germany’s long-restrictive fiscal strategy.

Introduced in 2009, the debt brake mechanism was designed to keep the country’s budget balanced in the wake of the financial crisis. It limits annual government borrowing to 0.35% of gross domestic product on a structural basis. While it has been broadly criticised internationally for being overly stringent and contributing to economic underperformance, Germany’s politicians had been reluctant to pursue reform until very recently.

US foreign policy has proven a catalyst for the reform and created real momentum for Germany’s fiscal efforts. Following the German elections on 23 February, Friedrich Merz is likely to become Chancellor and form a two-party centrist coalition that will take over from the incumbent three-party government. Mr Merz is taking advantage of a window to reform the debt brake rule in the German constitution while there is still a two-thirds parliamentary majority in favour of change.

There is clearly a radical shift under way

While the details remain to be worked out on a package worth potentially more than EUR 500 billion, and the procedures to put the programmes in place are complex, at this point there is clearly a radical shift under way: the key German government actors are in agreement, and the political process is moving rapidly. Debt markets are reflecting the change. The benchmark German government 10-year Bund yield rose more than 20 basis points on 5 March.

Delivering in a crisis

Together with the European Commission’s push for new measures to loosen its fiscal rules and boost EU defence spending, a substantive EU-wide response is coming into place after a series of disappointments. The bloc has a history of delivering coordinated responses only in times of crisis, such as the creation of the European Stability Mechanism in 2012, or the pandemic Recovery Fund set up in 2021. Germany’s action comes in a week of urgent European diplomatic activity after decisions by the US administration to halt military support to Ukraine and make concessions to Russia.

We see these potential fiscal commitments strengthening German growth in 2025, and more so over the following couple of years as spending accelerates. This should boost an economy that has underperformed its potential after shortfalls in public investment over many years, and represents a complete change in defence spending. In the euro area, we anticipate Germany’s fiscal reforms to contribute to improving GDP growth, while much of the boost would not come until 2026. This year we see the euro area’s economy expanding by 1.1%, compared with 1% previously.

US tariffs, and their responses by the EU, will certainly be a negative for Europe’s economies, but additional government spending will help to offset those impacts.

The ECB’s monetary policy will not need to loosen quite as aggressively

The fiscal boost to the economy also suggests that the European Central Bank’s (ECB) monetary policy will not need to loosen quite as aggressively.

We have changed our expectations for ECB interest rates cuts. We now see the central bank cutting its deposit rate by another 100 basis points, and so take the region’s terminal rate to 1.75%. Rather than take rates to accommodative, we think that this would be at the lower end of estimates of the euro area’s ‘neutral’ rate, or the level of interest rates that neither stimulates nor stagnates economic growth.

In the light of this improving outlook for Europe, and our changed forecast for monetary policy, we are reviewing our positions in European financial assets.