Germany fiscal package: Quicker, bigger, implying upside risks to Germany and euro area’s medium term growth

Moving fast.

On the next day after the German election result, Fredrich Merz, Chancellor to be, expressed his willingness to use the current Parliamentary seat breakdown (in place until the 24^th of March) – in which CDU/CSU, SPD and Greens have a two-third majority - to amend the constitution, setting up a new defence focused off budget vehicle worth €200bn (4.6% of GDP). While already aiming at doubling the size from the previous fund set up in 2022, the key element was in our view the clear willingness to move fast by contrast with a benign tone during the campaign (for more see our preview).

Moving big. 

Aspart of their “grand coalition” talks, the CDU/CSU and the SPD reportedly agreed yesterday on what could be one of the largest fiscal expansions in Germany’s post-war history. The plan is to make three key changes to the constitution (still aiming at using the current seats breakdown): First, setting up a new off budget special investment fund worth €500bn (11.6% of GDP) with a lifetime of ten years dedicated to infrastructure, digitalisation, energy, and education. €100bn of this amount would be specifically allocated to Landers (states). Second, reforming the debt brake so that all expenditure for defence above 1% of GDP will be exempted. Finally, landers would be allowed to run deficits worth 0.35% (from 0%) aligning them with current federal rules (implying 0.7% overall public deficit when consolidated with the federal level). They also mention discussions to further reform the debt brake later, likely towards what the Bundesbank has recently argued, though where they will have to compromise with Die Linke.

Should the above be legislated as is, and taken hand in hand with the expressed willingness of EC President Ursula Von Der Leyen to allow national governments to trigger the national escape clause, this is a material de facto lift to all spending constraints (EU and national) that Germany would face on defence spending. However, Federal defence spending has averaged c.1.2% of GDP in the past 15 years, and it is only thanks to the 2022 special fund that Germany was able to reach the 2014 NATO target of 2% (2.1% estimated in 2024). In fact, prior to that, the last time that Germany hit that mark was in 1991. Thus, decades of underinvestment likely means that industrial capacity to absorb the (theoretically) unlimited spending will certainly be biting, thus capping the positive impact on GDP in the short-term. This goes hand in with the fact that according to the Commission March 2024 EDIS communication, c.80% of defence acquisition by EU member states between the start of the Russia-Ukraine conflict and June 2023 were made outside of the EU (with the US alone representing 63%).  

From short-term downside to long term upside risks. 

The defenceindustry supply bottlenecks and the looming 25% US tariffs on European goods means that downside risks are likely to continue to dominate our 2025 German (0.2%) and euro area (0.9%) growth outlook. However, for 2026 and beyond, the perspective of large fiscal loosening from Germany and other member states - though likely of smaller magnitude – which are to be free from the national escape clause - certainly support higher growth than otherwise envisaged, everything else being equal. Beyond public spending going according to plan, we will in particular monitor the crowding in effect to the private sector lifting up a large range of industrial activities, besides spurring sentiment. Some evidence of the latter is already at play, looking at the euro dollar exchange rate moving up from 1.05 to 1.07. Besides, since end-February and the beginning of rumours, 10y bund yields have gained 35bps to 2.7% (at the time of writing). Our models suggest that this is consistent with 1.5-2ppt of expected additional public deficit -  consistent with a regime shift with higher medium term growth.

No change to our ECB baseline but risk is for a longer pause when at neutral. 

We think overnight and possible decisions at tomorrow’s special EU meeting will carry virtually no weight into tomorrow’s (nor April’s) ECB rate decisions, reflecting the lack of details on new fiscal spending by Germany and any other member states, little new information on activity to attest private sector crowding in, while US tariffs are likely to be imposed. We thus see the ECB continuing its back-to-back rate cuts, taking the depo rate to 2.0% in June. From then and prior to more news on the abovementioned elements, we maintain the rest of our baseline: foreseeing the ECB cutting to 1.5% in December, albeit seeing this now as offsetting the somewhat larger expected negative impact of US tariffs on the Eurozone. We nonetheless envisage that after the June meeting – when the depo rate will be at 2% - that the ECB GC may be enticed to make longer pauses (we had envisaged moving from every meeting to every quarter) depending on the scale of adjustment in trade policy and the pace of reaction to the new fiscal stimulus.