Germany's bold decision to scrap its fiscal rules could be a turning point for Europe's faltering economy, and Europe's largest country could once again become a driving force in a lethargic bloc that is lagging behind global competitors, Reuters estimates.
Faced with the threat of losing its military patron and biggest customer after a change of administration in Washington, Germany has announced huge investments in defense and infrastructure, representing one of its biggest political changes since the fall of the Berlin Wall in 1989.
The decision came just hours after the European Commission proposed changing EU budget rules to allow borrowing of up to 150 billion euros for rearmament, as well as greater freedom for member states in their own spending.
Both steps, according to Reuters, were initiated out of fears that Europe, with Donald Trump in the White House, can no longer be sure of American protection while Russia threatens the continent's eastern flank.
These two moves represent a huge change, especially for Germany, which after two consecutive years of economic contraction has been derided as the "sick man of Europe" and criticized for its government's refusal to spend despite its large fiscal capacity.
“A real big bazooka,” wrote Berenberg economist Holger Schmiding. “The proposals for an immediate relaxation of German fiscal rules are likely to be adopted. They represent a major fiscal milestone for Germany.”
"Everything you thought you knew about Germany's economic outlook three months ago, or even three weeks ago, you need to throw away and start your analysis over," said Jim Reid of Deutsche Bank. "If this goes through, the rules of the game are changing."
TS Lombard analyst Davide Oneglia said it was a historic fiscal shift that “could also mark a turning point in fiscal stances at the EU level,” especially when viewed in combination with the greater freedom allowed by the Commission’s new stance.
The German proposals - which must receive the support of a two-thirds majority in parliament to pass - envisage the establishment of a 500 billion euro infrastructure fund, the exemption of defense spending above 1% of GDP from the fiscal brake and the possibility of German regional states running a small deficit.
With German debt just above 60% of GDP, half the level of the United States and two-thirds of the eurozone average, there are currently no major concerns that Germany is heading towards an unsustainable fiscal path, even if debt could reach 70% by the end of the decade, Reuters points out.
Bank of America described the move as big, bold, and groundbreaking, and could push German economic growth closer to 1,5-2% from 2027 onwards, a huge turnaround from the current stagnation.
Positive reaction
If Germany grows, so does Europe, since its huge industrial sector depends on suppliers across the EU, or at least that's what financial markets concluded yesterday.
European stock markets have surged, from Madrid to Budapest, the euro has strengthened, and the yield differential between German and other eurozone debt has narrowed, all of which indicates that investors see this move as a positive boost for the growth of the entire bloc.
Additional spending is also not seen as a threat to higher interest rates: investors expect three more interest rate cuts from the European Central Bank this year, with the first expected today, suggesting that increased borrowing is not a cause for concern for now.
This is likely because the Trump administration continues to threaten the EU with tariffs, which would likely provoke retaliation, weaken growth and curb inflation.
While few EU countries have room to increase borrowing, they do enjoy some protection from the ECB, which has promised to shield them from unjustified jumps in bond yields as long as they adhere to EU budgetary rules.
The change in fiscal rules proposed by the European Commission actually expands the protective umbrella of the ECB, which has proven during the pandemic that it can act immediately to calm volatile markets.
Questionable support in parliament
According to a survey conducted by the INSA agency, 49% of Germans support easing borrowing limits, while only 28% are against. However, changing fiscal rules and establishing a special fund requires a two-thirds majority in parliament.
Friedrich Merz's conservatives and the Social Democrats (SPD), who are in talks to form a coalition after last month's national elections, will present their proposals to the German parliament next week.
However, the Greens, whose support is crucial for implementing the reform in the outgoing parliament, refused to pledge their support, questioning why climate policies were not included in the plan.
The right-wing Alternative for Germany (AfD) has threatened legal action against what it calls a “debt orgy.” The Radical Left has also threatened legal action if Germany issues new debt to finance defense spending.
The conservatives and the SPD are rushing to get the proposals passed in the outgoing parliament, given that in the new parliament, the far-right and far-left parties will have the capacity to block them after achieving significant results in last month's elections.
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