Thoughts on Germany’s fiscal reform
A sea change in German fiscal policy is occurring. A massive package of fiscal stimulus measures for defense and infrastructure, passed by Germany’s lower house of parliament and the upper house. At the core of the pro-growth policy is an adjustment to the country’s famously strict borrowing rules and fiscal austerity paired with a renewed energy for German rearmament.
The fiscal package comes after years of a stagnant and often stumbling German economy, but the spending deal has gained immediacy due primarily to two developments. For one, the results from the late-February elections left only a handful of weeks for the lame duck parliament to push through constitutional changes requiring a two-thirds majority before the party composition shifts. Furthermore, President Trump’s rhetoric on possible lessening in American security support for Europe.
The landmark package consists of three principal pillars. First, the bill will exempt defense spending in excess of 1% of GDP from the constitutional borrowing restriction known as the “debt brake”, a federal spending law that currently allows for a maximum structural budget deficit of just 0.35% of GDP. With the policy change, outlays for defense above 1% of GDP will not be subject to any sort of fiscal limitation, meaning the federal government can borrow unrestricted to finance defense spending. This reform has potential for large-scale implications for both defense and nondefense spending.
Germany reportedly spent ~€90B on defense in 2024, meeting NATO’s target of 2% of GDP, through a combination of its regular budget, the use of special off-budget funds and some additional expenses. To the extent an exemption from the debt brake over and above 1% of GDP then frees up ~€45B of spending that previously took up room in the deficit, the extra headspace could potentially be used for additional, nondefense-related expenditures, while still adhering to the 0.35% debt brake.
Second, the bill allocates €500B over the next 12 years to an off-budget infrastructure fund. This fund earmarks money for specific expenditures for which the federal government can finance via issuing debt without being subject to the debt brake. The fiscal stimulus from this fund, roughly €42B per year if spread evenly, should begin boosting Germany’s economy within the next few quarters, whereas the impulse from defense spending is more likely to play out later in 2026 and 2027, given the time needed for large projects to be implemented.
Finally, the 16 states that comprise Germany are currently required to run balanced budgets, and the spending package that was enacted today will now allow individual states to run deficits of up to 0.35% of GDP. This could allow for an additional ~€15B in state-led fiscal stimulus per year.
All together, the package could be a momentous change for the German economy, and ultimately the broader Eurozone economy. The bill could amount to roughly €100B in additional nondefense expenditures per year, taking into account the portion of the deficit that could be freed up, state spending and the off-budget infrastructure fund. For context, this translates to 2.3% of GDP, which would be equivalent to an extra annual $680B in federal outlays if the U.S. were to enact a similarly sized stimulus. Theoretically, the additional outlays on defense spending are unlimited, making ~€100B the lower bound for the stimulus, and it is conceivable the impact from the measures comes closer to 3.3% of GDP by 2027 as defense spending ramps up.
Maybe Germany will little by little do what much of the world already do, living on debt and spending more than they should. It took the decisive moments of recent weeks to overcome Germany’s deeply ingrained aversion to public debt and, in effect, suspend the debt brake by amending the constitution. The CDU/CSU, SPD, and Greens rushed the process as they will no longer command the two-thirds majority required to amend the constitution in the new Bundestag.
While fears over debt and inflation dominate public discourse, the economic potential of loosening the debt brake has received little attention. With real GDP currently no higher than in 2019 and a negative output gap of 1 percent, a boost to government demand appears well justified. Improved infrastructure will enhance productivity and competitiveness, while higher defense spending is expected to drive technological advancements in artificial intelligence, satellite technology, drones, and quantum computing. Given Germany’s relative weakness in these fields, the reform offers a rare opportunity to escape what some have termed its mid-technology trap.
Germans are likely not positive to increased debt and spending more than you should. Why are governments incapable of balancing budgets? Why do they spend more money than they have? These questions will continue to be asked, in particular by conservatives. So this new venture better work for the new government led by CDU/CSU. Failure to do so would likely lead to the Alternative für Deutschland (AfD) emerging as the strongest party in the next general election.