Germany’s “fiscal bazooka” and the consequences for Europe

An historic agreement. Although opposed to the idea during his election campaign, Friedrich Merz, leader of the CDU (the party that came out on top in February’s federal elections) has had a change of heart, in light of a crumbling of the post-war certainties which underpinned his country’s relationship with the US heralded by Donald Trump’s return to the White House. His goal? Utilizing debt to jolt the German economy out of its recent torpor and offset any loss of trade with America.

Joining forces to reach an agreement, the conservatives, social democrats and ecologists announced the creation of a $545 billion fund over ten years to modernize the country’s infrastructure in what amounted to a seismic shift in the nation’s relationship with debt. From now on defense spending in excess of 1% of gross domestic product is excluded from this country’s traditional debt cap, which has been enshrined in the German constitution since 1949 and was accentuated in 2009 following the subprime crisis. At that time, the federal government’s annual borrowing was capped at 0.35% of GDP.

Despite its reputation as Europe’s model student when it comes to debt, Germany is going to try the “whatever it takes” approach popularized by Mario Draghi and Emmanuel Macron during the Covid-19 pandemic, by amending its rigid budgetary rules. The country has several priorities in its sights.

Vorsprung durch politik
A tune-up of the German economic machine has been a long time coming, in order to restore the competitiveness in its export industry, analysts believe. In 2024, the German institutes Ifo, DIW and IWH forecast that the country would need an investment of €600 billion just to maintain its public capital. As the incoming government doesn’t have that kind of cash to hand, this deal will provide it some margin for maneuver.

Thanks to an agreement struck between the green party and the conservatives, a fifth of the budget will be earmarked for the energy transition, with the aim of making Germany a European leader in this field. However, Stefan Hofrichter, Head of Global Economy at AllianzGI, cautioned “Let’s not kid ourselves. This does not mean that the entire infrastructure fund will be directed towards investments aimed at achieving climate targets.”

The automotive industry, one of the pillars of the German economy, could suffer considerably from Trump’s tariffs, with the price-sticker on the average German car in a US showroom set to jump by between $10,000 and $17,000

As a major exporting country, Germany is particularly vulnerable to the sorts of tariffs imposed by Donald Trump since his return to power. The United States is Berlin’s second-largest economic partner, with trade between the countries worth over €252 billion in 2023, according to the World Trade Organization. The US is the destination for 10% of the goods and services Germany exports annually. The Trump administration’s flurry of executive orders since January 20th have therefore finally convinced German politicians to break with the fiscal conservatism that characterized their nation in an effort to unleash Germany’s growth potential and limit exposure to the US market.

A decision that Donald Trump’s ballyhooed “Liberation Day” has further vindicated. On April 2nd, the White House imposed new tariffs on every country in the world. Covering all sectors, they rise to 20% for members of the European Union. The automotive industry, one of the pillars of the German economy, could suffer considerably, with the price sticker on the average German car in a US showroom set to jump by between $10,000 and $17,000. The US automobile sector, which sold some 500,000 German-made vehicles in 2024, is likely to be much less lucrative for the likes of Audi and BMW for the foreseeable future.

Trillion-dollar army
A willingness to readjust international relations has also been confirmed by the current US administration’s stance on the conflict in Ukraine. The former Apprentice judge stunned the Western alliance by choosing to go over the heads of Brussels and Kyiv and negotiate directly with Russia, and by criticizing the European NATO countries for not invested enough in defense. In response, Germany, under the American umbrella since the end of the Second World War, wasted no time in mobilizing.

In February Boris Pistorius, Germany’s defense minister, estimated that military investment should be increased to over 3% of GDP, or around €1 trillion over ten years, excluding inflation. This represents a historic turnaround for Germany, where debt could reach 80% of GDP over the next decade. It currently stands at 63.6% for an annual federal budget of around €480 billion euros. By way of comparison, debt as a percentage of GDP was 112% in neighboring France in 2024.

Despite its reputation as Europe’s model student when it comes to debt, Germany is going to try the “whatever it takes” approach popularized by Mario Draghi and Emmanuel Macron during the Covid-19 pandemic, by amending its rigid budgetary rules

Despite taking a hammer to the piggy bank, the German economy won’t rebound immediately, according to Stefan Hofrichter: “It takes time for infrastructure investment to have a concrete impact.” He adds: “In 2025, we expect growth to hover around 0%. But the “fiscal bazooka” should unleash Germany’s potential in the medium term. “In a decade’s time, German GDP could have risen significantly, by 10 to 20 percentage points.” Could this prospect benefit the rest of Europe?  

On the surface, this agreement looks like a boon for Europe, with the world’s third-largest economy spending and investing to show its neighbors the way. Germany remains the main trading partner of most EU members: In 2023, it was the leading destination for the merchandise exports of 15 of the 27 other member states, according to the WTO. A rising Germany economy, therefore, should lift all boats.

According to the economist, this trickle-down effect can affect various sectors, notably infrastructure and defense: “Germany’s objective is not to build national champions. Federal projects will be open to competition and may benefit other manufacturers.” For example, France, as the world’s second-largest arms exporter, stands to benefit from increased German spending in this area.

Specter of inflation
Massive state investment of this kind routinely leads to price rises. This was the case with the “whatever it takes” policy and the state-guaranteed loans needed to limit the economic damage caused by covid half a decade ago. Stefan Hofrichter believes that investment in the defense and construction sectors will be inflationary and, all things being equal, will see inflation top 3%. While this figure remains reasonable, it could eventually be affected by soaring price rises, should Donald Trump continue to play tariff hardball.

In a sign of growing instability, stock markets, fearful of a full-on trade war between the US and the rest of the world, opened in free fall on April 7th, following the US President’s latest announcements. In Paris, the CAC 40 was down 6.94%, while the Frankfurt Dax lost 9.3%. Proof that the German government made the right decision embrace debt, since the sun appears to be setting on the era of globalization.