Germany: Breakthrough in Attempt to Unlock Debt Brake?
It does seem as if effective German Chancellor-elect Merz now has enough parliamentary support to amend the so-called debt brake and unlock more spending and borrowing to be directed toward added defense and infrastructure. Thus, it does seem as if Germany and its economy are undergoing a sea-change, one that looked highly unlikely before what was an election result last month that hardly pointed to any fresh electoral mandate. We discuss what may result both in how and when!
Media sources suggest an agreement by Germany’s likely next coalition partners and the Greens has enough possible support to amend the so-called debt brake and thus provide the economy with both fresh fiscal scope and new economic aspirations. It thus points to an end (or at least a diminishing) to the budgetary shackles that surely have not only contributed to weak growth in Germany (and probably much of Europe) in recent years but also that has probably been curtailing the economy’s potential.
What are effective changes to the constitution would seemingly have three effective prongs. Perhaps most high-profile is that defense spending above 1% of GDP would be exempt from any debt brake – effectively removing a ceiling on borrowing so that Germany could more easily increase such expenditure from the current 2% of GDP to an aspiration of 3%-plus. But in terms of size, it is the planned deficit-financed infrastructure fund worth EUR 500bn (ie around 11% of GDP) that may be the most ground breaking even though it to be spread over a ten-year period. But there are also now plans to allow the federal states (Laender) to run small deficits rather than being compelled to balance their budgets.
The bottom line is that a German budget gap that looked to be around 2% of GDP could turn into one of well over 4% probably not this year but into and beyond 2026. As a result, the government debt ratio would rise from its current 63% of GDP towards 90% over the next decade possibly without negative repercussions – not least as Germany has already suggested EU-wide fiscal rules (which this initiative compromises) need to be relaxed. While the increase in defense spending has attracted most attention given its international perspective, perhaps any plan to upgrade Germany’s fragile and aging infrastructure is the most important, especially as unlike the defense initiative it will (by definition) be spent domestically. But some of this will boost imports as will defense spending even with an aspiration of being directed towards domestic producers. As a result, it looks very likely that the circa-6% of GDP current account surplus likely this year will be reduced – both helping growth elsewhere and politically speaking addressing the source of what may be growing trade tensions and trade wars.
We therefore see German GDP picking up to 1.5% next year after a lame 0.3% this year, but with a further and possibly larger pick-up beyond 2026, but there are many uncertainties of not imponderables. This reflects several factors, the most notable being that it will take time for the additional spending on both defense and infrastructure to take effect and that there is little spare capacity, certainly in the German labor market – the exception may be the recession bound construction sector. Moreover, defense spending does not boost GDP on a one-to-one basis, and only partly due to the likelihood that much of the equipment spending will be imported. In addition, both through what may be a shift higher in the euro and in terms of interest rates (higher yields and possible deferred ECB easing) financial conditions may be tighter than otherwise. Finally, it is widely considered that not only frail infrastructure has been holding back the German economy but(over) regulation and bureaucracy have been even more restrictive. The question is the extent to which this can and will change, especially as support for the likely CDU led new coalition may have to be at least partly bought with more social spending too.