Germany Attempts to Unlock Debt Brake

Germany’s likely new Chancellor Friedrich Merz has (and as has been flagged since his election win last week) announced plans to amend the country’s constitutional fiscal restraints, the so-called debt brake and within the confines of the current parliament. Merz said Tuesday evening the motto “whatever it takes” must now apply to the country’s defence which may be separated from the debt brake and reflects Europe’s increasingly alarm by the seeming shifts of the Trump administration in the U.S. toward NATO and Ukraine and with the announcement from Merz to radically increase German defence spending coming in in advance of a summit of the EU’s 27 national leaders in Brussels on Thursday.
The plan is a marked shift in Germany’s traditionally conservative fiscal stance and where the debt brake has been enforced in its constitution in 2009, which limits government borrowing and keeps the structural deficit at 0.35% of GDP.
In detail, the proposal is that defence spending above 1% of GDP be exempted from the restrictions of Germany’s constitutional debt brake. Given that Merz announced the plan on spending alongside the leaders of the Social Democratic Party (SPD), with whom his conservatives are currently in talks to form a governing coalition clearly suggests their cooperation and where the latter suggested a more fundamental reform of the debt brake by year's end to allow for additional spending on infrastructure initiatives. In fact, the aspiration is that the future coalition will introduce another constitutional amendment to set up a EUR 500 bln fund for infrastructure, which would run over 10 years. They are also planning to loosen debt rules for states.
But there are risks not least the likely need to get the Greens to approve the plan before the current parliament stands down and then to get approvals from the new parliament which may be more difficult given that the far right (AfD) and Left (Der Linker) would block a 2/3 majority. NB: The current parliament can be convened until it ends on March 25. Given the plans explicitly implies a boost to the economy as well, it is unclear what will be considered to be defence spending. There is also the question as how the ECB may react, with the lack of details at this juncture meaning that the Council decision tomorrow unlikely to encompass the German initiative, especially in terms of updated forecast. But the possibility is there that the ECB could react to what may be an EU initiative of the boosting defence spending from the current circa-2% of GDP to 3.5% (ie EUR 250 bln per year) by amending its QT plans – although any decision on these issues may be too early at this juncture.
But for Germany, this fiscal shift is possibly game changing, both as an antidote to previous budgetary conservatism and as a means to offset likely damage from US tariffs which Germany is most likely to suffer the most as far as the EZ is concerned. The defence shift could add some EUR 40 bln per year to the economy (nominally and potentially), ie some 1 ppt. The question being how much would actual boost German growth and how soon Germany as defence companies but currently purchases over 75% of its equipment spending from abroad and mainly from the U.S. That could change if German companies are confident the defence boost will persist but in the short-term Germany would also find it difficult to get rapid increases in defence equipment given existing lags in orders. But the infrastructure initiative could raise nominal GDP by 1%-plus annually but again may take time to get underway as there will be questions about what are the spending priorities, although the speed at which the CDU and SPD have agreed this initiative bodes well for their likely collation. More notably, the initiative could also raise Germany’s feeble potential GDP rate which the EU estimate is a current paltry 0.6% per year. With Germany some one third of the EZ a possible 1% boost to growth into 2026 could add up to 0.4 ppt to EZ growth and possibly more with Germany also calling for EZ fiscal rules to be relaxed more generally.